The road to re-regulation


 

The road to re-regulation[1]

 

Dieter Helm

12th Jan 2015

 

 

The Labour Party has followed up its manifesto promise to freeze prices for 20 months if they win the General Election in May with a proposal for legislation now. Ed Miliband says: "We're going to bring before the House of Commons a vote in Parliament to say the government should bring forward fast-track legislation to ensure that we give the regulator...the power to cut prices."

 

He is not alone. George Osborne has demanded falls in fossil fuel prices feed through to electricity customers, the Competition and Markets Authority (CMA) is already on the case, and OFGEM has already imposed a 4-tariff restriction on what the companies can do.

 

Much of this is to be expected in an election year and in the face of a 50% fall in oil prices. Politicians demanding companies cut prices to reflect falling costs is nothing new. It is endemic when it comes to petrol pump prices. It usually fizzles out. But not this time: Labour is going to fix prices directly for a “temporary” period, and it wants the regulator to have the general power to fix prices. Not for them the verdict of the CMA. Not for them liberalised markets. The Rubicon is being crossed – prices are being re-regulated by the back door. The companies will no longer have the right to decide. Rather they must convince the regulator, and if they fail to do so, the regulator can “cut prices”. Every time they want to put up prices the regulator will have little option to “check” the costs, and every time fossil fuel prices fall, the politicians will demand the regulator “checks”.

 

Unintended consequences

 

This is increasingly a one-way ticket to ever-greater intervention. At every turn, difficult questions come up which the regulator and the government will have to try to answer, and at every turn they will be sucked further into regulation. If the regulator is given the power, how should it be used? What are the detailed rules? What is a “fair price”? Once a “fair price” is defined, cost-based and rate of return rules are the required building blocks. They will have to be followed. It is called “regulation” – indeed it is close to rate of return regulation.

 

Think what happens if the regulator chooses not to act. Judicial review? Political and media pressure? The list of questions goes on. What happens to the very competitors who the politicians have been so keen to encourage? Since the regulator is fixing the prices, it is effectively fixing the room for the competitors, and implicitly it is starting to decide who can compete on what terms. Already the small competitors do not have to pass on all the levies. It is called “regulated competition”. Regulation has a horrible tendency to beget more regulation – and it will.

 

The fork in the road

 

Behind the popularism (and it is undoubtedly very popular) lies something altogether more fundamental. There is little doubt that Labour has a point. Competitive switching is not working very well, and it never has except on occasions for those who have the time and enthusiasm to sit in front of their computer screens scrolling through the conflicting and confusing barrage of adverts. The energy companies are not trusted. The status quo just is not working for the bulk of customers who just want to pay a fair price with the least hassle.

 

There are two possible ways forward, and there is a real political choice to be made. The first is to make the market more competitive. Labour says it will use the period whilst its price freeze is in place to reform the wholesale market and re-create the electricity pool. Quite how this increases supply competition is far from clear. Such reforms might be useful, but they are never going to solve the problems.

 

The second is to re-regulate supply, and that is what Labour will be doing with its price freeze, and by getting Ofgem to force the companies to reduce prices to map current wholesale prices.

 

The trouble is that Labour wants to do both – increase competition and increase regulation. What Labour has not noticed is that the latter undermines the former – regulation of prices is not a temporary expedient, but likely to fundamentally change the market itself. Fixing prices is what monopolists and governments do from above: in competitive markets prices emerge from the market process.

 

The logic of Miliband’s position

 

The puzzling thing about Miliband’s latest contribution is why he is so reluctant to go all the way – and just re-regulate prices, full stop. There is at least an entirely consistent and rational argument for re-regulation. Customers would not have to waste time and effort searching and switching, and the companies would not have to waste time and computer system costs on the switching. Companies would know their demand and hence face lower risk. The result would be a lower cost of capital, and hence a lower margin. The regulated supply market in Northern Ireland has recently been set at a regulated 1.7% margin – whereas the Big 6 have argued they need 5% or more. Competition, Miliband might reasonably argue, has costs as well as benefits.

 

He could argue further that a regulated margin could cut through the costs of hedging and contracting. Prices could simply reflect the combined wholesale spot market, the capacity charge, the use of transmission and distribution systems, and the policy levies – in effect, a modern version of the CEGB’s Bulk Supply Tariff.

 

In the Miliband world, the issue of trust might go away. The companies would still be open to challenge on their customer service, but a big chunk of this – switching – would go away. Contrast this with the somewhat ludicrous defence put up by for example Paul Massara at RWE Npower. He claims that we should trust his company because he says that the joint ownership in RWE of generation and supply has little impact at all on the supply business’s behaviour, and that the reason prices are not falling now is – irrespective of costs – that Labour has threatened to freeze prices (in the face of falling costs) in six months’ time. In addition to the sheer novelty of Massara’s apparent idea that there is little value in joint ownership of generation and supply (CMA take note), no company in a genuinely competitive market can “choose” not to reduce prices if costs fall on the grounds of some future constraint. They would be wiped out. “Trust us” is even more vacuous as a defence than it sounds.

 

When Miliband’s became Secretary of State for Energy and Climate Change, he made an important and thoughtful speech in which he questioned the scope of the market to solve the investment and decarbonisation challenges. He argued, contrary to Nigel Lawson market-based approach, that there are significant limits to the market. Energy companies should read it. What he has now suggested is consistent with that speech. He wants to continue the road he started back then. What he needs to acknowledge is that it leads to a modern version of the CEGB.

 

In this he is not alone on the road back to the CEGB. The Coalition has gone a long way already towards re-regulation. Almost all new investments in electricity generation are already determined by government, not the market – through either Feed-in-Tariff contracts or capacity contracts. It encouraged the 4-tariff retail approach. Indeed the Prime Minister wanted to put everyone on the “lowest tariff”.  Under Chris Huhne and especially Ed Davey, the government massively enlarged the scale of subsidies and levies. Huhne and Davey have all but emaciated competition.

 

Indeed, so distrustful is Davey of the market (and certain he knows which way oil and gas prices are going – for him, ever upwards) that he wants to protect customers from “volatile” and “rising” gas prices. Presumably he would not now be in favour of passing through falls in gas prices – instead “protecting” them from such volatility. Not for him, market-based prices.

 

Contrary to the mantras trotted out on all sides about it being a competitive market, most is not. After six years of the Miliband-Huhne-Davey policies, the state and the regulator now fix the levies for energy efficiency and FiTs for renewables and nuclear, fix the capacity and therefore the capacity contracts. They issue financial guarantees to new projects – from Hinkley to DRAX. They fix the transmission and distribution costs. They fix the carbon price. The main bits they don’t – and cannot – fix are the prices of gas and coal – and for the moment supply prices.

 

The time has come for a serious debate about whether the hybrid that has emerged from a sequence of individual Miliband-Huhne-Davey interventions is worse than the CEGB. The CEGB would never has paid out over £1billion to old nuclear stations and lots of small scale “car-park” generators in the capacity auction just held. Instead it would have spent probably less than £200 million on sensible precautionary measures for old coal and got a couple of new gas CCGTs built. The CEGB would not have wasted billions on switching. It would have passed through the benefits of the massive fall in coal costs over the last few years. It would have been reducing prices now. It is worth remembering that the average cost of coal and gas combined has sharply fallen, even when the generators were passing through the rising marginal cost of gas.

 

Workable competition instead – or renationalisation?

 

The advocates of more competition have a lot of ground to make up. The CEGB is not the obvious answer. Collective amnesia has set in about the scale of the capture by producer interests.  There is a perfectly coherent and practical model of workable competition – competition for capacity contracts, competition for fuel inputs, and competition for customers. But for those who want to take this route, the status quo is not a good place to start. Huhne and Davey have followed through Ed Miliband’s policies in the last government. The current mess is all their own making, and it is not surprising that competition is not working as a result.

 

When the Financial Times recently called for a fundamental review of energy policy, it was right. The question it should address is simple and straightforward – whether to build a proper working electricity and energy market, or to re-regulate and go back to state planning and state price-fixing. Either is probably preferable to the current position.

 

It is to his credit that Miliband has forced this choice onto the agenda. All he now needs to do is follow through with the logic of his position – and advocate regulation instead of competition. And while he is at it, he might as well go for full nationalisation too, since without competition there is not much point in paying a private sector cost of capital, when the state can borrow at much less. Why pay EDF and the Chinese nuclear companies around 10% real rate of return for 35 years, when the Treasury can borrow at around 2%?

 

But before he does this, he might reflect on the longer-term consequences of his short-term popularism. We have lots of examples of state control, and not all of them are happy ones. He should spend time reading the history. At a time of enormous innovation, with new technologies coming thick and fast, and faced with the challenge of decarbonisation, now is not an obvious time to place one’s faith in the state. Workable competition has a lot going for it.

 

 

 

 



[1]  These EFN papers are published on a monthly basis. For membership and subscription details, please contact office-support@dhelm.co.uk.

 

© Dieter Helm. All rights reserved.Copyright & Terms|Contact