Three big energy problems we need to crack

The energy sector, and electricity supply in particular, is an area of economic activity that tends to attract more than its fair share of enthusiasts with plans, schemes and bees in bonnets. Lenin was an early pioneer (‘Communism equals Soviet power plus the electrification of the whole country’) and he has many latter-day followers. In consequence, there is no shortage of suggestions and proposals for new government or regulatory ‘fixes’ to energy markets, usually motivated by the desire to obtain some specific outcome or achieve some specific target.

There is a history of what happens when liberalised energy markets are burdened with increasing numbers of fixes and manipulations: their effectiveness is severely impeded (like software that has become too complex and cumbersome), and in some cases they simply collapse. It is against this background that the potential role of the Competition Commission (CC) should be considered.

Why a CC reference?

The most familiar rationale for a CC reference is that the ‘Big Six’ energy suppliers are, in some way or another, ripping off consumers. Thus, there have been generalised allegations of collusion or cartelisation, or claims that the market operates in ways that do not lead to appropriate and timely reductions in retail energy prices when wholesale energy prices are falling.

These concerns have been articulated by consumer organisations for some time, and could have formed the basis for a reference, by Ofgem, in early 2008. Instead Ofgem conducted its own investigation, reached conclusions that have been strongly criticised by leading economists, and has suffered consequential reputational damage.

For example, no evidence capable of substantiating a claim of collusion in retail energy pricing has been put forward by any party, and nor has any such evidence been uncovered by Ofgem. In the event that evidence were forthcoming, the UK has an excellent competition law framework to deal with the problem, with the Office of Fair Trading acting as the principal enforcement agency. It is not, therefore, a matter on which it would be productive to ask the CC to dwell.

Similarly, there have been several investigations of wholesale-retail pricing linkages over the years by the CC and its predecessor (the Monopolies and Mergers Commission) in other economic sectors. Petrol retailing is the best known, but the investigations have also covered less obvious markets such as soluble coffee, where there were complaints that falling world prices for coffee beans had not been reflected in lower prices for instant coffee on supermarket shelves.

The typical conclusion of these investigations is that there are leads and lags in price changes at the wholesale and retail levels, and that the speed of adjustment of retail prices can differ as between periods of rising and falling prices, but that, averaged over reasonable time periods, wholesale price movements are fully reflected in retail price movements. Since, on currently available evidence, this seems to be the case in energy markets also, the CC might feasibly be able to render a quick and authoritative verdict on this matter.

These retail pricing matters are, however, by no means the most serious of the policy issues that we face, and they should not be allowed to distract attention and divert effort from the really big issues.

Three bigger issues

In popular rhetoric, talk of the ‘Big Six’ gives the impression that six is a small number of major suppliers to have operating in retail energy markets. It isn’t; against realistic benchmarks, six is a large number. There are not that many major banks, and not that many major supermarkets. Nor are there that many major energy suppliers in the vast majority of retail energy markets across the globe.

The small number to bear in mind in this sector is the number one. That is how many energy suppliers there used to be, and it is the number of economic agents that will have a decisive influence on prices if the current trend of public policy toward recourse to market fixes and manipulations is continued. Such fixes and manipulations are, after all, monopolistic handiwork.

What is most questionable about the supply structure of the UK energy sector — the first ‘big issue’ — is not the number of major suppliers, but rather the lack of a hinterland beyond those majors. Most markets are populated by numbers of smaller- and medium-sized enterprises which although their collective market share may not be very large nevertheless perform important functions in competitive dynamics.

It is sometimes said that these smaller enterprises are seed-beds of innovation, and there has been a long-running debate in economics about the relative merits of larger and smaller organisations in that regard. However, the more salient point is probably to do with difference and diversity.

The perspective and behaviour of smaller organisations tend to be different from those of large organisations; these differentiating factors contribute to the overall effectiveness of markets, at least when they are not sustained by protectionist measures. (The qualification here is significant since the number of smaller enterprises in a market can be increased by restricting competition and raising prices, which is not a recipe for effectiveness).

In the UK, liberalisation to date has successfully increased the number of decision makers (competitive markets are a form of resource allocation by the many; centralised command and control amounts to resource allocation by the few), but, to date, it has had less success in increasing market diversity. Good questions to ask the CC are (a) why? (b) are the resulting effects harmful? and (c), if so, how might matters be progressed?

A second, even bigger issue is what I will call the ‘Great Regulatory Flaw’. This is the tendency of government to get itself into a state of denial about key economic trade-offs, and to pursue incompatible policy objectives by means of conflicting regulatory policies.

This is the same flaw that is the prime suspect in giving us the current financial debacle. In the financial sector we saw the attempt to pursue the incompatible, combined goals of cheap credit and prudential banking; in energy it is the attempted combination of competitive markets (with their inevitably unpredictable consequences) and prescribed market outcomes.

In the first instance, these are matters for politicians to resolve, not for the CC. However, it would be advisable to abandon such confused energy policy as quickly as possible since no solidly grounded progress, including by the CC, can be made until it is: the Commission is a serious public body, not a collection of magicians.

The third of the big issues concerns the regulatory regime, whose effectiveness has declined as new policy priorities have emerged, particularly in relation to environmental issues.

Regulatory policy is a major influence on market structure, so the CC, in investigating whether or not there are features of the market that give rise to adverse effects on competition, would be bound to consider the policy regime to some extent. However, given the magnitude of the influences of policy on market structure, it would do no harm for any reference to the CC to make clear the importance of this aspect of the prospective investigation.

The language of ‘market failure’ has tended to be prominent in policy discourse over the past few years, and it is easy to forget the rather longer history of learning concerning ‘regulatory failure’. The post-privatisation ‘poster-child’ period of UK energy regulation can too easily be assumed to be the norm, whereas in reality it was an exception (albeit a less isolated exception as institutional innovations were adopted in other jurisdictions). The study of regulation shows that it has, very frequently, been a major source of restrictions of competition and restrictions of trade.

This is not an abstract point. Anyone concerned with potential cartelisation of markets will have noted that the one very obvious step in this direction over the past year is attributable to Ofgem’s decision to prohibit ‘undue’ price discrimination. Such a measure tends to lead to greater ‘harmonisation’ of consumer prices, just like a cartel.

Regulatory ‘fixes’ to energy markets, aimed at achieving specific outcomes or targets, can also be a major cause of future security of supply problems. In the face of public policies based on a continuing stream of such ‘fixes’, energy companies will, rationally, be more cautious about committing themselves to investments. The incentives are to hold back whenever government is expected to make decisions that will likely affect the profitability of the relevant investments.

And that is where we are at the moment. Rather than an incentive structure that rewards those who innovate, act early and take initiatives, we are developing an energy sector in which companies find it more rewarding to wait until politicians and bureaucrats have made up their minds on this or that issue of the day. Since political preferences are rarely stable over time, one implication of this situation is that, in addition to chilling investment, it creates an environment in which good management can become all but impossible. Some of the histories of management of public corporations illustrate the point.

Is there a case against a CC reference?

This regulatory/political uncertainty point is sometimes used as an argument against a CC investigation of energy markets, which might provide further reasons for delaying investment as companies wait for the outcome of the Commission’s deliberations. However, the argument tends not to be accompanied by reference to the realities of a CC investigation under its current procedures. It may have once been true that the Monopolies and Mergers Commission could be an inscrutable body, capable of producing surprises at the end of a very long inquiry; but reforms introduced by successive chairs of the Commission make the process much more of a conversation than it used to be.

Progress in policy development does not stop while the CC does its work. Rather, its work simply becomes part of a wider policy discourse. It could act as a catalyst for more rapid sectoral development, subject to one important qualification: any reference should be framed against a background that makes the broad characteristics of future energy policy clear-- is there to be one master (central planning) or many (the competitive markets approach)? That is, the Great Regulatory Flaw needs to be addressed, the pursuit of incompatible goals abandoned. The CC can then focus on ‘how-to’ questions, which is where its potential contributions are greatest.

More specifically, if the direction of energy policy is reset toward greater reliance on market processes, better buffered from the subverting effects of political and regulatory ‘fixes’ by reformed and strengthened independent regulation, the Commission could be of considerable assistance in developing the practical reforms, particularly to aspects of current regulatory arrangements, that will be necessary to achieve the broad policy aims.

Once the general direction of policy is clear, capital markets are perfectly capable of recognising the positive aspects of such a resetting of policy, and of responding appropriately.