Are the electricity price increases justified?

Energy Futures Network: Paper 22

Dieter Helm

15th February 2017

Following from the almost complete victory of the energy companies over the CMA (apart from Martin Cave’s dissenting position), and the subsequent political delays in translating the PM’s comments at the Conservative Party conference about the problems in the energy markets into meaningful actions, the companies can be forgiven for thinking that they now have an open goal in front of them. Lots of words about “JAMS” and “broken markets” have as far amounted to little more than political rhetoric. It is precisely these JAMS who are most affected. The shots at goal from some of the companies are coming thick and fast, with 10% price increases for electricity being the aspiration for the most aggressive.

Nothing in the promised Green paper from the Treasury has frightened the companies away from pushing thorough the increases. Growls from OFGEM look just that – growls. The failure of the small independent GB Power late last year, and the desperate lobbying to support the price increases from the entrants who want even bigger margins to aim at, have been successful.

This is the opportunity, and it has been taken by several of the companies. But two questions won’t go away. Are the price increases justified? And: If the answer is “no”, then what should be done?

Are the price increases justified?

It is tempting - and convenient for the companies – to say that we have very little idea. Electricity bills should be simple, and it should be obvious what costs have increased. Yet they are opaque, and following the CMA’s decision to encourage tariffs proliferation, it is probably going to get even more opaque.

Electricity is an homogenous product. All electricity is the same. The costs comprise three main parts. First there are the fixed elements: the fixed capacity and feed-in-tariff contracts, and fixed grid and distribution charges. Second, there are the variable wholesale prices; and third there are the costs of doing the supplying, such as billing and metering and debt collection. In a competitive market, where prices tend to harmonise since rivals eliminate arbitrage opportunities and customers switch around, the price should converge on these fixed costs (which are completely outside the control of the companies), the wholesale price, and a similar margin. It really is pretty simple.

So ask yourself the following question: have you any idea from your electricity bill how it relates to these three separate elements? Do you know how much you are paying for fixed feed-in-tariffs, fixed capacity contracts, fixed grid charges and use-of-system, and fixed distribution charges? Do you know what is the part played by the wholesale price and in particular how your price relates to this cost? Do you know what the margin is?

Given the host of fixed costs which your supplier can do nothing about, there are actually only two bits which matter in considering whether the price increases are justified – the wholesale costs and the margin.

Let’s start with the wholesale bit. It is true that the wholesale cost has gone up. But from what base? The wholesale price was going down for over three years – very substantially. No one cut the Standard Variable Tariff (SVT) bills as a result. So now it is going up from a lower wholesale price base, why are prices rising? The answer in a competitive market is that the price should have been falling for three years and then it should go up. That is not what happened. Why?

That is the question the CMA was supposed to address. One answer given by the companies is that their wholesale costs are determined through hedging and forward purchasing strategies. Thus, their wholesale costs are not the wholesale spot price. But in a competitive market this would not matter. Companies can hedge as much as they like, but prices would revert to the mean, and someone trading only spot would always have been able to undercut SVT. But they didn’t over the three falling price years. Why? Because the Big 6 had market power – lots of it. Indeed the CMA at one stage thought this amounted to around £1.4 billion excess charging. 60-70% customers did not switch.

How could this be the case? The companies did offer lower prices, but only to switchers. They used the captured customers on the SVT to cross subsidise low prices to switchers. It is argued that this is what happens in other comparable markets. But this is disingenuous: if other markets are competitive the result of offering lower prices is that all prices tend to harmonise around the actual costs of providing the service. The SVT did not: on the contrary the gap between the SVT and the wholesale price got (a lot) wider.

In other markets, the resulting costs may not matter too much. But in electricity they do. It is an essential infrastructure, it has a USO, and the fact is that people do not switch at anything like the level necessary to get a competitive outcome. Nor are they likely to do so. It is this combination of features that makes the end result politically toxic.

The companies could use the “Schumpeter defence”. He argued that monopoly was a good thing in that it produced the excess profits that attracted entrants into the market in a process of creative destruction. That is indeed why the entrants like the price hikes. But tell that to the PM’s JAMs: why should they pay by being exploited in order to encourage the others?

Is 10% justified?

A further question to ask is why 10% is the right answer, even if there is a case for increasing prices. Wholesale prices have not suddenly gone up 10%, and neither have the fixed costs that are passed through to customers. Whatever the right answer is, it is very unlikely to be 10%. The “right” price is the competitive price and the competitive price is the wholesale price plus the fixed costs plus the margin that reflects the cost of bills and debt collection. Interestingly no company offers this tariff.

What should be done?

The level of trust in energy companies is rock bottom, and this is what is to be expected from a decade when several companies were miss-selling, being fined, giving poor customer service, and were failing to treat the loyal customers fairly, and in particular to lower prices to these loyal customers when costs were falling. If customers are exploited when wholesale costs are falling why would anyone trust them when they are rising?

The options facing the government are pretty simple. Option one is to trust in switching, to pray that if exploitation carries on eventually all the loyal customers will switch, and therefore to encourage switching through database sharing and giving exemptions to entrants from some of the fixed costs as a subsidy to entrants. Option two is to put in place a fair default tariff now.

Option one is unlikely to work. Why? Because there are big economies of scale in customer bases. Supply is naturally oligopolistic. It is true that these economies of scale might bring in even bigger players who try to multiple sell through the household broadband hub. But this will take time, the suppliers control the meters, and in the meantime the loyal customers get exploited.

Option two is the answer a competitive market would deliver, and it is a tariff that the companies should in any event be offering. It is the wholesale price (as an index) plus the fixed costs plus an unregulated margin. The only proviso is that the suppliers publish their margins. This tariff is set out in my paper on The CMA Market Investigation: Companies 5-0 CMA? (http://www.dieterhelm.co.uk/energy/energy/the-cma-energy-market-investigation-companies-5-0-cma/) Helm, 2016.

But cry the Big 6, if this tariff was offered, loyal customers would not switch. If this is true, it gives away their position. For if it is bad to offer a fair and reasonable tariff, it is not only a confusion of means and ends, but it argues that there must be monopoly profit. This tariff offers reasonable profits to the supplier – and they can set the margin. Anyone coming in with lower costs based on innovative ways of selling electricity can go lower. Is this monopoly position really what we want from the electricity market?

Action now

The government has a choice. It can continue down option one, and reap the consequences. As households get squeezed by inflation, by rising interest rates and rising utility bills, the energy pips are going to carry on squeaking. The electricity price increases are not going to go away, and the companies have few incentive to go after fair prices. They have not done for the past three or so years, so why should they do this now? They have not offered the default tariff above to anyone, even if it is the outcome of a competitive market, open to being undercut and allows the companies to compete on margins (which reward the costs they actually control). Instead they continue to milk the SVT.

What the government should do is implement option two now, and recognise that the CMA has made a poor job of its analysis of the market. Or, to be precise, the majority made a mess of this. Martin Cave did not. He recognised that the detriment was far to great to be allowed to stand, and far to great for the bulk of customers to be solved by the limited protection offered in the penalty tariffs to the pre-payment meter customers (inadequate though this is). What Martin Cave worried about is coming to pass. It may get worse. Governments can act now, sort the problem and then get onto other more pressing energy policy matters. But they can be pretty certain that if they don’t act, the problem will haunt them all the way to the next General Election and beyond.