The true cost of energy – how competition in the energy market affects energy bills
The cost of an average energy bill has risen dramatically in recent years: from £605 in 2004 to £1,060 in 2010. 2011 alone saw rises of up to 19 per cent which were a key factor behind the high inflation in that year and contributed to the squeeze in living standards faced by many families in the UK.
Perhaps it is therefore not so surprising that in a poll published in May more voters put action to reduce energy bills as the top priority for politicians than any other issue. While the summer provides something of a respite, as consumers use less energy for lighting and heating and therefore have lower bills, some suppliers have suggested that big increases in bills are likely towards the end of 2012, which will throw the price of energy firmly back into the spotlight.
In May this year IPPR published a major investigation into the price of energy. We used publicly available data to analyse how much it costs suppliers to provide electricity and gas to consumers and whether consumers are getting a good deal. We found evidence that competition is not fully effective in the energy supply market and that some consumers are losing out as a result.
Whether competition is effective in the energy market is not a new question – doubts are already widespread. This is mainly because the market is dominated by six companies (British Gas, EDF, E.ON, Scottish Power and SSE) whose origins are in the regulated companies that existed before the market was opened to competition. Their major interests in both generation and supply give them huge influence over the dynamics of the market. On the supply side, the fact that the so-called ‘Big Six’ provide energy to 99 per cent of all domestic consumers, that no new entrant has ever reached and sustained a significant scale and that the number of people who switch supplier each year is showing signs of long term decline are often taken as indicators that there are problems with competition. The evidence we have gathered gives additional reasons to doubt whether competition in the market is in good health.
Practice doesn’t make perfect
We found that in 2010 the least efficient of the Big Six spent 113%, or over £50, more on their operations per year for each customer than the most efficient. What’s more the difference between the most and least efficient was larger in 2010 than it was in 2007. In a market such as energy, where price is overwhelmingly what drives purchasing decisions, this runs counter to what market theory suggests should happen. If competition is working effectively we should expect suppliers to be engaged in a relentless pursuit of efficiency and cost savings, which, over time, would mean their operational efficiency converges. The reverse appears to have happened.
We found other evidence to suggest competition is not driving efficiency savings in the supply market as it should. The energy markets regulator, Ofgem, publishes regular estimates of energy companies’ costs and how these relate to the average energy bill. Ofgem’s evidence shows not only that there haven’t been efficiency savings in how much the Big Six spent on average on their operations per customer from 2007 to 2011, but also that their costs in fact increased in real terms. While some of this change is likely to be explained by the accounting methodology used by Ofgem, the pattern of rising rather than decreasing costs is notable. If competition is failing to drive the suppliers to improve their efficiency and pass these savings on in reduced bills then consumers are losing out.
Ofgem believes that competition is not fully effective in the supply market and has launched a major package of reforms, the Retail Market Review, aimed at improving competition. But the previous package of reforms, launched in 2008, failed to improve conditions and, according to Ofgem’s own research, conditions have actually deteriorated on some measures. UK consumers literally cannot afford these new reforms to go the same way.
Options for Ofgem
So what should Ofgem do? First, it should enforce its existing policy that suppliers must offer tariffs that reflect their costs.
This would ensure consumers pay a fair price for energy. Further, it should restrict the advantage gained by the Big Six through having retained large numbers of price-insensitive customers from the period before the market was liberalised: currently the Big Six can overcharge their less price-sensitive customers in order to offer heavy discounts to others; discounts which new entrants and smaller suppliers struggle to match, thereby reducing competition in the market.
IPPR analysed the tariffs offered by suppliers and found that several did not appear to be complying with the requirement on cost reflectivity. We found that some consumers, even where they used the same supplier, could be paying as much as £330 a year more than their neighbour for using the same amount of energy – a difference that cannot be accounted for by differences in the supplier’s costs.
Ofgem has launched an investigation into whether one of the suppliers, ScottishPower, is complying with the rules on cost reflectivity. But over a year later they have yet to provide any update on their progress. On the face of it, it looks like Ofgem needs to take a firmer approach to enforcement and act faster.
Alternatively, it may be that the policy is very hard to implement, in which case Ofgem should say so and look for alternatives. At the very least it should publish an update on why the ScottishPower investigation is taking so long.
Second, Ofgem should simplify the tariff offerings that are available in the market. This will encourage consumers to switch supplier more often and increase competition. However, it must do so in a way that retains flexibility for suppliers, allowing them to innovate with their tariff offerings. Ofgem has proposed to introduce a two-tier tariff system in which fixed term tariffs will be very lightly regulated and ongoing tariffs will be highly restricted. This is unlikely to reduce the complexity of the market for consumers and restricts the ability of suppliers to innovate with non-fixed term tariffs. A better solution is to introduce a cap on the number of tariffs a supplier can offer, covering both fixed term and ongoing types of tariff.
The shape of things to come?
There is also a new threat to competition in the supply market that Ofgem should be aware of.
The Government has published the Draft Energy Bill 2012 which proposes to introduce a set of feed-in tariffs with contracts for difference to bring forward investment in low carbon generation. These contracts are to be based on ‘obligations’ between generators and suppliers. The level of exposure that smaller suppliers are likely to face could result in a negative impact on their credit rating, which could increase their cost of capital. Without a strong balance sheet to stand behind, smaller suppliers may find the survival of their business at stake. Ofgem should immediately issue a fast-track consultation to assess the impacts the proposed arrangements will have.
The solutions presented here should help to improve competition in the supply market and improve outcomes for consumers. However it is not clear that ‘full’ competition is ever actually attainable. Whilst everyone needs to buy energy, it is quite simply an uninteresting consumer product. This means the market is never likely to see the levels of consumer engagement that occur with consumer electronics, for example, which will serve to limit competition. If outcomes for consumers are not improved through the competitive market then alternative structures should be considered, such as a return to price regulation. However, there are also wider priorities that must be factored in.
As currently conceived, energy supply is the last link in a value chain that begins with energy generation. This needs to be turned on its head. Demand reduction and management is likely to be the cheapest way of meeting our decarbonisation goals: every unit of energy not used is one less that needs to be generated, and less generation should mean the overall costs of the energy system is reduced and consumers pay less.
Energy efficiency is also the best way for consumers to directly reduce their energy usage. While energy companies make the bulk of their revenue from supplying energy, demand reduction and management will always struggle. We need to transform the market incentives so that energy saving and demand management receive the same priority as supply. This should have been the focus of Ofgem’s Retail Market Review.
Energy bills are high and are likely to remain so. Policy makers must do what they can to bring them down or, perhaps more realistically, limit increases. Ofgem is right to focus on improving competition in the supply market and the solutions laid out here will help it do so. But there also needs to be much wider consideration across Government of how we can reorient the energy market so that demand reduction and management are central.