Tuesday, March 21, 2017


Theresa May’s Conservatives have been rediscovering the virtues of a number of what were once familiar Labour themes, but perhaps their most surprising volte-face is the threat to impose price caps on at least some energy utility tariffs.  Populist interventions in what are supposed, in theory at least, to be competitive markets, are often bad news from a perspective of efficient markets and effective policy. And Ed Miliband and Labour were pilloried for this suggestion. On the other hand there is little evidence that the current UK retail market is working effectively, there is evidence that “captive” or “loyal” consumers get a bad deal, and consumers appear to be no happier with their utilities than in the “bad old days” of nationalised industry.

The real problem, at least in the electricity sector, is that there are a number of features of current market arrangements that are seriously dysfunctional. This is in large measure a reflection of “energy only” approaches to the construction of wholesale prices that are “baked in” to much of current thinking. Energy only wholesale prices, based around short run marginal costs, are incapable of rewarding investment. This has been a problem of the UK market since the NETA reforms in 2000, and has become an increasing problem for the rest of Europe. The UK government is now grappling with the resulting problems, including threats to supply security, through the mechanisms of capacity auctions, but these are aimed primarily at incentives for new capacity.

This is by no means a problem unique to the UK. It has been very evident for German companies in the power sector, and has had a number of adverse effects on their balance sheets, and may have damaged their ability to invest in new low carbon or indeed any form of generation, most notably in nuclear power (for RWE and EON).

The fundamental issue is that investors in infrastructure require the support of assurances over their long term revenue stream, support that had in the past normally been provided either by long term contractual or government commitment, or by the security of vertically integrated monopoly. To a significant degree the owners of conventional thermal generating plant lost that support, and found themselves in possession of stranded assets that find it increasingly hard to earn revenue in a world where marginal costs are often zero. Many of the companies anticipated the strategic problem many years ago and found at least a partial solution through vertical integration into the retail business, where market imperfections allowed them to recover some excess profit to compensate for the losses to which they were exposed in respect of their stranded assets.

The utilities, in this interpretation of events, can be viewed as both victims and villains. On the one hand older thermal plant constitutes an asset that has been stranded, at least partly through government policies for the power sector. As victims of this process, their attempt to recover lost ground through vertical integration was a necessary and logical response to that position. However this does imply that vertical integration confers an ability to exploit some form of market power, and is in some sense anti-competitive. The power that accrues to the supply companies comes through the inertia of their customers. That allows them to be portrayed as the villains.

As an illustration of this undue market power, we might contrast typical margins in retail supply with the view taken by previous regulatory bodies.  Prior to the introduction of retail competition, supply margins were generally assumed to be very low.  Thus a 1995 Monopolies and Mergers Commission Review held that 1.0% margin for Scottish hydro supply business was too high and set it at 0.5%.  Retail supply is not capital intensive and the “value added” is limited. In setting price controls in 1998, Offer and Ofgas considered a margin on sales of 1.5% would adequately take into account the increased risks from the introduction of competition.

In the “competitive” UK retail sector, margins have varied but have often been around 4%. Prima facie this looks like the extraction of extra revenue from the consumer for a function, supply, in which the retailer adds next to nothing in the way of extra value. If we add to this some of the extra costs of competing to do business (eg marketing costs) this does not look like good value for the consumer. Suppliers compete aggressively to maintain or gain market share, but a large number of consumers do not want the chore of perpetually searching for the best deal, and would prefer simply to get an uncomplicated service at a fair and reasonable price.

However it seems unlikely that imposition of a government price cap will resolve the deeper underlying issues of the power sector. What we really need is a more fundamental re-think of what we expect from retailers. My own view, expressed in more detail on another page, is that retail supply should be playing a much bigger role in shaping the future of the power sector, and that there are ways in which retail supply could become genuinely innovative and competitive.

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