(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Oct 19 (Reuters) - Britain’s government has published draft legislation which would cap gas and electricity prices for most residential customers until the end of 2020, the most startling intervention since privatisation three decades ago.
The caps come after a review by the Competition and Markets Authority (CMA), which concluded in 2016 that retail gas and electricity markets were not working well for customers.
Residential energy prices have become a sensitive political issue after gas and electricity prices rose much faster than inflation (and incomes) since 2004.
Real electricity prices rose by 75 percent between 2004 and 2014, while real gas prices rose by 125 percent over the same period (“Energy market investigation”, CMA, 2016).
Six large energy firms dominate the supply of gas and electricity and supply almost 90 percent of domestic customers.
And a complicated system of tariffs has left residential customers paying wildly different amounts for essentially the same gas and electric supply.
The combination of rising prices, concentrated supply, and extensive price discrimination has created widespread concerns about profiteering and unfairness.
The CMA investigation and now the proposals for a price cap are intended to address some of those concerns in the short term, while hoping that structural reforms produce more competition in the longer term.
Wholesale fuel and generation costs account for 40-50 percent of residential gas and electricity bills, according to the CMA.
Transmission costs add another 25 percent, and retailing, including profit margin, accounts for around 20 percent.
Retailers must also meet a variety of environmental and social obligations, including support for renewables and discounts for vulnerable households, which add 15 percent to power bills and 5 percent to gas bills.
In the case of electricity, the main drivers for increasing bills have been increasing transmission and distribution charges and social and environmental obligations.
For gas, price increases were driven in roughly equal proportion by higher social and environmental obligations, network costs, wholesale prices and other indirect costs.
Much of Britain’s gas and electricity transmission and distribution systems were built five decades ago and now require expensive upgrades, which is a major driver of higher bills.
But the government has also chosen to pursue a range of social and environmental objectives by loading the cost onto bills rather than taxpayers.
Like any intervention, the cost of social and environmental obligations was initially low but has risen over time and is now testing the limits of bill payers’ acceptance.
The bigger problem comes from the widespread price discrimination practiced by gas and electricity suppliers which has left households paying widely varying amounts for the same service.
“There is a wide variation in the prices that different domestic customers pay for energy, which is particularly striking since electricity and gas are entirely homogenous products”, the CMA observed.
Some customers are paying 20-25 percent more than others for an identical service, according to CMA’s calculations.
Gas and electricity retailers have employed various forms of price discrimination over the last 15 years, some of which have subsequently been banned by regulators.
The current system mostly involves offering fixed-price, fixed-term tariffs at a steep discount, while the bulk of customers remain on, or default back to, a higher “standard variable rate” tariff.
Discounted fixed-price fixed-term contracts are designed to attract new business, or prevent defections, while the standard variable rate tariffs exploit customer inertia.
In effect, standard variable rate customers are cross-subsidising cheaper tariffs for customers on fixed-price fixed-term contracts.
“Several of the six large energy firms told us that there is an inter-relationship between their pricing of standard variable tariffs and non-standard products,” the CMA noted.
“In setting the price of a cheap non-standard product, they told us they assume that a certain proportion of customers will revert to the standard variable tariff (for which there is a bigger margin) at the end of the product’s fixed term.”
“They have argued that is only because this happen that they can offer the cheapest of their non-standard products.”
Price discrimination is common in the supply of many goods and especially services, although it is often carefully disguised, as it clashes with entrenched notions of “fairness”.
The various strategies for charging different customers different prices for essentially similar products with similar cost of supply are long-established (“Characteristics and types of price discrimination”, Machlup, 1955).
The problem in gas and electricity is that the services are so nearly identical and tariffs diverge so much the entire charging system has become discredited.
“We have observed that there are significant disparities in the tariffs charged by the six large energy firms that cannot be fully explained in terms of cost,” the CMA found.
“Our view is that the six large energy firms enjoy a position of unilateral market power over their inactive customer base and have the ability to exploit such a position through pricing their standard variable tariffs materially above a level that can be justified by cost differences from their non-standard tariffs.”
The critical question is whether gas and electricity suppliers should be prohibited from practicing price discrimination and required to charge the same tariff to all their customers.
But the CMA investigation and the government’s response have ducked this question and instead opted for a price cap that would try to limit the amount of discrimination without banning it altogether.
The fundamental idea behind Britain’s deregulated retail electricity and gas markets is that engaged customers will shop around the for best deal.
The resulting switching between one energy supplier and another will bear down on prices and improve service quality for everyone.
The problem is that few customers actually want to engage with the market in this way and energy suppliers have become adept at discriminating between switchers and non-switchers.
A two-tier market has emerged, according to the government, in which a minority of switchers benefit from competitive tariffs, while the majority of non-switchers remain on poorer value tariffs.
Policymakers have been trying to increase the volume of switching for a decade but without much apparent success, as the CMA itself noted.
According to the authority, the last major review of energy markets was launched in 2010 “with the stated purpose to promote customer engagement in energy markets in order to improve the competitive constraint provided by customer switching”.
But as the CMA notes “the evidence we have on the impact is not particularly encouraging. There are few if any signs that customer engagement is improving materially.”
“Those who were disengaged before [the review] appear to remain so,” it concluded pessimistically.
Unfortunately, the CMA’s investigation and the government’s price cap appear to be repeating the same mistake.
The CMA investigation recommended a transitional price cap for some particularly disadvantaged customer groups and even more intensive exhortations on other customers to switch suppliers.
The CMA price cap was intended to be simply a transitional measure until the introduction of smart meters towards the end of the decade and more switching promote greater competition.
The transitional price cap for particularly disadvantaged customers on prepayment meters came into force in April.
The government’s draft bill would extend capping to all customers on standard variable or default tariffs (“Draft domestic gas and electricity (tariff cap) bill”, Command Paper 9516, Oct 2017).
The experience of other heavily regulated industries, with a small number of dominant suppliers, and extensive price discrimination, including banking and insurance, is not encouraging.
Britain’s retail gas and electricity suppliers are drinking in the last chance saloon, with politicians’ and customers’ patience wearing very thin.
If there is no improvement over three years of the transitional price cap, it may be time to consider more radical measures, including a ban on price discrimination altogether. (Editing by David Evans)