SWITCH OR TRANSFORM THE FUTURE OF THE RETAIL ENERGY MARKET

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1 BRIEFING PAPER JUNE 2015 SWITCH OR TRANSFORM THE FUTURE OF THE RETAIL ENERGY MARKET SIMON SKILLINGS The Competition and Markets Authority (CMA) is currently investigating competition in the GB energy market and is about to publish provisional findings and possible remedies. This is an important moment for energy consumers since the new government has a manifesto commitment to implement the final recommendations. Separately, there is the increasing expectation that the advent of new digital technologies and the reduction in costs of home generation and storage systems will lead to a revolution in the way that energy is consumed. Rather than being unrelated, these issues are, in fact, closely linked and the recommendations of the CMA must be framed in this broader context. The key market failure that the CMA will need to address involves the high proportion of customers who are unwilling to go through the simple process of switching supplier - even though this could save a typical customer more than 100 each year. Even if measures could be introduced to ensure that many more customers switch to the cheapest available tariff, the overall economic benefits would be minimal and related to marginal reductions in supplier profitability. On the other hand, the overall economic benefits associated with encouraging more dynamic and efficient energy use are potentially enormous and could run to billions each year. However, the cost reductions available to individual customers are likely to be rather lower than 100 each year and realising these benefits will demand upfront investment and/or behaviour change. This means that it will be far more difficult to encourage consumers to provide dynamic demand services than simply to switch supplier. It is beholden on the CMA to demonstrate how their proposed remedies encourage full participation in this more challenging situation. It is not acceptable to focus purely on the short term issue of supplier switching since there is a far greater prize that delivers real benefits to all consumers. Achieving this goal will require new thinking about the customer decision process. Tariff choices need to be expressed clearly and simply and must ensure that a quick intuitive response by the customer leads to the best outcome for them and overall energy system alike. It is difficult to see how this can be achieved without a tight regulatory framework for retail energy supply. 1 E N E R G Y M A R K E T R E F O R M : U N F I N I S H E D B U S I N E S S

2 Context The Competition and Markets Authority (CMA) is currently undertaking a broad investigation into the GB energy market, in particular exploring aspects of the market that might prevent, restrict or distort competition. It is about to publish provisional findings along with possible remedies and will produce a final report before the end of the year. These recommendations have particular significance since the new Government has a manifesto commitment to ensure that they are implemented. Separately, there is an increased expectation that the advent of new digital technology and more efficient home generation and storage devices create the prospect for a revolution in the way energy is consumed. Smart technologies will provide consumers with greater control over their energy usage, thereby improving comfort and convenience in addition to reducing costs. This potential revolution has attracted political endorsement and in February, European Commission Vice President Šefčovič set out his intention to create an Energy Union with citizens at its core, where citizens take ownership of the energy transition, benefit from new technologies to reduce their bills, participate actively in the market, and where vulnerable consumers are protected 1. Many now see it as simply a matter of time before the old energy value chain is no longer relevant and traditional utility business models are abandoned. Indeed, the large German-based utility E.ON has already decided to re-position as a downstream business focused on providing customer services. These two developments might seem largely unrelated but they are, in fact, closely linked. By exploring the limitations on competition in energy markets, the CMA should unearth valuable lessons on how a revolution in energy consumption might unfold. Moreover, it should become apparent how remedies might be applied so that this revolution is expedited to the benefit of individual consumers and society as a whole. Market failure All energy consumers in GB have had the opportunity to choose their energy supplier since 1998 and this was seen as one of the core goals of the original privatisation process. It was envisaged that competition would drive innovation with different suppliers aiming to increase earnings through reducing the costs of energy procurement and providing value-adding services for customers. This would result in a reduction in overall national energy resource costs and more satisfied customers. There are a number of reasons why this initial thinking was flawed. The opportunities for suppliers to achieve sustainable competitive advantage through competitive energy procurement are extremely limited. Supplier costs are driven wholesale gas prices (either directly in the gas market or indirectly in the electricity market) and there is no reason to expect any supplier to be able to predict the future of gas prices any better than its competitors. This leaves a strategic choice between taking a bet on future prices in the hope that you have backed the market correctly and simply trying not to lose out by mirroring the 1 Energy Union Communication: 2 E N E R G Y M A R K E T R E F O R M : U N F I N I S H E D B U S I N E S S

3 hedging strategies of competitors. Although neither option is ideal, most investors in utility businesses would have a clear preference for the latter thereby eliminating to desire to seek out lower cost energy supplies. As it has transpired, we have now reached the situation in which all major generation investment decisions are driven by Government procurement processes (renewables obligation, feed-in-tariffs, capacity mechanism) rather than those of suppliers and any possible impact of supply competition on resource efficiency has been further diluted. This leaves suppliers with the option to differentiate through innovative products and services and competition did indeed spawn a vast array of tariff choices. However, Ofgem recently concluded that this level of choice served more to confuse than inform customers and opted to introduce regulations to limit the number of tariffs that each supplier could offer 2. It remains an open question as to how active suppliers will be in harnessing new smart technologies to develop innovative customer propositions and whether the current market structure promotes or inhibits deployment. However, there are some worrying indications from previous experience in the market. In the absence of a significant cost differential between suppliers or distinct and compelling service propositions, it would be expected that in a competitive environment consumers would have little to gain from switching supplier. However, this is evidently not the case in the current market where many customers have the opportunity to save a year through switching supplier. Although increasing numbers have taken this opportunity, many have not and considerable political and regulatory effort is devoted to encouraging these passive customers to switch. Since this can have little or no impact on overall resource efficiency it is presumably based on the premise that suppliers in a fully competitive market at equilibrium would be prepared to operate at lower average profitability than is currently the case. This may well be correct, but the challenge of activating the disengaged rump of consumers is not insignificant. Relatively few customers are prepared or able to devote the time and effort that is necessary to find the best energy deal. Instead, they make quick intuitive choices plagued by the biases that are becoming increasingly well understood by psychologists. Making it easy for consumers to make the best choice with little or no effort is therefore a key policy challenge. It would also be necessary to find more explicit ways of dealing with vulnerable customers who often demand high levels of service and are least likely to pay their bills, thereby making them an extremely unattractive proposition for a supplier operating on very tight margins. The key issue facing the CMA as it ponders proposed remedies is, therefore, how to tackle those customers who are not prepared to engage with the market. It is important that the recommendations are not purely focused on the current market situation but consider how the market might evolve and the opportunities this presents E N E R G Y M A R K E T R E F O R M : U N F I N I S H E D B U S I N E S S

4 The demand side challenge Whilst the economic benefits associated with supplier switching are likely to be small and associated with marginal reductions in supplier profitability, those potentially available from a more active demand side to the market are huge in comparison. Various studies have shown how more efficient and flexible consumption can dramatically reduce overall resource costs whilst also improving security of supply and reducing carbon emissions. For example, the EU Commission has recently calculated that a fully active demand side of the market could save bn each year across Europe 3. However, estimates of the cost savings available to those domestic customers providing flexibility services suggest that they are unlikely to exceed 100 per year and are more likely to be a few 10 s per year 4. It is obviously important that market arrangements are designed to ensure that the value available to consumers is maximized and much of the current policy thinking is focused on this objective. However, the evidence from current experience in the retail energy market suggests that focusing on this issue alone might be insufficient to deliver the full potential benefits. If a large proportion of consumers are not prepared to switch suppliers when the annual benefits exceed 100, how many are likely to take the opportunity to provide flexibility services when the benefit will probably be considerably less than 100? Moreover, the ability to provide such services will either require the installation of some form of automated home energy management system or a degree of personal inconvenience and behaviour change, thereby creating greater barriers to participation than are involved with switching supplier. This suggests that the proportion of the consumer base that will be disengaged from providing demand flexibility will be rather greater than the proportion reluctant to switch supplier. Moreover, it is likely to be even more difficult to address these barriers to participation. This has important implications for the CMA. The solutions that are proposed to address concerns arising from the proportion of consumers who are currently unwilling to switch supplier may not be appropriate to address the more challenging problem of those consumers who are not prepared to provide demand flexibility. Given that the overall economic benefits of achieving an active demand side to the market far outweigh those associated with improving switching rates, the priority should be to ensure that the proposed remedies promote consumer engagement in this more challenging situation. Achieving the goal of a dynamic and engaged demand base will require a range of policy interventions and market developments and cannot be fully addressed by any silver bullets fired by the CMA. Most importantly, evidence from the US suggests that those improvements in demand side participation that have been achieved have required strong top-down political direction 5. This can most readily be achieved through establishing ambitious targets for the SUPERGEN HiDef Dissemination Event, 29 th April 2014, Goran Strbac, Imperial College, Slides on GB flexibility value; Report for DECC, Redpoint, Baringa and Element Energy, Electricity Systems Analysis, Future Systems Benefits from Selected DSR Scenarios, August Harnessing Demand Side Resources in Electricity Markets, Evidence for the United States, Taylor Dimsdale, Simon Skillings and Manon Dufour, E3G, June E N E R G Y M A R K E T R E F O R M : U N F I N I S H E D B U S I N E S S

5 proportion of total demand that can respond to a price signal or dispatch instruction. New appliance and building standards will be required to ensure the basic capability for an active demand becomes the norm and the regulation of network companies will need to change in order to ensure that the value of demand side services is fully utilised. Of greatest relevance to the CMA, tariff choices should be presented to consumers in a way that is clear and simple and ensures that the intuitive response leads to the best outcome for consumer and energy system alike. It is difficult to see how this might be easily achieved without a tighter regulatory framework for retail energy suppliers. Pivotal moment or missed opportunity The energy supply market now stands on the cusp of a revolution. The new technologies exist that have the potential to improve consumer comfort and convenience and dramatically reduce overall system costs. However, breaking out from the shackles of the past will not be easy and will require a concerted effort from the entire policy community. The CMA has an important role to play in this regard. Its thinking must not be constrained by outdated beliefs about consumer behaviour the old price and pray approach to demand response will fail to deliver anything like the full potential of the demand side resource. Moreover, the CMA must not be trapped by the old paradigm that high levels of switching are a good thing. Instead, they are an indication of a significant market failure that is the core issue to be addressed. Encouraging increased switching and reducing the price differentials currently seen in the market may have some limited benefits but these are dwarfed by the huge prize of an active demand side to the market. The remedies proposed by the CMA must be framed in this context. It is beholden on the CMA to demonstrate how the remedies it proposes will help overcome the significant barriers that exist to the active consumer participation in the market rather than simply focusing on increasing levels of supplier switching. 5 E N E R G Y M A R K E T R E F O R M : U N F I N I S H E D B U S I N E S S