Where is the ‘smoking gun’ on energy market failures?

George Anstey and Matthew Mair take a look at Ofgem’s proposal to refer the energy industry to the Competition and Markets Authority. and find that the evidence is far from clear-cut.

Since the launch of the Energy Supply Probe in 2008, Ofgem (and policymakers more generally) have shown an increasing scepticism about competition in the British energy market, with repeated investigation and regulatory intervention.  On 27 March 2014, Ofgem launched a consultation on referring the energy market to the CMA for an independent and full-scale market inquiry.[1]

As we have written elsewhere, the evidence of a direct competition problem in the sector is limited, with no obvious “smoking gun”.[2]  Much of the focus of the most recent investigation (as well as those that preceded it) has been on the structure of the industry and, in particular, the position of the big six.  Profits in the supply segment of the big six have been rising over the last few years.  Pre-tax margins on domestic energy sales were around 0.9 % in 2009, and rose to 4.3% in 2012, averaging 2.7% over the period.  Profits have been even lower over the longer term – Ofgem reported in 2011 that profit margins were 1.6% between 2005 and 2010.[3]  These profit levels are below Ofgem’s own benchmarks for the profits of supply business of between three and nine per cent.  (Despite accusations that companies are squirrelling away profits in their generation segments, Ofgem, the OFT and the CMA’s most recent analysis suggests that “the generation sector is covering its cost of capital but no more.”)[4]

If the evidence for lack of competition in the sector is unclear, similar doubts pervade the authorities’ claims about the features of the market that lead to the allegedly anticompetitive outcome. Much of the purported evidence is as consistent with the presence of competition as with its absence.

The State of the Market Assessment (SMA) highlights Ofgem’s concern about “market segmentation” – the observation that customers who remain with their incumbent supplier are less likely to switch than customers who are with an entrant supplier in their area, and pay higher prices as a result. However, differential pricing is to be expected in competitive markets with switching costs, where entrants have to offer lower prices than incumbents in order to obtain market share.   In any case, the fact that particular customers do not switch does not demonstrate that the prices they pay are not being constrained by competing suppliers, merely that the price differentials are insufficient to induce switching. Evidence from consumer surveys suggests that over half the customers who had never switched said it was because they were happy with their existing supplier.[5]

Moreover, some of the evidence presented is either misleading or simply inconclusive.  For instance, the SMA emphasises the role that the vertically-integrated structure of the industry has in increasing barriers to entry by reducing liquidity on the wholesale market.  While they may be vertically integrated, in practice the big six have large imbalances between the volumes of electricity they buy and sell, creating a need to trade in a liquid wholesale market.

In one respect, however, the latest investigation represents a significant step forward in the debate over the level of competition in the energy sector: recognising that regulation itself is part of the problem.  The SMA argues that the burden of regulation keeps small suppliers out, and exemptions from regulations for small suppliers discourage entrants from growing.  As Ofgem, the OFT and the CMA acknowledge, the problem goes deeper than that:

“In addition to the regulatory barriers to entry, the industry is affected by a high degree of policy change, political and media scrutiny, and negative publicity.  As part of our assessment, we spoke to a number of firms that had previously considered entering the retail energy market.  A consistent reason for not entering was the political environment surrounding the energy market and uncertainties surrounding the future course of policy.”[6]

While a two year inquiry may do little to resolve “uncertainties surrounding the future course of policy”, if the inquiry validates the initial finding that regulation is part of the problem then it could mark the beginning of the end for ever stricter regulation and a return to competition in British energy markets.

[1]        Ofgem (2014), Consultation on a proposal to make a market investigation reference in respect of the supply and acquisition of energy in Great Britain, 27 March 2014.

[2]        See for instance, NERA (2014), Energy Market Insights: Tantalus and Other Myths of the British Energy Market, March 2014, page 3.

[3]        Ofgem (2011), The Retail Market Review – Findings and initial proposals, Supplementary Appendices, ref: 34/11, 21 March 2011, page 40.

[4]        Ofgem, OFT, CMA (2014), State of the Market Assessment, 27 March 2014, page 120, paragraph 6.79.

[5]        Ofgem, OFT, CMA (2014), page 14, paragraph 1.38

[6]        Ofgem, OFT, CMA (2014), page 13, paragraph 1.35.

Authors: George Anstey is a senior sonsultant at NERA Economic Consulting, where he works on energy and competition issues.  Matthew Mair is an analyst at NERA, where he works on wholesale and retail energy market issues.

This article is taken from the May issue of New Power

Also in this issue:

In this issue:

State Aid: direction is clear, details are not

Interconnectors ‘could save consumers £1 billion

Shale gas plays and political flashpoints

Will marine renewables reach 100MW?

No guarantees on ‘learning effects’

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1 comment for “Where is the ‘smoking gun’ on energy market failures?

  1. September 8, 2014 at 2:36 PM

    I’ll preface what I’m going to say with the following – I’m a power engineer with an MBA that specialised in International Taxation. Most of the players in UK energy markets are generators and retailers with HQ, not-based in the UK. Although the article was not intended to amuse this part had me laughing out loud:

    “Despite accusations that companies are squirrelling away profits in their generation segments, Ofgem, the OFT and the CMA’s most recent analysis suggests that “the generation sector is covering its cost of capital but no more.”

    Transfer pricing and its variants require the services of forensic accountants to uncover. I rather doubt that the UK’s (non)regulator and the other acronyms were either able to access for example, EdF’s UK accounts or were able to deploy said forensics – so of course all would look in order – after all that’s what auditors are for – to make sure the i’s are dotted t’s crossed etc.

    In the case of “barriers to entry” it is a pity the authors did not mention the cost of acquiring an electricity license (£500k++?) this deters smaller suppliers quite apart from the cost of acquiring customers (we know we waste 50% of the marketing budget we just don’t know which 50% etc). At least in Germany the stadtwerke to some extent have the muscle to keep the usual suspects honest. There is no equivalent in the UK and no prospect of them.

    As far as the final para is concerned “a return to competition in British energy markets” – I assume this was where the writers uploaded their irony sub-routine? There never was “competition” in UK energy markets and given the actions on the UK’s (non)regulator there never will be.

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