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Utility Week 20th October 2017

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12 | 20TH - 26TH OCTOBER 2017 | UTILITY WEEK Policy & Regulation Market view P rime minister Theresa May is backing legislation that she claims will fix a "broken" energy market that now "rips off " British consumers. While in the short term millions will see an annual reduc- tion in their energy charges, it will lead to a restructuring of the UK retail energy market, a significant strain on a number of large and small energy suppliers – with around £1 bil- lion wiped off revenues – and ironically, less choice for customers in the future. The recent announcements from the gov- ernment in support of caps and an effort to control market prices indicate a policy shi away from market choice and customer switching towards more regulation and direct intervention. The government's new approach to pric- ing of power contracts seems driven in part by the historic apathy of UK energy custom- ers: only 15 per cent of households regularly compare prices and switch suppliers. This apathy tends to undermine the ability of competition to bring down prices over time. Thus, the only way to force down rates is by legislating for lower ones. The price cap on the standard variable tariff (SVT) will lead to an overhaul of energy pricing – including the elimination of some of the discount deals suppliers have used to lure customers from rival power companies. In fact, some fixed-contract prices could rise as suppliers look for ways to offset lower profits from the cap. More significantly, it may even reduce the number of competitors in the market. Some large suppliers were already confronting losses – both EDF Energy and Npower were in the red in 2016 – and would see even fur- ther erosion following the imposition of a cap. Smaller would-be competitors may also struggle as they find it more difficult to grow because customer switching is curtailed by the narrower range in pricing that is apt to develop – and further customer apathy may be created by the cap. Indeed, for the 15 million households that Ofgem estimates are on the SVT and not already protected by "vulnerability" caps, capping could initially be good news. Although no mechanism has yet been defined for the cap, these customers would save about £100 per year if the new cap replicates earlier limits for customers on prepayment meters. While the proposed cap would not take effect until at least 2018, it should result in a significant reshaping of the market and by our calculations as much as a £1 billion drop in power company profits – based on today's pricing. While the overall cap may take some time to implement, Ofgem will be extending existing price caps to an additional one million vulnerable customers this winter – a move that is likely to cost suppliers around £120 million in the short term. By constraining prices in the market, this series of caps will give a competitive advan- tage to suppliers with low operational costs, which can eke out profits even in low-pricing environments. They will be able to con- tinue to offer price options below the caps because of the flexibility provided by rela- tively low expenses. For some smaller power suppliers, the only option may be consolidat- ing to increase scale and provide capital for investment in digital systems that can reduce customer service costs. It's possible that suppliers will simplify the tariffs structure, resorting to an option of a single tariff. This approach has previously been taken by Bulb, which implemented the Vari-Fair tariff, and Octopus Energy, which started the wholesale market tracker tariff. The quest will be to find competitive advantage, and some suppliers will offer new services in the form of bundled offer- ings that include managed services such as energy efficiency, home generation and stor- age, and connected home services. Retail energy businesses have been under pressure for years from declining consumption and squeezed margins, so the cap will acceler- ate efforts by suppliers to differentiate them- selves and generate more revenue by going beyond energy supply. In fact the cap could have the benefit of accelerating the push for the development of the connected home. Among the big six suppliers it will be necessary to fundamentally redesign busi- ness models that have been heavily reliant on SVT revenues. The combined domestic supply profits of the big six were about £1 billion in 2016, but a cap of £961 (as esti- mated by Investec) would cost £1.5 billion (based on SVT levels at the end of 2016). Even a less severe cap of £1,000 would cost £900 million. That said, the big six do have some com- petitive advantages that will help them work through the change. For instance, their scale helps them to develop power and gas hedg- ing strategies to manage market fluctuations. This ability to hedge may become increas- ingly important for preserving margins, par- ticularly as the current preferred approach is an absolute (rather than wholesale energy price related) cap. Smaller suppliers will need to develop a clear strategy for growth and profitability, focusing on their unique selling points. For example, suppliers of "green tariffs" that are exempt from the cap will want to continue to develop their environmental credentials. The bottom line? The government has concluded that customer choice has not driven down prices as hoped, so it appears to be designing a more protectionist customer approach in which reduced choice seems to be the inevitable outcome. Keric Morris, energy partner, Oliver Wyman Price cap could curb choice Energy price capping could mean more than just lower energy bills for some consumers – it may lead to fewer suppliers and therefore reduced choice for customers, says Keric Morris. Key points Only 15 per cent of households regularly compare prices and switch suppliers. The proposed cap would not take effect until at least 2018. The combined domestic supply profits of the big six were about £1 billion in 2016. A cap of £961 (as estimated by Investec) would cost £1.5 billion (based on SVT levels at the end of 2016).

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