Regulating the Energy market: Not as easy as it looks

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June 1, 2014 by Paul Goldsmith

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Ed Miliband was right, and supported by ex-Tory Prime Minister John Major, to highlight that the market for gas and electricity is failing us as UK consumers. Heat is one of our needs, and therefore the decision on whether or not to heat out homes should not be an ‘economic decision’. In plainer English, we shouldn’t be choosing to “heat or eat” – yet many of our population are doing exactly that. The question is – what to do about it.

If it is caused by more expensive costs for the “big six” firms that supply 99% of our energy, because they are importing gas in particular from abroad, then the policies we use must bear that in mind. We could look for alternative sources of energy (shale gas from fracking anyone?) to lower the costs for the firms.

If it is caused by more expensive costs because of the obligations that our energy firms have to meet in terms of generating a proportion of our energy from renewables – part of the commitments we are part of in the EU to combat climate change – then the policies we must use should bear that in mind. We could take those costs out of our energy prices and pay for the R&D and higher generation costs of renewables at the moment out of general taxation.

If it is caused by the monopoly power of the “big six” firms – who may or may not be acting in unison to raise prices, and may or may not be taking advantages of the fact that they have a captive customer who lacks the will and the way to find an alternative provider when prices rise (particularly if they all rise the same amount) – then the policies we use should bear that in mind.

A government (or in our case the Competition and Markets Authority) that wants to successfully regulate the energy industry needs to think about the following:

1) A lot of investment is needed to meet the energy needs of individuals and firms in this country, particularly if that energy needs to be “clean” and “renewable”. Those investments can come from companies, using their retained profits (made from our money that we pay over and above their costs remember), or they can come from governments (using our taxation that we also pay remember). The point is, the money has to come from somewhere – simply saying to the energy companies that we are going to cut their profits but STILL expect them to make the same amount of investment is populist but economically naive.

2) It is possible that having six dominant firms in the energy industry is actually the CORRECT number of firms. It is possible that the total demand for energy in the UK (say 60m customers) divided by the ‘minimum efficient scale’ which is the total output needed to take advantage of all the advantages available for large firms (economies of scale such as bulk buying, better financial credit terms and the ability to use storage and transport with bigger volumes) could  be six. If so – breaking up those firms could mean that costs, and thus prices actually rise for consumers. This is also why measures to improve the ‘contestability’ of the energy market (lowering barriers to entry so other companies can come in and compete to offer lower priced energy) might also not be the most effective method of regulation.

3) The trouble with a price freeze, as suggested by Ed Miliband, is that the firms involved have little control over their costs. If they rise, then a price freeze could mean that at the maximum price they are allowed to sell at, they will be prepared to supply less than consumers demand – which results in a shortage of energy, which could be disastrous. If their costs fall – a price freeze will actually INCREASE profits for the energy firms, as their prices are frozen but their costs are falling.

If you think this is unlikely to happen – think again – because in March SSE announced a price freeze and on May 9th British Gas did too. As the Labour Party danced around in joy as they claimed a political victory I said to my students at the time that it would be happening because those firms know something we don’t – which is that their costs are falling. Sure enough wholesale gas prices are at their lowest level since 2011 after a mild winter reduced EU demand for heating. So, instead of cutting their prices – as they could do without reducing profits – they are announcing politically convenient price freezes and increasing their profits.

Worse, SSE, at the same time as announcing their two year price freeze, announced also that they were saving costs by abandoning plans to build six of seven possible offshore wind farms, landing a major blow to the government’s offshore wind planning. So the long-term damage of the pressure being applied to these firms could be huge to the UK.

Ultimately – the best case scenario for the energy market would be for all the companies within it being able and incentivised to produce at the lowest costs possible (called ‘productive efficiency’), with enough competition or incentive to produce the largest output possible at the lowest price possible to consumers (called ‘allocative efficiency’) whilst also investing in securing the supply for our future energy needs in a sustainable manner utilising the latest technology (called ‘dynamic efficiency’). Anybody who tells the UK electorate that they can deliver all that is probably stretching the truth.

It’s hard being in government. It’s hard regulating these massive industries. There are no easy answers. Which is why it is such an interesting area to write about when you are an economist. Just remember, every policy has its good and bad points. Anyone who tells you otherwise is just full of (far less useful) hot air.

 

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