This article was originally published in Energy Spectrum Issue 686 on 14 October 2019.
Ofgem published its State of the Market 2019 Report on 3 October, giving us a comprehensive overview of the retail and wholesale energy markets and much more besides. Now in its third year, the report sees Ofgem diligently following the Competition and Market Authority’s (CMA) 2016 recommendation to publish it.
In this Energy Perspective, we consider Ofgem’s views on the market expressed in the report and in Chair Professor Martin Cave’s launch speech to glean how the regulator may be thinking on issues including its new strategic priorities and the potential for removing the default tariff cap.
Roots and shoots
Ofgem was instructed to produce the report by the CMA so it would “better placed in the future to make decisions using relevant information on the revenues, costs and capital employed (and hence profitability) of the principal firms active in these markets.” The report would “provide Ofgem with information that will allow it to provide a clear and trusted assessment of the GB energy markets” and also help it in “preparing opinions on government’s draft policy proposals that are likely to have a material impact on GB energy markets”. This year Ofgem published its framework on the conditions for removing the default tariff cap on the same day as it launched the report.
In his speech Cave directly tied the state of the market report to the priorities. Set in July 2019 when Ofgem published its strategic narrative, there are three:
- “enable competition and innovation which drive down prices and result in new products and services
- decarbonise to deliver a net zero economy at the lowest cost to consumers, and
- protect consumers, especially the vulnerable, stamping out sharp practice and ensuring fair treatment.”
Reaffirming the point, the priorities are also listed at the beginning of the report’s executive summary. Cave addressed them in a different order, starting with decarbonisation. He praised the reduction of greenhouse gas (GHG) emissions, saying that this “is mainly down to the huge growth in electricity generated from renewables – growth which Ofgem’s regulation and administration of government environmental schemes have supported.” But progress has begun to stall, prompting Cave to comment: “While the government will continue to set the direction of energy policy, it has indicated that it plans to move away from direct decision making in the energy market. This could leave Ofgem to play a bigger role in building Great Britain’s low carbon energy system as we push ahead to net zero.”
Bee in the bonnet
In the report Ofgem noted its responsibility to protect current and future consumers. Accordingly, “sustainability is an integral part of our medium-term strategy, which includes facilitating decarbonisation efforts to deliver a net zero economy at the lowest cost to consumers”. In terms of practical steps Ofgem is taking, Cave added: “Internally, we are reviewing the sustainability guidance given to teams to ensure that environmental impacts are robustly assessed.” Ofgem is to publish a decarbonisation action plan early next year alongside its annual Forward Work Programme document. On a national perspective, the report expressed concern that overall UK carbon emissions fell only 12mn tonnes in 2018, the slowest rate of decline since 2012, presenting a risk to meeting decarbonisation obligations.
To support its arguments, the state of the market report for a second year includes third-party modelling for the costs and benefits of various decarbonisation policies for consumer bills. The analysis includes estimates of the impact of decarbonisation policies on emissions between 2010 and 2018 (see Figure 1). Carbon prices and large-scale renewables are indicated to have had the most significant impact. The carbon price has cost consumers around £31/t of carbon emissions avoided between 2010 and 2018, while small-scale renewable subsidies cost consumers around £322. Overall these policies have added an average of £42/year to a typical household electricity bill with an extra £5 since 2017.
I never promised you a rose garden
On the competition objective, Cave commented that there has been a slip in customer service standards over the past year, adding that Ofgem is “tightening up our licensing regime to drive up standards in the retail market and reduce the harm – and costs – of supplier failure”.
Cave added: “While in many cases competition is the most effective instrument, it is no longer the only tool we use, nor always the first we reach for.” This comment alone underlines how far the regulator’s thinking has changed in these days of price caps and provisional orders. On the default tariff cap itself the report claimed that it “has saved customers £1bn, but it is too early to reach conclusions on its wider market impact.”
- Structural changes are facilitating or can be expected to facilitate the competitive process – this includes the progress of the smart meter roll-out
- Well-functioning competitive process – there should be no significant barriers to consumers being able to access, assess and act on information on product offerings in the market, and
- Fair outcomes for consumers – the competitive process should be expected to deliver fair outcomes for consumers in terms of what matters to them, including prices, range of tariffs to suit needs, good quality of service, and ease and reliability in switching products
Overall the retail market has seen concentration continue to fall despite several supplier failures. According to the report 12 active suppliers left the market between June 2018 and June 2019, with nine through Ofgem’s Supplier of Last Resort process. In addition to acquiring customers via switching, medium suppliers have absorbed the majority of the customers from the suppliers that ceased to trade. This has resulted in the market becoming less concentrated as medium suppliers grow and exert more competitive pressure on the large suppliers. Large supplier profit margins fell to a nine-year low of 3% on average in 2018.
Ofgem expressed concerns over the “big increases” in the number of Ombudsman cases relating to small suppliers. In Q119, the Energy Ombudsman accepted more than 100 cases per 100,000 small supplier customer accounts, compared to around 20 cases in Q117.
The reliability and speed of switching was also a concern, despite the record high achieved in April 2019. It found that average switching times remain around 15 days or more.
In the non-domestic retail market, Ofgem found that microbusinesses on average pay much more per unit of energy than other businesses. In Q119, very small businesses paid on average nearly twice as much for gas and 30% higher for electricity. Ofgem is currently working on its Microbusiness Review Action Plan, due to be published in the winter – this evaluation of the market matches up with the regulator’s argument for an intervention.
Ofgem concluded that wholesale price changes, have been largely as a result of global factors with British wholesale electricity and gas markets working “reasonably well”. Electricity wholesale prices fell in 2019 and the number of generators increased, reducing the opportunity for any generator to exert market power or make excessive profits. But wholesale electricity markets are still moderately concentrated compared to the wholesale gas market with a large number of gas producers enabling greater competition in the market.
Concerning Ofgem’s objective to protect vulnerable consumers, Cave chose the price cap as an example, remarking that it can only be lifted before 2023 if “the conditions for effective competition” are in place (Ofgem published the conditions on the same day as the speech, see Figure 2). “We will make this determination to the best of our ability in an entirely independent way, and next summer we will publish our first assessment, although the decision to lift the cap rests with the Secretary of State”, Cave commented. In terms of setting a baseline for that evaluation, the report found that energy bills as a proportion of household spending fell modestly between the financial years ending 2017 and 2018, while the proportion of households in fuel poverty has fallen across each of England, Scotland and Wales. Although disconnections due to debt are rare, with just six in 2018 compared to 17 in 2017, self-disconnections remain a concern, with 14% of prepayment meter customers self-disconnecting in 2018.
An apple never falls far from the tree
Networks appeared in an entirely new chapter in the report. Cave emphasised that network companies’ business plans for the next price control period, RIIO-2, “must help put the UK economy on the path towards net zero by 2050 at the lowest possible cost to consumers”.
Opening the new chapter in the report itself, Ofgem stated: “We aim to expand our coverage of networks in future years and welcome any comments as to which areas would be of most interest.” The regulator praised the networks for “providing safe and reliable energy to consumers, with high levels of customer satisfaction and reliability and availability levels at around 99.99%”.
Networks have come under increasing scrutiny in recent months – Labour took aim at the companies in May this year with a nationalisation plan. The tone in the new chapter is of a need to tighten up. Ofgem considers the financial returns earned by network companies to be above its expectations, with almost half of the network companies achieving double-digit percentage returns in real terms throughout the RIIO-1 price control period.
Ofgem points to a number of factors, including efficiency, good performance against targets, or companies innovating to cut costs. However, it also reflects a combination of forecasting errors, some budgets set too high, and some targets set too low.
On our reading the state of the market in 2019, according to Ofgem, is: a less concentrated retail market with several supplier exits; high switching; declining quality of customer service; still too many in fuel poverty; microbusinesses paying too much; network companies earning too much; and energy decarbonisation policy losing momentum.
In this report, Ofgem is setting the evidence base for the action it wishes to take in the coming months and years. In response to the poor customer service and supplier exits, Ofgem will wield the Supplier Licensing Review. RIIO-2 presents Ofgem with a chance to right the too lenient regime RIIO-1 has turned out to be. The microbusiness workstream shaping up over the in the winter will set out how Ofgem intends to improve conditions for smallest consumers in the non-domestic sector. And on decarbonisation Ofgem stands ready to do more and is setting out to put its own house in order first.
This year the state of the market report is not just a chance to see Ofgem’s assessment of the energy market, it also provides a baseline for its decision on whether to remove the default tariff cap. This is especially pertinent as Ofgem’s framework is long on principles and short on data measurements. Our take is that it the state of the market report shows a retail market that is operating more effectively than it was a year ago, with engagement in particular much higher.
But it is on decarbonisation where the report makes its strongest play. Since the publication of Ofgem’s new strategic narrative, it has intensified its interest in decarbonisation and net zero. Cave appeared to positively embrace a new decarbonisation evaluator role for Ofgem in his speech.
Ofgem does not have specific regulatory powers or requirements on companies regarding their carbon emissions. Its significant forays into decarbonisation to date mainly concern the administration of policy schemes. If, as Cave said, Ofgem is “to play a bigger role” in decarbonisation, the state of the market report gives some clear pointers as to where the regulator thinks it can be most useful.
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