Energy suppliers engage in price discrimination – that’s a good thing

Most consumers are equal parts confused and outraged at energy prices. It’s not simply that they’re too high (although they could be lower), it’s that two customers who get identical products can pay vastly different prices. ‘Loyal’ (low-engagement) customers on standard variable tariffs (SVT) pay substantially more for their energy compared with active switchers who shop around for the best deal. OfGem reckon that customers on the worst deals could be as much as £230 better off each year if they switched to a better deal. But customers don’t even need to shop around to get a better deal. Simply going online and moving from the default standard variable tariff to a fixed rate tariff can save you over £100.

Politicians left and right have condemned this. Tory MP John Penrose writes on ConservativeHome:

“What other industry doesn’t give their most loyal customers any discounts or special deals, but charges them higher prices than anyone else instead? Which companies believe that loyalty should be exploited, not rewarded? Who treats their longest-serving customers as chumps, to be quietly and secretively switched onto expensive, unfair deals when they aren’t looking, and then milked; ripped off mercilessly for as long as possible.”

It just seems unfair. As a result politicians like Theresa May and Jeremy Corbyn have called for price caps. Penrose himself has called for a slightly different policy, backed by the centre-right think-tank Policy Exchange, a relative price cap. He thinks we can fix the energy market by banning firms from charging vastly different prices to different customers.

Penrose is opposed to price discrimination – the practice of charging vastly different prices for goods that cost roughly the same amount to produce. A retailer can charge all customers the same price for a certain product. But some customers might have been willing to buy it for more than that, and some customers won’t be willing to pay for that at all. A Venti coffee at Starbucks costs a penny more than a Grande to make, but lets them charge frugal customers less and profligate customers more for what is basically the same product, allowing them to sell to more customers and maximise revenues. It sounds unfair, but when firms have high fixed and sunk costs it's consumers that benefit.

Take research and development intensive industries like pharmaceuticals. In order to produce a new drug, a pharmaceutical firm will have to spend heavily on researching and testing new cures. Producing the first pill is very expensive, but producing the second, third and fourth is incredibly cheap, costing next to nothing. The more drugs a firm can sell the lower the average cost per drug is. That’s why pharmaceutical companies invest heavily in drugs aimed at a mass-market and require subsidies or philanthropic donations to tackle rare diseases. If discriminating between consumers, charging high mark-ups to some and tiny mark-ups to others allows them to sell more pills then they’re able to spread their fixed costs widely, lowering average prices for all.

Politicians are typically quick to blame huge price differentials on a lack of competition. Penrose writes for Bright Blue’s CentreWrite magazine that “This shows this market is completely broken. So broken that even the basic laws of supply and demand aren’t functioning properly. Clearly, we must reform the sector so it behaves like a normal industry where the customer is king – not the regulator, or the politicians.”

But, firms in competitive markets frequently engage in aggressive price discrimination strategies. Take fast food. No one can deny that competition in the market for a quick burger and chips is intense (The Guardian amongst others frequently is concerned about there being too many takeaway firms). But McDonalds doesn’t adopt a strategy of uniform mark-ups. As airline deregulator Michael Levine points out: “It is a commonplace in the business that a fast food restaurant sells hamburgers with a much lower mark-up from variable cost than is entailed by the prices of french fries and soft drinks (which are sold separately at very high margins above variable cost). How can we explain this in a world without market power? …firms constrained by competition from earning monopoly rents will adopt price discrimination as the optimum strategy to allocate common costs among buyers.”

If McDonalds didn’t engage in this kind of price discrimination they would almost certainly go bankrupt as KFC, Burger King and Wimpy would have substantially lower average costs.

The same is true for energy costs. Building a power plant is expensive, but once the power plant is up and running the marginal cost of an extra kilowatt of energy is relatively low. Charging price insensitive customers (those who can’t be bothered to switch) more allows them to cover their fixed costs and charge marginal customers almost no mark-up whatsoever.

This isn’t just elegant, if counter-intuitive, theory. There’s real world evidence to back it up. Sinnhauser and Whish-Wilson, two economists working for large Australian energy incumbent AGL, compare two Australian regions Southeast Queensland and Victoria. Victoria’s retail energy market is almost entirely deregulated with huge price differentials between tariffs, while Southeast Queensland has a regulated price-cap.

In Victoria prices vary massively with some consumers paying 30% more than others and standard variable tariff offers well-above (around 10%) average unit cost. Southeast Queensland on the other hand has much less price dispersion as the regulated cap forces firms to set tariffs below average unit cost. Many politicians would look at each market and conclude that things were working better in Southeast Queensland. They would be wrong.

Consumers behave very differently in the two different markets. In Southeast Queensland 46% of customers stay on the default more expensive standard variable tariff, with just 22% benefitting from medium-level discounts (there are no high-level discounts). Deregulated Victoria is a different kettle of fish. Just 11% of customers stick on bad-deal standard variable tariffs with 45% accessing high-level discounts and pricing being set at marginal cost for many. Switching rates are also much higher in deregulated Victoria, suggesting that Penrose is wrong to claim “because, at the moment, contrary to all economic theories, the amount of switching does not increase as the size of the potential cost savings rise.”

Based on Sinnhauser and Whish-Wilson’s analysis, capping standard variable tariffs would push average prices up and hurt consumers. But we shouldn’t need economic theory or data from Australia to know it’s a bad idea. We should simply look at OfGem’s recent interventions to simplify the market and reduce price discrimination to see why price controls are a bad idea.

In 2008, OfGem brought in non-discrimination to remove ‘unfair’ price differentials. Banning practices such as offering higher prices in regions where they were the incumbent or largest supplier and lower prices in regions where they were trying to increase their market share. The result? “Competition reduced, customer switching fell by half, and profits of major suppliers increased by nearly £1 billion, at the expense of customers” according to economist and former Director General of Electricity Supply Prof Stephen Littlechild.

But, if at first you don’t succeed, try and try again. Rather than learn the lessons of their failed 2008 intervention, OfGem (under significant political pressure) forced firms to ‘simplify’ their tariffs, forcing firms to only offer four separate tariffs. As Littlechild once again points out "Suppliers naturally chose to keep their most popular and profitable tariff types and phase out their minority preference tariffs…”. The best deal on the market fell foul of the regulations (it was too complex apparently) and was withdrawn. Worst of all, E.ON’s StayWarm tariff that offered customers over 60 years of age a fixed monthly bill regardless of how much energy the customer used was withdrawn. Ironic for OfGem considering that they had singled the tariff out for praise in 2001 because it addressed the needs of the fuel poor.

Price controls simply don’t work. They reduce competition, cause popular tariffs to be withdrawn and push up average prices. The Government should ditch its manifesto pledge to cap energy prices and instead boost competition by scrapping OfGem’s misguided interventions.