How to fix the ‘dysfunctional’ energy market

Oct 7, 2016

One of the clear narratives emerging from Theresa May’s speech at the Conservative Party conference this week was that her Government is likely to pursue a more interventionist approach – intervening more in markets to help consumers and workers, particularly those left behind by de-industrialisation, globalisation, and the financial crisis. The Prime Minister stated that “where markets are dysfunctional, we should be prepared to intervene”. Referring to energy markets specifically, she commented, “It’s just not right that two-thirds of energy customers are stuck on the most expensive tariffs”.

This narrative reflects the reality that the energy market has become increasingly segmented – with some customers paying far more than others. This ‘tale of two markets’ is best illustrated in the analysis by the Competitions and Market Authority (CMA).

Firstly there are the ‘switchers’ – who have moved supplier within the last three years, and make up roughly 30 percent of the market. They are likely to be in higher socio-economic groups, on higher incomes, better educated, and younger than non-switchers – perhaps in the ‘metropolitan elite’, which May refers to in her speech. They are technologically and financially savvy, and shop around for energy and other products and make substantial savings. The energy market has served them well in recent years. In January 2014, the cheapest fixed price deals cost around £1,100 per year for the average household (source: CMA final report), but by early 2016 this had fallen to less than £800, generating savings for switchers of hundreds of pounds per year.

Then there are the ‘non-switchers’. They typically haven’t switched for several years – if ever. The CMA’s analysis shows that non-switchers are disproportionately likely to be vulnerable or elderly households, on lower incomes, less educated, or have poorer access to technology. They are stuck on ‘Standard Variable Tariffs’ (SVTs), which are far less competitive than the fixed-terms deals offered to switchers. The average energy bill per household on an SVT tariff increased from £600 in 2006, to nearly £1,200 in 2014, and has only dropped marginally since then, despite falls in wholesale electricity and gas prices.

The CMA’s analysis clearly shows that energy suppliers are making all of their profits from the ‘non-switchers’. In effect the ‘non-switchers’ are subsidising the ‘switchers’.

The Sun: ‘The Big Fix: Energy fat cats fleece families of £400 a year’

In response to this, The Sun has been running a campaign on what it describes as ‘The Big Fix’. This culminated in a front page story this morning. The article highlights the huge disparity between the best and worst deals offered by ‘Big 6’ energy suppliers. For example, the article asserts that customers on SSE’s Standard Variable Tariff are paying £389 per year more than customers on SSE’s cheapest deal, and that collectively the Big 6 suppliers are over-charging customers to the tune of £6 billion per year (the Competition and Markets Authority suggests a much lower figure of £2 billion). The Sun also reveals that amongst the Big 6, only Scottish Power does not prevent existing customers from accessing the best deals.

The Sun proposes that all suppliers (including Big 6 and non-Big 6 suppliers) should be forced to put all customers on to their cheapest tariff. They also suggest that in doing so, suppliers should not simply be allowed to ‘pull’ their cheapest tariff, and that energy suppliers should no longer be able to restrict existing customers from moving to their cheapest tariff.

Whilst these proposals may appear to be appealing from a consumer point of view, there are some significant downsides. Forcing energy suppliers to move all customers on to the cheapest tariff would mean that, in effect, suppliers could only have one tariff. Given that the suppliers have to recover a fixed cost through consumer bills, this tariff would need to be somewhere between the current SVT and the best fixed-term deals. In other words, moving to a single tariff would lower prices for currently those on a SVT, but would increase prices for those on a fixed-term deal. Everyone would simply move towards the middle.

Electricity is a pretty homogenous product, and suppliers face almost identical costs. They all buy power from the wholesale market, and pay grid charges and green levies in exactly the same way. Boiling things down to a single price per supplier would mean that all they would be competing on is their ability to purchase energy successfully from the market (i.e. their hedging strategy), their margin (or profit), and their operating costs. If this is what The Sun intends, then why not go the whole hog, and simply regulate suppliers’ profit margins?

Whilst this all sounds simple and straightforward, it would have a devastating impact on competition and innovation in the energy retail market, and bring a sharp end to the liberalised energy market that has been in place for the last three decades. It is not clear that consumers would be better off (collectively) than they are at present – there would be winners and losers.

The CMA: Energy Market Investigation

The alternative would be to continue to follow the approach recommended by the CMA, which largely revolves around the belief that if people switched more, then this would put more competitive pressure on suppliers, and they would reduce prices.

What the CMA has failed to grasp in its analysis is that some households simply don’t want to switch supplier. They either like their supplier (most people trust their own supplier more than other suppliers), find it hard to compare alternative suppliers (or get confused when they try), have had a negative experience of switching in the past, or simply cant be bothered to switch. Many households simply don’t understand what they are paying for energy, and therefore find it difficult to compare suppliers (this is borne out by the sheer number of calls to Citizens Advice, in which consumers frequently identify a level of confusion around energy bills).

One of the CMA’s key recommendations is that the non-switchers should be put on a database (administered by Ofgem) and that suppliers should then be allowed to market their services to people on the database. Can you image the deluge of flyers through our letterboxes, and the consumer backlash against this approach? Granted, the CMA has said that people should be able to opt out, but I suspect that this would do nothing to rebuild trust in the energy industry.

The CMA has gone further by suggesting reforms to the regulation of Price Comparison Websites – the main route by which people switch. Until recently, Price Comparison Websites had to display all of the deals available in the market – literally ‘compare the market’. However, the CMA has recommended that this requirement should be relaxed – thereby allowing PCWs to display only the deals that earn them a commission. The CMA’s thinking is that the current PCW business model is not financially sustainable, since if all sites display all deals then they cannot differentiate themselves.

The CMA’s recommendation was heavily criticised by members of the Energy and Climate Change Committee, and some consumers groups – since it would allow PCWs to hide the best deals from consumers, and only display those where they are making a commission. I have tried explaining this proposal to a few non-energy specialists (i.e. ‘ordinary human beings’), and they generally can’t believe what the regulator is proposing. ‘Why would they allow Price Comparison Websites to hide the best deals?’ they say. The CMA’s recommendation seems to work well for PCWs, but not consumers (unless you mistakenly believe that consumers will be prepared to shop around on multiple PCWs until they find the best deal – which they don’t).

The CMA also proposes to relax rules around the number of tariffs that suppliers can offer. Under the Cameron administration, Ofgem introduced the Retail Market Review, which limited each supplier to offering a maximum of four tariffs. The CMA proposed that this restriction is lifted, to allow suppliers to increase the number of tariffs on offer, which in their view will allow suppliers to innovate. The downside of this, of course, is that there is likely to be a proliferation of tariffs in the market, creating more confusion for customers.

Credible Alternatives?

So, are there credible alternatives to the proposals offered by the CMA and by The Sun – which go some way to addressing the ‘consumer detriment’, whilst stopping short of re-regulating suppliers?

My starting point would be to ask: what is the specific problem we are trying to fix? And how should we measure it?

The salient message that I take from Mrs May’s speech and The Sun’s article is that some consumers are paying more for their energy than other customers, and that seems unfair. So why not limit the ability of suppliers to segment their customers in this way? I have sat down with suppliers in the process of setting their prices. This is largely a process of working out the total cost they face, and then allocating this between customers. Some suppliers choose to offer very cheap fixed-price deals to gain market share, and inevitably have to keep their SVT rates high. Other suppliers offer slightly less competitive fixed-price deals, and pass on savings to their SVT customers. This is a choice.

So, if as society, we think that people should pay broadly the same amount for their energy, then why not simply cap the differential between a supplier’s most expensive and least expensive deals? Provided that this cap is set at the right level, then it would reduce, but not eliminate the cross-subsidy between non-switchers and switchers, and allow competition and innovation to continue. In other words – it could be a sensible compromise between the proposals offered by the CMA and The Sun.

On tariff simplification – again, why not simply find a sensible compromise? Four tariffs is arguably too few, but an infinite number of tariffs is arguably too many (particularly for a homogenous product, such as energy). What about ten tariffs per supplier? I cant think of more than ten ways I would like to sell electricity and gas…

It is also possible to think of better ways to encourage people to switch than the CMA’s suggestion that customers should be put on a database of non-switchers – and have their mailbox filled with junk. One big step could be made by changing the language used to describe tariffs. ‘Standard Variable Tariff’ doesn’t mean a lot to most people. But terms like ‘Out of Contract’ resonate with people – and are used in other consumer markets such as mobile phones and mortgages. Rather than putting people on the database, why not require suppliers to contact all their SVT customers (starting with those who haven’t switched for more than three years), tell them that they are out of contract, and talk them through the options, or refer them to organisations such as Citizens Advice.

In terms of PCWs – clearly they need to make some commission in order to be viable, but hiding the best deals from consumers is unfair. Again, there is an opportunity to find a sensible compromise. My proposal would be that PCWs should be required to display all deals available in the market, with the exception of exclusive deals negotiated between suppliers and other PCWs. This would allow PCWs to negotiate exclusive deals with suppliers in the knowledge that these would not be available on other sites. At the same time, the PCWs would have to display all other tariffs, whether or not they were taking a commission. The rules could also build in safeguards against suppliers ‘gaming the system’ – for example, allowing PCWs to group together similarly priced tariffs from the same supplier (otherwise, there is a risk that suppliers could crowd out competitors through the design of their tariffs).

Conclusion

In summary, there seems to be a desire on the part of the new Government to intervene in energy markets, in order to secure a better deal for consumers. This is hard to argue with as a position, but needs to be done carefully. The types of policies suggested by The Sun appear appealing on paper, but could destroy competition and innovation in the energy market, and may have unintended side-effects. At the same time, the reforms suggested by the CMA have clearly failed to resonate or rebuild trust in the sector. Whilst fine in theory, some of the proposals (such as the reforms to PCWs, relaxation of the four tariff rule, and the database of non-switchers) could seriously backfire. There is still an opportunity to forge a path between these two extremes, which reduces consumer detriment whilst maintaining competition in the energy market.

Author

Richard Howard

Richard Howard
Director of Development & Head of Environment & Energy Read Full Bio

Related Publications

Latest Tweets

Fleet of Russian submarine drones could cripple Britain, says @MailOnline - referencing our report by Rishi Sunak MP on undersea internet cables' vulnerability dailym.ai/2BqMn7R

Share This