Price freezes and price caps won’t work: we need a competitive energy market
Likely effects of an energy price freeze
A freeze anticipated
The likely consequences, mainly unintended, of the September 2013 proposal are analysed in a forthcoming IEA publication on energy price controls. Those consequences depend, inter alia, on the reaction of energy companies to a retail price freeze announced long in advance, even if it is never implemented. An anticipated freeze gives energy suppliers an incentive to begin the freeze at as high a base as possible and so a strong disincentive to reduce prices in the interim. One of the reasons Mr Miliband has been moved to make his second proposal may be that some of the undesirable consequences of his first proposal have already become apparent. Energy companies have clearly been reluctant to reduce retail prices in the recent past and those prices may well now be higher than they would have been had a freeze not been in prospect.
A freeze implemented
As for the effects of a freeze which is actually implemented, they would occur in a UK energy market where the environment is already not conducive to new investment. The coalition, following in the footsteps of Gordon Brown’s administration, has created a centralised, managed market in energy in which government is heavily involved in major investment decisions (such as the types of electricity generating plant that should be built) and in which Ofgem has been interfering in retail prices, ostensibly to promote “simplicity” and “fairness”. The actions of both government and Ofgem have, in practice, been price-increasing, suppressing competition and imposing high-cost energy sources on consumers. They have also created considerable political and regulatory uncertainty, leading to a reluctance to invest, particularly in electricity generation. A serious and damaging consequence of a freeze would be to add to existing uncertainty, raising the energy companies’ cost of capital, further dampening investment and reducing supply relative to demand. Consequently, it might well have a perverse effect, tipping a market where suppliers are already reluctant to invest into future shortages, leading eventually to higher not lower prices. Security of energy supply might also be compromised by the adverse effect on supply.
The effects of enforced price cuts
Mr Miliband’s second proposal would use Ofgem as its instrument, giving the energy regulator new powers to force suppliers to cut retail prices, apparently in line with falling wholesale prices.
Ofgem as an instrument of government policy
Using Ofgem as an instrument in an interventionist strategy is not a new idea. It has indeed been pursued by the present coalition (and the Brown administration before it). Fifteen years or so ago, Ofgem was a regulator largely independent of political control, dedicated to promoting competition in markets other than “natural monopolies” (gas and electricity networks). Unlike a traditional regulator, it avoided guessing at market outcomes and enforcing those it thought desirable: it accepted that such outcomes are unknowable in advance and should instead be allowed to emerge via a competitive process. However, regression to a centralised government energy policy has over time turned Ofgem into a creature of government. Its objectives have been changed, so that it no longer gives primacy to competition and it is constrained to bring about the government’s stated “energy strategy and policy”. The difference is startling. Instead of trying to establish competitive conditions, Ofgem has now reverted to more old-fashioned regulatory habits, such as intervening in supplier decisions about tariffs.
Problems in implementing coercive price cuts
Implementation of Mr Miliband’s price cutting proposal would take Ofgem much farther along the road to interventionist regulation, significantly augmenting its powers. How Ofgem would determine whether or not retail prices should be cut is not clear. It could, for example, be given intrusive powers to demand detailed information about a supplier’s wholesale energy costs and its other costs to determine whether or not its retail prices could be justified. Or there might be a more general price control which linked retail prices to some average of wholesale prices under a “pass-through” provision. Then there is the issue of what happens when wholesale prices rise again: can suppliers raise retail prices or must they seek permission from Ofgem, after it has checked their costs? A control that initially linked retail prices to declining wholesale prices and would not work satisfactorily might well gradually develop into more general cost-plus regulation, which has the well-known disadvantage of significantly blunting incentives to operate efficiently.
However the controls were operated, there would almost certainly be major practical difficulties and an element of arbitrariness which would lead to increased regulatory uncertainty. Moreover, the increase in Ofgem’s powers would inevitably increase the influence of government on the regulator. A government would find it hard to resist interfering as Ofgem applied the powers newly granted to it. Thus there would be greater centralisation of policy and added political uncertainty which would further dampen an already depressed incentive to invest in energy supply in the UK.
The underlying issue
However misguided the “solutions” they suggest, the underlying issue that Mr Miliband and his advisers are trying to address with their freeze and price cutting proposals is indeed a real one. UK energy consumers are not well served by the present state of the market. In the last few years, although world energy prices have been increasing until recently, the frequency with which retail prices have been raised by energy suppliers – clearly confident that their “competitors” would always follow – suggests that there is little effective competition in UK energy. At the turn of the century, the market was competitive to an extent it is not now and it was policed by a regulator intent on promoting and maintaining marketplace rivalry. For energy consumers, that kind of market is a much better model than a politicised market characterised by price freezes, coercive price cuts and other government manipulations. In the long run, the latter model can only lead to a centrally managed market, lacking in efficiency incentives and with restricted choice for consumers.
Colin Robinson is Emeritus Professor of Economics (University of Surrey) and former Editorial Director of the Institute of Economic Affairs. Prof Robinson is the author of the IEA Discussion Paper ‘From nationalisation to state control: the return of centralised energy planning’. He is also the author of a chapter on energy price caps in the forthcoming IEA monograph ‘Flaws and Ceilings’.