Retail Energy Markets: Does Competition offer enough Protection?

From the Autumn 2012 Research Bulletin, by Catherine Waddams, Professor in Regulation

This article examines some of the issues facing the UK energy regulator as it attempts both to promote competition and ensure that vulnerable households are not disadvantaged in the process. Some of the remedies introduced after the 2008 Energy Supply Probe, including the non discrimination clauses, have proved to be less effective than hoped, and in some cases to have been counterproductive and to have slowed the competitive process. Both regulator and government have to choose in this highly sensitive household energy sector whether to focus on the competitive process, which is likely to lower average prices and encourage innovation, but cannot guarantee particular outcomes for given consumers; or on regulation which can protect vulnerable groups, but probably at the expense of higher prices for consumers as a whole.

In 2008 the British energy regulator, Ofgem, commenced what has proved to be a difficult path of intervention in the retail energy markets. A decade after the markets had been opened to entrants, and six years after the last price caps had been removed, their Energy Supply Probe indicated that competition was not working in the way many wished. In particular, while switching rates were high compared to many other products, a group of ‘sticky’ consumers had stayed with the incumbent (previous monopolist) supplier in each area. This combined with the regional nature of the market (14 regions in England, Wales and Scotland) enabled the consolidated descendants of these incumbents (each previously monopolist in two or three regions) to charge more to the sticky customers in their home regions than to those they were trying to lure away from other incumbents elsewhere. While some saw this as a fundamental dynamic of the competitive process, others were concerned that the sticky customers were being exploited, that a disproportionate number of them were disadvantaged or vulnerable customers, and that the market displayed characteristics of co-ordinated effects between the ‘Big 6’ players (the consolidated electricity incumbents and the gas incumbent, British Gas) who together supplied 99% of the residential market.

Ofgem’s 2008 Energy Supply Probe[1] introduced a number of measures to help consumers to be more active in the market, and to address the market power of the vertically integrated big players, who were able to use the retail market to hedge against the volatility of the wholesale energy markets, which proved a major obstacle for new entrants. On the tariff front, the Probe established that electricity companies had been charging around 10% higher mark-ups in areas where they were incumbent (mainly to consumers who had never switched supplier) than in other areas where they were discounting to attract consumers away from other incumbents. Ofgem proposed a non discrimination clause to prevent such differentials in mark-ups. Unfortunately, as three academics (including CCP[2]) pointed out at the time, this could have a chilling effect on competition. After representations from the companies, Ofgem introduced the clauses in mid 2009, with a three year ‘sunset clause’, but allowed special temporary deals for marketing purposes. They clearly hoped that by forcing the prices charged in and out of area closer together, companies would reduce the higher prices being paid by the inactive customers. 

Such non discrimination clauses are not necessarily anti competitive, but in a paper published in The Economic Journal in July, Morten Hviid and Catherine Waddams[3] showed that it would indeed hamper competition in the particular circumstances of the energy market. Each of the big 5 has the majority of its customers and profits in its home areas. If it has to bring prices closer together, it will lose more profits by lowering these in area prices, than if it raises its prices in other areas, even though such price rises will mean they recruit fewer new customers. And each company knows that all the others are in the same situation. Since the only other major player, Centrica, the gas incumbent, pursues a national policy, each electricity company will profit most by focusing on its own ‘sticky’ consumers, rather than lowering their prices in order to compete strongly elsewhere. Ironically the ability to make special offers to lure customers may make things worse. Such offers had to be for a limited period of time, and at the end of the offer customers would revert to the (higher) standard offers, sometimes without realising this. Thus the exception might prove a ‘bait and switch’ trap for unwary customers, including the very vulnerable consumers who the regulator wanted to protect.

Subsequent events provide support for the economic model’s predictions. Standard prices did indeed come closer together, reducing the potential gains from switching to a new supplier, and, unsurprisingly, switching has fallen dramatically. CCP’s switching research[4] confirms that the biggest influence on switching rates (in energy and other markets) is potential savings, so if these decline, so will switching rates. Of course prices are not the only influence, and the withdrawal from door step selling by the Big 6 in 2010 is also a likely factor.  The graph below illustrates how both available benefits from switching (the blue line) and the amount of switching (the red line) have fallen since the non discrimination clauses were first mooted in 2008 in one region. Switching and available offers show a significant positive relationship, though this pattern is not so obvious in every region. But nationally, switching rates have fallen dramatically for both electricity and gas, by over half between its height in mid 2008, just before price differences started to decline,  and the most recent figures for the second quarter of 2012[5]: hardly the stimulation of the market which Ofgem had hoped for. Company profits have also increased since 2008, suggesting that companies have indeed raised their lower prices rather than reduced their higher prices[6].   

 

But what of the special offers? These have increased dramatically in number, introducing confusion rather than stimulating switching. Concerned by this development, the regulator published its Retail Market Review[7] at the end of last year. This proposed a series of remedies to enable consumers to make better choices between tariffs, including a standing charge determined by the regulator for all suppliers, to help consumers choose more easily between different offers. The related consultation elicited many responses[8], including several challenging the wisdom and effectiveness of such drastic intervention in a supposedly deregulated market. Ofgem paused both to consider the issues raised and to seek further evidence on the likely consequences of the proposed remedies, and have promised to outline their next steps ‘before the winter’[9]: their proposals for next steps should be known by the time this article is published. Meanwhile the non discrimination clauses were due to lapse in summer 2012; Ofgem initially proposing to ‘roll them over’ while the retail market review continued, but responded to evidence[10] that they may have had harmful effects by allowing them to lapse, and continue to monitor price differentials informally.

The question facing the regulator is whether it should continue to encourage competition in the retail energy market, or ensure the protection of vulnerable consumers. For while competition usually lowers the average level of prices in a market, there is no guarantee that it will lower every price, so that each consumer benefits equally. And by its nature, competition offers incentives and rewards to those who are active in seeking out better deals, who are not necessarily the most vulnerable or needy. Moreover a fundamental characteristic of competitive markets is the choice of whether or not to participate. Consumers can be helped, but not forced, to take part and seek out better deals for themselves. And insights from behavioural economics show that many consumers do not choose the best deal for themselves[11], and providing more information may deter rather than stimulate activity. Competitive markets cannot be manipulated to deliver benefits to particular groups of people without distorting the competitive process itself, as the non discrimination clauses demonstrate.

But these market  characteristics are strongly challenged publicly, in the media  and politically, resulting in proposals to  ‘manage’ these markets, amidst a feeling that the companies are ‘ripping off’ consumers and that the vulnerable are not benefiting from the competitive process. If companies are indeed abusing their market power, either singly or collectively, the remedy is through a competition investigation. Vulnerable consumers could be protected by regulation, though this would probably involve higher prices across the market because of the inefficiencies of any regulatory process. The final judgement, in the UK with its long experience of deregulated markets, and elsewhere where competition is just beginning, must lie with governments. They cannot eat their cake and have it, enjoying the benefits both of competition and protection; in making the choice, they would do well to recall that the road to hell is paved with good intentions.

 


[3] Non-Discrimination Clauses in the Retail Energy Sector by Morten Hviid and Catherine Waddams Price, http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0297.2012.02537.x/abstract

[4] Effective empowerment: Empirical estimates of consumer switching behaviour , by Catherine Waddams Price and Catherine Webster, forthcoming CCP research paper Ref to forthcoming paper with CWe

[5] Available from the Department of Energy and Climate Change at http://www.decc.gov.uk/en/content/cms/statistics/energy_stats/prices/prices.aspx#domestic

[11] See Do consumers switch to the best supplier? By Chris M Wilson and Catherine Waddams Price, Oxf. Econ. Pap. (2010)62(4):647668 for some evidence on consumer errors

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