Price Caps Are the Wrong Solution for U.K. Energy
The shares of British utilities promptly lost billions after Prime Minister Theresa May announced plans to cap electricity and gas prices at the Conservatve Party conference. The draft bill, published Oct. 12, introduces a cap on “standard variable tariff,” the most common rate in the U.K. that covers 15 out of 27 million households. Unfortunately, customers are unlikely to gain from the move. Price caps are a cure for an illness that energy retail markets in the U.K. do not have; and they fail to solve the problem government policy should be addressing.
Since deregulating the sector in the late 1990s, electricity and gas retail prices in the U.K. have fallen and the quality of the service has substantially improved. A recent inquiry by the Competition and Markets Authority, Britain’s antitrust body, found that not all was working as it should. While there is no evidence of collusion among the largest suppliers, a significant share of residential customers fail to take advantage of the most convenient offers, leaving money on the table. Because of this, utilities can exercise what it called “unilateral market power” taking advantage of the (actual or perceived) high switching costs some consumers face to charge them rates higher than normal. The CMA also found that regulations that had been introduced with the aim of empowering consumers, resulted in the opposite: for example, the so-called “simpler choices” rules, under which suppliers were not allowed to offer more than four tariffs, were found to reduce the customers’ freedom of choice, while not leading to lower prices.
It finally suggested a “transitional safeguard tariff,” -- that is, a price cap -- on customers who use prepayment meters and face higher switching costs than other consumers. The mechanism was implemented by Ofgem, the country’s energy regulator, on April 1, 2017. While this latter measure may be questionable, its underlying assumption is that markets work, and that only a particularly vulnerable group of consumers deserve special protection.
Price caps assume that the problem originates with energy suppliers; but that is a misnomer in the U.K. case. One crucial finding of the CMA inquiry is that many customers could save significantly on their energy bills, if only they were more active in exploring alternatives. If customers are truly disengaged, as the CMA argues, a policy that nudges them into more activism could makes sense. But some of them may not switch simply because they are happy with their supplier, and attach a significant value to a long-term relationship. Either way, potential shortcomings in retail competition come from the demand side, not the supply side; hence any proposed policy should make customers more active, not suppliers less profitable.
It follows that the question the U.K. prime minister should ask to her experts is: Will a regulated price promote customer engagement? Acer -- the agency that coordinates EU energy regulators -- provides data on switching rates and potential savings for a sample of 23 EU member states. Of these, 13 had no price regulation, whereas 10 had either price regulation or some other form of price-setting intervention. In the electricity markets, the average switching rate in countries with no price regulation was 7.7 percent, vis-a-vis 5.9 percent in countries with price regulation. By the same token, the average (potential) saving was higher in countries with no regulation (113.5 euros per year) than in countries with regulated prices (85.3 euros per year). The U.K. stands well above the average, with a switching rate and a potential saving of, respectively, 12.2 percent and 206 euros per year.
There are at least three explanations for this. First, regulated tariffs tend to be perceived as safer (whether or not they are so) by customers. Second, especially when regulated tariffs are set below costs, competitors exit (or do not enter) the market, leading to negative consequences and lack of innovation in the long run. Third, regulated tariffs may work as a focal point and facilitate tacit collusion among the suppliers. And any of these could exist in combination. Price regulation does not improve competition, but is associated with lower customer engagement. That is exactly the opposite of what Britain needs.
To contact the editor responsible for this story:
Therese Raphael at firstname.lastname@example.org