Once again we hear in the news the ominous threats of energy price caps in response to retailers raising their prices, and while the desire of politicians to respond to consumer anger is understandable, this is a temptation they need to resist. The dangerous logic of price caps assumes that prices are inflated in order to line the pockets of the shareholders of the big energy suppliers – by setting caps on retail prices, the government would be effectively setting limits on what it considers acceptable profits in the sector, which is hardly the hallmark of a free market and starts to look like a regulated price control.

 

Price caps can have unintended consequences

Of course, the danger is that any cap would be set without due reference to the cost pressures faced by the suppliers. When wholesale prices are free to fluctuate without constraint, and when suppliers increasingly face other external costs, largely due to government environmental and social policies, those corporate profits can quickly turn into significant losses. Losses eventually put companies out of business, which in the case of the Big 6 would leave the government with the prospect of using taxpayer money to bail them out or risk continuity of supply to “ordinary working people”.

The sorry tale of price caps in California in 2000/01 should provide a cautionary lesson for policymakers, where price caps in poorly designed electricity markets contributed to multiple large-scale blackouts, the collapse of one of the state’s largest energy companies.

BEIS and Ofgem are concerned about the low levels of consumers switching suppliers – in 2016 a record number of consumers switched, but this only involved 5 million households. This means that large numbers of consumers are paying so-called “standard variable tariffs” which tend to be expensive, and there is an assumed correlation between inactive and vulnerable consumers.

“There are still 20 million people who are stuck on some of the most expensive standard tariffs, paying over the odds for their energy.” – Vickie Sheriff, Director for campaigns and communications at Which?

It’s right that the government should act to limit exploitative behaviour by suppliers, but the suggestion of price caps, as with previous policies of limiting the number of available tariffs, is the wrong answer to the wrong question. The most recent proposal is for relative price caps, limiting the value of the most expensive tariffs to 106% of the cheapest tariffs. Inevitably such a proposal would lead suppliers to raise the levels of the cheaper tariffs to defend their overall economics, which would penalise currently active consumers without necessarily benefiting those who are not active around switching.

 

How to improve switching rates

A 2015 paper by the Energy Policy Group at the University of Cambridge found that the reasons for low switching rates included the complexity of household energy tariffs, consumers’ lack of attention to issue of energy prices, expectation on the costs of switching process and lack of switching experience. Low levels of consumer trust in energy companies may well be another factor. The report concluded that:

“policies which emphasise simplification of energy tariffs, increasing convenience of switching, improving consumers’ concerns about energy issues, improving consumers’ confidence to exercise switch are likely to increase consumer activity.”

The government could go some way to solving these issues by requiring suppliers to provide a full cost breakdown on each bill detailing what costs underlie the amount paid by the consumer. This should set out the level of wholesale prices, supplier operating costs and margin, transmission costs, the costs of government environmental and social policies further broken out by type, and taxes.

Full, detailed disclosure of this information should also be included in each tariff so that price comparison services could expose the elements of energy prices that can be controlled by suppliers, being their profits and overheads, and to a certain degree the wholesale prices they pay which can be affected by the buying strategies and hedging policies employed.

 

Price transparency is key

Making this information transparent will also enable all market participants to clearly understand whether external pressures risk making the market uncompetitive – for example if the portion of bills under the control of suppliers becomes too small due to the rise of policy-related costs, then supplier prices would converge and switching would become moot. This would enable policymakers to consider alternative cost recovery methods for policy-related costs, if those costs began to undermine market competitiveness.

Allowing consumers and commentators to understand the actual drivers of bills would end the current rounds of finger-pointing and provide a basis for re-building trust in the sector. (And to ensure this isn’t undermined by billing errors, serious penalties for inaccurate or incomplete information can be imposed.)

It would also allow consumers to see what the actual difference between the suppliers is based on how their internal costs compare. I do not suggest the suppliers separately disclose their profits – by combining profits and operating costs suppliers will have an incentive to increase efficiency and set their prices accordingly – it’s not unreasonable for more efficient companies to also be more profitable.

electricity tariffsBy providing properly transparent billing information, consumers will be able to identify which suppliers provide the best deals, and price comparison sites should allow easy comparison of standing and unit charges which can be difficult to find, helping consumers see more easily how varying their consumption would also change their bills. (I was very interested to see how variable standing charges are for any given property, but this information can only be compared by manually extracting the values from the details of each individual tariff, which is cumbersome.)

Price transparency will remove a great deal of the posturing around energy pricing and allow the discussion to move on to realistic means of cost control at the policy level, the supplier level and the consumer’s own level. Setting price caps will not achieve any of these aims and risks creating further market distortions with potentially damaging consequences.

 

 

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