Anyone who has been involved in Retail energy for any length of time is battle weary from the continuous barracking received from government, media and regulators over the level of tariffs and their fairness. The long awaited CMA investigation was hoped to put the debate to bed, but clearly didn’t work. So, we now await the Conservative manifesto, which, we are lead to believe, will have central to it a proposed ‘price cap’ on electricity prices (whether absolute or relative) to be set and enforced by the regulator, OFGEM.
Every retailer in the market whether large or small, I believe, genuinely wants to do the right thing for its customers, and in times of increasing competition, wants to offer them attractive deals. Often reading the media, you would think that at least the Big 6, and increasingly the medium players too, are out to stitch up customers and blatantly profiteer.
It was therefore genuinely refreshing to read Scottish Power’s proposed remedy which would move the energy market much closer to the insurance market model. Like insurance, their proposal is that all customers would be forced to renew contracts on a periodic basis. This by default would actively expose all to the range of competitive offerings available to them. Whilst radical, this would, I agree, once and for all take the heat out of the debate- Yes, Big 6 players may well take a profit hit in the short term, but in the longer term would create a genuinely competitive market.
The real issue is risk management
The real issue here is not the level of tariff. The Big 6 are between a rock and a hard place, whereby they hold a massive legacy customer base who, for whatever reason, have no engagement with the market. These customers, whilst often highlighted as the most vulnerable, and who undoubtedly deserve protecting, in reality hold all the cards when it comes to running a profitable supply business. The supplier has no control over when the customer will decide to leave, they are obliged to continue to supply the customer come what may, and most importantly they have to buy the energy to supply to those customers in advance not knowing how much they will need and for how long. In this context they also need to set a tariff which is designed to ensure they make some margin. If their forecasts of what they need to supply these customers are wrong, they have to either buy or sell the difference back to the market in real time which carries with it significant price risk. Short term markets are notoriously and increasingly more volatile than a longer term balanced play.
The nature of privately owned business
All suppliers are privately owned businesses, and therefore are under, not unreasonable, pressure from their shareholders to deliver profit and effectively manage risk. It should therefore be no surprise that the so called ‘Standard Variable Tariffs’ (SVTs)which are those variable default tariffs for any customer who has not switched to a fixed tariff, include within them a ‘risk premium’ which protects the supplier from the risk that they get their forecasts wrong. This risk premium is seen in the media, and apparently now the government, as profiteering. Like all other risk based businesses, the premiums are designed to protect the business from losses which inevitably means they are relatively high. The premiums are not however designed to fleece customers. Smaller suppliers have some fun at the big 6’s expense by jumping on the bandwagon- but let’s remember they have grown up with the standard being fixed priced contracts and relatively few customers rolling onto default SVTs. They do not face the same legacy volume risk as the Big 6 and can be significantly more agile in flexing their tariffs due to their size. There is effectively unfinished business that was never dealt with post privatisation for customers on flexible tariffs- there is no comparable post privatisation market, hence the continual noise.
Price caps, whether absolute or relative, will ultimately result in price convergence and depress competition. Why even look to switch when there is almost no price benefit in doing so? If OFGEM are setting the price caps, why not go the whole hog and have standard tariffs on a national basis- or simply renationalise the industry?
If we genuinely want to grow and develop the retail market, the alternative ‘insurance’ model of forcing a transition to fixed period contracts will allow all supply companies to operate on a level playing field. There will still be a need for penal default tariffs for those customers who don’t respond, but still want to keep their lights on, but it would be a minority rather than a majority. By forcing a waking up of the legacy base, competition would be accelerated and all customers would win. It is a brave move from Scottish Power to suggest it, but the action of a business wanting to compete on a level playing field and not fight the continual bashing from the centre. Sadly, the proposal I suspect will fall on deaf ears.
Managing price caps would be no mean feat. Even the nacent prepayment tariff caps are already needing review- by its nature the energy market is a continually moving beast, which requires sophisticated models and risk management to manage. Asking OFGEM to define caps effectively requires them to define default risk management and hedging policies to underpin their assumptions. Surely that is not the role of a regulator?
Where will it all end? Everyone in the retail market wants the debate to move on, whether big 6, medium players or new entrants. The emotional rhetoric, misinformation and lack of understanding is wearing in a market where it is increasingly hard to make reliable margins, ironically because competition is making it so. Maybe it will take one of the big 6 to withdraw from the market to make the point. It would never surprise me.
Jo Butlin is an energy consultant at EnergyBridge. For help and advice on investing in and navigating UK energy markets please contact firstname.lastname@example.org