Monday, 24 October 2011

Energy Market Reform

There has been a lot of discussion recently about rising domestic energy prices and competition failures in the market, most recently the figures published by Ofgem on the profit made per customer by the big six energy suppliers. While these snapshot figures may not be particularly helpful in telling the whole story, they certainly reveal enough to raise the issue to the top of the agenda.

The market is poorly functioning and there is too much complexity, lengthy tie-ins on the best deals and better deals for new customers.  This is an inevitable consequence of different suppliers selling essentially an identical product, with price being the only comparison.  The lights aren't brighter with electricity from one supplier compared with another, only cheaper or dearer.

From the supplier's perspective, the Corporations have a legal responsibility to maximise return to their shareholders and this over-rides any other legal or ethical requirements. For example, perhaps ten years ago, and certainly 20 years ago, some corporations would take a view on whether it was cheaper to prevent pollution or to pay the fines for pollution, often choosing to pay the fines. In some jurisdictions this is no longer possible as directors can be held criminally responsible and there can be a significant cost attached to gaining a bad reputation. In terms of maximising returns to shareholder, not only the cost of fines but also the loss of sales resulting from bad publicity need to be factored in to the decision – a cost which is difficult to quantify. The same approach must be applied to any regulation imposed on the market - the suppliers will tirelessly search for loopholes to squeeze the maximum profit from their customers.

In 2002, Steve Thomas of the University of Greenwich presented a paper "Why retail electricity competition is bad for small consumers: British experience" to an international conference in Washington DC which contained an interesting table reproduced below:

Monopoly system
Economies of scale minimise costs.
Avoidance of wasteful duplication of facilities.
Ability to achieve wider environmental, social and macro-economic objectives.
Public accountability.
Lack of control over costs with consumers left to foot the bill.
Overinvestment to minimise any risk of power shortages.
Social and economic measures became fossilised and cease to serve useful purposes. Disruptive government interference.
Technical dominance of utilities makes it difficult for their judgements to be questioned.
Competitive model
De-integration and atomistic competition in wholesale and retail markets forces prices down to the long-run marginal cost. Competition is a ‘free good’.
Supply and demand balance because overinvestment avoided as a result of market discipline.
Investment risk borne by investors, not consumers.
Shareholders exert financial discipline.
Indigenous fuel and equipment industries are forced to become competitive.
Social and environment policy objectives are decided by central government, not utilities and paid for by taxpayers not consumers.
Vertically integrated oligopolies give an illusion of competition. Creating markets requires huge investment in by consumers in software and high running costs.
‘Hog cycles’ of over- and under-investment lead to wasted investment and mean security of supply is put at risk.
Oligopoly powers mean extra costs still land on consumers.

So how can we reform the market to reward more efficient energy use by consumers, encourage sustainable investment in our electricity generation and distribution systems while allowing shareholder a modest return?

To start with, if profits are driven by the number of units sold there is no direct incentive for the energy suppliers to encourage energy saving measures therefore it would be preferable to align profits to the number of customers rather than introducing market distorting incentives.

The Prime Minister suggested that there could be a standing charge per customer, set by government which would cover costs such as marketing, account administration, meter reading and a contribution towards profit with the suppliers competing purely on unit price. Rather than encouraging competition, this would enforce a state controlled oligopoly, where the retailers would very quickly arrive at the same unit price for energy - some possible higher for gas, others higher for electricity but overall pretty much the same.  This would introduce the worst aspects of both the monopoly and competitive systems with the only plausible benefit being separation of most of the profit from units sold to customer numbers.

The most radical option would be to re-nationalise the industry.  Government would then be able to target investment in infrastructure directly to meet climate change and energy security objectives: the free market chose gas as the quickest and cheapest power stations to build but are now shackled by high gas prices, a commitment to carbon emissions and costly incentive schemes to encourage alternative energy sources.  Obviously this would meet significant resistance from the main suppliers, which are international organisations causing further political difficulties with any attempted nationalisation.

One option that could be made to fit the current market could be a system where energy saving or micro-generation measures are installed by the energy companies at their own expense but where they receive a proportion of the saving.  Crucially, profit could be made by reducing consumption.  For example, if they install loft insulation in a property that cuts the property's energy use by 20%, the customer gets a 10% reduction from their bill and the energy supplier is still paid for the other 10% over a sufficient period to cover the cost of the installation and generate a profit.  The downside for the supplier would be that they are taking a risk on installing the most effective measures and may lose out if they do not perform as well as expected.

Another option could be for community groups to go it alone and begin generating their own renewable energy.  This approach has been taken to develop a number of community wind farms which are partly owned by the community and partly by a professional developer.  This is not as effective as it could be as the wind farms still sell their energy to the grid and individual households still buy their electricity from one of the big suppliers.

Unfortunately, the spineless government look unwilling or unable to tackle this problem or take any action to disrupt the status quo, with Chris Huhne coming out of his tough talking meeting with the energy suppliers with his tail between his legs, urging consumers to shop around. Obviously it is us consumers that are choosing to pay excessive energy prices and the suppliers are only satisfying our demand.

One thing is for sure and that is that energy prices won't be coming down for a long time yet, not until we have much higher penetration of renewable energy. The only answer is to take what steps we can to control and reduce our energy use.

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