An energy price cap could kill competition – here's a better idea

The Conservatives have announced their manifesto will include a pledge to cap the price of energy bills. This comes just two years after Labour campaigned to freeze household energy prices

The Tories are yet to flesh out the details of their plan, but it has already drawn strong reactions both for and against. The price of energy stirs deep emotions in part because it is a necessity, one which absorbs a much higher proportion of the income of those in poverty and “just about managing” than of richer households.

But there are two other important features: the first is that electricity and gas are essentially the same whoever supplies it (with a few exceptions for renewable generation or billing services). The second is that many people are paying more than they need to. Around 70% of British households are on the default “standard variable tariff” even though, thanks to competition between energy firms, cheaper prices are available to those willing to switch suppliers.

This raises the question of whether we should worry if people simply don’t take advantage of these deals. After all, what counts as “fair” in the energy market? Is it about equal access to the best offers, or whether we end up paying the same price?

Some people may find the process difficult, for example because they have built up debt which they need to repay, or because they don’t use the internet, or find bill comparisons challenging. These people are missing out on the best deals. Most people don’t face such barriers, however – they’re held back by a lack of information, or put off by the time and effort it takes to switch supplier.

The problem is that a competitive market keeps the energy firms on their toes. When customers can easily choose the best deals, suppliers will compete to offer lower prices and new services. If people don’t switch, these firms have less incentive to innovate.

An effective price cap would lower the highest prices, but it would also limit the “headroom” for new firms to undercut prices. So while a cap can lower the price for some consumers, it may reduce competition.

Relative price caps, which tie one set of prices to another, are particularly likely to damage competition. We saw this effect when the energy regulator introduced non discrimination clauses between different regions in 2009, which was followed by softer competition between the companies, higher profits – and higher prices.

Regulating prices is a good plan if the aim is to ensure fairness ahead of lower average prices. But such a move is likely to sacrifice the benefits of a dynamic energy market, and higher average prices will be felt most keenly by low income households who already spend a much higher proportion of their incomes on energy.

Alternatives to price caps

Smart meters, set to be rolled out at considerable cost over the next few years, are intended to help lower bills as people will realise how much energy they’re using – and when. But the benefits depend on people actually acting on this information.

Protecting consumers from making decisions about the energy market now may mean we are all rather lazier about engaging with opportunities in the future.

The government could of course go even further than a cap and simply give everyone free energy at the “meter”, or some form of free energy allowance paid for by taxation. But this might encourage people to use more energy, which would harm the environment. And is energy any more essential than housing, food or water, none of which are provided by the state for free?

There may be a better way to ensure fairness while also retaining the benefits of competition: hold an auction to supply the “sticky” customers. That refers to the 55% of energy buyers who have been on the more expensive tariffs for at least three years. In a recent investigation into the energy market, the Competition and Markets Authority recommended that suppliers should give the details of those customers to the regulator, who might then make the contact details available to competing suppliers. Instead of encouraging competitors to approach these customers individually, they could be invited to make a better offer to them as a group.

There are many challenges to designing such an “opt-out” auction, but it has the benefit of providing a potentially better deal for the “disengaged” while harnessing the true power of competition. While auctions provide competition for the market itself rather than acting as a competitor within the market, they still give firms an incentive to provide the best offer. In doing so, auctions are less damaging to competition than most forms of price cap, and certainly less damaging than a price freeze.

This article was originally published on The Conversation. Read the original article.

Catherine Waddams receives funding from the UK Energy Research Centre, though this article is not based on this current research. She has previously received funding from the Economic and Social Research Council for her research into energy markets. This article does not reflect the views of any research council or centre.