In my previous post, I described the findings of Dieter Helm’s review into electricity pricing. Here I will explore in more detail the section on supply costs and his recommendation that a default electricity tariff be implemented, which is particularly relevant in light of the legislation to cap electricity prices which is currently passing through Parliament.
Are excess profits being earned by the Big 6?
CMA found a consumer detriment of over £1 billion
In his review, Helm describes the role of electricity suppliers. The retail supply part of the electricity value chain has generally involved metering, billing, and collecting customer payments – a relatively simple business, selling a homogeneous product without the responsibility for physical delivery. Over time, additional responsibilities have been added including the collection of levies, and the costs of transmission and distribution; engaging in hedging and other wholesale price and volume risk management; and the smart meter roll-out (there have been other responsibilities relating to energy efficiency that Helm did not mention, and some suppliers also engage in activities such as the sale and maintenance of boilers, although that sits under the gas rather than electricity market activity).
The Competition and Markets Authority carried out an in-depth investigation into supply businesses following concerns of abusive practices and found that the domestic customer detriment due to overcharging by suppliers was around £1.4 billion per year over the period 2012-15 under once analysis approach, and around £720 million/year over the 2007-14 period using a different method.
Adjusting for the time difference, the two approaches would result in consumer detriments of £1.1 billion/year versus £1.2 billion/year for the period 2012-14, for the two approaches. According to the CMA, up to 70% of customers have been paying a significant premium as a penalty for not switching supplier.
The identified detriment under both approaches was heavily contested by the companies, and indeed, Iain Conn pointed out that the combined annual profits of the Big Six are less than the £1.4 billion found under one of the CMA’s methods of analysis.
Helm questions the CMA’s focus on returns to capital as retail is a margins business, employing very little capital, other than working capital. The risks that equity-holders face for customers on standard variable tariffs (“SVTs”) are from poor hedging, inefficient billing, poor customer service, IT systems failures, poor cash management and bad debts.
The evidence is that the major suppliers have from time to time indeed offered poor customer service, resulting in fines from Ofgem. Hedging has also been inadequate at times – hedging performance is one explanation of why margins fell sharply in 2016, and there have been well publicised IT failures.
Sticky customers allow such practices to persist, and some of the practices of the major suppliers add to the stickiness, by offering multiple tariffs thereby reducing the ability of customers to understand the different offers. Further confusion arises then suppliers bundle electricity and gas supplies into dual-fuel products (although arguably consumers may prefer the administrative efficiency of combined tariffs).
Understanding supplier margins
Helm argues that the conventional margins analysis understates the economic margins that suppliers are earning as it is based on the full electricity supply chain, much of which is outside the control of suppliers (FiTs, low carbon CfDs, capacity contracts, transmission and distribution costs, and other taxes and levies).
Helm asked BEIS to re-calulate supplier margins based on the costs which they are able to control. In the first instance, BEIS took domestic supply EBIT divided by total domestic supply revenue minus network costs minus environmental/social costs. In the second instance, BEIS also removed direct fuel costs.
I have reproduced the data here, including the full analysis from the companies’ Consolidated Segmental Analysis reports (the 2015 data for Centrica differ from those set out in Helm’s report, for reasons I have not been able to determine. It should also be noted that SSE has a March year-end and the data presented here is for the periods 2013/14, 2014/15, 2015/16, 2016/17 for consistency with the Helm report, ie it has not been converted to calendar years).
In relation to the domestic electricity segment, the calculations show that, with the exception of 2016, margins were significantly higher when exogenous costs are excluded, however this approach assumes that there are no costs or risks to suppliers from what is effectively, a rent-collecting activity. In practice there are a number of costs and risks, including forecasting errors, bad debt, increased working capital requirements and loss of customers in advance of recovering cost pass-through elements. The data also show that in this segment profits have generally been falling across the period, significantly so since 2014.
Helm argues that there are good reasons for expecting margins to fall for all customers, as new technologies should reduce the costs of handling customer databases, and smart meters should make it easier for new entrants from outside the electricity industry to offer bundled products over and above electricity and gas. However, whether margins should fall to the extent they have is questionable.
I have shown the full CSS data above rather than just the domestic electricity and gas data, since, as Helm points out in his commentary, it is unclear how some costs are allocated across different operating segments by the energy companies, particularly in relation to dual-fuel services. It is also abundantly clear that the claim of over £1 billion of excess profits in the domestic energy market is completely inconsistent with the above data: the total EBIT for the Big 6 across each segment was:
The only way that over £1 billion of excess profits could be made based on this data is if vertically integrated operators were recording profits in non-domestic segments including generation that were in fact earned from domestic end users (or the figures are completely wrong/distorted in other ways).
The Consolidated Segmental Statements are prepared by the companies and audited by their auditors based on guidelines prepared by Ofgem. While it is possible that the figures are being manipulated, the degree of this manipulation would have to be very material in order for the £1 billion figure to be justified (and one would expect the regulator to take action in this case).
How to ensure margins are not excessive
While Helm does call into question some of the CMA’s methodology, he appears to accept the overall findings, referring to the £1.4 billion detriment as persisting in certain situations. Unless the CSS data is being rejected as flawed – something Helm does not do – then it is difficult to give credence to such a large estimate of customer detriment as a result of excess profits.
However, I am inclined to agree with Helm’s assertion that the margins being earned by the Big 6 once the pass-through effects of external costs are removed, have been on the high side, although it should be noted that they also display significant variability across the companies. While overall trends appear to be consistent across the group, the absolute levels vary considerably.
The question that follows from this, is what level of margin would be considered acceptable: how much is too much? And then, what should be done if margins are indeed higher than can reasonably be justified.
Helm makes no real attempt to answer the first question. He refers to the regulated margin in Northern Ireland as a possible benchmark, but there is no detailed analysis on what would be a fair margin in the UK context. In 2016, half of the Big 6 had negative margins on their domestic electricity business, and of those that were profitable, the highest margin on a controllable costs basis was 17.3%, which doesn’t seem to be scandalously high.
Given the increased scope of these businesses as described above, it is difficult to consider what benchmarks would be suitable. One might compare the traditional metering and billing part of the business with telecoms providers, but the responsibilities for smart meters, efficiency schemes and so on (and the wider media activities of modern telecoms companies) make the comparison difficult.
Comparisons with regulated utilities also make little sense, and it’s not clear how much value there would be in making comparisons with energy supply companies elsewhere in the world where market structures are different. For reference, Bloomberg data indicate that the average EBIT margin for FTSE-100 companies (of which Centrica and SSE are both members) is in the range of 5-7%, so on that basis, there may be scope for improvement, although an economy-wide benchmark is a very blunt tool.
While overall margins may not be particularly excessive, this does not mean that some consumers are not overpaying. The CMA and Government are concerned that so-called “inactive” consumers, ie those who do not switch suppliers for whatever reason, are exploited by suppliers, who over-charge these customers in order to provide discounts to more active consumers.
This cross-subsidisation is not visible in the CSS data since there is insufficient granularity in the data, but it is reasonable to suppose that suppliers are behaving in this way since this is a rational course of action to take in a competitive market. The Government is legitimately concerned that vulnerable consumers significantly overlap with inactive customers, making this type of cross-subsidisation undesirable for reasons of social justice.
If it is assumed that some customers will never be incentivised to switch supplier, then it is reasonable to implement a regulatory framework that would protect these consumers. Helm outlines the following potential remedies:
- allowing the situation to persist in order to maximise the incentives to switch;
- capping the prices to some proportion of SVT customers;
- providing full transparency through a default tariff, either as a version of a comprehensive SVT price cap, or instead.
The first of Helm’s options above is essentially to maintain the status quo. As this is clearly not working at the moment, and there are no good reasons to suppose that inactive consumers will suddenly start to switch, this does not seem to be a viable solution.
The second option is the path the Government has chosen with its Tariff Cap Bill, though which an absolute cap on SVTs will be implemented (assuming the Bill passes successfully through Parliament). I have written before about the dangers of this approach.
The third option is Helm’s preferred solution, where the focus is on margins, and the costs the suppliers actually control. The default tariff (whether called “SVT” or not) would incorporate all the costs of energy as set out in the review, with generation costs being indexed to wholesale prices, and with some margins allowed for the risks associated with collecting system costs through bills. Margins would be transparent and published on Ofgem’s website.
A simplified default electricity tariff
In my view (as I have stated many times before!), the first step should be to remove network and environmental costs from electricity bills altogether, and recover these amounts through general taxation. This will mean bills are based on the costs controlled by the supply companies, and the fuel costs they incur.
This would immediately reduce electricity bills by around 45%, while increasing the range of prices as a percentage of the price level.
Fuel costs could be split out so that consumers could see the margins being earned by the suppliers on the basis of the costs they are able to control. The default tariff would then consist of market-indexed generation costs, the supplier’s overheads, the supplier’s margin and taxes. Each component should be explicit on the bill.
Standing charges also need to be addressed. These are not mentioned in the review, but they add further complexity to tariffs and their application is obscure. Simplicity would suggest that standing charges in the default tariff would be set to zero, with the costs being included in the supplier’s overheads, further encouraging suppliers to improve operational efficiency.
Helm says that the main objection to his default tariff proposal is that it may inhibit competition. He argues that:
“by focusing on any fat margins that exist, the default tariff will accelerate, not impede, the development of competition. In a competitive market, margins (and the prices of supply) will converge on the competitive margins and prices. There will be no incentive to increase margins.”
Helm suggests that this option could be a version of the price cap or an alternative to it. In fact, in order to limit the amounts that could be charged to inactive consumers, there would need to be some form of limit on the allowable margins since it should be assumed that customers on this tariff will not switch suppliers under any circumstances (hence the term “default” tariff!).
Rather than capping the overall level of the tariff, which would be risky for a variety of reasons, the level of the margin could be capped. This cap could be set quite aggressively which would incentivise suppliers to reduce operating costs through efficiency gains, and also to engage more effectively with their consumers to try to persuade them to switch to more value-added services where margins may be higher (of course the Government and regulators would need to be mindful of the risks of mis-selling, and potentially borrow concepts from financial services around treating customers fairly and testing the suitability of products sold to them).
It was disappointing that Dieter Helm did not develop the section on supply costs more in his review. The discrepancy between the CMA’s assessment of the consumer detriment and the reported profits of the supply companies requires investigation, as this is a primary driver for the proposal to cap prices. If the £1.4 billion figure is indeed correct, then Ofgem needs to act to make the Consolidated Segmental Statements produced by the suppliers reflect this.
The notion of a cap on the default electricity tariff in order to protect inactive consumers has many risks associated with it, but these could be mitigated to a large extent by capping the margins suppliers could earn on this business. However much more analysis is needed to determine the appropriate benchmarks for setting the level of any margin cap.
Electricity bills could be made more affordable and more transparent by removing external costs such as network, environmental and social policy costs. These are entirely outside the control of suppliers and therefore have no bearing on competition. They do however contribute to public dis-satisfaction with energy prices, and exacerbate issues of affordability for those in fuel poverty. Removing these costs to general taxation would allow them to be recovered from those with the means to do so, and (potentially means-tested) rebates could be offered in relation to energy efficiency measures.
In the current debate about price caps, these are all areas that should be open for consideration so that confidence in electricity pricing can be restored.