Yesterday the Government published its draft Domestic Gas and Electricity (Tariff Cap) Bill, essentially imposing caps on some energy bills until 2020, with a possibility of extending until 2023.
“The Government wants markets to thrive and we continue to promote competition as the best driver of value and service for customers. The Government is prepared to act, however, where markets are not working for all consumers, and the energy market is a clear example of this.
Last year the Competition and Markets Authority found that customers of energy suppliers were paying £1.4 billion a year more than they would be in a truly competitive market. Vulnerable and low-income customers are more likely to be on the most expensive standard variable tariffs,”
– Greg Clarke, Secretary of State for Business, Energy and Industrial Strategy.
What does the proposed Bill say?
As soon as practicable after the legislation is passed, Ofgem must modify the standard supply licence to include conditions that impose a cap on all standard variable and default rates that may be charged by the holders of supply licences in the domestic market, excluding those customers on prepayment meters who are covered by an existing cap, or those whose tariff was chosen in relation to certain environmental benefits. Ofgem may modify the tariff cap conditions from time to time.
For the purposes of the cap:
- “standard variable rate” means a rate that is not fixed for a period specified in the contract, and
- “default rate” means a rate that applies if the customer under the contract fails to choose an alternative rate.
In setting the cap, Ofgem must consider a number of factors:
- the need to protect existing and future domestic customers who pay standard variable and default rates;
- the need to create incentives for holders of supply licences to improve their efficiency;
- the need to set the cap at a level that enables effective competition for domestic supply contracts;
- the need to maintain incentives for domestic customers to switch to different domestic supply contracts;
- the need to ensure that holders of supply licences who operate efficiently are able to finance activities authorised by the licence.
Ofgem must set out how the cap is to be calculated, and may make provision about assumptions behind the calculation, and any information required from suppliers in determining the cap. There must also be rules defining how a standard variable or default rate is to be identified.
Ofgem may also “may make different provision for different areas or different cases”, but may not exempt any suppliers from the cap, or make different provisions for different holders of supply licences.
Ofgem will be required to carry out a competition review in 2020, and annually thereafter if the cap is extended, in relation to domestic supply contracts. The review must consider, among other things, the extent to which progress has been made in installing smart meters in domestic properties. Following the review, BEIS will determine whether the domestic energy market is sufficiently competitive, and if not, the cap will be extended for the following year, with 2023 being the final year for which the cap could apply.
Is there a genuine problem with energy bills?
In the notes to the draft Bill, the Government asserts that a two-tier market has developed in which engaged customers are able to benefit from the most competitive tariffs available while those who are unable or unwilling to switch are lumbered with expensive value standard variable tariffs. There is a wide variation in the prices that different domestic customers pay for energy, despite the fact that electricity and gas are homogenous products.
The Government highlights the recent increases in energy prices, with average domestic electricity prices rising by around 36% between 2006 and 2016, and average domestic gas prices rising by around 43% in real terms over the same period.
The Competition and Markets Authority (“CMA”) report in 2016 identified weak consumer response having an adverse effect on competition in the domestic retail market and that the Big Six suppliers have unilateral market power over their standard variable tariff customers. The report set out that customers of the Big Six pay an average of £1.4 billion a year more than they would in a truly competitive market.
Ofgem has reported that differences between typical tariffs for people who switch supplier and those who don’t rose above £350 per year in February 2016, and have typically been well above £225 per year. Around two thirds of households, approximately 18 million, remain on standard variable tariffs, and in 2016 7.8 million gas and electricity switches took place. The CMA found that those who least can afford it are more likely to be on standard variable tariffs.
Centrica CEO, Iain Conn recently told Spectator Magazine that price caps have been shown to reduce competition:
“Price caps have been used in many countries, in Australia and New Zealand, in California, in Ontario, in Spain, Hungary. And in every single case, competition has fallen, prices have tended to bunch around the cap level and so customers end up ironically with less choice and in many cases average prices have actually gone up, not down…. You’ve seen it most recently in the UK with the pre-payment meter price cap which came in just earlier this year where on average the prices are now within £2 of each other and they have all bunched around the cap, with quite a few of them going up not down.”
He also took issue with the CMA’s assessment that consumers were paying £1.4 billion more than they would in a fully competitive market, asserting that £1.4 billion is more than the entire annual profits of the energy industry.
“If customers are being overcharged by that amount, the inference is that the expectation must be that everyone loses money supplying energy. That’s clearly not sustainable.”
According to the Ofgem data above, Conn is correct – the Big 6 suppliers collectively do not earn as much as £1.4 billion in profits and therefore the CMA’s claims seem unrealistic. While it is important to note that Ofgem’s data comes from the suppliers themselves, there are guidelines covering their preparation and they must reconcile with the supplier’s audited financial statements.
Steve Smith, director of energy switching firm Flipper and former Ofgem board member agreed that the £1.4 billion figure from the CMA, was “entirely hypothetical” and controversial:
“They talk about this £1.4 billion of excess profits – it’s not money you’d go and find in the [energy] companies accounts, it was a very hypothetical view of the Competition and Markets Authority on how the companies should run themselves and how efficient they could be.”
Elsewhere Ofgem illustrates that the large suppliers are earning pre-tax margins of 4.83% on their dual fuel energy bills. Based on an average tariff of £1,142, that represents £55 of the average bill. It has been widely reported in the press that the cap is likely to reduce bills by £50-100, which would wipe out the average margin earned by energy suppliers.
However there are some who claim the cap does not go far enough. Justin Bowen, National Secretary of the GMB union said the proposal “falls short” of what is needed to protect consumers from “excessive profiteering” by energy companies. He went on to say that the government should intervene directly in the energy markets, with powers to limit the profits of energy companies:
“The only way to really protect consumers from being ripped off in a monopoly situation is if Ofgem is abolished and its regulatory functions are taken over by the government itself, making its regulatory role subject to scrutiny and accountable to parliament with the powers to cap prices.”
Other responses to the proposed price cap
There are genuinely mixed opinions about the proposed price cap, with some commentators, such as the GMB saying it does not go far enough, while others fear there will be negative implications for competition.
Richard Neudegg, head of regulation at uSwitch.com, called the proposal negligent, and said the Government is “sending out completely the wrong message” by suggesting that a price cap would make the retail energy market more competitive.
“In fact they will condemn millions of households to higher gas and electricity bills by lulling them into a false sense of security. Right now consumers can save an average of £357 in just minutes by switching – far more and far quicker than any cap will offer. But this won’t happen if they are told to stay where they are and not take advantage of the cheaper tariffs available.
The Government cannot have it both ways. This intervention will remove the most effective weapon in keeping prices down – competition. Instead they should focus their efforts on widening access to the Warm Home Discount for vulnerable households.”
Consumer group Which? was enthusiastic cap but cautioned against unintended consequences.
Former energy minister, Liberal Democrat MP, Ed Davey was also critical of the move, saying the cap would actually harm competition. The Lib Dems were the only main political party to oppose price caps during the last election.
Meanwhile Citizen’s Advice was supportive calling the draft bill “an important step towards an energy market that works better for consumers”, while also urging the Government to ensure that Ofgem monitors the impact of cap closely, in order to take prompt action if bills is not impacted as expected.
“We agree with the government that an absolute cap is a better option than a relative cap, and will help to ensure the market remains competitive so that consumers who shop around can still get a good deal.
However, a cap on prices isn’t the end of the story when it comes to fixing the broken energy market, which is why it is vital that Ofgem takes into account the need to protect vulnerable consumers, encourage efficiency, and incentivise switching when it sets the cap. This is particularly important given the temporary nature of the measures.”
Martin Lewis, founder of MoneySavingExpert.com, also said that he was pleased to see the cap is an absolute rather than relative cap, but sees it as a halfway house, with politicians needing to make a choice between competition and regulated prices:
“For switching to work you need big price differentials – so some will have to pay more than others. A price cap narrows the differential. Those who did switch may end up dis-incentivised to do so. Those who don’t switch will save some money, but not as much as if they embraced the competitive market or all prices were regulated.
If we are to stick with competition, what we need to do is decide who is and who isn’t an acceptable victim of competition. If I – as someone who is web-savvy, affluent and financially informed – chooses not to switch, that’s my problem. If a struggling 90-year-old granny who’s not on the web is too scared to switch, it needs fixing. A price cap however is an indiscriminate solution, which isn’t ideal.”
So what does the price cap mean?
The cap will affect households in England, Wales and Scotland on standard variable tariffs and other default tariffs.
According to Ofgem, the average dual-fuel bill is currently £1,142. The prepayment price cap is currently £1,031 per year, so it is likely that the new price cap will fall between these two levels – as noted above, the expectation is that the impact will be in the region of £50-100 per year. In other words, all of this may be for a pound a week off bills, which hardly seems consistent with the rhetoric from either side of the argument.
The other thing to note is that it will be some time before the cap comes in to force. The bill must first be scrutinised by a committee of MPs – a process that usually takes 3-4 months – before passing through Parliament. This means the cap certainly won’t be in effect this winter, and MoneySuperMarket has suggested it may not be until spring 2019 that customers on standard variable tariffs see their bills reduced by the cap.
Over the same period, the costs of environmental policies are set to increase, so despite the cap, customers may well see no overall reduction in prices, just marginally smaller price rises. That could be a politically toxic outcome, but may serve to bring greater transparency to the underlying price pressures at work in the market.
On top of this, it is very difficult to semi-regulate prices, and suppliers may find other ways of re-cooping their costs, for example by increasing standing charges (as I have described previously, these are an obscure component of bills, with standing charges varying across suppliers for the same property).
The track record for energy price caps globally is poor, with various unintended consequences – it’s unlikely that Ofgem will be able to implement anything better. If the cap makes a real difference to consumers it risks forcing the suppliers into financial difficulties, but if the cap is in the range suggested, it will be barely noticeable and is likely to be seen as a failure.
In the meantime it will be a major distraction from the many other challenges the regulator is dealing with, and its time and resources would arguably be better spent elsewhere.