What would the impact of an energy price cap actually be?

Going into the snap election both the Conservatives and Labour are proposing variants on an energy price cap. The details are yet to be confirmed, but it is likely that  both plans will involve the regulator being able  to set a maximum cap on standard variable tariffs, as with customers who are on prepayment meters. The Labour plan may be slightly different, but as there is approximately 0% of Jeremy Corbyn winning the election I will focus on what is expected to be the conservative policy.

The debate goes roughly as follows:

For – Most people don’t switch energy supplier. This allows energy companies to charge higher prices to inactive customers than they would in a truly competitive market. In the absence of effective competition there should be a cap to ensure that inactive consumers aren’t over-charged.

Against – Most people don’t switch energy supplier. If a cap is implemented fewer people would have an incentive to switch, and people would continue to blame their high prices on government inaction rather than their own failure to engage. In the long run this will end up with higher prices for households, worse customer service, less innovation and underinvestment by retailers whose profits will be squeezed.

In an attempt to bring some clarity to the issue let’s now go over a couple of the claims which are made in the debate.

  • Switching rates have been higher in the past

James Plunkett from Citizens Advice recently wrote in a blog post that “switching rates in Britain seem to be lower now than when energy price caps were in place around the turn of the century. And switching rates have fallen in recent years even as the savings from switching have risen.” The graph below shows that, superficially at least, he is correct. He uses this as evidence to suggest that consumer incentives to switch are not aligned with potential savings and that a price cap would have little effect on switching rates. However, he ignores one important point that explain the trend in the graph below. It is true that switching rates peaked in 2008 with 5.43 million switches for electricity. It subsequently dropped to 3 million but is now at 4.42 million per year. The reason for this change was that the big six stopped doorstep selling, which everyone can agree is a pretty good thing. Once you exclude the years that doorstep selling stopped happening, you can see that customers are responsive to potential price savings, which is also why peaks in switching usually occur in the winter when costs for consumers increase.

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Markets also have a substantially different makeup now compared to a decade ago. Much switching is no longer about shuffling customers between the big six, it is now about moving to smaller suppliers. These companies are leaner, more efficient and many are implementing innovative business models. It is no surprise that these are the market leaders in time-of-use tariffs and green tariffs. I would argue that switching to these suppliers is much more beneficial for the market as a whole, as given the room to grow they are likely to be more efficient and innovative than the big six.

 

  • A price cap would reduce incentives to switch

This is a hard one to answer the answer is probably – yes, ‘a bit’. The question is whether the long run effects of reduced incentives to switch would be balanced out by the short term gains from the cap. If anyone has good international examples of where this has been implemented I would be interested to hear. The only case study I could point to would be Northern Ireland where switching appears to be increasing even with a incumbent which is subject to price controls, but this is slightly different as there is only one incumbent rather than the six in the rest of the UK.

  • Consumers over-pay for their energy

Energy markets are not competitive enough – true – but so are many markets in the UK. Estimates for over-paying for energy in the UK ranges from roughly £1.2 to £4 billion each year. Households overpay a far higher amount for their mortgages (around £29 billion a year) and a lower, but not insignificant, amount for their broadband (1.5 billion a year). Compared to these two energy seems not too unreasonable. You make similar parallels to any number of situations where consumers opt for convenience/ a lack of planning over the cheapest possible option – bottled water could be a good example.

So…

First, the notion of a price cap being something that would kill the competitive market completely is probably false. If the price cap was implemented sensibly there seems no reason that the effect on competition would be too bad. It also would certainly work in the short term, with lower prices before the cap creeps up. The harms really start to occur in the long run with higher prices, worse customer service and underinvestment by retailers. Look at rail networks (another consumer-facing industry with oligopolistic tendencies and partial price regulation) for a good example of what the long run implications may be. It is also fashionable in academic energy debate to focus on ‘engaging’ with citizens about their energy. A price cap threatens to do the exact opposite and re-entrenches the notion that energy markets are something for the government to centrally manage.

Ultimately the strongest argument against a price cap is a philosophical one. In a liberal society individuals are responsible for their own actions and inactions. Switching energy supplier is incredibly easy and almost always painless. If people fail to engage with the market then one must only assume that those people are willing to pay slightly more not to have to worry about their energy supply or usage.

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What would the impact of an energy price cap actually be?

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