Why freezing energy prices is a bad idea

Posted September 26, 2013
by John Fingleton CBE

Ed Milliband’s proposal (if elected) to freeze prices from 2015 and re-structure the market has a number of serious problems. First, it is very unlikely to work in practice.

  • It is very difficult to regulate retail prices to consumers when the wholesale price is so variable. California tried it a decade ago with disastrous results. If final prices are frozen, and wholesale prices rise, energy companies could be obliged to supply below cost, risking lower investment or bankruptcy. On the other hand, lower wholesale prices might not get passed on and lead to huge monopoly profits.
  • Generally, restructuring markets for competition reasons is done by the Competition Commission. This is an independent body, and the outcome cannot be guaranteed. Freezing prices would make the Commission’s job of assessing the competitive alternative more difficult, so could hamper the analysis.
  • It will be impossible to re-structure the market in the 20-month period for which price regulation is imposed. Airports took the best part of 7 years to restructure.
  • At a practical level, it is not clear what happens to off-grid customers. Those who rely on oil or LPG for domestic fuel, not intended to be subject to a price cap, may be among the less well off.

Second, the proposal is very likely to harm consumers and competition over the long term.

  • A price freeze is likely to result in convergence of prices, and will hugely reduce the incentives of the companies to compete for our business. How does a company that offers better value signal that to consumers?
  • A price freeze will also discourage new entry, and render it near impossible if wholesale prices rise significantly.
  • Investment is likely to be harmed not just by the price freeze, but by the political uncertainty about the regulatory framework. Even once the price freeze is lifted, the perceived threat could damage investment.
  • Even if this were a good idea, announcing it two years in advance is not. The energy companies will have incentives to game the system. For example, they could try to raise prices before the measure is introduced. They will have less incentive to reduce costs between now and 2015: if profit is seen as bad, then one way to reduce profit is to allow costs to rise. And they may act in ways that harm consumers through worse service or quality, or by finding non-regulated components where they can hike fees.
  • Making companies and their boards more focussed on pleasing politicians and regulators at the expense of pleasing their consumers could lead to further inefficiency inside the energy companies.
  • Research by Stephen Littlechild suggests that when the government and Ofgem intervened in 2008-10, it caused average prices to consumers to increase by 6%! Well-intentioned measures can sometimes have unintended consequences.

Third, this is a politically risky game.

  • Taking personal political ownership for consumer energy prices when you don’t have control over the main drivers of that price (wholesale gas and crude oil prices) is, as Sir Humphrey might say, very courageous.
  • It sends a very negative signal about policy stability in the UK. When politicians step outside of established processes for issues such as market failure, it creates waves of uncertainty across the entire economy, increasing the risk premium, and therefore jeopardising investment.

Ed Milliband is right about two things.

  • The energy market structure is a problem: Ofgem should have referred it to the Competition Commission years ago, and still should.
  • Ofgem, the regulator, may not have covered itself in glory; but it has been hampered by politicians asking too many different thing of it.

The energy companies do not come out of this particularly well either. They have threatened under-investment. Their record of customer service isn’t great, for example presenting customers with deliberately complex and confusing pricing structures. We should be able to have an adult conversation, where issues such as the nation’s energy security and fuel poverty are not decided according to headline-grabbing and anecdote.
Notwithstanding the culpability of the politicians, the regulator, and the energy companies, we must not lose sight of the cold, hard, fact that input costs for energy have risen globally. Consumers would be feeling the pinch even if the actions of these institutions had been exemplary.