Capping energy prices? Still a bad idea

Freezing energy prices was a very bad idea when Ed Miliband proposed it. Yet two years after the electorate rejected it Theresa May is putting forward the same idea and rebranding it a 'cap'. The facts on the ground haven't changed, yet just like workers on boards and the living wage, Red Ed's Zombie Policies are on the march. 

In a complex market with low rates of switching and an apparent oligopoly in the Big Six, capping the expensive Standard Variable Tariffs that the vast majority of bill payers are on might seem like common sense. But it's a bad idea for two main reasons.

First, the Prime Minister is justifying her intervention into the energy market on the grounds that the market isn't functioning properly and that her cap would save bill payers around £100 a year. Britain used an incredibly competitive energy market with the highest rates of active customer switching in Europe, but since 2009 well-intentioned regulators have implemented rules that have lead to a nearly 50% fall in switching rates. Keep in mind that this happened in the era of and GoCompare spending massive money on advertising the benefits of switching. Suppliers used to have a great deal of freedom to offer better deals to customers with different suppliers creating an incentive for customers to frequently switch providers. OfGem's regulations impeded them from doing this, reducing flexibility and innovation.

In a scathing op-ed for The Telegraph (paywalled), five ex-regulators set out the OfGem regulations that undermined competition in the market:

Ofgem’s 2008 probe found “unfair price differentials” totalling £500m. Ofgem introduced a non-discrimination condition. The price differentials disappeared – but by increases in the lower prices, not reductions in the higher ones.

Ofgem also imposed strict constraints on direct marketing, including doorstep selling. Because of both policies, customers engaged less in the market – particularly poorer customers. The customer switching rate halved.

Suppliers competed by introducing new tariffs. Ofgem argued that these baffled customers. In 2012 Ofgem introduced a “simple tariffs” policy that limited the number and variety of tariffs. This did not assuage public concern, or restore the previous customer switching rate.

When the Competitions and Markets Authority (CMA) looked at the problem in 2016 they proposed lifting many of the restrictions imposed by OfGem. 

Theresa May's plan is to cap the Standard Variable Tariff (SVT) that most bill payers are on. It's true that the gaps between the best deals and the SVT can be as much as £200.

Theresa May might believe that price discrimination is unfair. Why should ordinary 'loyal' (lazy) customers pay more? But capping the Standard Variable Tariffs will only reduce competition. With a price cap customers will have little incentive to switch between suppliers. Suppliers may then see little point in offering better deals for switching, so while passive consumers may see their bills fall, the consumers who keep the Big Six honest will see their bills rise.

Regulation often begets regulation. By reducing competition between energy suppliers, we should expect even greater opportunities for suppliers to collect monopoly rents. This paradoxically pushes prices up and leads to further calls for price controls to curb supplier profits.

That brings us to the second problem with the PM's proposal. Profits incentivise investment; if you cap prices to curb profits you discourage new investment. There's an added cost for suppliers too - uncertainty. Firms lack perfect foresight. They make investments knowing that there might be big downsides if energy prices collapsed for instance but also bigger profits if energy costs increase. If you cap the upside but don't cap the downside, otherwise viable investments will be cut. 

Governments won't stand by while power stations go unbuilt – if a politician can't keep the lights on they'll soon be kicked out of office. That's why I think that warnings of a future of power cuts are overblown. What we'll end up getting instead might be just as bad though; an increasingly centrally planned energy sector where politicians not businesses decide which energy sources and projects are worth investing in.

In many ways this is already the case. As leading energy expert Dieter Helm puts it:

The direction of policy has been increasingly to replace markets and competition with state-backed contracts. Onshore and offshore wind, solar panels, and biomass are all based on government-determined subsidies passed through to electricity customers. The grid charges reflect grid investment partly to support the intermittent renewables on the fringes of the existing systems. Extra capacity is needed to manage the intermittency too. Then there are energy efficiency subsidies, many with a social element. Customers are paying for the roll out of smart metering.

That's without mentioning white elephants like Hinckley Point C where the Government has guaranteed a strike price far beyond what the market would normally bear.  As Sam Bowman has pointed out before "High energy prices are mostly caused by high wholesale prices, and energy firms are not generally more profitable than other large firms". Pushing the energy market on the path towards greater state control will push up wholesale costs as otherwise uneconomic projects will be favoured by bureaucrats who lack the incentives and the knowledge to pick the best projects.

Theresa May should tread carefully. An energy price cap might poll well now, but its consequences will be felt long beyond the electoral cycle.