Utility Week

16 | 19TH - 25TH JANUARY 2018 | UTILITY WEEK Policy & Regulation Market view C onsumers get a good deal when sup- pliers must compete for their business. This idea has long been the foundation of UK government policy in the energy sec- tor. And an apparently competitive energy market has emerged. In 2006, there were ten suppliers of electricity and gas in the UK. Today there are more than 60. Nonetheless, the government is dis- satisfied with the results. Switching rates are lower than it would like, and prices are higher – especially standard variable tariffs. So it is going to cap the prices energy suppli- ers can charge. If competition cannot protect consumers, it reasons, the government must. However, the problem lies not in the idea that competition promotes consumer welfare so much as the government's understand- ing of competition in energy markets. Rather than capping prices, the government should be making it easier for energy suppliers to innovate, most notably, in linking prices to the time of energy use. Competition and innovation Competition benefits consumers in two ways. The first is price discipline. Suppliers can- not overprice because competitors will steal customers by offering lower prices. A market with many suppliers and low switching costs ought to provide this protection to consum- ers. And there is strong evidence that the UK energy market does, because energy supply margins are a mere 3 per cent on average. These low margins demonstrate that, while standard variable tariffs are high, the much better deals some customers enjoy are loss leaders. If all customers were on the cheapest tariffs, suppliers' margins would be negative. Price caps on high margin tar- iffs will force energy companies to increase prices elsewhere. Nor is the switching rate evidence that competition does not work. First, it is not obvious that the circa 15 per cent annual switching rate in the UK is low. It compares favourably with the 2 per cent switching rate in banking, for example. More importantly, a low switching rate may simply indicate a lack of differentiation between suppli- ers. Which brings us to the second way that competition benefits consumers: namely, by encouraging innovation. A company that can find a better or cheaper way of satisfying customers' prefer- ences will enjoy "super profits" until com- petitors catch up or surpass them with yet better innovations. The competitive impera- tive to "keep ahead of the pack" explains why consumers served by competing firms tend to enjoy consistently improving quality and value for money. Government interventions, such as price caps, which prevent companies from reaping the rewards of innovation, discourage them from investing. Over the long run, such inter- ventions make consumers worse off. This is especially true when progress is most likely to be made by innovations in pricing itself, as in the energy market. Energy suppliers act as a commercial hub in the system by allocating customer pay- ments to networks and generators. However, settlement on the basis of predefined cus- tomer types (profiles) means the true cost of using electricity at different times is not reflected. Lacking these price signals, cus- tomers have little incentive – or ability – to manage the times at which they use energy. The resulting lack of consumption-smooth- ing over time increases the required capacity of the system – and the cost of supply. If suppliers faced more cost-reflective price signals, they would pass them on to customers but not necessarily in the same way. Precisely how to link price and time of use would be another dimension on which suppliers would compete, better aligning propositions with customers' preferences. Cost-reflective pricing would also help the electricity system manage intermittent renewables at scale and support the busi- ness case for storage, further improving effi- ciency and reducing prices over the long run. Making prices better reflect costs would require regulatory reforms: most notably, the introduction of half-hourly settlement across all customer types and network usage prices that vary more sharply in line with usage across the day. Competition isn't broken The government's move towards capping energy prices is misconceived and risks stifling innovation, which ultimately is the only thing that will deliver for customers, says Andrew Perry. The signs so far are not promising. The introduction of half-hourly metering for smaller industrial and commercial sites was delayed by years. And, while Ofgem is looking into expanding this to small and medium-sized businesses and residential customers, progress will inevitably be slow. There are still no firm plans to follow the introduction of smart meters for residential properties (which will enable half-hourly metering) with changes to settlement. And there has been a retreat from cost- reflective network pricing due to fears of embedded benefits leading to a two-tier sys- tem. The introduction of a price cap, and the precedent it sets for moving away from mar- ket pricing, can only impede progress toward prices that accurately reflect demand and the cost of supply. Targeted protection Some argue that vulnerable customers could be the losers under a liberalised and more cost-reflective energy pricing regime, being potentially least able to shi their energy usage away from peak periods. These changes could also create complexity for customers, with many more moving parts to pricing and product definitions. However, these concerns create opportu- nities for retail energy suppliers to innovate. Successful firms will design propositions that are simple and compelling for custom- ers, seeking to differentiate themselves in a congested market. Such propositions are likely to include premium fixed-rate tariffs that protect customers from time-of-use risk, and services that help customers shi demand from peak times to reduce bills. Vulnerable customers who remain on higher priced products should be protected by the regulator and government. But protec- tion should be targeted at those in need. It should not be provided by across-the-board restrictions on pricing. Such interventions will only serve to stifle the kind of innovation that can genuinely reduce bills in the long term. Andrew Perry, Energy Practice senior consultant, Oliver Wyman

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