OFGEM MAY INADVERTENTLY RAISE ENERGY BILLS

Regulatory requirements on energy retailers that prevent them from charging different prices in different part of the country are more likely to raise prices for all than lower prices for some. That is the central conclusion of research by Professors Morten Hviid and Catherine Waddams Price, presented at the Royal Economic Society’s 2010 annual conference.

The study, conducted by the Centre for Competition Policy, examines last year’s decision by the UK’s energy regulator Ofgem to impose a ‘non-discrimination’ requirement on energy retailers, aiming to protect vulnerable customers who do not switch suppliers.

The authors argue that the problem lies with customer loyalty to energy providers. Because customers often need large price differentials to switch providers, new entrant companies have to offer large discounts, which means much lower prices than in areas where they are the incumbent.

If energy firms are asked to bring their prices closer together, they are more likely to raise prices in regions where they are entrants rather than lower prices in markets where they are incumbents and have loyal consumers and high profit margins.

The authors conclude that a more appropriate policy would be to tackle the source of customer loyalty:

‘It is frustrating that as the empowerment of consumers to switch is increased, good offers that provide the necessary motivation to do so are eroded.’

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In September 2009, the UK energy regulator, Ofgem, imposed a non-discrimination requirement on energy retailers, preventing them from charging different mark-ups in different regions. Ofgem justifies this clause on the grounds of fairness, to protect vulnerable consumers who do not switch suppliers from being (relatively) disadvantaged in the market.

While regulatory intervention may have been needed, this paper questions Ofgem’s decision by demonstrating that the intervention is more likely to lead to higher prices for all consumers rather than lower prices for some.

A significant number of consumers are loyal to firms with incumbency status. They need large price differentials to switch, which means heavy discounting by entrants relative to incumbents to attract new customers.

As each UK region is characterised by a former regional (electricity) incumbent and a former national (gas) incumbent, as well as several entrants, all of whom are (electricity) incumbents in other regions, this results in a given energy retailer charging different prices across different regions according to whether it is an incumbent or an entrant. The existing economic research literature suggests that banning price discrimination may lead to some or all prices increasing. We confirm that this prediction holds for assumptions that fit the particular circumstances of the UK retail energy market.

The intuition is simple. If a firm is asked to bring its prices closer together, they are more likely to raise the price in regions where they are entrants, with little consumer loyalty and lower profit margins than in markets where they are incumbents, have very loyal consumers and high profit margins.

If all firms increase their prices where they are entrants, this reduces the competitive pressure on the incumbent electricity and gas suppliers who are likely to respond by increasing their prices. Such a response is possible since all price constraints were removed from the market in 2002.

Ultimately, the firms may decide to withdraw from effective canvassing of new consumers in areas where they are entrants, even if they technically remain in the market. Essentially, it may be better for a firm to concentrate on markets where consumers are loyal and willing to suffer higher mark-ups.

The preference for short-term ‘fairness’ is not uncommon – for example, campaigns for national pricing to avoid ‘postcode lotteries’, even if everyone pays more. This raises important and widespread challenges for an appropriate model to capture such preferences, where the primacy of equity issues displayed by politicians and consumer groups often seems contrary to the recommendations of standard economic models.

A more appropriate policy intervention would be to tackle the source of consumer loyalty as the regulator has also done. It is frustrating that as the empowerment of consumers to switch is increased, good offers that provide the necessary motivation to do so are eroded.

ENDS

‘Non-discrimination clauses in the retail energy sector’ by Morten Hviid and Catherine Waddams Price, ESRC Centre for Competition Policy, University of East Anglia

The ESRC Centre for Competition Policy (CCP), at the University of East Anglia, undertakes competition policy research, incorporating economic, legal, management and political science perspectives, which has real-world policy relevance without compromising academic rigour.

More information about CCP and its research is available from: www.uea.ac.uk/ccp

Contact: Morten Hviid Email: [email protected] Phone 01603 593715

Catherine Waddams Price Email: [email protected] Phone 01603 593715