Will greater competition or greater intervention fix the energy market? What can we learn from the CMA report?

Feb 18, 2015

The Competition and Markets Authority (CMA) today published its updated ‘Issues Statement’ relating to its investigation of the energy markets in Great Britain. The focus of the CMA’s investigation is to establish whether there are features of the energy market which are preventing or distorting competition. The long awaited Issue Statement sheds light on the workings of the market, the CMA’s current thinking, and how the enquiry is likely to proceed over the coming months.

The CMA’s report clearly shows that the energy market is broken in many respects – but there are clear ideological differences between the coalition and the shadow energy team on how to fix it. The coalition favours the use of competitive forces, whilst the shadow energy team takes a more interventionist approach. In this blog we draw out some of the main findings from the CMA report, and use this to critique these conflicting approaches.

The Coalition Approach: competition, switching, and tariff simplification

The coalition approach to fixing the energy market is essentially about using competitive forces to ensure that customers get the best possible deal. It is about promoting customer switching, reducing barriers to entry to the market, and simplifying tariffs – as summarised neatly by the following tweets today:

 

The CMA’s analysis demonstrates that there are very real savings to be made from switching supplier – finding that 95% of customers could have saved money by switching, with an average saving of £158-234 per year.

However, current switching rates are pretty low. In the three months to Sept 2014, there were around 1.2 million switches (gas and electricity customers combined) – compared to a peak of 2.6 million switches in Q3 2008. The Big 6 are losing customers to independent suppliers (whose market share has increased from 1% to 7-8%), but overall switching rates are in decline.

Moreover, it is clear that the market has segmented into a group of proactive switchers, and a rather larger group of disengaged ‘non-switchers’. According to the CMA’s analysis, around half of consumers have never switched, and a third say they have never considered switching or thought it was impossible. There is a high level of ‘incumbency’ – a legacy of the historic regional supply monopolies. The non-switchers are more likely to be elderly, live in social accommodation, have fewer qualifications, and be on lower incomes.

The CMA also shows that the energy suppliers are making greater returns from ‘loyal’ or ‘sticky’ customers on their Standard Variable Tariffs (SVTs) than those on other plans. Again, those on SVTs are unlikely to have switched, are more likely to be struggling financially, and are more likely to have been with an incumbent supplier for a very long time. It is somewhat perverse that vulnerable households in greatest need of making savings on their energy bills are amongst those least likely to have switched.

So switching could be part of the answer – but in order for it to be truly successful the government would need to do far more to engage currently disengaged consumers and dramatically increase switching rates.

On tariff simplification (or the ‘Retail Market Review’), the CMA’s analysis suggests that to some extent the policy may have backfired. In reducing down to 4 standard tariffs, many suppliers have removed discounted variable tariffs, prompt payment discounts, rebates, and cash-back offers. The CMA’s findings fit with a wider industry narrative that RMR may have stifled innovation, and may not be consistent with the direction of travel – towards Smart Meters and Time of Use Tariffs.

Competitive pressures are nibbling away at the dominance of the Big 6 – with independents taking market share in both supply and generation, but this will take time to fundamentally alter the market.

The Labour Response: freeze prices, strengthen regulation, break up the Big 6, and return to the ‘pool’

Labour’s approach to fixing the energy market is far more interventionist. A Labour government would freeze (or cap) prices by giving new powers to the regulator to cut bills. Labour has also spoken previously about breaking up the Big 6 (into separate generation and supply businesses), and returning to a ‘pool’ model for wholesale markets in order to increase liquidity.

 

Whilst Labour has correctly identified the problems (i.e. rising bills, customer dis-satisfaction), it is questionable whether they have picked the right remedies.

On the price freeze – it is unclear how this would work in practice, and unclear where suppliers would or could find savings. Consumers perceive that the suppliers are making vast profits, when in reality supply margins are relatively thin (CMA analysis suggests margins on energy sales of 3.3%). It has also been suggested that the vertically integrated players conceal profits in their generation businesses – but again the CMA shows that the “main technologies are all making a return that was in line with or below the firms’ cost of capital”, and that wholesale market prices are not above competitive levels. Whilst wholesale prices are now falling, this is offset to an extent by a continual increase in policy costs (a point to which we will return in future reports) – and suppliers are limited in their ability to pass on savings immediately due to the way in which they hedge. In short – it is unclear how a price cap or price freeze would work, or what it would achieve – since the CMA seems to think the suppliers are already passing through costs in a competitive manner, and not making excessive profits.

Whilst the above is true in general, this masks what is going on at the level of individual customers. The CMA report shows that revenues are higher for ‘sticky’ customers on Standard Variable Tariffs than for the more engaged customers who have switched. But it is not clear how a price freeze or price cap would address this particular issue. An alternative remedy would be to force companies to place all customers on their cheapest tariff (rather than the current system whereby suppliers simply indicate the cheapest tariff on the bill). But the implication of removing market segmentation would be that the price would go up for some, and down for others, compared to the current prices they are facing.

Another pillar of Labour’s proposed reform would be to break up the Big 6, and return to a ‘pool’ model for the wholesale market (which effectively renders internal trading impossible). Based on the CMA’s analysis, it is questionable whether such substantial changes are required. The CMA report documents the history of NETA, and the incentives it gave for vertical integration in the early 2000’s, but argues that many of these incentives have now all but disappeared. The CMA suggests that the value of self-contracting has reduced, that wholesale market liquidity is now ‘strong’ (at least near term liquidity), and that there are not significant concerns with regard to wholesale market transparency. Furthermore, the CMA concludes that the vertically integrated companies do not have sufficient power to push out smaller players through ‘customer or input foreclosure’. The market is already changing in any case – with independents taking market share in both generation and supply, and E.On announcing the separation of its generation and supply businesses.

Summary

In summary – the CMA report indicates some serious concerns about the functioning of the GB energy market, although in some areas it appears to dismiss previously held ‘theories of harm’. The segmentation of the customer base into engaged and sticky customers appears to be the most substantive issue – but not one which is sufficiently addressed by current policies.

The coalition’s focus on switching seems to deal with the symptoms but not the root causes of energy bill increases, and is limited by the low level of consumer engagement (despite the size of their bills). Competition from independents and the gradual dis-integration of some of the Big 6 are having an effect, but these are very gradual processes.

On the other hand, it is also unclear how Labour’s more interventionist approach would address the issues at hand, and some of the proposed reforms (such as breaking up the Big 6 and recreating the pool) now seem somewhat unnecessary.

We don’t profess to have all the answers (yet), but there certainly needs to be further debate about the best way forward. And to that end – Policy Exchange will be hosting an energy debate entitled ‘The Return of the State’ on the 24th March – with keynote speeches from Professor Dieter Helm, the Rt Hon Caroline Flint MP, and the Rt Hon Ed Davey MP. Further details will be circulated in due course, and I very much look forward to the debate!

Author

Richard Howard

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