British consumers, change your provider!

An investigation led by the British Competition and Markets Authority on the retail gas and electricity markets has found that they would operate better if consumers took the time to sign up for better offers. To encourage consumers to do this, the CMA plans to create a database listing the most inert consumers. The database would be available to all gas/electricity suppliers and energy service providers, which they could use to seek new customers.

1. A two-year investigation

On 24 June 2016, as we learned the results of Britain's EU referendum in astonishment, the British Competition and Markets Authority (CMA) published its final report following a two-year investigation on the distortions affecting competition in the energy sector. The results of the investigation are as astounding as the length of the documents. The report itself is some 1,400 pages long, while the summary is a ‘mere’ 80 pages in length, not to mention the fifty-odd appendices for readers with some time on their hands. The proposals made in the report are somewhat unconventional given that, to explain the anomalies it detected, the CMA levels equal criticism at the energy sector regulator (Ofgem), the government (Department for Business, Energy & Industrial Strategy), consumers and energy suppliers alike. Unlike many other investigations into unfair competition, in this case the suppliers fared relatively well. The remainder of this article will focus on the electricity market.

2. A regional oligopoly

Because electricity is a homogenous product, and marketing costs are relatively low for newcomers to the market, the CMA believes that competition should be enough to align retail prices with the level of costs, including a 'reasonable' return on capital. However, not only do the prices vary according to the provider, the type of contract and the method of payment (which could be justified by differences in operating costs), the margins also differ greatly. For instance, over the period from 2011 to mid-2015, the average price paid per kWh by customers on the standard variable tariff to the main energy providers – roughly 70% of their customers – was around 11% higher than the average price paid by customers on other tariffs.[1]

The first explanation the CMA examined is that the larger suppliers are vertically integrated in respect of electricity production, which could give them an advantage over retailers with no production capacity. The fact is that the smaller retailers are both customers and competitors of the larger suppliers. However, the CMA does not believe there is any competition bias because the wholesale market - where retailers with no production capacity purchase energy - operates efficiently.

So what about horizontal concentration? On the retail market, there are six large firms of comparable size, and around thirty smaller suppliers. Because electricity is a homogenous product, the number of suppliers should ensure a healthy level of competition. Yet this is not the case if we go by the small number of customers who actually switch to different suppliers despite the potential savings on their electricity bill. According to an investigation of 7,000 electricity consumers run by the CMA, 36% of respondents were unaware they could change suppliers, rates or method of payment, 34% said they had never considered changing suppliers, 56% said they had never done so, and 72% stated they had never changed rates charged by their supplier or were unaware that they even could.

What causes so many customers to remain so inert? The six large energy firms are the former integrated regional suppliers. Despite the liberalisation of the electricity sector, whereby suppliers can now offer their services to consumers across Great Britain, each of the firms retains its historical customers whose loyalty (regardless of the reason) keeps them from being lured away by other suppliers. There is therefore a lack of healthy competition on the market affecting almost everyone except customers who are not linked to an incumbent supplier. For these passive customers, the market is more or less made up of regional monopolies. The CMA would like to see all consumers engaged in greater competition across Great Britain.

3. Potential savings

The fact that some consumers pay more for electricity because they don’t shop around for the best deal wouldn’t be a problem if the populations concerned were not elderly customers, low-income earners, and/or those living in rental accommodation. For instance, 35% of customers with an annual income of over £36,000 switched suppliers in the past three years, while only 20% of those with an income of less than £18,000 did so. Similarly, 32% of those with a university degree switched suppliers in the past three years, while only 18% of those without a degree did so.

The respondents gave various reasons for not switching. In random order, these include: “electricity is a homogenous product, so why bother shopping around”, “conventional meters are not very visible or immediately informative”, “it’s easy to do so on the internet, but not everyone has access to the internet”, and “the price comparison websites are unreliable”.

To assess the detriment to British households caused by the large firms’ pricing policies that take advantage of consumer inertia, the CMA calculated the average prices offered to their customers and compared them with the most competitive alternatives. The total detriment amounts to an average of £1.4 billion per year for the 2012-2015 period, rising to nearly £2 billion in 2015.

The total amounts are astounding.  However, at a household level (of which there are around 20 million), the potential gains to be had from real price competition are more moderate. In 2015, consumers could potentially save £100 a year, or around 10 euros a month. However, this figure is an average, and it is worth remembering that the most inert customers - those who pay the most - are also the poorest. The CMA views this as a market flaw and believes that it must come up with remedies to improve competition.

 

4. Remedies to improve competition

The CMA has come up with around thirty measures designed to improve competition on the retail electricity market. Some of the measures are fairly conventional, such as improving transparency, while others are more unusual for non-specialists of the industrial economy and are worthy of explanation. For instance, the CMA is asking Ofgem to remove all tariff restrictions imposed on suppliers, such as limits to the number of tariffs on offer and the levels of discounts possible. Because electricity is a homogenous product, companies are expected to differentiate themselves through financial and commercial innovation. It is therefore counterproductive to impose limits on that innovation. The CMA believes that Ofgem is taking the wrong approach, and is making matters worse rather than better.[2]

A more original and also more controversial idea is the creation of a database of “disengaged” customers. The database, that would be set up and managed by Ofgem, would list consumers on variable tariffs for three years or more, who have therefore been paying more for their energy for a long time. The database would be accessible to all energy retailers and service providers, which could then make attractive offers to those customers. Ofgem would control access to the database and its use, including for instance the frequency and form of marketing allowed.

Among the safeguards to be included, consumers who could be included in the database must receive a letter from their provider about the creation of the database and asking them whether they wish to opt-out and have their name removed from the list. Once the database has been compiled, marketing may only be sent by post because, as per British law, email marketing would require the customer to make a deliberate “opt-in” request.

These measures appear relatively ineffective for several reasons (for more details, click here). Firstly, customers inundated with advertising are likely to throw such mail straight in the bin, the way they do with letters from various charities. Secondly, there are two types of cost that prevent customers from changing supplier: search costs and switching costs. The database would help to reduce search costs, but it would have no effect on switching costs. Furthermore, it is still not understood why well-informed consumers do not switch. Is it because they misunderstand the terms and conditions of switching? If so, consumers flooded with advertising may end up making the wrong decision and choose an option of little or no benefit to them. Or is it because they understand but remain unconvinced, like patients who refuse to take generic medicines? In that case, informing them is pointless. Furthermore, providers are unlikely to refrain from contacting consumers by email or phone. And once the database has been compiled, the names will no doubt be used not only by electricity retailers but also providers of other goods and services. 

* * *

The inertia of electricity consumers concerning prices remains a headache that the CMA seems unable to remedy. The fact that energy cannot be stored and is used more or less constantly might explain why consumers want security. After all, the extra cost they are willing to pay can be seen as a kind of insurance premium.

Consumers’ lack of interest in shopping around poses other questions, ranging from political-philosophical issues (should the authorities be expected to make consumers happy despite themselves?), to more practical issues (how to ensure a successful energy transition when it requires the active participation of consumers?), which we will come back to later.

 

[1] On fixed-rate plans, the price remains stable for a period of 18 or 24 months. At the end of the period, the provider switches the customer to a variable-rate plan. With variable rates, the provider decides when to raise or lower prices, and informs customers with 30 days’ notice in case of raises. Customers can opt to terminate the contract at any time free of charge, unlike with fixed-rate plans where fees apply for early termination.

[2] An interesting analysis is given by Waddams Price C. and M. Zhu (2016), “Non-discrimination clauses: their effect on GB retail energy prices,” in The Energy Journal, vol. 37 No. 2, 111-132.

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