COLUMN-For UK utilities, Ofgem's bark may be worse than its bite: Kemp

Thu Mar 27, 2014 12:00pm EDT

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(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, March 27 (Reuters) - Britain's gas and electricity markets are characterised by high entry barriers, weak competition and possible tacit collusion among the six largest energy suppliers which helps keep prices and profits high, according to regulators.

"Suppliers are able to segment their customer base, and charge different groups of customers different prices for what is essentially the same product," the Office of Gas and Electricity Markets (Ofgem) complained in a scathing report on the state of competition in supplying residential and small business customers.

Ofgem found plenty of other things to be critical about in its first annual competition assessment, including the sharp rise in profits the Big Six are making from residential customers and the impact of vertical integration in reducing competition in the electricity market.

But the ability of the Big Six to charge different customers different prices for the same service, exploiting customer confusion and apathy to charge legacy customers higher prices than new ones, lies at the heart of its concerns about the way in which domestic gas and electricity markets are working.

THE DEVIL CUSTOMERS KNOW

More than 60 percent of customers cannot remember ever having switched supplier, and another 14-16 percent switched just once, according to Ofgem. The proportion switching in search of a better deal, never very high, has actually been falling since 2008.

As a result, more than a decade after switching was allowed, most customers have stuck with their incumbent supplier. Over 40 percent of gas customers are still being supplied by Centrica , the country's former gas monopoly, and 37 percent of electricity customers are still being supplied by the former monopoly electricity supplier in their region.

Customers who have stuck with their legacy supplier are typically paying more than those who have switched to another of the Big Six, and much more than if they had switched to one of the smaller, newer companies that have entered the market.

Customers who manage their account online, pay by direct debit, and fix the cost of their energy for 12-18 months at a time get a much better deal, according to the regulator.

Ofgem estimates customers could make annual savings of almost 100 pounds on average by switching from their incumbent supplier to another one of the Big Six, and almost 250 pounds by switching to the best online deal offered by one of the smaller suppliers.

DELIBERATELY CONFUSING PRICES

Britain's retail gas and electricity prices are not directly regulated. The market-based regime relies on customer switching to constrain the pricing power of suppliers. But Ofgem now doubts whether that constraint is effective.

Nearly all customers are aware of the possibility of switching (84 percent) yet few do. "Some customers feel there is no point ... either because there isn't any difference between suppliers to make switching worthwhile or say they have checked prices and believe they are on the best deal," Ofgem says.

"Many customers doubt that switching could lead to the kind of benefit (financial savings and/or improved customer service) that would justify their time and effort and the risk that things could go wrong," according to the regulator.

In 2012, the Big Six offered a choice of no fewer than 161 different plans. Most were so complicated that were hard to compare. The result was confusion rather than genuine choice.

"Consumers considered the (tariff) information available to be unclear, complicated and deliberately confusing," Ofgem says.

Even after switching, only seven in 10 customers who switched were fully confident they had made the right choice. Ofgem found evidence some customers actually switched to plans that were more expensive.

The number of tariffs has been radically simplified following Ofgem's Retail Market Review. But by now most customers have already given up.

The proportion of customers who do not trust their energy suppliers to be open and honest with them hit a new high of 43 percent in 2013.

PRICE DISCRIMINATION

Britain's utilities are not the only businesses to practice what is benignly called "market segmentation" or less benignly "price discrimination" among their customers.

Banks, mobile phone operators, insurance companies and a growing number of other businesses increasingly charge different prices to different customers for an identical service.

The aim is to attract new customers with lower prices without losing revenue by offering similar price reductions to existing customers.

Price discrimination conflicts with most people's sense of fairness. The concept that all customers should pay the same standard "list price" for the same service is deeply ingrained.

But from a marketing perspective, each customer should be charged a price that reflects their willingness to pay, subject to the cost of supplying them.

It is no accident that many businesses offer cheaper prices and better deals to new customers, while exploiting the inertia of existing users.

Fairness implies the most loyal and longstanding customers should get the best deals, but profit maximisation suggests customers who have revealed their stickiness are the easiest to exploit.

Some analysts have suggested gas and electricity suppliers should be required to offer a single price to all customers, similar to the list price charged at a filling station for gasoline.

The aim would be to promote transparent price competition among suppliers and force prices to converge on the lowest cost, eliminating excess profits.

But suppliers, and not just the Big Six, argue "petrol station pricing" would restrict their opportunity to innovate by offering new tariff plans - for example discounts for off-peak energy use.

Moreover, given how pervasive market segmentation is becoming in the modern economy, it is hard to see how regulators could justify banning it in gas and electricity while permitting it in other areas like banking and insurance, which also have utility-like characteristics.

EXCESS PROFITS QUESTION

Under market segmentation, sticky customers subsidise bills for those who are more flighty. If switching actually became much more widespread, or a uniform list price was strictly enforced, savings for the average customer would prove to be far less than the 100-250 pounds quoted by Ofgem, unless suppliers really are making substantial excess profits.

Yet it is far from clear that Britain's energy suppliers are making excess profits that could be squeezed. This is the part of the report where Ofgem is most tentative.

"Based on the available data, there are indications that suppliers may have had an opportunity to earn high profits, although further work is required to establish this conclusively," was as far as the regulator would go.

In fact, data on profitability paint a confusing picture. Overall profits reported by the Big Six have risen moderately from 3 billion pounds in 2009 to 3.7 billion pounds in 2012.

But while profits from supplying residential customers have soared from 233 million pounds to almost 1.2 billion pounds, the profitability of non-residential supply and generation has shrunk.

Margins on the retail supply of electricity have fallen while margins from supplying gas have surged over the same period.

Ofgem hints at evidence of cross-subsidisation between gas and electricity, residential and non-residential customers, and between generation and retail.

But identifying and quantifying, let alone unpicking, all those subsidies will prove immensely hard.

One option would be to return to a strict separation of retail from generation, forcing all generators to sell into an open market, and all retailers to buy from it.

But with regulators still uncertain about whether the Big Six are actually making any excess profits at all, the ultimate reduction in customer bills could turn out to be very small.

Some customers (mostly the legacy non-switchers) might see a small reduction in their bills, while others are likely to experience a rise (the most avid users of price comparison sites and internet billing).

Ofgem estimates suppliers made an average pre-tax margin of just 7 percent in March 2014 on the residential supply part of their business, the only one where profits have been consistently growing since 2009.

So unless the regulator can identify a large amount of excess profit in the generation business, something Ofgem has struggled to pinpoint so far, the scope for squeezing the average residential bill is not very big. (Editing by Pravin Char)

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