Labour's price cap proposals for UK energy

Despite the torrent of scorn, ‘economically literate’ people should welcome Miliband’s energy price cap proposal. There isn’t a single commentator – or energy company – that thinks that the domestic gas and electricity markets are working well. Nevertheless, the Labour proposal to cap energy prices for a two year period has been greeted with withering contempt by the energy companies and their friends. Sensible people should be more optimistic: it might be only way to begin the process of building a responsive and effective market in power and gas. Don’t listen to what the crazy fundamentalists say. When markets have failed so badly, tinkering around the edges will never work. Miliband’s proposal is the first recognition of the need to forcefully kick the energy industry into a different and more competitive equilibrium.

Nobody, but nobody, defends what has gone on in the last decade or so. The oligopoly of the Big Six has become entrenched. Prices have tended to rise more sharply than other countries, albeit from relatively lower levels, and consumer satisfaction has dipped to new lows. The regulator Ofgem has worked hard but increasingly looks outgunned by the big companies. Consumer switching has fallen even as the main suppliers continue to churn their complex and hard-to-compare offers. Even as the power companies promise to be more chaste in their marketing, the last two months has seen 49 separate changes in retail price offers. (Some of these switches have been from small players but the majority were from the Big Six).

Perhaps most critically, wholesale energy markets are highly illiquid, reducing price transparency and discouraging investment in generation because investors aren’t able to assess whether the billions going into new plant will ever make money.

Ed Miliband’s proposal, which looks as though it is an attempt to subvert the operation of markets, may actually be intended to make them work better. The logic is this: if the energy companies are forced to commit to hold prices for a twenty month period, they will be obliged to buy large amounts of power and gas in the forward markets. (A forward market allows me to buy something at a pre-agreed price for guaranteed delivery on a certain date). Otherwise the Big Six will be exposed to future rises in power prices that they would not be able to pass on. If the companies are all actively buying and selling energy for delivery in one or two years’ time they will have created a much deeper and more liquid power market.

At the moment, all the utilities are exposed to the rapid swings in short term wholesale prices. As a result they are obliged to move prices several times a year in periods of volatility. Forcing them to buy most of their power in forward markets will move the industry into a new mode of operation. Importantly, it will make long-term wholesale prices much more transparent and ‘real’, encouraging investment rather than deterring it as the jeremiahs suggested yesterday. If we are worried about the lack of long-term price signals holding back investment in new generation, Miliband’s plan is absolutely what we should want.

It can be correctly pointed out that the wholesale energy prices are only about 50% of the domestic consumer’s bill. Even if the Big Six can buy power today for delivery in 2017, it doesn’t reduce their exposure to rises in other costs. The most important of these are transmission charges (the regulated prices charged by the owners of wires and pipes and about 20% of the household bill) and social and environmental costs (about 10%, covering feed in tariff payments and home insulation subsidies among other costs).

Both of these other categories of cost are tending to rise as a fraction of the typical bill. But the expenditure is reasonably predictable because Ofgem has laid out the likely course of transmission charges and the Treasury has capped the rise in payments to sources of green energy. The Big Six will be able to budget effectively for both.  Ignoring the 5% VAT charge on the bill, the other expenditures of utility companies on metering, credit control and customer service are all controllable.

In in all, a well-managed utility company should be able to live easily with the 20 month price cap proposed by Miliband. Most importantly, the effect on the incentives to build new generating capacity is likely to be strongly beneficial as the plan improves the functioning of the market for electricity and gas to be delivered in a month or a year in advance.  Combined with an enforced legal separation between the retail arms of the power companies and their generating plant - another proposal from the Labour Party - there might at last be a chance of creating a functional energy sector for the UK.

And despite what we sometimes like to think, most other European countries have profound interventions in the operation of their utility industries and reject many of the assumptions of British market fundamentalists. Some countries regulate prices, others target financial rates of return. No other country has concluded that untrammelled independence is the right way to regulate energy producers or energy retailers.


Addendum: some recent comments from Ofgem (June 2013). Economist-speak but very powerful.

Our analysis suggests that liquidity in the electricity wholesale market remains insufficient. The volumes traded along the forward curve are lower than in other markets and bid-offer spreads remain wider. Qualitative feedback also suggests that firms find the current levels of liquidity unsatisfactory. In addition, small suppliers face particular barriers to accessing wholesale electricity products.

Poor liquidity acts as a barrier to entry and competition. It limits the ability of generators and suppliers to trade and manage their risks. As a result, poor liquidity prevents consumers accessing the benefits of competition: downward pressure on bills, better service and greater choice.