In need of repair

Energy prices have been a subject of controversy for quite some time, entangled in wider concerns about living costs, and featuring prominently in the political debate in the run up to the May general election. The combination of rising gas and electricity prices, deterioration in the standards of service, and news of soaring profits in parts of the industry have stretched public trust in the market to breaking point. Last year, the Gas and Electricity Markets Authority (Ofgem) made a reference to the Competition and Markets Authority (CMA) for a full investigation into the energy market in Great Britain, “to clear the air” by considering “once and for all whether there are further barriers to effective competition”. This week the CMA published the provisional findings from this investigation. The results revealed a highly dysfunctional market, serious flaws in regulation and government policy, and damaging tensions between the two. It is not all about profits Contrary to popular belief, the increase in energy prices is not mainly related to increases in industry profits. CMA’s analysis indicated that, between 2009 and 2013, the main drivers of domestic price increases for electricity were the costs of social and environmental obligations and network costs. For gas, there has been a broadly even percentage increase in wholesale costs, network costs, obligation costs and indirect costs, with net profits increasing significantly after 2009. The CMA report highlighted a “lack of shared understanding of the factors that have led to price increases”, in particular the relative contribution of wholesale costs, network costs, policy costs and profit. It called for trusted and transparent information on the costs incurred, and the profits earned by energy companies, to help inform the public debate and policymaking, and to improve confidence in the regulatory system. The reporting systems of the six large energy firms were considered inadequate for this purpose. While industry profits are not the main driving force behind the rise in energy prices, they appear to have been a contributory factor. The CMA’s analysis suggests that suppliers “have the incentives and ability to raise prices above costs to a significant segment of their customer bases who are disengaged or only periodically engaged in retail energy markets”. In other words, suppliers have “unilateral market power” in relation to their inactive customer base, which they exploit through price discrimination − pricing standard variable tariffs (about 70% of their customers) significantly above (about 10% for electricity and 13% for gas) what they could achieve in a fully competitive market. Consumer behaviour is not helping Seen from a different angle, the CMA estimated that the average prices offered by the six large energy firms in 2009-13 were around 5% above the competitive level in the domestic segment, and around 14% in the SME segment. This would imply that domestic customers paid around £1.2 bn (and SME customers around £0.5 billion) more on an annual basis than would have been the case in a fully competitive market. The CMA argues that part of the problem is widespread consumer disengagement, which is “impeding the proper functioning of the market”. It quoted a survey that found that over 34% of respondents had never considered switching provider. It concluded that lack of awareness of what deals are available, confusing and inaccurate bills, and the real and perceived difficulties of changing suppliers all deter switching. The sector regulator Ofgem does not come out well in the picture The CMA concluded that the regulator has taken some decisions “that have not had the effect of promoting effective competition”, namely the decision “not to approve the introduction of locational charging of transmission losses; to prohibit regional price discrimination; and to ban complex tariffs”. It also raised concerns about the motivations underpinning the regulator’s decisions and, in particular, whether there is sufficient clarity over its role and the role of the Department of Energy and Climate Change (DECC) and whether some of the actions of the latter had forced Ofgem’s hand in ways that threatened its independence. DECC is also not spared in the CMA’s report Perhaps the most damning remarks are those related to the subsidy that DECC awarded to offshore wind projects through an administrative process (the so-called “Final Investment Decision enabling for Renewables” scheme − FIDeR). In comparison to the levels of subsidy awarded under a recent competitive auction, the CMA’s analysis indicates that the support cost under the FIDeR scheme was between 30% to 60% higher than the support cost of similar offshore wind projects awarded through competitive allocation a few months later. DECC’s decision to award a large proportion of the available “contract for difference” budget outside a competitive process (under the FIDeR scheme) might have resulted in an increase in costs for consumers of approximately £250– £310 million per year for 15 years, equivalent to a 1% increase in retail prices. These and other topics are part of a wider, ongoing debate about the quality of economic regulation in the UK. The Institute for Government, in partnership with the City of London Corporation, will contribute to this discussion through a series of events that will bring together key figures from the private and public sectors to discuss how far the structures and practices for economic regulation in the UK remain fit for purpose and what future reform might be needed. Watch out for more details.