Dec 08 2017

Competition and the UK retail energy market: Lessons for Australia?

The UK and Victoria pioneered retail competition in the energy sector. Internationally, it is working well for business customers. Yet in both places there is now talk of reimposing price controls for residential customers. Why is this and will it be good for these customers? I have been in Melbourne this last week to discuss what lessons we can learn from past experience.

Until 2008, the UK regulator Ofgem (the Office of Gas and Electricity Markets) repeatedly affirmed that the competitive market was developing well. Then suddenly it became concerned about “unfair price differentials”. The large incumbent retail suppliers were offering lower prices to attract customers outside their previous monopoly areas than the prices they charged their existing customers within their areas.

Ofgem imposed a non-discrimination condition to equalise these prices. But the retailers did not reduce their higher prices, they simply withdrew their lower prices. Ofgem observed that customer switching between suppliers fell, and supplier profits increased. It did not renew the non-discrimination condition.

Ofgem concluded that customers were not switching supplier because they were baffled by complex tariffs. So around 2012 it mandated Simple Tariffs. Retailers were not allowed to offer discounts and were limited to 4 tariffs each. But this did not help. In 2014 Ofgem asked the Competition and Markets Authority (CMA) to investigate.

In 2016 the CMA reported that Simple Tariffs had not increased switching but had reduced price competition, variety of tariffs and innovation. The CMA required Ofgem to withdraw the Simple Tariffs regime.

Why did Ofgem adopt measures that were ultimately against the interests of customers? The sudden doubling of domestic energy prices in the mid-2000s was  a real problem for many customers. Ofgem was under great pressure to Do Something.

Although the media widely blamed the retailers, this was not a failure of retail competition. The real cause was the increase in world fuel prices. If anything, retail profits were on average negative over the preceding three years.

The CMA concluded that “Ofgem’s inability to address concerns about profitability … led to Ofgem interventions that had an adverse effect on competition”. It recommended that the retailers routinely provide Ofgem with more information to assess profitability.

Thus, among the lessons we can learn is the importance of not responding to public pressures about energy prices without serious examination of what is determining these prices.

Increases in retail prices might reflect excess retailer profits and a failure of competition. Alternatively, they might reflect fuel cost or network cost increases, or lack of wholesale competition, or vertical integration problems, or increases in government-mandated social and environmental costs, etc. The remedy should reflect the nature of the problem. It should not be hurriedly concluded that retail competition is not working.

Similarly, although there may be public concern about tariff complexity, or different prices for what seem similar products, this does not mean that competition is not working. Retailers look for innovations – like free energy at off-peak hours or days - that will be more attractive to potential customers. They offer price reductions to attract new customers where they could not afford to reduce prices for all customers. Blanket regulatory restrictions on such marketing variations could make some or all customers worse off.

The possible reintroduction of price controls – or in Victoria the possible obligation to provide basic service at a regulated price – is a serious measure. It seems to respond to serious political concerns. But these measures have not been justified by well-founded demonstrations that the retail market is not competitive.

In the UK, for example, pressure for price control has been driven by the CMA’s finding that there was a customer detriment averaging £1.4bn per year over the period 2012-2015. However, this did not reflect excess profit. Rather, the CMA assumed that a purely hypothetical supplier operating at “an efficient scale” and  “in a steady state” and earning a “normal return” would charge prices that in aggregate would lower customers’ bills by £1.4bn.

The CMA admitted that “a large part of the detriment was likely due to inefficiency rather than excess profit”. But there are surely some inefficient firms in all competitive markets. And if these firms are consistently making losses – as two of the large UK retailers have been – this suggests that shareholders rather than customers are suffering.

As for excess profits, after adjusting for differences in risk, the average profit rate was about the same as in the large customer market, which is agreed to be competitive.

So, the political pressure for price control is driven by a £1.4bn figure that does not stand up to closer examination.

The CMA itself argued against widespread price controls. They would reduce customers’ incentives to engage and suppliers’ incentives to compete. This would “undermine the competitive process with potentially worse outcomes for customers in the long run”.

Instead, the CMA recommended measures to increase customer engagement. Ofgem has been trialling these, consulting with consumer organisations and others. Letters to customers from their own suppliers, or from Ofgem itself, have doubled or even tripled the switching rate of the less engaged customers, with consequent savings in energy bills. Ofgem is also implementing the CMA’s recommendation that retailers have regard to their customers’ ability to make informed choices.

Australian retailers have agreed similar measures with the Prime Minister. In both countries lower prices are being secured for vulnerable customers. And tailored advice and support could enable more customers to benefit from the offers available in the market.

In short, impulsive and heavy-handed responses to political pressures are not the answer. Government, regulators, the industry and consumer bodies can together develop measures to enhance rather than suppress the competitive market.

In a presentation on 29 November, Professor Stephen Littlechild outlined developments in the UK retail energy market and draws out potential learnings for Australia’s competitive retail electricity markets.

Watch the full presentation

View the accompanying PowerPoint slides

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