After the announcement that the UK has struck a deal with EDF to build a new nuclear power station at Hinkley Point C in Somerset, it is all hail, Atoman!
Energy bill prices have long been high up the list of economic issues voters care about. They have become more politically important after Ed Miliband used his party conference speech to pledge that if elected in 2015 he would freeze energy prices for 20 months. He says he would use this period to increase competition in the sector. Last week British Gas announced an increase in its average energy bill of about 10 per cent. The week before, SSE said its customers would on average have to pay 7 per cent more per year for their gas and electricity. Today Npower announced the highest recent price rises of the Big Six.
The coalition government is introducing legislation which it says will ensure consumers are put on the “lowest tariff” by default. Meanwhile, Ed Davey, energy secretary says they should “shop around” to exert pressure on energy suppliers. The prime minister did not say they should wear a jumper but he tends to stress policies that are focused on consumers rather on companies.
The Big Six energy companies say there is little they can do to avoid price increases, which they say reflect the costs of buying energy on the wholesale market, delivering it to homes, improving the network, and the government’s green policies.
Here is a reminder of the sources of energy bill costs, according to Ofgem:
When I boil the kettle I am using electricity bought from an energy supplier. The supplier, presumably one of the “Big Six”, will have bought the electricity on the wholesale market or directly from a generator. This energy is put into the transmission system before moving to the distribution system and then in to my kettle. A similar four-part system applies to gas: (1) wholesale; (2) transmission; (3) distribution; and (4) retail. Transmission and distribution prices are controlled by Ofgem, the regulator – wholesale and retail prices are not, or at least not directly.
Whenever there is a discussion about problems in the energy market, it tends to concentrate on one or two aspects. This, along with a lack of transparency, prevents a comprehensive understanding of the market’s flaws, contributing to mistrust. Price freezes are a crude instrument but their popularity shows the depth of the public’s anger. Yet, as Mr Miliband well knows, intervention like this must be followed by genuine reform. This must tackle the real Big Six problems in the market.
When economists talk about “market failures” they could mean that there is (1) concentrated market power (e.g. monopolies); (2) information failures (e.g. when consumers don’t know about all available prices); or (3) “externalities” that are not fully priced in the market. Looking at the energy market, there are clearly several of these failures contributing to high prices and mistrust …
1. Consumers are not exerting competitive pressure on suppliers. All the jumpers in these isles would struggle to boil a kettle. We all need energy. Without changing appliances it is difficult to substitute one form of energy for another. However, the retail market should be ripe for competition. Price is by far the main reason consumers cite when choosing a supplier. The final product is effectively the same.
Instead, there is ferocious competition for the customers who are willing to switch, while those who stick to their deals pay more than they have to. Sixty per cent of consumers have never switched and 30 per cent said they have but would not do so again, according to Which? It would be perfectly logical for companies to focus their marketing.
Ultimately, the entire model for the British retail energy market is predicated on the idea of consumer pressure. (Competition + consumer choice = a good deal for everyone.) The government’s response to Mr Miliband’s price freeze suggests that it remains keen on making this a reality, rather than reforming the structure of the industry. Regardless, all parties are committed to more consumer power. But the number of switchers recently hit a new low (in late 2011), according to IPPR. The precise proportion of disengaged consumers is debatable but the data suggest that policy cannot rely on a model of consumers in which they are active and rational.
2. The market does not make it easy for consumers to exert this pressure. Britain’s retail energy market could keep researchers in behavioural economics busy for decades. Whether by design or accident, it is hard for the average consumer to figure out the best deal. There are about 900 different tariffs, a number that suggests an overwhelming complexity for the average consumer, according to Which?.
Research from the consumer group suggests that only a small minority of people can select the cheapest tariffs from the information typically provided by energy suppliers. Standard tariffs may sound the cheapest but they are often not. The segmented nature of bills makes it difficult to accurately compare across deals, especially when we tend to pay too much attention to the headline price. Consumers suffer from default bias when they are rolled over into tariffs which by that point are not always the cheapest available.
Ofgem’s licensing requirements state that price differences should have “cost reflectivity”, which in English means that if a bill is more expensive this is because it cost the company more to supply the energy. (For example, it costs less to process online and direct debit customers so they should pay less.) This is ultimately impossible to verify but Which? is sceptical given the sheer number of deals and companies’ targeted marketing.
Even switching, the answer often given to price rises, does not guarantee a better deal. Price comparison and switching sites are helpful but the information they require can be hard to find and hard to calculate. Introductory deals offered to new customers can skew the results given by these sites and take advantage of our short-term biases. Exit fees may not be incorporated into the sites’ analysis. Studies from the Centre for Competition Policy (note: from 2005) and Ofgem (2008) suggest that from one-third to 40 per cent of consumers do not move on to cheaper tariffs when they switch.
Some consumer choice is better than no consumer choice. One analyst’s lack of switching is another’s sign of loyalty (though customers satisfaction figures undermine this idea). But again, the vision of active, rational, empowered consumers is still a dream.
3. The “Big Six” are under little competitive pressure from new entrants. The current market for the supply of Britain’s gas and electricity has been in place for about a decade. The previous Labour government continued on the path begun by Margaret Thatcher, who privatised British Gas and regional monopolies for supply and distribution. It took until the late 1990s for competition among these companies to be introduced. Price controls were gradually lifted, under the aegis of Ofgem, the regulator. By 2002, when the last controls were removed, Britain had perhaps the most liberal energy market in Europe. The 14 regional monopolies became five companies and together with British Gas became known as the “Big Six”.
Since the market opened, 16 companies have entered under their own licence. Seven of these remain, supplying a total of 2 per cent of UK households. This could be evidence of commercial brilliance. But no company without links to the period before liberalisation has been able to gain a foothold in the market. Incumbency seems to be a powerful weapon. Herd-like pricing behaviour also suggests little worry about smaller, newer companies taking customers from the Big Six.
Some competition is better than no competition. But more is necessary. It is often said that the UK has some of the lowest energy prices in the EU, where price controls and regulated monopolies remain common. Like-for-like comparisons across countries are hard to make but when taxes are excluded, the UK has some of the highest electricity prices and is near the middle of the pack in terms of gas prices, according to IPPR.
4. It is hard to know whether retail prices fairly reflect wholesale prices. Whenever retail price rises are announced, energy companies often refer to prices on wholesale gas and electricity markets as the primary reason for the increase. (Although in the latest round charges to upgrade the country’s network were the biggest single cause of the rise, at least in the case of SSE.) Wholesale costs make up more than half of both gas and electricity bills, according to Ofgem (see charts above). Nevertheless, the vast majority (84 per cent, according to a recent Which? poll) of the public believes that “profits” are the reason for price rises.
Presumably, there is a bit of both at play. And most Britons tend to accept that companies have the right to make profits. However, an important point is often lost in the aftermath of price announcements: the Big Six do not merely accept the prices on the wholesale markets. As noted above, the Big Six supply energy to 98 per cent of UK households – but their generation businesses are responsible for about 70 per cent of electricity generation. This “vertical integration” allows for efficiency within the firm but it also means that it is impossible for outsiders to analyse whether retail prices fairly reflect wholesale costs.
The Big Six companies either self-supply energy, source it from other vertically-integrated companies or buy it on the wholesale markets. The electricity market, in particular, suffers from a lack of liquidity. Often for good reasons of commercial sensitivity, there is a lack of information about the volumes and transfer prices of energy, and about how risks are shared across different parts of the businesses. This quickly suggests parallels with the British banking industry, where investment and retail arms will soon be ringfenced. Some critics of the energy market propose that supply and generation arms of companies be ringfenced too.
I don’t know whether that would make much difference. But that is partly the point – there is a lack of transparency about how wholesale prices translate into retail ones. A similar point goes for whether “investment” is reflected in retail prices. Little wonder then that there is a shortfall in trust in what the Big Six are saying.
5. There seems to be little in the way of operational cost efficiency. When Ofgem depicts the sources of energy costs (as above), it combines wholesale costs, supply costs and profits into one category. In theory, competitive pressures, from consumers and from new and existing entrants, should be leading to decreases in supply/operation costs. It is almost impossible to separate these from the broader category but a recent IPPR analysis found that “the least efﬁcient company spends twice as much per customer on their operations than the most efﬁcient”. What’s more, it found that there had been no convergence of operation costs over time.
This also matters when it comes to the argument that the government’s green and social policies are causing bills to rise. They are – but they can also be implemented more or less efficiently. The think tank says that SSE, for example, “are delivering their policies in a way that adds £35 less to the average bill than British Gas.”
In a blog post to accompany SSE’s recent price rise, Will Morris the company’s retail managing director, writes that: “About 85% of a typical bill is made up of costs outside our direct control.” It is important to understand the role of network charges, government policies, and uncontrollable wholesale price changes have on bill costs. But it is equally important to remember that many other businesses have to deal with situations where they only control a minority of the pass-through costs.
Mr Morris adds that: “over the medium term we think an average profit margin of 5% is a fair amount to make for the important work we do through our Energy Supply business.” I just wonder whether a Tesco or Sainsbury’s executive would ever use similar language.
6. Ofgem has not fulfilled its remit to ensure that competition serves all. This may be asking too much of the regulator but it is hard to look at the above and conclude that it is serving the majority of consumers well.
The Hinkley Point deal has been long in the works. It is good news that Britain is taking long-term decisions about its energy future. But unless there is greater trust in the whole market, it will continue to be difficult to make the sort of choices Atoman would love.