Flawed in almost all its parts – the final CMA report on electricity markets

 

Flawed in almost all its parts – the final CMA report on electricity markets

 EFN Paper 19

 Dieter Helm

 

The CMA spent roughly 80 years and spent £5 million, identified that the bulk of customers (around 70%) were being charged around £1.4 billion in excess of the “competitive” price, and concluded that it was mostly their own fault for not switching.  The £1.4 billion is, for the CMA, the result of “inefficiency” in the market, not monopoly behaviour. Making them switch will, in the CMA’s view, solve the problem.

The CMA supported the novel idea that loyal customers should be charged more, not less. There is no supermarket “loyalty discount” here: instead there is a “loyalty penalty”. The companies should be freed from the Ofgem imposed constraint to limit the number of tariffs on offer, despite recognising that the obvious fact that electricity is an homogenous produce sold on price.

When it comes to making the customers switch, the CMA thinks that establishing databases of those who have been too lazy, ignorant or poor to switch, so that they can be bombarded with mail shots from rival suppliers should do the trick. This (temporary) measure is required until smart meters come along and solve the problem.

The diagnosis and the conclusions are at best misguided, depending on a failure to take proper account of not only what is currently going on in this market, but also failing to undertake any serious analysis of the fundamental shift from wholesale to capacity markets. Future electricity markets are not going to be driven overwhelmingly by wholesale prices: capacity contracts, Feed-in-Tariff  (FiT) contracts and system charges will make up more and more of the final bill.

It is no wonder that Martin Cave dissented from the final report: he had good reasons to do so. His valid concerns about the CMA remedies are well grounded, though they only scratch the surface. Soon we will see whether he is right. The CMA has now set itself up for a clear and empirically observable test. The CMA must be expecting a really big fall in the market share of the Big 6 between now and 2020, and a very sharp fall in the number of Standard Variable Customers. They must be predicting that their remedies will reduce the £1.4 billion to just tens of millions by 2020. After 2020, when the smart meter cavalry has come along, it should be “mission accomplished”.

So what is missing? Why is it so misguided? Why have other remedies been disregarded?

Misunderstanding the wholesale and capacity markets

The CMA has concluded that wholesale markets are working well. Whilst this is disputable, the important point is that it is increasingly less and less relevant. As more and more zero marginal cost electricity comes onto the system, it undermines the wholesale price. The result – already very apparent – is that there are no significant investments in electricity that do not come with a fixed priced, government-backed contract. These are the FiTs (covering wind, solar, biomass and nuclear) and capacity contracts (covering everything else). The dynamics of this development are obvious (except to the CMA): the wholesale price is falling, and will over time probably go on falling. Eventually the economics of electricity will look like the economics of the Internet and broadband: capacity not energy will get to be a bigger and bigger driver of electricity prices.

The CMA might nevertheless argue that the wholesale price will continue to set the market price, and hence determine the merit order. Again, this is what might be described as a “driving looking out of the back-window of the car” approach. As batteries, storage, electric cars, smart meters and demand side responses develop, both the price and the volatility of the wholesale market declines.

In a increasingly zero marginal cost world, the guts of the market shifts to the allocation of the system fixed costs – none of which can be switched away from, except by defecting from the system. The customers on the CMA’s new database will carry on paying regardless of what happens. The market will be increasingly in customer capacity, and they will be paying more and more of their bill for this fixed and unavoidable cost. There is nothing to switch too: suppliers will be in the business of recovering these fixed and sunk system costs.

There are lots of interesting questions that emerge in the transition away from variable wholesale markets to fixed priced ones. In this emerging world, the government is the single (monopoly) buyer. Indeed, it already is. The monopoly this implies on the supply side opens up lots of issues around who should pay. Without the ability of customers to avoid these costs, governments can decide to protect vulnerable customers, or like Germany bias FiT costs to domestic customers and away from industry. These are incredibly important issues, almost entirely ignored by the CMA, because it sees the electricity market through the eyes of the wholesale market.

In this single buyer, fixed price contract world, the role of suppliers reduces to that of billing and debt collection. Analogous to broadband providers, they are not really in the supply business. This is the job of distribution companies in supplying capacity. The smart meters are incredibly important still, but for the very different reason of coordinating and managing a much more disaggregated and diverse electricity system.

Wholesale costs

In the short run, wholesale costs do of course remain relevant to final customer bills. Except that the CMA seems not to have noticed that since its enquiry process was kicked off when Ed Miliband announced the Labour policy of a temporary price freeze, wholesale prices have fallen over 30%. Yet the 70% of customers on the Standard Variable Tariff have seen little of this (save for the small offset from rising FiT and other charges). Incredibly, the CMA has presided over a market on which a 30% fall in costs results in no fall in final prices for 70% of customers.This would not be incredible over a period of a few months or even a year. But this has been going on for at least three years.

The CMA prides itself on understanding competition and markets. But consider a very simple question: why has no major supplier (or any supplier) offered a lower Standard Variable Tariff? The CMA has no answer.

Ask another question: what is wrong with Standard Variable Tariffs as a way of selling electricity? The CMA does not even seriously consider this question, let alone provide an answer – except to confuse Standard Variable Tariffs with price regulation, a mistake to which we return below.

The case for Standard Variable Tariff is very simple – and very compelling. Customers want the supply of a homogenous product on a fair and reasonable basis. They do not want to spend their evenings on the Internet searching through ever more complex tariff structures. Switching is at best a means, not an end. So what would constitute a stable and fair basis for buying a simple product like electricity? Loyal customers should reasonably expect a tariff that reflects the underlying costs, and a fair profit margin on top. That is what would happen in a competitive market. They understand that if costs go up, so should prices; and conversely if costs go down, so should prices. They expect this automatically to happen through their billing. And that is precisely what they do not get.

In a well functioning competitive market, suppliers would compete to offer Standard Variable Tariffs. They would be “standard” because the product is homogenous. They would be variable (with lags of course) because costs vary. What could be simpler than this? The suppliers would make their returns by setting a margin.  This is what initially happened as the market liberalised, but obviously no longer.

Misrepresenting Standard Variable Tariffs as price regulation

Martin Cave wanted temporary price protection for those on the Standard Variable Tariff, on top of the pre payment meter customers. The majority of the CMA panel strongly objected.  They thought this would kill off competition, because if customers on a Standard Variable Tariff got a reasonable and fair deal, then they would have no incentive to switch. Consequently the majority thought that price regulation could not be temporary: it would be permanent.

Put aside the interesting question of why this outcome would be so bad, the key point here is that the CMA saw no future in intervening on the form of tariffs offered and competition. Thus, when I proposed a simple default tariff (Penalty tariffs, open-ended regulation and embedding overcharging – a critique of the CMA provisional findings and remedies, EFN Paper 12, July 2015[1]), this was interpreted as price regulation. It was not, and it is not.

The non-price regulated approach to the Standard Variable Tariff goes like this. The suppliers would be required – amongst the multitude of tariffs they might want to offer – to set a tariff which comprises the wholesale cost, plus the fixed costs (FiTs, capacity payments, transmission and distribution costs) plus a margin.

Since the CMA concluded that there were no problems with vertical integration, and no problems with the workings of the wholesale market, it should follow that customers should face prices, which reflected the wholesale costs. Hence there is no problem here. The suppliers can’t manipulate the wholesale cost, so apart from a bit of hedging (which the evidence shows tends to be worse than pass through), in a competitive market these should pass through. Price should reflect costs. The suppliers obviously can’t change the fixed cost. What they can do is read the meter better than others do, and they can send out bills better than others. These costs within their own control are really all that competition is about in this market. For this they should be able to charge a margin – an unregulated margin.

This is not a price regulation. It is simply one tariff amongst many possibilities, but it should at least be available. The only further suggestion I made was that these margins should be published, and hence customers should know how much profit each supplier is making out of reading their meters, billing them and collecting the debts. What is there to object about this?

This sort of competition for margins has a lot of scope to benefit customers as the market evolves from wholesale towards fixed costs. For there are quite a lot of services provided on a capacity basis to households through their broadband hub (of which the smart meter is just a part). There are broadband services, TV packages, water and a lot of emerging Internet-based technologies coming down the track. Yet none of these providers will probably want to get into the whole complexity of the upstream stuff. The default tariff I propose maximises that chances that these new rivals can get into this market. Who needs a margin of say 3-5% for the limited functions of supplying an homogenous product based on price, when the household can be sold a bundle of services? Less than 1% might be manageable. Yet the CMA approach adds lots of complexity, which makes this very difficult: the CMA is increasing the barriers to entry.

Game, set and match to the companies

The companies have done fantastically well in this inquiry. There are no obvious parallels. Who could really have imagined that wholesale costs could fall over 30%, prices remain constant for 70% customs, margins go up significantly, all during an inquiry, and the CMA basically exonerate the companies. They and their advisors have done a great job in getting such an outcome. I wrote of the initial report that it was “Companies 5-0 CMA”(The CMA Energy Market Investigation: Companies 5-0 CMA, EFN Paper 17, March 2015[2]). The final report is even better for the companies: not even the £1.4 billion excess is now described largely as caused by inefficiency.

Yet, again as I noted in that earlier paper, there is a risk in such a comprehensive victory. Even the companies can win too much. Now the CMA has delivered its final report and recommendations, and the companies welcomed these findings, the market has to deliver. The Standard Variable Tariff customers will need to be switching in droves, and the £1.4 billion will have to go away.  My argument is that this is based upon a fundamental misunderstanding of the ways in which the wholesale, capacity and retail markets are going, how the costs are evolving and on – most importantly of all – a fundamentally misguided appreciation of the interests of customers. The CMA has confused means with ends. 

What should be done?

Ministers now have an opportunity to take stock and reflect on the likely consequences of implementing in full the CMA majority proposals. They will have to decide whether it is reasonable to expect that a lot of mail shots, based on the new database, are going to have much effect.

If ministers conclude that it is implausible to believe, with the majority of the CMA, that we about to witness a database and mailshot-induced mass switching breaking out, then they will have to act fast to head off what otherwise might be a very angry public and political debate in the run up to the next election. It would give some relief to the 70% of customers paying the extra £1.4 billion.

They have an excuse: Martin Cave has rightly dissented.  The best approach centres on an approach that builds on the Standard Variable Tariff, not try to kill it off. They do not need to resort to price regulation (as Martin Cave proposes). Rather they can build on the Standard Variable Tariff. It is a good framework and 70% of customers rely on it.  The problem is that more the 30%+ fall in wholesale prices has not benefitted the large majority of customers. It should - the wholesale costs should be passed through. The intervention needed is to require that this tariff continue to be offered (nothing new here), that the wholesale costs (unregulated) and the capacity and FiTs (determined by government) and the transmission and distribution costs (regulated) are passed through, and that the margin (unregulated) charged on top is published. This is the database that Ofgem should set up – and put the results on every bill too for good measure.



[1] http://www.dieterhelm.co.uk/energy/energy/penalty-tariffs-open-ended-regulation-and-embedding-overcharging/

[2] http://www.dieterhelm.co.uk/energy/energy/the-cma-energy-market-investigation-companies-5-0-cma/

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