Ofgem has asked the Competition and Markets Authority (CMA) to review the workings of the UK energy market. As a result, we’re now in for three to six years of investigations, draft decisions and endless appeals. The energy firms will spend £10m a year on City lawyers contesting every single paragraph that the CMA produces and little will eventually change. Regulatory processes in the UK stink. Let’s look on the bright side. The document setting out the reasons for Ofgem decision is really clear, well-written and comprehensive. But it’s 120 pages long. So here are some of the most striking factoids that back up Ofgem's conclusion that the Big Six aren't competing effectively in supplying domestic customers.
In summary, Ofgem said that it had evidence of four different problems with the working of competition
a) For some customers, including those in vulnerable groups, the individual companies had the power to hold prices too high, particularly in the regions of the country in which they used to be the local electricity monopolist
b) Many features of the market make it possible for the Big Six to 'coordinate' their price changes. This has allowed the companies to increase prices more than would normally be possible in a truly competitive market. This problem, Ofgem alleges, is getting worse as the amount of switching between suppliers falls. Prices rise faster than they come down in response to changes in costs. No illegality is suggested: 'coordination' is not outside the law if it is done without any form of direct communication between companies. Ofcom is at pains to say it has found no evidence of any form of illegal price rigging.)
c) Although smaller entrants have made headway in the last year, they don't threaten the dominance of the big companies. This dominance is exacerbated by several features of the electricity market, including the relatively small amounts of electricity trading and by the 'self-supply' of the vertically integrated Big Six.
d) The growing discontent with the electricity and gas companies is causing consumers to disengage from switching between suppliers or actively looking for better deals. This is bad for competition.
- Average dual fuel prices increased by 24% between 2009 and 2013 compared to a 14% rise in the CPI. Average energy use per home has fallen, meaning that expenditure on electricity and gas has only risen slightly faster than inflation. (1.1 and 1.2)
- The cost of wholesale gas and electricity used to service the average dual fuel customer fell by 5% between 2009 and 2012. (Figure 1)
- The total earnings (EBIT) of the Big Six, including profits from generation, supply to businesses and supply to homes, rose from £3.1bn in 2009 to £3.7bn in 2012. Generation profits fell, as did business supply.
- Profits made from domestic customers more than compensated for this rise by increasing five fold from £233m to £1,190m over the four year period.(Figure 2)
- Overall, the generation businesses of the Big Six just about covered their costs of capital. (6.79)
- At the level of the individual customer, the average retail margin before operating costs to a Big Six supplier from a dual fuel account approached £300 in 2013 having been almost nothing at the end of 2005. (Figure 36). This is in addition to generation profits, of course.
- Margins for domestic electricity fell from 2009 to 2012 from 2.2% to 1.8%. Gas supply margins rose sharply from -0.3% to 6.7% over the period. (1.6)
- Some suppliers contend that an overall 5% return from domestic customers is a ‘fair’ margin. Ofcom found no evidence to support this. (1.8)
Evidence for suppliers having the power to charge more in regions where they are in a strong position (‘unilateral power’)
- Market shares for incumbent electricity suppliers (companies that used to have regional monopolies before privatisation) are materially higher in their home regions. Centrica, which had a nationwide monopoly of gas supply still has a 40% share of domestic gas sales. (1.10) 37% of electricity customers are with their incumbent suppliers (4.5)
- On average, 48% of the customer base of a Big Six electricity supplier is in its home (incumbent) region. (4.18). For single fuel electricity customers this number is even higher at 69% (4.20)
- Incumbent customers generally switch less (4.5) The figure is about a quarter of the level of non-incumbent customers (Figure 23). This gives the suppliers the ability to force up prices disproportionately in their home regions. (So called ‘unilateral’ power)
- ‘Suppliers are able to segment their customer base, and charge different groups of customers different prices for what is essentially the same product’. Non-switching, or ‘sticky’ customers pay more partly because they tend to be on single fuel tariffs.
- On average, single fuel incumbent customers pay £40 a year more than if they shopped around for electricity or gas from another supplier.
- Crucially, therefore, Ofgem finds ‘these price differentials to be consistent with suppliers having a degree of unilateral power’. (4.29)
- New, non-Big Six, suppliers now have over 5% of both the gas and the electricity markets up over 2 percentage points since early 2013. However ‘it is unclear that any existing supplier will achieve sufficient scale in the near term to act as a disruptive constraint’. (1.11)
The Big Six are tending to converge and ‘tacitly coordinate’ their price changes.
- Switching rates have shown a strongly falling trend since 2008, despite persistent price differentials. (1.12). The rates of switching among the Big Six are tending to converge. (4.55). Retail margins are also tending to converge. (4.57). Taken together, this evidence is consistent with ‘tacit collusion’, a legal form of diminishing competition and a second reason, after ‘unilateral’ power why the market seems not be to working well.
- Average retail prices among the Big Six are increasingly tracking each other. (Figures 31 and 32). This is also a feature of a market with tacit collusion or coordination.
- Price changes have become more similar in size over time among different suppliers (4.68).
- These features of the market push Ofgem to say that the evidence suggests that tacit collusion may be becoming more effective over time (4.62)
- Ofgem thinks that the evidence for tacit collusion is reasonably strong. The large suppliers announce price changes around the same time and of a similar magnitude. Profitability of domestic supply has risen for all large suppliers and supply margins have converged.
- The intensity of competition for domestic customers is falling. (4.11)
Prices go up faster than they come down
- Large suppliers raise prices rapidly when costs are increasing, and cut them slowly when costs are falling. (1.28)
- More specifically, ‘we found that suppliers do not adjust their prices as quickly when costs come fall compared to when wholesale costs rise. We ran this analysis using a number of different model specifications all of which showed this asymmetry.’ (4.86)
Switching behaviour is increasingly ineffective at constraining the big suppliers.
- 62% of customers could not recall ever having switched supplier. (1.13) Another 14-16% have only switched once. (3.17)
- One in ten of all consumers are not aware that it is possible to switch supplier. (1.43) The DE social group figure is 21% and the number for ‘Black and Ethnic Minority Groups’ is 39% (3.8)
- A 2013 survey suggested that 43% of customers do not trust energy companies to be open and transparent, up 4 points from 2012. Ofgen considers this to be ‘an extremely high figure’ for an essential service. (Para 1.16)
- Ofgem says that the market is highly segmented. Many customers are non-switchers and this segment of the market faces persistently higher prices. At the other extreme, customers who manage their accounts online, pay by direct debit and buy fixed price deals do better. Because the new suppliers are obliged to focus on this segment, their profitability is inherently lower. (This last sentence is my inference from 1.17)
- Ofgem says that competition for domestic customers isn’t working properly. It points to the existence of the persistently non-switching segment, who are systematically charged more and three other factors. These are ‘tacit coordination’, barriers to entry and expansion and weak customer pressure. (1.20)
- Typical single fuel customers would benefit by £100 by switching to the best priced single fuel tariff. But the average customer requires a saving of at least this amount before she/he thinks it is worthwhile.
- Ofgem found a price difference of £250 between the average ‘incumbent’ single fuel tariffs and the best online dual fuel direct debit tariff offered by small suppliers (1.25)
- 62% of people think there are too many tariffs available. 54% said that they understood their options ‘not very much’ or ‘not at all’. (1.44)
- 26% of those switching in the year to April 2012 would not do so again. (1.45)
- Only about 20% of customers are on fixed term tariffs. (2.11)
- Customers are ‘bewildered’ and feel ‘disempowered’ by the choice of tariffs. (3.12) ‘If consumers cannot easily or effectively compare… products … this may allow firms to exercise market power (3.9)
- Language experts hired by Ofgem concluded that a lack of clear communications and standardised language compounds the belief among consumers that the energy market is confusing. (3.14)
- Switching rates are falling and switching behaviour is increasingly concentrated in a limited, better off subgroup. Vulnerable consumers are ‘disproportionately’ likely to never switch.
Vertical integration is harming competition by restraining new entrants
- Vertical integration is a key feature of the UK market. The Big Six own 70% of electricity generation capacity. (1.36) This is double what it was in 2000 (5.58)
- Vertical integration makes entry and expansion difficult, partly because it means that the wholesale market for electricity is not liquid and neither does it enable long-term hedging of prices (that is, new entrants find it difficult or expensive to buy in advance the electricity they need for future months and years).
- Trading in the UK electricity market has fallen substantially in the last decade. The average unit of electricity was traded 7 times before delivery in 2002 and only 3 times in 2013. These later figure is much lower than in Germany, which has an even more concentrated retail supply market. (5.26, 5.27)
- Furthermore new entrants are unable to fund the high capital requirements to become fully effective participants in the buying and selling of energy.
- Ofgem concludes that it is ‘concerned that vertical integration may have a detrimental effect on competition by imposing barriers to entry and expansion and by reducing liquidity in the wholesale market’. (5.92)
Other findings pushing Ofgem into thinking a full competition investigation is required
- Satisfaction with suppliers has gone down 12 percentage points to 52% in the last five years.
- Customer complaints are rising, sharply in the case of some suppliers. Complaints are up 50% since 2011. (3.21)
- 18% ‘completely distrusted’ energy suppliers in 2013, up from 13% in 2012. (3.22)
- The numbers saying that they are not switching because they are happy with their current supplier was 55% in 2013 compared to 78% in the previous year. (Figure 14)
- The time taken by industry participants to organise a switch of supplier is now five weeks though the suppliers have committed to cutting this by a half within a year. (3.44)
- Ofgem says that some companies have looked at entering the energy supply business put have been put off by the risk to their wider reputations from being involved in an industry with severe customer relations problems.
The Ofgem document is a fine piece of work and a model of clarity and terse argument. Congratulations to the people who wrote it.