Hot on the heels of widespread annoyance over energy suppliers’ mythical profits, comes a new report from the Centre for Policy Studies saying that the price cap is stifling energy market competition and costing consumers money. In fact, this is just the latest in a long line of studies showing that price caps reduce competition and consumer choice. The authors say that over the past two years, almost all tariffs have been priced at or just below the cap level, and while the latest data do not cover July (when the Energy Price Guarantee expired), there is little evidence this pattern is being broken. A few fixed price deals have emerged, but primarily for existing rather than new customers, and generally priced within 1% of the cap level.

“The [price cap] has now well and truly become something it was never intended to be. It has gone from being a temporary policy aimed at protecting a particular segment of customers to a system in which the Government sets the market price which almost everyone pays, with little end in sight. And a policy originally intended and justified as a bridge to stronger competition has ended up contributing to its destruction,”
– Dillon Smith, Researcher for Energy and Environment Policy at the Centre for Policy Studies

The cap has been praised for keeping costs down for consumers, and being transparent although neither is really true. It is unclear if consumers have genuinely benefitted since they have been burdened with more than a £ billion in Supplier of Last Resort costs as a result of the high levels of supplier failures caused by Ofgem’s disastrous administration of the cap. It is also not particularly transparent since Ofgem is constantly tinkering with the calculation methodology and introducing elements consumers find difficult to understand such as the Market Stabilisation Charge and the SVT cost recovery allowance. It was also never the intention for the cap to insulate consumers from fundamental cost increases resulting from energy itself being more expensive.

We were warned about the impact on competition prior to the introduction of the cap

When the cap was first mooted back in 2017, the then Centrica CEO, Iain Conn told the 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,”
– Iain Conn, then CEO of Centrica speaking in 2017

Of course, as the boss of British Gas, he was easily dismissed – just as turkeys are unlikely to vote for Christmas, so too, energy suppliers were deemed unlikely to want a price cap. And the cap has been bad for British Gas, as my recent post on their profits showed, the company’s domestic supply margins have been roughly in line with the 1.9% allowed under the cap since its launch, a very poor level of profitability compared with British industry more broadly.

Price caps are difficult to implement, and tend to create unintended consequences. The GB price cap was directly responsible for half of the country’s suppliers going out of business in the latter part of 2021. The cap is also responsible for the recent “bumper profits” suppliers are earning as they are allowed to recover costs they were unable to pass through back in 2021/22 – of course, this only applies to those suppliers that managed to survive the impacts of the cap at the time. From October, Ofgem is increasing the EBIT allowance by 0.5% to 2.4% in part to provide suppliers with a larger financial cushion in case of future market volatility.

Study after study has shown that price caps are blunt tools that often fail to meet their objectives. In 2019, this paper from the Universities of Warwick and Exeter found that the GB cap was “inadequate to meet the stated aims”, and said that the Government’s assumption that the retail market was broken was false, and that the cap was likely to “achieve the exact opposite of the stated aim of increasing competition and will in fact stifle competition in the energy market”. The paper is worth reading as it sets out the reasons for discounting the assumption that the energy market was broken and required a radical fix such as a price cap, although I disagree with the authors’ proposed alternative approach (see below).

The Adam Smith Institute has been consistently against the price cap since it was first proposed, pointing out that it would be detrimental to investment:

“Profits incentivise investment; if you cap prices to curb profits you discourage new investment. There’s an added cost for suppliers too – uncertainty. Firms lack perfect foresight. They make investments knowing that there might be big downsides if energy prices collapsed for instance but also bigger profits if energy costs increase. If you cap the upside but don’t cap the downside, otherwise viable investments will be cut.”

It later suggested the Big Six, as it then was, should be forced to divest 10% of their customers much as National Power and Powergen had to divest power stations in the early days of privatisation, as an alternative means of boosting competition.

Back in 2016, economists Paul Simshauser and Patrick Whish-Wilson compared two retail electricity markets in Australia: Southeast Queensland, which had a regulated price cap, and Victoria which was fully deregulated. At the time, there were two incumbents and eight rival retailers in SE Queensland with tariffs bunched around the price cap with small discounts creating price differentials of around 8%. In Victoria there was a greater degree of competition (three incumbents and 17 rivals) and price differentials were significantly larger, up to 30%.

“…theory predicts and empirical evidence confirms that regulatory efforts to cherry-pick differential prices in asymmetric markets will damage consumer welfare,”
– Simshauser and Whish-Wilson

In SE Queensland, 46% of customers stayed on the more expensive capped tariff with 22% moving to slightly cheaper deals offering mid-level discounts, while no consumers had access to high-level discounts. However, in Victoria only 11% of customers stayed on high cost standing offers with 45% accessing high-level discounts, and pricing being set at marginal cost (zero mark-up) for many.

When the Queensland cap was lowered in 2012, just over 45% of consumers were on the standing offer, and just under 40% received mid-level discounts, with the remainder receiving low-level discounts. By 2015 the proportion accessing medium-level discounts had almost halved, while the proportion on standing offers remained stable. In contrast, Victoria saw the proportion of consumers on standing offers almost halve over the same period as the proportion benefitting from high-level discounts increased rapidly.

In other words, the price cap in Queensland limited consumer choice and removed the availability of the cheapest tariffs. It also led to increased levels of consumer inertia, as postulated in the Warwick/Exeter paper, which noted that the presence of the price cap itself might dis-incentivise switching since consumers may assume they are now being protected by the regulator and that the regulated SVT will be the fairest and “best” tariff, removing the rationale for considering alternatives.

This leads to an interesting question: do policy-makers think wide price differentiation is a good thing in a market seen as being commoditised? There is a natural assumption that in a commoditised market, pricing becomes a zero sum game – where some consumers can “win” by accessing cheaper tariffs, others will have to “lose” by paying more to fund those better deals. It is easy to see how the press would take hold of such narratives, as well as complaining about “postcode lotteries” in pricing (although regional differences exist under the cap anyway).

Deregulation allows the market to discover what works for consumers. Prior to Ofgem’s non-discrimination and “simple tariffs” rules which were designed to reduce price differentiation, some suppliers had experimented with tariffs with no standing charges for example. With the advent of flexible energy assets in the home, such as heat pumps and electric cars, tariffs designed to capture that flexibility are starting to emerge. These could potentially go much further with the supplier optimising assets on behalf of the householder, or bundling appliances with the supply contract in a similar way to the way handset costs are often bundled with call/data offers in the telecoms sector.

Different types of offers would have an inherently different costs to serve, reducing the likelihood of the market actually being zero-sum. Ofgem’s interventions (including restrictions on door-step selling) significantly reduced consumer engagement because it naturally removed much of the benefit of engaging.

Ofgem’s administration of the cap has been poor

In the original version of the price cap legislation (the Domestic Gas and Electricity (Tariff Cap) Act 2018), Section 7 explained that the cap would remain in place until “conditions are in place for effective competition for domestic supply contracts” – ie there was no explicit objective to protect vulnerable consumers or the fuel poor.

The Act requires Ofgem to implement the default tariff price cap with regard to the following statutory objectives:

  • 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 holders of supply licences to compete effectively for domestic supply contracts;
  • the need to maintain incentives for domestic customers to switch to different domestic supply contracts; and
  • the need to ensure that holders of supply licences who operate efficiently are able to finance activities authorised by the licence.

A fifth condition was added in 2022:

  • the need to set the cap at a level that takes account of the impact of the cap on public spending.

Ofgem has made it clear that it considers these objectives to be optional, and for much of the time the cap has been set at a level that fails to meet most of them. In Ofgem’s defence, it’s difficult to see how any cap could “maintain incentives” for switching, since it is inherent in the nature of the cap that it will reduce incentives to switch, and once the cap became the cheapest tariff in the market – something the new objective makes more likely – the incentive to switch is removed altogether.

Ofgem has introduced other measures that actively discourage switching, in particular the Market Stabilisation Charge which requires a supplier that gains a customer through switching to reimburse the previous supplier. This measure was necessary, since the capped default tariff became the cheapest rate in the market, meaning most customers want to be on it, but there is no guarantee they will stay on it or with the supplier. That means suppliers take significant volume risk when hedging themselves, since they can never be sure how many customers will remain with them/ on the SVT. Since the cap is relatively prescriptive in terms of the hedging suppliers are expected to do, an “efficient” supplier would be expected to hedge in line with the cap formula, and could therefore lose money if the customer left.

Ofgem is now so concerned about supplier failures – and a large reason so many failed in 2021 was due to hedging mis-matches – its entire regulatory focus has shifted towards reducing the chances of supplier distress. It justifies this approach on the basis that supplier failures impose significant costs on consumers through various mutualisation schemes and the reimbursement of credit balances in the Supplier of Last Resort process.

As with previous regulatory interventions, the price cap is reducing consumer choice, reducing consumer engagement, and reducing the availability of genuinely competitive tariffs. None of this is a surprise, but what is surprising and disappointing is that Ofgem has failed, publicly at least, to deliver this message to Government. While it has joined calls for a social tariff, it has failed to point out that the statutory objectives of the cap are contradictory and the cap is unlikely to deliver its original objective of ensuring competition under any circumstances.

Dealing with the loyalty penalty

A key motivator for the price cap was the concern that consumers that did not switch either supplier or tariff were penalised. This concern is not unique to energy markets, it applies in a variety of sectors, and in some, the Government has been motivated to act. While in the energy sector, a price cap was chosen, in the insurance market, the Government opted for rules that force providers to offer existing customers rates that are no less attractive than those offered to new customers.

This is an approach that could be applied just as well to the energy market. Regulations could set out the communications that must be made with consumers as their contracts expire, setting out the alternatives open to them, for example listing the available tariffs it has available and informing the customer that other suppliers will likely offer different tariffs which they may wish to consider, and linking to information on the Ofgem website regarding price comparison sites.

In fact, this approach has already been tested: in 2017 Ofgem reported on a three year trial in which consumers (other than the control group) were sent letters about alternative tariffs either by Ofgem or by their supplier to see what impact the provision of information had on switching rates. It found a clear increase in switching when consumers were informed of their choices, with a higher degree of switching when contacted by the supplier than by the regulator.

It is now widely accepted that the focus on switching rates as the sole determining factor in assessing whether the energy market was genuinely competitive was flawed. This should actually be pretty obvious – some consumers might value other aspects of the supplier offering more highly than price, such as good customer service or not being regularly pestered for to install a smart meter. The Warwick/Exeter paper cited above shows that back in 2017, switching levels in the energy sector were comparable with mobile phone switching rates and double that in the banking market for current accounts, although one notable difference is that in mobile phone and banking products the customer has engaged with the market at least once to set up the deal, whereas this is not necessarily the case in the energy market where you can inherit an existing tariff when moving house.

However, I disagree with their overall conclusion that the market would be improved if suppliers were not allowed to move consumers to the SVT after the expiry of their contract, but maintained the contract terms on a rolling 30-day basis as is the case for mobile phone contracts, or were allowed to terminate the contract altogether. This would make it difficult for suppliers to manage price risk, while cancellation of supply contracts would likely lead to inadvertent dis-connections as consumers fail to select a new tariff.

The authors believe this would force consumers to engage with the market, while placing the primary risk of renewals on the supplier, but it would make that risk un-acceptably high – the cost to serve for an energy contract is significantly more volatile than for a mobile phone contract where there is no requirement for providers to buy minutes or data in a wholesale market and re-sell them.

What kind of supply market do policy-makers and the public actually want?

Policy-makers appear to want consumer choice, but on such narrow terms as to be practically impossible to deliver. They want to see engagement, but consistently remove incentives for consumers to engage. They want competition and tariff differentiation, but are worried that this will result in some consumers over-paying. They want to protect “vulnerable” consumers without having a clear understanding of what is meant by “vulnerability”. And they want to see innovation yet have created a low margin, highly regulated environment that is likely to stifle investment and the development of new business models.

They also seem to expect policy initiatives to have almost instant results – many of the mis-conceptions about the retail market being uncompetitive in the mid-2010s were a symptom of market change happening slowly and organically rather than reflecting a fundamental lack of competitiveness. This was explained clearly by Stephen Littlechild in this paper. In fact some regulatory interventions actively slowed the development of competition in the market, un-intentionally favouring the status quo and legacy suppliers.

Small numbers of tariffs clustered around the price cap are not a sign of a vibrant market and will not encourage consumer engagement (what is the point of taking time to think about tariffs when there is so little to choose between them?) but a wide range of tariffs means some may be significantly higher than others, which might imply some people are being ripped off.

However, in a properly deregulated market, suppliers would be free to experiment with different types of differentiation…some consumers might be happy to pay a premium for guaranteed service levels such as a dedicated customer service team much like in the private banking sector. Others might want the cheapest possible rate and be willing to pay extra for customer service on a pay-as-you-go basis in the same way that some software subscriptions work (or you get x number of free calls to the service desk per year). Other (ill informed) consumers might be persuaded to pay a premium for “green” energy.

“Despite recent reductions in the price cap, households are still facing bills that are well above historic levels. This has raised questions about the cap’s purpose, its efficacy in safeguarding consumers, and its impact on tariff competition. In light of this, it becomes crucial to explore alternative measures that can better protect consumers, promote fair competition, and ensure affordable and transparent energy pricing for all,”
– Craig Lowrey, principal consultant at Cornwall Insight

Capping the amount suppliers can charge dis-engaged consumers further reduces their incentives to engage, creating a self-fulfilling prophesy and a degree of moral hazard – to what extent should consumers be expected to take some responsibility for themselves? In a free market not affected by cartel-like behaviours, suppliers that are genuinely over-charging should lose market share. The argument that some consumers are unable or unwilling to switch is not a sufficient justification for forcing all consumers to accept higher prices – if people are unwilling to pursue their own best interests why should others do it for them? Of course, the exception is for people who are genuinely unable for whatever reason to do this, but here targeted approaches would be more appropriate.

This might seem harsh, but it is a view shared by consumer champion Martin Lewis who told the BEIS Select Committee in March last year:

“I would prefer to see, in normal times – and I do stress that – us defining who are legitimate victims of the market. If I or you choose not to switch, hard luck. You should know better. If a struggling 90-year-old grandmother who has dementia chooses not to switch, she needs much greater protection than the price cap currently affords…”
– Martin Lewis of Money Saving Expert

Suppliers and Ofgem already collect data on dis-engaged consumers (ie those who have not switched in three years or more) so it is possible to identify who these people are, and whether they are vulnerable or simply lazy (the latter not being in need of regulatory protection). Many of these concerns could be removed through the introduction of a social tariff – under such a scheme, vulnerable consumers would likely qualify for some level of social tariff, and therefore the issues of switching would be moot – yes they could switch supplier to receive better customer service, but if service levels are regulated, which they are, the existing service level should be acceptable – not everyone needs to receive the “best” level of service, particularly if they are not able to articulate what that means to them (in the sense that different people value different aspects of the service offer).

The other problem policy-makers and the regulator have is that they have allowed a narrative to develop that it is wrong for energy companies to make “excess” profits and the understanding of “excess” appears to be anything more than a minimal amount. In a fully deregulated market (for tariffs) some suppliers would earn high profits…the key word here being “earn”. Those profits would be the result of providing services that are valued by their customers, encourage new customers to join and few to leave. It is not profits or tariffs that need to be regulated, but service levels. There are rightly restrictions on customer disconnection and moving consumers to pre-payment meters. There are also minimum service levels around accuracy of billing, answering customer queries and complaints and levels of customer satisfaction.

If Ofgem adopted the FCA Principles, suppliers would be required to communicate with consumers in a clear, non-misleading way, and treat them fairly, and specific licence conditions could be introduced around the communication on expiry of fixed term deals as described above. Indeed, this could be expanded to require suppliers to write to all customers at least once a year describing the available deals and the potential benefits of switching.

Market reform is overdue

Most people agree that the retail energy market is not working. Unfortunately, policy-makers seem stuck in a rut of unrealistic expectations, unable to manage public sentiment in a world of high costs. We need radical reform and for policy-makers to articulate clearly what they expect from the market. In doing so, they are more likely to realise the trade-offs inherent in market design, and identify how they should be prioritised.

This will enable a more rational market design that will be more likely to meet the needs of consumers, but it will require an acceptance of both higher supplier profits and a wider range of tariffs. Rules to ensure equity at renewal should prevent the exploitation of vulnerable consumers, so tariff variation will reflect difference in the cost to serve for different customer offerings, rather than being a zero sum game where dis-engaged consumers subsidise those who are more pro-active. Genuinely vulnerable consumers can be protected with a social tariff structure.

Alternatively, if policy-makers want a homogonous environment with low tariff differentiation and consumers to pay for and receive the same service, then they should simply re-nationalise the industry. What we have now is quasi-nationalised, where the Government, via the regulator is essentially setting prices and thereby defining business models – profits are uniformly low, and innovation is lacking.

The status quo pleases no-one…it’s time for the Government to decide what it really wants – a vibrant, competitive market offering genuine consumer choice, or a return to a nationalised industry with no choice, no differentiation, and no perceived lack of “fairness”. Either way it’s time for change.

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