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Editor's Pick: The Dark Arts of removing price caps

Anna Moss Anna Moss Retail Manager
6th August 2019

This was originally published on 22 July 2019 in Energy Spectrum.

The regulator is facing a difficult challenge. Tasked by the legislation that introduced the mechanism, Ofgem now finds itself in the position of establishing whether competition in the market is “effective” enough to remove the cap on default energy tariffs. It has the opportunity to make the decision each year between 2020 and 2023, when legislation currently states the cap will end.

In this Energy Perspective, we discuss some of the key indicators in Ofgem’s proposed methodology for removing the cap, and suggest further transparency in outlining the combination of measures that might give a gauge to understanding the circumstances in which the regulator might remove the cap.

Somewhat counterintuitively, the default price cap started on 1 January this year during a period of record switching, high price differentials and increasing market innovation. Further context on the state of competition came shortly before the cap’s implementation, when the Competition and Markets Authority (CMA) signed off a merger of the second (SSE) and sixth (npower) largest competitors in the domestic supply market without condition. Having reviewed the merger to see if it would create a “substantial lessening of competition”, the CMA decided that this act would not result in worse outcomes for consumers. 

In the end the SSE/npower merger did not proceed and Ofgem has set its own terms for defining effective competition (see Figure 1). But responses to this issue to date include a critique from former regulator Professor Stephen Littlechild, which expresses concern that “effective competition” is being used to achieve socially desirable outcomes. We also see industry cynicism that the cap will be removed, particularly at a time when the regulator may well face political pressure to keep prices down.

The unbreakable vow

In Ofgem’s opinion, achieving effective competition will only be possible if there is rigorous rivalry between firms that results in good outcomes for “most consumers”. The regulator does not define “most consumers” but appears to be keeping a wider and subjective mandate to ensure vulnerable consumers are not subject to excessive prices. Ofgem’s thinking here is clearly moving on too, the regulator having released research last week outlining the potential implications of introducing a “cost-pass through” tariff as an alternative to standard variable tariffs (SVT) for disengaged customers.

For its assessment, the regulator has established three broad conditions. The first looks at structural change, including reforms from the government and itself. These changes encompass the smart meter rollout, many of the recommendations from the Competition and Market Authority’s (CMA) 2016 Energy Market Investigation and are expected to be “supplemented by a package of reforms identified, through the Future Energy Retail Market Review”, jointly with BEIS.

What this approach does not acknowledge are the longstanding delivery issues, particularly in the smart meter rollout programme, many of which sit outside the suppliers’ direct control and yet have had a direct impact on their ability to meet the rollout target. However, the Domestic Gas and Electricity (Tariff Cap) Act 2018 specifically requires Ofgem to consider the process of installing smart meters – perhaps the opportunity here is to look beyond this measure to its impacts.

The transition to smart meters should enable consumers to better manage their energy use and save money, while opening the market to innovation and new business models. Indicators then could assess changes in consumption patterns through the seasons, the use of in-home displays, or the number of smart-enabled tariffs on offer, for example.

While the issues and subsequent delays impacting the smart meter programme have been commented on widely across the industry, the challenges of delivering the more forward-looking work programmes have not yet fully been identified. Yet they could have an impact in determining the future of the cap. 

The sorting hat

To assess whether the conditions have been met, the regulator said it will not set specific thresholds for each of the indicators being monitored, instead comparing them “in the round”. Ofgem intends to assess the direction of travel across the various metrics.

The indicators are a starting point for creating the framework. It is likely to evolve over time, and the final version may not include all those outlined in the first draft. Currently, the indicators fall in to four broad categories: market structure, consumer behaviour, supplier performance and outcome. While the full list consists of some 29 measures, we have outlined four themes that we think are important in Figure 2. For profitability, supplier entry, market concentration and price differentials we assess some of the changes in the market since the Tariff Cap Act received royal assent in July 2018. 

Lumos!

To assess supplier performance, Ofgem will consider EBIT margins and operating costs, taken from the consolidated segmental statements (CSS). On average, the large suppliers recorded an EBIT margin of 3.0% in domestic supply in 2018, falling for three consecutive years prior to this. More broadly, across 16 of the small and medium suppliers reporting financial results, eight reported a loss, with an average across the group of -1.9%.

As the half-year results season is about to start, we confidently expect to see a decrease on the 2018 figures. Those companies that reported for the first quarter of the year have already shown a squeeze on profits, with suppliers citing price caps as an influencing factor. Here, the regulator will need to decide what a positive change would look like. Pressure on profit margins may suggest leaner, more efficient businesses to some, but it also runs the risk of deteriorating service, further forced exit, and limited innovation. 

On entry, 10 suppliers have joined the market, taking the total number of supplier options to 90[1]. But there have also been 12 market exits over this time, through the Supplier of Last Resort process or by acquisition (Figure 3). The net position shows overall decline, but it does not provide the bigger picture of changes in the commercial models, driven by reasons that include the application of the price cap. The last 12 months has seen a shift in entry towards a lower risk, white label option, away from the fully-licensed alternative. Predominantly led by local council suppliers, the change was a signal of the tough market conditions that had dissuaded other companies from entering.

Market concentration, as measured by the Herfindahl-Hirschman Index (HHI), was 1,092 at a national level in April 2019. Down from 1,175 at July 2018, the HHI has been below the threshold that signifies a competitive market[2] since July 2016, and has continued to fall. But regionally, HHI is still above 1,500 in two regions.

 

Considerable discussion at Ofgem’s 24 June workshop concerned the way the regulator would consider price differentials. In that month the difference between the average dual fuel SVT offered by large suppliers and their average cheapest fix was £209 a year, up from £190 in July 2018. Over this period the differential fell as low as £50 in December but saw increases through 2019, reflecting the implementation of the price cap and the lag in its methodology for wholesale prices. Set against the cheapest tariff in the market, the price differential from the average large supplier SVT has been fairly consistently over £300.

The direction of travel here is changeable, influenced by factors including the lag in wholesale prices in the cap formulas. The regulator will need to consider the level of savings required to encourage engagement especially if it intends consider the level of potential consumer detriment.

Of the indicators here, it appears that two have “improved” over the timeframe, one has declined, while price differentials will require further consideration of the overall aim.  

Wizards Unite

Whatever Ofgem decides to do, it must build from the framework determined by the CMA last year. It seems illogical to suggest that the market has effective competitive enough for a merger between two of the largest competitors, but not enough to remove a cap price, unless that decision is heavily qualified because of competition effects on specific groups of consumers. The choice of metrics reflects a tension between identifying good outcomes and not creating too onerous a task for all involved. At this stage, the existing metrics are already assessed on a semi-regular basis, many of which are available on Ofgem’s Retail Market Indicators online tool. These should be further consolidated with the additional indicators, allowing industry and consumers to see the relative changes as they occur.

While relative changes can be identified, there is no absolute view as to what good looks like, or how the metrics will be prioritised – and whether these factors will be discussed publicly. The regulator has suggested that it will determine the direction of travel, rather than set thresholds using the empirical data. Of those we have outlined, the last 12 months provides a mixed picture, determined by different perceptions of what the ultimate objective is. Here Ofgem will need to be clear on the purpose of the metrics in order to justify any decision.

[1] Including fully licensed and white label suppliers
[2] The U.S Department of Justice considers a market with an HHI of less than 1,500 to be a competitive marketplace

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