10 May 2017

Why a price cap won’t fix the energy market


Proposals to impose price caps on energy bills highlight the mess Britain’s energy policy has got into. For some time, politicians of all parties have been imposing policies that force up energy costs. Now they want to cut the energy bills that have been driven higher by their own policies.

The only good argument for price caps is the Leninist principle of “the worse, the better,” as the move brings forward the day when the entire policy collapses.

In its June 2016 energy market investigation, the Competition and Markets Authority noted the role of decarbonisation policies in pushing up costs. “Pressure on prices is likely to grow in the future, due in part to the increasing costs imposed by climate and energy policies,” the CMA stated.

The CMA was being polite. Thanks to fracking, there is a worldwide glut of hydrocarbons which should have seen electricity prices in Britain fall.

In the mythology being spun by BEIS ministers, the Big Six energy suppliers act like privileged insiders, extracting rents from customers. This will come as news to three of the Big Six (Centrica, EDF and RWE) who between them lost £132m on their domestic electricity supply business in 2015.

Rather than excessive profits, the CMA’s analysis pointed to a “material degree of inefficiency” in current prices. This is one reason why the CMA came out against imposing a price cap for all standard variable tariff customers, warning that price caps ran the risk of undermining the competitive process, “likely resulting in worse outcomes for customers in the long run.”

In its report, the CMA complained about lack of “customer engagement”. That is to say, the reluctance or inability of customers to shop around for better deals. This was especially true among the elderly, those living in social or rented housing and those who have relatively low levels of income or education.

In most markets, it can be rational to let others incur search costs as competitive dynamics deliver better prices for everyone else. The important issue, ducked by the CMA, is why this isn’t happening in the electricity supply market as it would then raise the fundamental question of the economic value of having retail competition in the first place.

Taking domestic electricity, in 2015 the aggregate costs of the Big Six supply activities (including their profit margin) was £2,902m compared to total revenue of £27,311m. That is to say, only 10.7 per cent of the electricity value chain is actually within the direct control of electricity suppliers. The remaining £24,409m, equivalent to 89.3 per cent of the total bill, represents fuel costs, transmission and distribution costs and government levies. In other words, supplying electricity is essentially a pass-through business.

In properly functioning markets, shifts in demand between downstream retailers drive upstream changes in wholesale markets. The problem in electricity is that they don’t. As I wrote for Capx when energy bills were a hot topic before the last election, Britain’s energy market is back under state control. The failure of the retail market for electricity is overwhelmingly caused by the failure of the wholesale electricity market which is a direct result of government policies mandating the generating mix and pricing off coal, the cheapest energy source.

These interventions have created a class of privileged insiders who have done very well out of government energy policies. Looking at the Big Six generating profits by generating type reveals who they are. In 2015, nuclear power generated earnings before interest and tax (Ebit) of £13.77 per MWh, thanks in part to Britain’s unilateral £18 per tonne carbon price floor. Renewables generated £51.64 of Ebit per MWh, in 2015 obtaining an average price 78 per cent higher than electricity from gas and coal-fired power stations to give investors a whopping 46.4 per cent profit margin.

Capping retail prices does nothing to curb this egregious rent-seeking. By contrast, in 2015 the Big Six’s gas and coal-fired power stations lost £3.70 per MWh at the Ebit level. The huge profit margin for renewables results in over-investment in unreliable and high-cost wind and solar capacity and virtually no investment in the new low-cost thermal capacity needed to keep the lights on.

BEIS ministers have convinced themselves that there is widespread popular support for the aggressive decarbonisation policies that are making energy more expensive. They should have the courage of their convictions and acknowledge that high and rising energy bills are a consequence of the decarbonisation policies they claim are so popular. Once they’ve done that, we can have an honest debate about how best to fund decarbonisation.

Centrica’s boss Ian Conn argues that green levies and other policy costs should be funded from general taxation. That would be a lot fairer than loading the costs on to energy bills and letting the poorest in society pick up the tab.

Rupert Darwall is the author of 'The Age of Global Warming: A History' (Quartet, 2013).