Capping energy bills won’t kill competition
It’s now fairly clear that the Conservative manifesto will commit to capping energy bills.
There are mixed views on what precisely the cap will look like. But from the sound of briefings, the plan could be a full cap on the Standard Variable Tariff, the energy deal that two thirds of Britain’s households are on.
That would be a bold option, cutting bills by somewhere in the region of £100 for as many as 18 million households. As a result, there are now live debates about whether politicians are giving up on competition in the energy market.
This isn’t quite right because it is possible to cap energy bills without killing competition. To see why, it’s important to understand the problem policymakers are trying to solve.
Our latest analysis suggests consumers lose as much as £300 a year on poor value energy tariffs, the same as the estimate produced by the Competition and Markets Authority during its major investigation into the energy market. At the time of the CMA study, this amounted to consumers paying over the odds by a staggering £1.4 billion a year. And, of course, vulnerable households are more likely to be on poor value energy deals, so the effects are unfair as well as wasteful.
What exactly causes this problem? The simple answer is that the price of standard energy tariffs does not feel pressure from competition, even while other tariffs do.
This means it’s helpful to think of Britain’s energy market as not one market but as two markets that operate in different ways.
First, there is the part of the energy market that works moderately well, at least as far as prices are concerned. Let’s call this the Active Energy Market. This covers around a quarter to a third of customers who switch fairly regularly (27% of energy customers have switched in the last three years).
These engaged customers are seeing the benefits that were envisioned when competition was introduced to the energy market in the 1990s. They choose from over 50 energy suppliers, often using Price Comparison Websites to compare deals, and the price they pay tracks the cost of providing energy fairly closely.
Second, there is the other part of the energy market. Let’s call this the Passive Energy Market. It includes the 18 million households, around two thirds of all energy customers, who are still on a standard tariff with one of the big six energy suppliers. And, because nearly 80% of Britain’s elderly, disabled and low income households say they haven’t switched for three years, it includes the large majority of vulnerable households.
The problem isn’t just the comparative size of these two markets but that energy companies know, with a fair degree of accuracy, which customers fall into which group.
This means they can pursue two different pricing strategies for each market: compete fiercely for active customers with attractive deals and, at the same time, push up prices, often significantly, for passive customers.
And that’s precisely what’s happened to prices. The chart below, from the CMA study, shows the prices of competitive energy tariffs shaded in grey, so you can see the price of the most competitive tariffs at the base of the grey area. The price of these tariffs tracks energy costs quite closely (the blue line). This is what you’d expect from a competitive market.
Meanwhile, the price of standard energy tariffs, the green line, has stayed stubbornly high even when energy costs fell. And that’s why the gap between standard and competitive tariffs grew from £100 to around £300 between 2011 to 2015. This is a sure sign that the Passive Energy Market is broken.
Britain’s energy market: a tale of two prices
This all takes us to the question that confronts any government wanting to bring energy bills down: how can you fix the Passive Energy Market without breaking the Active Energy Market?
The response from opponents is that this is impossible. Their argument is that there is really only one energy market, so you cannot cap prices for some customers while expecting competition to thrive elsewhere.
This argument has dominated the debate for a long time. And that’s why, in the years since competition was introduced to Britain’s energy market, public policy has focused on one thing: trying everything imaginable to move people from the Inactive to the Active group. So far, that’s included: prompts on bills, simpler tariffs, more complex tariffs, fewer tariffs, more tariffs, more restrictions on price comparison websites, and fewer restrictions on price comparison websites, among other approaches. The CMA’s investigation recommended a series of further steps in this vein.
So while these efforts should continue, and the CMA’s recommendations are worth pursuing, you can see why patience has run thin.
Something can be done
This then takes us to the debate that will play out in coming weeks: the idea that any action to bring down energy bills will inevitably kill competition.
This is too fatalistic for several reasons.
For one thing, it would be possible to cap prices in a targeted way. For example, had politicians wanted to move more slowly, they could have started by proposing a cap on energy prices for people who are eligible for the Warm Home Discount. This is a group that includes low income households containing pensioners, disabled people or young children.
Taking this step would cut bills for an extra 2.6 million people, on top of the 4 million people who will already be helped by the price cap for prepay energy meters that was proposed by the CMA. It would also target those who are most in need and, because these households are highly unlikely to switch anyway, it would have little effect on the active part of the energy market.
But beyond this, there’s also reason to believe that even a full price cap on standard energy tariffs — the kind of step now being weighed up as a Conservative manifesto commitment — would not kill competition in the energy market.
This is partly because a sensible price cap would focus only on standard tariffs — in essence, it would put a ceiling on prices, to stop the most unreasonable exploitation of passive customers, without affecting the price floor, which would still be set by the competitive market. (This makes a price ‘cap’ very different from a price ‘freeze’, because the latter would constrain the price of all tariffs on the market, including competitive tariffs.)
Even so, some will still argue that a cap on standard energy tariffs will dilute competition. After all, cutting the price of standard tariffs would make switching to a competitive tariff less worthwhile, and this could reduce the number of active customers.
This argument has some merit, but it also has limits. For one thing, a price cap would not be set anywhere near as low as the best prices on the market, so switching away from a standard energy tariff would still be worthwhile.
But more than this, the evidence does not show a clear link between switching rates in the energy market and the savings you can make from switching. In fact, as the chart below shows, switching rates in Britain seem to be lower now than when energy price caps were in place around the turn of the century. And switching rates have fallen in recent years even as the savings from switching have risen.
Energy switching rates since the introduction of competition
So it’s not at all clear that there’s a simple choice between capping standard energy tariffs and allowing competition to function; you can limit the worst exploitation with a cap and still allow competition for active customers.
There’s one final argument to consider: wouldn’t a full-scale price cap threaten security of energy supply, causing blackouts?
This is doubtful for a few reasons. For one thing, a sensible price cap wouldn’t be absolute, it would track wholesale costs. This means any reduction in energy supply would push up wholesale prices, which would push up the price cap, which would encourage investment in supply. (This is another downside of a total ‘price freeze’, which would distort incentives more.)
It would also be important to set any price cap carefully; the goal is not to stop energy companies turning a profit. The goal is just to squeeze excess profits and encourage greater efficiency. In its investigation, for example, the CMA estimated that, of the £1.4bn consumers are overpaying for energy, around £650m is excess profit while the rest is lost to inefficiency. The goal of a price cap is to squeeze both these numbers down.
Finally, some will argue that a price cap will hit investor confidence by creating uncertainty. But what could be more destabilising than the political climate that has surrounded the UK energy market in recent years? This political attention is inevitable when a market is so broken. If anything, fixing this problem — if it’s done in a careful and well-implemented way — could make returns in the energy market more predictable.
This all helps to explain why, from the many examples of energy price caps around the world, there’s no clear evidence that well-implemented price caps threaten security of energy supply. And it adds to the case that something can be done to bring down energy bills, particularly for vulnerable customers, without breaking the wider energy market.
