Stuart Jackson is Chief Financial Officer of Octopus Energy.

Surely an energy price cap is misguided leftist meddling – anathema to any right-minded Conservative?  Not true: designed correctly it can be a tool to unlock competition.

As an entrepreneur, energy company director with a background in economics and tribal Tory, I naturally find it counter-intuitive to back any form of intervention – but the retail energy market is a demonstrably failing market.  Today, it is skewed in favour of big suppliers at the expense of the majority of customers and perpetuates inefficiency.

We’ve yet to see the detail on the energy price cap announced by the Prime Minister, but the intent to force energy suppliers to compete hard for new business on a level playing field through a smart, market-sensitive measure for the benefit of the consumer is clear.  A ‘relative’ cap on the difference between standard variable tariffs and acquisition tariffs, along the lines proposed by John Penrose, could untie Adam Smith’s ‘invisible hand’ in the retail energy market.

A relative price cap is a far cry from a blunt Milibandesque price control that is insensitive to the market, or forced switching that over-rides customer choice.  However, it is perhaps unsurprising that the Big Six have been the most vocal in opposing Mrs May’s proposal as for so long they have benefited from the market’s bias in their favour.

Cornflakes and kilowatts

Well-functioning consumer markets are kept competitive by the few that shop around assiduously for the benefit of all consumers. In the grocery retail market, most shoppers don’t need to do comparisons every week: we all know that some bargain hunters will keep retailers sharp. Tesco can’t afford to increase the price of milk because it’ll lose customers – so all customers benefit from the threat asserted by the most price-sensitive shoppers.  Similarly, if Tesco want to win new customers by cutting the price of Cornflakes, all shoppers benefit from cheaper Cornflakes.

The grocery market works because price is a signal visible to all. The most price-sensitive shoppers keep prices down for everyone, and force retailers to be lean in order to compete. At the core of the energy market dysfunction is the fact that price signals are not visible to everyone. Unlike grocery retailers, energy companies are able to charge different prices to new customers and loyal ones.

The energy retail market has several layers that obscure the real cost for any but the most analytically gifted and time-rich consumer. First, pricing structures are complex with both ‘unit’ and ‘standing’ charges for each of gas and electricity, and in some cases differential rates for day and night. Second, because consumption changes with the seasons, it’s hard to compare spend from one month to the next. Third, to smooth payments, suppliers use a regular direct debit, which is typically fixed and rarely changes at the same time as prices move – effectively masking increases.

And of course, to avoid interruptions to energy supply at the end of a fixed contract, the regulations require that consumers are automatically moved onto a standard variable tariff (SVT) once the ‘teaser’ deal ends. This means you continue to rack up debt even if you cancel your direct debit.

If consumers can’t clearly see what they’re really paying, no amount of exhortation or offers to intermediate will get people to switch. This creates the perfect basis for price discrimination between new and existing customers.

The formerly nationalised suppliers systematically exploit this by increasing prices for existing customers by as much as 50 per cent at the expiry of fixed tariffs.  They are able to use the high margins generated in this way (on standard variable tariffs) to distort the market for new customers. Many of the ‘loyal’ customers are ones they inherited at privatisation. These are not competitive companies who’ve had to fight to win customers – they’re able to charge monopoly prices to long-disengaged customers.

The consequence of this is that the market isn’t forcing efficiency, because the bloated, inefficient suppliers are able to use the generous margins generated by the 16 million or so customers on their SVTs to subsidise switching prices and appear competitive. Analysts have recently calculated that the Big Six players are making 20 per cent gross margins overall and over 30 per cent on their large standard variable tariff books. And yet some of these are still not able to generate a profit thanks to their astonishing overheads.

There are now over 50 retail energy suppliers – many of them entrepreneurial businesses, efficient, agile and focused on their customers. But until price acts as a signal of efficiency and switchers create pressure to bring costs down, there will be insufficient competitive tension. The energy market does not behave like a market. To deliver real market dynamics we need the simplest possible reform – not more regulation that creates further opportunities for gaming and unintended consequences.

The devil is in the detail

An ‘absolute’ cap on the prices that companies can charge for energy would deliver a quick impact, but it would be a blunt tool, and wouldn’t make this a functioning market. It would mainly dull the extent of failure, and give credence to high rates charged by Big Six suppliers.

A relative price cap, on the other hand, would turbo-charge competition. If the Big Six could no longer run loss-leaders to win new customers, they would experience very significant customer attrition, but with no compensatory gain. Choosing to maintain a high standard variable tariff at the cost of dramatic customer losses would not be tenable for long, and they’d have to reform, bringing down prices for their long-term customers – or exit the market through the sale of their customer book. Meanwhile prices in the switching market would not rise as newer entrants now lead price setting for switchers. For more information and analysis around pricing in the energy supply market, go to the Octopus Energy website here.

With competition finally working to keep prices down for both ‘switchy’ and ‘non-switchy’ customers, we could start to slim down the regulation, much of which has sought to correct for this market failing. Just as with supermarkets, everyone could enjoy good value; inefficiency would find no hiding place; and unhappy customers could vote with their feet without the fear that the next supplier will be as bad as the last.

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