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UTILITY Week 4th April 2014

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UTILITY WEEK | 4Th - 10Th AprIL 2014 | 15 Policy & Regulation Ofgem's market assessment (prepared with input from the Office of Fair Trading and the CMA) flagged up five areas for inspection: weak customer response; incumbency advantage; "possible tacit co-ordination" of prices; vertical integration and barriers to entry; and profitability. Let's take each of these in turn: 1. Weak customer response Switching rates and trust in energy companies have fallen in recent years, Ofgem finds. In 2012, 11 per cent of domestic gas customers and 12 per cent of electricity customers switched supplier, down from a peak of 19 and 20 per cent respectively in 2008. That is still more than double the rate in telecoms, for example. Ofcom figures show only 5 per cent of households switched phone provider in 2012. Ofgem tries to have it both ways on switching. On the one hand, it cites low switching as evidence of weak competi- tion. On the other, it has intervened to reduce both the opportunities for switching, by banning doorstep selling, and the value of doing so, by limiting the number of tariffs companies can offer. As for low trust, the regulator speculates this may prevent consumers engaging with the market. Whether that is true or not, there is no obvious fix. 2. Incumbency advantage The big six inherited customers from privatisation and retain a "disproportionately high" number of customers in their incumbent regions, says Ofgem. The "sticky" customers who have never switched supplier could on average save £100 by switching to the best deal on the market. Here again, there is a trade-off between allowing the price differentiation that encourages switching and protect- ing potentially vulnerable customers from overcharging. In the past, Ofgem has favoured the latter. In 2009, it banned energy companies from offering discounts to potential customers outside their incumbent area. Unfortunately, this led to an increase in "out-of-area" prices without lowering "in-area" prices. It is also worth noting here that energy secretary Ed Davey singled out British Gas for criticism in a letter to Ofgem last month. He drew attention to its particularly large share of the gas supply market and relatively high profit and prices in that part of the business. If the CMA agrees that is a problem, it could make British Gas sell off some gas accounts. 3. Possible tacit co-ordination Ofgem admits it did not find evidence of explicit collusion between suppliers, but says there may be "tacit co-ordina- tion". They follow similar strategies and raise prices by similar amounts at around the same time, Ofgem says. It also gives credence to the complaint that prices rise more quickly than they fall in response to changing costs. Tacit co-ordination does not breach competition law and would be weak grounds for a referral on its own. However, stripped of jargon, the idea that energy companies are all in cahoots has a fairly strong hold on the general public. What is more, if Labour wins the next election, it promises to set up a tough new regulator that will force energy companies to pass on cost reductions to customers. It makes sense to address the issue as part of the wider review. 4. Vertical integration and barriers to entry Aer a growth spurt in the past few months, independent suppliers now account for 5 per cent of the market. There are 18 companies offering dual fuel accounts. This is not plural enough for Ofgem, which says there are barriers prevent- ing new entrants posing "a disruptive competitive threat". The one that gets most airtime is vertical integration, which mainly applies to the electricity market. Between them, the big six own around 70 per cent of UK power generation capacity. That allows them to sell power to their own retail businesses without trading it on the open market. The upside of this is that it provides a financial hedge, reducing the risk associated with investment in generation assets. Lower risk means cheaper finance and that saving can be passed on to customers. The downside is it can make it harder for independent generators and suppliers to break into the market. Ofgem is attempting to address some of those difficulties with reforms to boost liquidity in the wholesale power market. It is not clear whether vertical integration is good or bad for the market overall. Ofgem says more detailed work is needed, but the benefits are not "clear cut" and the costs "could be significant". New entrants can also be held back by hey collateral requirements, complex regulation and poor liquidity, Ofgem found. Some would-be competitors have been put off by a hostile political climate. Even if they succeed on a small scale, independents face certain costly social and environmental obligations when they hit 250,000 accounts, discouraging expansion. 5. Profitability Ofgem notes the big six's supply and generation profits have risen from £3 billion in 2009 to £3.7 billion in 2012, with "no clear evidence" of increased efficiency. It questions the suppliers' contention that 5 per cent is a reasonable profit margin. In fact, for all but Centrica and SSE, that 5 per cent figure is an aspiration, rather than reality. There is a wide variation in supply margins between companies, with some making a loss. Again, the regulator admits the evidence is "not conclusive". Its comments on the subject are more of a nod to popular concern than a damning indictment. Talking points: Ofgem identifies five areas of concern A broken mArket? The CMA's independent investigation will examine a number of issues of concern 11% proportion of domestic gas customers that switched supplier in 2012 £100 Average annual saving for customers who have never switched energy supplier 70% proportion of UK power generation capacity owned by the big six £3.7bn big six supply and generation profits in 2012, up from £3bn in 2009 18 Number of independent suppliers that offer dual fuel accounts 12% proportion of domestic electricity customers that switched supplier in 2012 5% Independent suppliers' share of the market £2m+ Cost to the CMA of the inquiry into the energy industry tHe StorY bY nUmberS

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