Andrew Perry, senior consultant, Oliver Wyman’s energy practice Customers, Energy retail, Policy & regulation, Opinion, competition, competitive markets

Andrew Perry discusses what the goal of competition in the energy retail market should be, and how can it best be achieved.

Consumers get a good deal when suppliers must compete for their business. This idea has long been the foundation of UK government policy in the energy sector. And an apparently competitive energy market has emerged. In 2006, there were 10 suppliers of electricity and gas in the UK. Today there are more than 60.

But the government is dissatisfied with the results. Switching rates remain lower than they would like, and prices remain higher – especially standard variable tariffs. So they are introducing legal caps on the prices energy suppliers may charge customers. If competition cannot protect consumers, they reason, the government must step in to protect them.

But the problem lies not in the idea that competition promotes consumer welfare so much as the government’s understanding 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 cannot 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 consumers. And there is strong evidence that the UK energy market is no exception to this rule – this evidence being the low margins of the energy suppliers, which are 3% on average.

These low margins demonstrate that, while standard variable tariffs are high, the much better deals some customers enjoy are actually loss leaders. If all customers were on the cheapest current tariffs, suppliers’ margins would be not low but negative. Price caps on high margin tariffs will force energy companies to increase the price of their other deals, not only to make up the immediate lost revenue but because the long-run value of acquiring customers with loss leaders will be reduced.

Nor is the switching rate evidence that competition does not work. First, it isn’t obvious that the ~15% annual switching rate in the UK energy market is low. It compares favourably with the 2% switching rate in banking, for example. More importantly, a low switching rate may simply indicate a lack of differentiation between suppliers. 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’ preferences will enjoy “super profits” until competitors catch up or surpass them with yet better innovations. The competitive imperative 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, that prevent companies from reaping the rewards of innovation discourage them from investing in it. Over the long run, such interventions 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.

Cost signals

Energy suppliers act as a commercial hub in the system by allocating customer payments to networks and generators. However, settlement on the basis of pre-defined customer types (profiles) means that the true cost of using electricity at different times is not reflected to customers. Lacking these price signals, customers have little incentive – or even ability – to manage the times at which they use energy. The resulting lack of consumption smoothing over time increases the required capacity of the system and, hence, the cost of supply.

If suppliers faced more cost-reflective price signals, they would pass them onto 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 business case for storage, further improving efficiency and reducing prices over the long run.

Making prices better reflect costs will 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.

The signs so far are not promising. The introduction of half-hourly metering for smaller industrial and commercial sites (profile classes five to eight) was delayed by years. And, while Ofgem is looking into expanding this to SMEs and residential customers (profile classes one to four), 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 system. The introduction of a price cap, and the precedent it sets for moving away from market 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 shift 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 opportunities for retail energy suppliers to innovate. Successful firms will design propositions that are simple and compelling for customers, 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 shift demand from peak times to reduce overall bills.

Vulnerable customers who remain on higher priced products should be protected by the regulator and government. But protection 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.