Why energy price caps will worsen the energy market for consumers

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May 16, 2017 by Paul Goldsmith


The energy market is a target for both the mainstream political parties. Both Labour and Conservatives have suggested price caps of some sort. Labour have gone further in their manifesto and suggested that they will set up a public energy company in each region to compete with the energy firms and take over the running of the National Grid (responsible for generation of energy). Energy is an electoral battleground for a very good reason. No-one should have to choose whether to heat or eat, and some of the reasons they have to do so have to do with the inefficiency of the energy market. However, the solutions to this are not simple, and a price cap is actually downright dangerous.

The inefficiencies in the energy market are down to the fact that firms within it have to be a certain size to take advantage of the economies of scale (cost savings that can be made as you increase size). There are huge ‘fixed costs’, meaning those that are paid regardless of output. It means that small firms find it difficult to compete. Repeated surveys of the market by the Competition and Markets Authority have suggested that breaking up the six firms that dominate the market into two (say dividing them into generation and distribution)  could mean costs would rise as no firm would be able to take advantage of those economics of scale. Meanwhile, having just one publicly owned company running the industry (the left-wing panacea to all its problems), inefficiencies will grow the other way. Starved of incentives to invest and cut costs, prices could rise as well. SO, the current market structure, which consists of the ‘big six’ energy firms and a number of small firms, may well be the optimum situation, with enough firms to provide competition to each other whilst having each one able to access the cost savings that come with scale.

Yet competition isn’t really working. Prices rise when wholesale energy costs rise, but don’t fall when energy costs fall (called ‘upwardly mobile, downwardly sticky’ in economics parlance. The firms’ net profit margins have risen to over 5%, providing good returns to shareholders, which include the French Government. At a distance, private shareholders receiving money at the expense of higher prices for hard-pressed consumers is hard to justify. Government intervention in the market is justified. Yet we also learn in Economics that just because Government intervention is justified doesn’t mean its benefits will outweighs its costs. Politicians like to point out a problem and say that if you don’t favour intervention you are happy with the problem. Not so, there is a concept of ‘government failure’, in which government intervention to correct a market failure creates a new one.

Price capping, in any form, is one of those interventions. It sounds so politically obvious. Put aside the chants of ‘Marxism’ shouted at Ed Miliband by the Tories when he came up with it in 2013, they knew it was a vote winner. So now Theresa May is going to include it in the Tory manifesto. She argues her idea is not the same as Labour’s, because of the operation of it. Put as simply on it, the Tories’ price cap puts a cap on the price of the ‘standard variable rate’ tariff that consumers are charged once any ‘introductory’ bonus rate has expired and they don’t change providers again, or if they have just never changed provider.

The problems with this idea are many: First of all, the truth is that energy companies are not in control of the majority of their costs, which is the cost of wholesale energy. Controlling the prices of firms that can’t control their costs gives them little room to manoeuvre. In an industry that relies on continual investment, to change to renewable sources or fix gas leaks or stave off power cuts, too much control and dampening of profit opportunities reduce that investment, as well as funding for it as shareholders disappear in search of better returns for their money.

Secondly, there is the effect on consumers. The other day I changed energy provider. I went to u-switch and it took about half and hour and I cut by energy bills by £40 a month. That deal may have been for new customers only, but it is funded at the moment by the amount those that don’t change pay. A price cap on the standard variable tariff will mean fewer good deals for customers that change, effectively reducing competition. Far better to make it even easier for people to change, and increase awareness even more, perhaps by every year sending every customer an automated assessment of how much they can save if they change provider based upon their current usage, backed up by data from the smart meters that everyone should soon have in their home.

Price caps are good politics, but in the history of economics, they have never worked.

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One thought on “Why energy price caps will worsen the energy market for consumers

  1. alistairfox2014 says:

    It surprises me (although on reflection it shouldn’t) that anyone, especially politicians who should have a basic grasp of economics, would think that price caps would be a viable or effective measure in any industry. Far better to let energy companies sweat it out by making the market really competitive, like supermarkets or car insurance.

    How? By ensuring they offer completely comparable pricing (no intro offers) fixed for a time period (1 year with no rises) with a compulsory choice of supplier at the end of the period. Couple that with a home profile based on your smart meter readings that would get you a better quote if you are a ‘good’ consumer.

    Your analysis is good, but fails to split the capital intensive parts of the industry – extraction, transmission and distribution from the less capital intensive retail side. Transmission and distribution, like rail tracks and water supply are natural monopolies so the choice is a regulated private monopoly or a nationally-owned monopoly.; the quality of both is dependant upon the regulation/regulator, not competition.

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