Can energy price caps ever work?

Last week the Conservative Party has announced a manifesto commitment to an energy price cap, despite warnings from across the industry, including in this blog, that the idea is unlikely to work, and may have significant unintended adverse consequences. In his recent address to Centrica shareholders, Iain Conn made reference to failed caps in New Zealand and Spain, and I have previously written about the disastrous price caps in California in the early 2000s.

De-regulation does not seem to have delivered value to consumers

Since de-regulation, many markets have seen prices rise, leading to consumer pressure for action. The question is whether this is a result of imperfect competition allowing utilities to exploit their market power at the expense of consumers, or whether other factors are in play. This study of US electricity prices by William B. Marcus, Principal Economist at JBS Energy, Inc. discussed the impact of de-regulation and found that although electricity prices were higher in de-regulated states than regulated ones, much of the difference was accounted for by the costs of deregulating.

This 2015 study by The Energy Institute at Haas came to some interesting conclusions about the de-regulation of the 1990s:

“We argue that the greatest political motivation for restructuring was rent shifting, not efficiency improvements, and that this explanation is supported by observed waxing and waning of political enthusiasm for electricity reform.

While electricity restructuring has brought significant efficiency improvements in generation, it has generally been viewed as a disappointment because the price-reduction promises made by some advocates were based on politically-unsustainable rent transfers.”

This paper by Georgetown University School of Law discussed some of the reasons why electricity de-regulation has been less successful than the de-regulation of other industries such as telecoms.

“The biggest flaw behind electricity restructuring was likely the belief that electricity markets can function competitively and efficiently to meet consumer needs in the short- and long-term without taking into consideration changes in market conditions and inevitable government intervention.

Mixing competitive markets with regulatory fiats has lead to many of the problems with restructuring…..that have distorted electricity wholesale markets, sending inaccurate price signals and leading to concerns of near- and long-term capacity shortfalls.”

Re-regulation in the GB market has made matters worse

Turning to GB, it is clear that the electricity market is failing. In well-functioning markets, competition delivers value to consumers, and price signals drive construction of new capacity, however despite the availability of more attractive tariffs, many consumers continue to pay the most expensive rates. Price signals have failed to deliver new generation capacity leading to wide-spread subsidies for new technologies and capacity auctions for traditional technologies.

In fact the GB electricity market cannot be described as “de-regulated” in the traditional sense since a significant degree of re-regulation has occurred. Successive governments have pursued decarbonisation policies that have imposed significant additional costs to the system both in the form of generation subsidies and transmission reinforcement.

In addition, as energy and balancing market prices do not reflect the full costs of delivering electricity in all periods, they fail to deliver the necessary investment signals to incentivise new generation, requiring further intervention in the form of the capacity market.

Rising wholesale prices and the increasing costs of government environmental and social policies are resulting in significantly higher retail prices. Suppliers offer a wide range of tariffs, with discounts to attract customers away from competitors, yet despite these incentives, many customers fail to switch and find themselves on the most expensive rates.

Capping prices “properly” is difficult and likely to fail

But imposing price caps is unlikely to deliver better value to consumers. Setting a relative price cap to prevent some consumers from paying “over the odds” will lead to a narrowing of the price differential between the highest and lowest tariffs, with currently active consumers effectively subsidising inactive consumers. But while a relative price cap is unlikely to work, an outright price cap risks causing significant damage.

This analysis by Europe Economics describes some of the practical challenges faced by regulators in attempting to set electricity price caps:

“…in a market where demand is volatile, or at the very least uncertain, it may be very challenging for the regulator to devise a cap, to apply in advance over an extended period (e.g. two years), in ways that limit the risk of serious errors. Energy producers might be expected to increase output and lower prices to avoid being capped.

However, high output would be an inefficient production decision when the price cap is not binding – too much output and too low a price. A rational producer would therefore prefer to decrease output to reduce inefficiencies in the non-capped situation. Further, when the price cap is binding, the profit margin is smaller and producers have reduced incentives to generate high output.”

If absolute price caps are set too high, they are ineffective; if they are set too low they can cause chaos as was the case in California. In the worst case, suppliers go bankrupt and require government bail-outs, but they also act as a dis-incentive to new entrants who may lack confidence in earning acceptable returns, hence stifling competition. If the level of the cap is too low to cover the actual cost of generation and delivery of electricity, it is essentially a consumer subsidy, which can further distort markets and stimulate demand.

The only rational justification for retail price caps is if there is evidence of suppliers earning excess returns by overcharging consumers, which itself would be evidence of market failure through imperfect competition or collusive behaviours. The recent CMA study found no such evidence, and did not propose price caps outside the narrow segment of pre-payment customers.

Alternative to price caps

This means there are other causes of high prices, which are, as I have illustrated in previous posts, rising wholesale prices and rising costs of decarbonisation and social policies. The lack of transparency creates difficulties in understanding the true drivers of prices, as does the complex web of generation subsidies. Adding consumer subsidies into the mix is highly unlikely to improve matters.

Instead, the government should implement the following changes:

1. Remove the costs of decarbonisation from consumer bills and recover these costs through general taxation (this will have the added benefit of making the true costs of decarbonisation more transparent and facilitate a debate on whether current energy policy is delivering value);
2. Ensure consumers pay the actual costs of generation and delivery of electricity, excluding subsidies designed to drive they type of generation being used, and without any price caps / consumer subsidies so the link between cost and consumption is retained to incentivise demand reduction and efficiency measures;
3. Re-structure the market for ancillary services to remove hidden subsidies and ensure that the full costs of delivering electricity are met in the energy and balancing markets – this will strengthen investment signals for new capacity and may render the capacity market redundant;
4. Require greater transparency and simplification of tariffs by suppliers, and the standardisation of standing charges (while allowing suppliers to offer tariffs that combine a fixed and floating element, these should be clearly and accurately described which does not appear to be the case currently).

These changes would result in a major simplification of bills for consumers and enable them to see how what they pay relates to the costs of generation and transmission. Tariffs could be designed to look like short-term mortgage products with consumers paying a spread over wholesale prices, with added features such as fixed or capped price offers for certain periods.

The next government needs to act to reduce the distorting effect of energy policy on the markets – retail price caps are unlikely to work and will make a failing market perform even worse.