Energy and Environment

Serious flaws in the CMA’s energy market investigation

On 17 March 2016 the Competition and Markets Authority (CMA) published its Provisional Decision on Remedies in its investigation of the energy market. The following is a summary of the concerns expressed by five former GB energy regulators (Stephen Littlechild, Sir Callum McCarthy, Eileen Marshall, Stephen Smith and Claire Spottiswoode). Their 11 April response to that consultation is available with other CMA publications and responses here.

1.         The investigation of the energy market by the Competition and Markets Authority (CMA) has found that the wholesale market is competitive and vertical integration is not a problem. Unfortunately, however, there still remain serious flaws in its analysis of the domestic retail market. These are associated with its concept of “weak customer response”, its calculations of excess charges and excess profits, its assumption about “efficient costs”, and its failure to analyse the full impact of previous regulatory interventions. These flaws lead the CMA to some inappropriate remedies. Moreover, this flawed analysis has serious implications for the future work of the CMA with respect to markets generally.

2.         The CMA finds that “weak customer response” constitutes an Adverse Effect on Competition (AEC). This is because many customers do not choose to switch tariffs or suppliers to reduce their energy bills. The CMA claims that savings available but not exploited by customers average £164 per year. But the CMA’s analysis overrules customer preferences and switching costs. It makes the unrealistic assumption that all customers would be happy to switch to online direct debit fixed-period tariffs. Realistic assumptions that respect customer preferences – for example, that assume switching supplier but not tariff type – yield much smaller savings available, averaging £65 per year. This is consistent with normal customer behaviour in a competitive market.

3.         In order to calculate the detriment associated with this “weak customer response”, the CMA proposes a “direct approach” and an “indirect approach”. The “direct approach” claims that the Six Large Energy Suppliers (SLEFs) have imposed excessive charges on customers averaging £1.7bn per year from 2012 to 2015, rising to £2.5bn in 2015. And yet aggregate SLEF profits amount to about £1bn per year, and the CMA calculates that “excess profits” average £241m per year. How the CMA reconciles these calculations is never satisfactorily explained.

4.         The CMA’s “direct approach” calculation is based on a dubious comparison between the prices charged by the SLEFs and the prices charged by two much smaller new entrants. This comparison ignores many relevant considerations. It is more than £1bn per year greater than the estimate yielded by the CMA’s alternative “indirect approach”, which is itself based on implausible assumptions. Neither approach yields a credible measure of customer detriment.

5.         The claim that the SLEFs have earned excessive profits of £241m per year over 2007 – 2014 is based on another dubious calculation. Instead of using their actual costs and capital employed, it uses lower costs and capital employed that it assumes to be needed by a hypothetical capital-light firm. Even thus inflated, excess profit of £241m per year amounts to less than £5 per year for each energy account, or less than 1 per cent of an average dual fuel bill of nearly £1200 per year.

6.         The CMA calculates that four of the SLEFs have inefficient indirect costs of up to £420m per year in total compared to the other two SLEFs. But cost differences are not a sign of market power in real competitive markets, which do not require three quarters of total output to be produced at the same level of cost. The Competition Commission never relied on such a contentious argument.

7.         The CMA finds that Ofgem’s various regulatory interventions since 2009 have had an Adverse Effect on Competition, primarily because they have limited the range of products available in the market, and limited innovation. This is a serious but justified finding. However, the CMA fails to consider the market-distorting effects of these interventions on customer engagement, price differentials and profits. Hence it underestimates the beneficial effects of removing them and overestimates the need for further remedies.

8.         As to proposed remedies, the CMA now accepts that its previously considered price cap on Standard Variable Tariffs (SVTs) would have serious adverse effects on competition and on customers. However, it now proposes a price cap on Prepayment Meter (PPM) tariffs, but does not explain why this would not have similar serious adverse effects. Nor does it consider the likelihood that suppliers would react by increasing prices to other customers. It does not attach weight to the overwhelming adverse financial impact on the one small supplier that has specialised in providing innovative service to PPM customers.

9.         The CMA proposes that suppliers should be required to hand over data concerning their “disengaged” customers so that other suppliers can approach them. It also proposes that suppliers, in designing their tariffs, should have a new obligation to have regard to the ability of customers to compare value for money. Such proposed obligations do not sufficiently take into account customer preferences, practical implications and lessons of recent regulatory history. Like the proposed price control, they run counter to the Government’s latest non-binding “Steer” to the CMA, which encourages the CMA to reduce unnecessary regulatory burdens on businesses.

10.        In response to concerns about mis-selling, Ofgem introduced some very severe conditions on direct marketing. The CMA’s failure to examine the adverse consequences of these means that it has not considered a remedy that could enable more and better engagement, including with Third Party Intermediaries (TPIs) and with vulnerable customers.

11.        The CMA’s analysis is thus seriously inaccurate and incomplete. It does not provide a proper understanding of the domestic retail energy market, nor a sound basis for further regulatory interventions. On the contrary, rather than seeking the most considered, responsible and defensible analysis of the market, the CMA seems to have sought out assumptions and interpretations to maximise the extent of customer detriment. This is not the stance taken by the former Competition Commission (CC), and will not increase trust in the CMA.

12.        If the CMA’s approach were applied to other markets, the potential for finding weak customer response and excessive prices, costs and profits would be enormous. The CMA’s energy market recipe is not to let the competitive market process work but to intervene to impose what it thinks would or should be the outcome if the market were “well-functioning” and if almost all competitors had “efficient costs”. The logic of this argument would imply intervention in every market where new entrants were challenging incumbents – that is, in every market that was not in or near a state of perfect competitive equilibrium. This does not seem a sensible direction for UK competition policy.

Member of the Advisory Council

Prof Stephen Littlechild is a Fellow in Privatisation, Regulation and Competition, at Cambridge Judge Business School, and Emeritus Professor at the University of Birmingham. He is a member of the  Academic Advisory Council at the Institute of Economic Affairs.

2 thoughts on “Serious flaws in the CMA’s energy market investigation”

  1. Posted 03/05/2016 at 14:28 | Permalink

    What a scandal that the (political)market for humility and common sense seems to have completely broken down in this area. Surely there needs to be an independent investigation, in competition with Littlechild et al.

  2. Posted 15/06/2016 at 12:47 | Permalink

    The CMA has again demonstrated a complete lack of basic understanding of consumer behaviour, and the energy markets. Measuring the effectiveness of a market purely on the number of people switching make no sense, but is easy for their economists to measure. Looking at past interventions by Ofgem, they have reduced market competition, not improved it.

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