Price freezes and price caps won’t work: we need a competitive energy market
14 January 2015
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In September 2013, at a time when energy prices were increasing, opposition leader Ed Miliband made an eye-catching proposal: a two-year freeze on the retail prices of gas and electricity. Last weekend, at a time of falling wholesale energy prices, Mr Miliband made another price control proposal: that the government should legislate to permit Ofgem, the gas and electricity regulator, to force energy companies to cut retail prices when wholesale energy prices decline. The second proposal needs to be seen in the context of the first.
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’.
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’.
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Some additional aspects not covered by this article:
OFGEM is now prohibited by law from criticising the cost consequences of green energy policies (see Miliband’s 2010 Energy Act, which requires it to presume that green policy is always in the consumer interest). In practice OFGEM have interpreted this to mean that they should try to obfuscate green costs as much as possible.
OFGEM has long benchmarked the industry on a presumption of 18 months of forward hedging (a basis that helps greatly with obfuscating real costs):
https://www.ofgem.gov.uk/gas/retail-market/monitoring-data-and-statistics/understanding-energy-prices-great-britain/supply-market-indicator
Therefore any call to reduce prices in line with recent precipitate falls ignores the reality of the benchmark, which energy companies cluster to so that their costs are not out of line with it. In effect, OFGEM is already mandating price freezes as the norm: Miliband’s call simply extended that from 18 months forward in September 2013 (i.e. just before the election this year) by a further 21 months. Since a) it was possible that the government would jump on the bandwagon and call for a freeze then, and b) it looked very likely that Miliband would win the election, energy companies duly went out and bought additional longer term hedges at great expense, and now face losses on them. The extra demand in hedging markets forced prices to be higher than they otherwise would have been (and has exacerbated the subsequent fall, as the demand is no longer there).
Hedging can be expected to have a cost – especially where the market participants providing the hedges know that the demand for price insurance is effectively baked in by regulation. Miliband’s latest proposal for a price cap has a substantial cost. A ballpark estimate for a two year strip of price caps at the money is of the order of 10% premium to market prices. It is a scandal that he is allowed to suggest this without discussing the cost. He should be arraigned before the FCA for providing investment advice while not qualified to do so.
I agree that Miliband’s proposed price freeze is foolish but I believe that he proposed a 20 month freeze, not two years as this article states.
@HJ:
Miliband’s proposal was made in September 2013 for a freeze through until 2017. For energy companies, their fear was that Davy would jump on the bandwagon, so in effect the freeze has been since the announcement. In any event, as I point out above, energy companies are encouraged to freeze prices 18 months forward already by OFGEM’s benchmark. Even if you price it as a delayed start call option (which might be exercised were Labour to win in May) the cost is very significant and has to be paid by consumers – all thanks to Miliband’s unthinking mouth.
When the government interferes in markets, one effect is to add political uncertainty to market uncertainty. In several ‘developed’ countries there is currently a lack of confidence, which is not helping their economies. To add the prospect of arbitrary and unpredictable political intervention, very likely with undesirable consequences, may well reduce confidence still further. Having said that, one of the ‘problems’ in the UK energy market seems to be the approach of the end of the economic lives of several nuclear plants, with not much provision for their replacement in the near future, thanks to the LACK of government action by the last government, when Ed Miliband was Secretary of State for Energy.