3 things we learnt from Policy Exchange’s big energy debate on the future of the energy market

March 26, 2015

Yesterday, in the final throes of the current parliamentary term, Policy Exchange held an event considering the role of the state in UK’s energy market. At the event we heard from a cast of speakers including Ed Davey MP, Caroline Flint MP, Professor Dieter Helm, Michael Leibreich, Professor Stephen Littlechild, and Rupert Darwall.
Here are 3 things we learnt from the debate, and potential implications for energy policy after the election:

1. The state is back in control of the energy market… and here to stay

State intervention in the UK energy market (particularly electricity) has increased substantially over the last decade. Dieter Helm argued that “despite having spent the last 25 years arguing for a commodity approach to electricity, we now have a central buyer”. Indeed, through the Electricity Market Reform (EMR) and the associated plethora of economic instruments, the government has become the sole buyer of new capacity: virtually no investment is occurring without some form of government subsidy.

Both Ed Davey and Caroline Flint argued that state intervention is necessary to achieve the UK’s decarbonisation and security of supply goals. Interestingly, Davey pointed to his desire, as a liberal economist, to find market solutions to climate change such as a global carbon price; but also identified practical realities and barriers which necessitate greater state involvement. The other speakers questioned the desirability and effectiveness of the current approach – what Rupert Darwall describes as ‘Central Planning with Market Features’ (see Darwall’s recent papers for Reform and the Centre for Policy Studies). Darwall suggests that the government has not given adequate consideration for alternatives: such as renationalisation, or a return to market-based solutions.

DECC’s vision has always been for EMR to be a temporary foray into state intervention, followed by an eventual removal of subsidies, alongside a stronger carbon price. But this vision seems ever more elusive, with what Michael Leibreich describes as a ‘midden’ (or refuse heap) of policies, and their associated costs and market distortions.

In short: it is clear that state intervention in the energy market is here to stay, whether we like it or not.

2. The CMA enquiry will be hugely important in defining the way forward… if politics can stay out of it

There is a great deal of discussion at present about the state of the UK’s energy market. Barely a day goes by without another news story on the Big 6 suppliers, or Labour’s proposed price freeze. The rhetoric is that the major energy suppliers are ripping off customers, making excessive profits, abusing their position and their customers, hiding profits in their vertically integrated businesses, and blocking market entry by new companies.
However, the inconvenient truth for the industry’s detractors is that most of this simply isn’t backed up by the evidence emerging from the Competition and Markets Authority (CMA) enquiry. As pointed out by Stephen Littlechild in a recent letter to the CMA – most of the proposed ‘theories of harm’ have already been largely debunked. The remaining substantive issue appears to be the lack of customer engagement in the energy market. The consumer base has essentially segmented into a relatively small group of active switchers, and a rather larger group of non-switchers. 50% of customers have never switched (or thought that it was impossible) – many of whom are the vulnerable customers that need help with bills the most.

The CMA’s evidence identifies a price differential between attractive fixed price deals (which suppliers are using to win customers), and Standard Variable Tariffs (where suppliers are making higher returns). But is this a problem, or simply a feature of a competitive market? Caroline Flint argued strongly that the gap between standard tariffs and the best deals is unjustifiable – and loyal customers are being over-charged. Leibreich suggested that unlike in other markets, switching is not helping all energy consumers; and furthermore that ‘big data’ is helping suppliers to punish non-switchers. But conversely Littlechild argued that customer segmentation and price discrimination is a sign of any competitive market, and that retail competition is being hampered by Ofgem’s rules.

It seems that the key unresolved question is whether we want competitive prices for some (but most likely at the expense of other consumers), or equal and therefore ‘fair’ prices for all (which implies that prices would need to go up for some and down for others).

Both Davey and Flint were challenged on their approach to implementing the CMA’s recommendations. Davey was clear that “the CMA’s recommendations should be taken very seriously…. There would need to be very strong grounds to over-ride them”. But Flint was clear that Labour would act on prices immediately after the election, several months before the CMA makes its final recommendations.

The CMA is spending enormous time and effort making sense of the energy market. The enquiry was supposed to be about rebuilding trust in the industry. It needs to be left to do its job, and its recommendations acted on accordingly.

3. Some inconvenient truths about energy prices and bills

Energy prices and bills have gone up substantially over the past decade. A large part of the increase in recent years was driven by rising commodity prices (particularly gas). Commodity prices have now fallen, with oil prices halving since last year, and reductions in spot gas prices. However, since suppliers hedge their purchases (typically up to 3 years in advance), they are simply not able to pass on all of this reduction immediately. Whilst the market is dropping, the smaller suppliers (who typically hedge less) are able to offer attractive deals, but this won’t go on indefinitely.

However, wholesale costs make up less than half of the average household energy bill. The costs controlled by government (policy, network, VAT) make up 32% of the average bill, and according to DECC’s analysis are rising sharply. DECC predicts an 18% real terms increase in retail electricity prices between 2014 and 2020, almost entirely as a result of spiralling policy and network costs (Source: DECC 2014 Prices and Bills report, central scenario). Strikingly, Caroline Flint commented that “the suppliers cannot blame policy costs for high energy prices”, but the evidence would seem to suggest otherwise.

It is unclear where all of this is heading. The price freeze/cap might just about be feasible if wholesale prices happen to be falling faster than policy costs are increasing over the 20 month period, but if not then the logic begins to unravel. Contrary to popular belief, the energy suppliers’ margins are already pretty thin at c. 3%, so they simply can’t absorb these additional costs. The idea of empowering the regulator to review the ‘fairness’ of prices sounds a lot like the current referral to the CMA, and would certainly shine an ever brighter light on the policy and network costs which government controls.

Here’s a roundup of top tweets from the event


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