Re-regulating energy retail will break it, not fix it

August 13, 2012

There is currently much public debate about whether the domestic energy market is working, whether big energy companies are treating customers and small suppliers unfairly, and about energy companies’ profits. Ofgem has proposed, under its Retail Market Review, far-reaching re-regulation of retail tariffs. But at a recent Policy Exchange event, professor Stephen Littlechild, the distinguished former electricity regulator, argued that the retail energy market is working and Ofgem’s proposals risk damaging it.

Customers are disillusioned with rising energy prices, but these have largely reflected higher international gas prices and not major problems in the energy retail market, which is one of the most competitive in the world. The UK has among the lowest energy prices in western Europe and Ofgem’s calculations suggest that energy companies have low or negative retail margins. The evidence is mixed on whether retail prices rise faster than they fall (in response to changes in wholesale gas price), but in any case a number of other markets have this feature. Customer switching rates have been falling in recent years, but they remain higher than in most other countries and many other product markets, such as banking.

Ofgem’s key concern is that inactive customers pay higher prices than customers who make the effort actively to switch. This is a feature of markets generally, and the existence of a return to search activity helps to drive competition. Even customers who don’t switch energy supplier appear well protected, with prices within 10-15 per cent of the lowest prices in the market. Nevertheless, Ofgem sees the need to re-regulate.

In 2009, Ofgem decided to regulate to prohibit charging higher prices to customers in an energy company’s original geographic region than to those who had switched to the energy company from elsewhere. Subsequently, average annual price differentials reduced from over £30 to £13 in January 2011. But this is likely to have arisen because of higher prices to those customers who had switched rather than lower prices to those who had not. This is consistent with the upward path of retail margins observed by Ofgem since 2009. Lower gains to switching also explain the falling levels of switching observed since the start of 2009, reducing competitive pressure on energy companies, as well as the proliferation of temporary tariff offers (not covered by the regulation). Despite this (a full assessment of its impact), Ofgem proposes both to extend the life of the regulation and to undertake further re-regulation.

Ofgem’s new proposals would restrict the choice of tariffs, allowing only one standard (variable) tariff per payment method. Ofgem itself would take responsibility for setting some prices (standing charges) each year. It argues that its proposals would lead to more effective competition.

But there isn’t the evidence that the proposals would stimulate switching. They would prohibit many of the market innovations that have benefited customers, including options for no standing charge, green tariffs, discounts for purchase online and discounts for dual fuel. They could also prevent innovation in new services facilitated by smart meters, such as time-of-use tariffs. Ofgem’s proposals would increase suppliers’ costs and risk, once again bringing energy price-setting into the political arena.

Energy companies have not made it easy enough for customers to navigate the number of products on offer, and particularly vulnerable customers. The market itself is beginning to address this, building on the many online comparison sites. Recent innovations have included some big suppliers setting out in energy bills how customers can save money through changing tariff. There has been the first collective switch. And there has been acceleration in market penetration by new entrant suppliers, with a number majoring on simple tariffs.

The proposals for re-regulation, restricting the number and shape of tariffs, will not work and will undermine the competitive market, damaging its ability to innovate and meet customer preferences. Steps that should be taken include removing Ofgem’s current regulation of price differentials, reducing the time taken to switch, reducing the regulatory burdens on growing small suppliers and improving tariff transparency.

Ofgem’s decision to extend its consideration of the options is welcome. As statutorily independent regulator, it must not bow to pressure that “something must be seen to be done” if the evidence suggests that the best interests of customers are served by regulating less.

This article originally appeared on Utility Week’s website

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