Written evidence from the Department for Business, Energy and Industrial Strategy (PLS0038)

I write with my response to the Committee’s Call for Evidence on the draft Domestic Gas and Electricity (Tariff Cap) Bill.

The Government welcomes the process of pre-legislative scrutiny that your Committee is undertaking and looks forward to receiving the final report as soon as possible. The Government intends to legislate on this matter as soon as possible, in order to protect domestic energy customers from excessive charges.

Objective

In its energy market investigation report of 2016, the Competition and Markets Authority (CMA) found that suppliers have ‘unilateral market power over their inactive customer base’[1] and can ‘exploit such a position by pricing their Standard Variable Tariffs (SVTs) materially above a level that can be justified’[2]. As of April 2017, three-fifths of consumer accounts were on variable tariffs.  The CMA found that customers of the six largest energy suppliers were paying £1.4 billion a year more than they would be in a truly competitive market. In his review of the cost of energy Professor Dieter Helm noted that “the CMA found one of the largest detriments ever – by it or its predecessors.”

The Government wants to ensure that the retail energy market works for all domestic consumers. The objective of the draft Bill is to provide temporary protection to those paying unjustifiably high prices for their energy, while the conditions for effective competition across the market are established.

The Government believes that competition is the best driver of value and service for customers, but where the conditions for effective competition are not present we are prepared to act. The conditions for effective competition have not yet spread across the whole market. There exists an information asymmetry between energy suppliers and their customers, whereby suppliers are able to identify which of their customers are unlikely to move to a new supplier, and therefore have little incentive to offer these customers a fair deal. This asymmetry prevents competition from functioning which, if it did effectively, would bring down prices for all customers. This has resulted in the emergence of a two-tier market where the fixed-term market is competitive and working well for engaged consumers, but customers who are not engaged,  and who are predominantly on their supplier’s standard variable or default tariff are penalised.

Ofgem have consulted on extending the safeguard tariff protection currently offered to prepayment meter customers to a further 1 million vulnerable households in February 2018 and have changed the rules to allow customers to roll onto cheaper fixed term deals instead of expensive standard variable tariffs. But these interventions will not cover all of the consumers who are losing out.  Measures are being undertaken to improve the operation of the market, such as reducing the time it takes to switch supplier, actions by suppliers to engage consumers about their tariff options and the Government’s Midata programme[3]  that will enable consumers to share their consumption data easily with trusted third parties. But these will take time to implement and become effective.

The current rollout of smart meters will help bring forward further market improvements.However, in the short-term many customers on SVT and default tariffs may trust well-established brands and assume that loyalty is rewarded with lower prices, when in fact the opposite is true. Therefore, temporary protection is needed for those customers who are overpaying.  That is why we have published the draft Bill, which provides for a temporary price cap for domestic customers on SVTs and default tariffs. The level of this temporary cap would be set by Ofgem, as the independent energy regulator, and would initially last until the end of 2020, with the potential to be extended by up to three years, if needed.

Provisions

The Government is confident that publishing this legislation in draft for pre-legislative scrutiny will help to ensure that the draft Bill will achieve our objectives. 

The Government believes that the matters in clause 1(6) that Ofgem must have regard to when putting the cap in place are the right ones, but the Government is open to considering the inclusion of other factors that might be suggested.  The level of the cap will be a matter for Ofgem, not ministers. As the independent regulator, Ofgem has the expertise to balance the relevant factors in determining the level of the cap. For the same reasons, Ofgem would review[4] whether the conditions for effective competition are in place and make a report and recommendation to the Secretary of State on whether the cap should remain in place.

The Government has heard the arguments for a relative cap.  However, we think this will likely prompt the withdrawal of more competitive rates by larger companies, while offering no protection to those on poorer value tariffs, which is contrary to the Government’s objectives.  A relative price cap would also have no upper limit on the price that can be charged.  Some energy suppliers, with large proportions of customers on SVTs, earn significant profit from disengaged customers.[5]  There is, therefore, a very real risk that they would preserve that profit by removing their cheapest deals, rather than by reducing their SVTs. However, the presence of many smaller and intermediate sized suppliers in the market competing on fixed term deals should ensure that the fixed term tariff market remains competitive.   Therefore, the Government remains of the view that an absolute cap is the right approach.  An absolute cap would be more difficult to ‘game’ as it would not permit suppliers to raise their prices beyond a certain level, and would provide a level of definite protection to all SVT and default tariff customers.

The Government is clear that the cap should be applied to tariffs that customers have not made an active decision to switch to. This includes SVT and other default tariffs (including fixed default tariffs).  12 million non-prepayment households remain on expensive SVTs and they, for very many reasons, do not or are unable to switch. In the smaller part of the market that is for fixed-term tariffs, competition is working well. According to Ofgem, in September 2017, the bill for a typical dual fuel household on a SVT with one of the Big Six energy suppliers was £1135. In contrast the cheapest tariff amongst all suppliers was £827 – a difference of £308.  The CMA found that those who don’t switch supplier to get the best deals include a disproportionate number of vulnerable people.  Households with low incomes, fewer qualifications, those in the rented sector and those over 65 are more likely to be losing out.  39% of customers living in households earning less than £16,000 have never switched supplier, compared to 29% of customers living in households earning above £16,000.[6] 

In determining the level of the cap the draft Bill requires Ofgem to have regard, in addition to the other matters listed, to the need to create incentives for suppliers to improve their efficiency, and to ensure that efficient suppliers remain able to finance their businesses. The degree to which individual suppliers will be affected will vary depending on a number of factors, such as: the price of their SVT tariff, the size of their SVT customer base, their cost base and opportunities to deliver efficiencies. Large and some mid-tier suppliers are most likely to be impacted as their SVTs are typically some of the more expensive on the market, and some of the largest six suppliers in particular have a larger SVT customer base. Smaller suppliers are expected to be impacted less as, in general, they have built their customer bases from active switchers taking up competitive tariffs. Evidence shows that the price of an average SVT with the six largest energy firms is over £100 more than the average SVT of all other firms in the market. In addition, some smaller suppliers have a large proportion of their customer base on fixed term tariffs, which tend to be priced below SVT and default tariffs. 

The Government’s view is that this intervention should not become a permanent feature of the landscape. Clause 7 of the draft Bill provides that the tariff cap is temporary until the conditions for effective competition are in place. The cap would be in place until the end of 2020 and may not be extended beyond 2023[7], by which time the Government expects that factors such as the roll out of smart meters, and other actions taken by suppliers and Ofgem, will mean that a tariff cap is no longer necessary. As the roll-out of smart meters expands, and the technology improves, consumers will find themselves in a better position to make informed choices about their energy suppliers, and barriers to engagement will be reduced. The roll-out of smart meters will allow people access to up-to-date information on their energy usage.  Bills will be based on accurate readings of actual consumption and In-Home Displays offered as part of the roll-out will provide near real-time feedback to customers on what energy they are using and how much it is costing.  Ofgem’s Consumer Engagement Survey for 2017 showed that consumers who have a smart meter are more likely than those who do not to have switched supplier in the past 12 months (23% versus 17%). Consumers can allow people other than their current energy supplier to access directly the detailed energy consumption data stored on their smart meters.  This complements the Government’s Midata programme for energy, as consumers will be able to choose to share their consumption data easily with trusted third parties such as switching sites, apps or advisors who can help them to find the best deal quickly and easily.

Impact

The Government has published an Impact Assessment for the draft Bill.  The impact would mostly depend on the level at which the cap is set, which is for Ofgem to determine.  Ofgem would publish an assessment of the impacts when it consults on its proposed methodology for determining the cap.

However, our assessment shows the primary cost would be a reduction of energy suppliers’ revenues from customers on SVTs and other default tariffs, which may lead to lower profitability if it is not fully offset by efficiency improvements.  Other potential costs include those to customers not on SVTs and default tariffs, if suppliers choose to raise these tariffs to counteract the impact of the cap. However, the presence of challenger suppliers, some of whom have a relatively small number of customers on SVTs and, therefore, will not see their revenues impacted to the same extent, should ensure that there are still competitive fixed tariffs for customers to switch to.

The key benefit would be the protection of SVT and default tariff customers from unjustifiably high tariffs until the conditions for effective competition are in place, reducing the detriment these customers face. There may also be an overall increase in public confidence in the market if customers feel that they are unlikely to be on a poor value deal. Lower revenues could drive efficiency improvements among suppliers, but may also reduce the ability of larger suppliers to sustain low or no profits in the competitive part of the market, leading to market share growth and greater profitability for more efficient challenger companies.

The Government has considered how other countries have regulated retail energy prices. It is difficult to draw useful lessons from many of them. They cannot be compared to Great Britain as many were not liberalised in the same way as the GB market.  We are aware that in some countries price caps have been set too low to cover costs, or were not updated to take into account changes in market conditions. The draft bill addresses this by requiring Ofgem to have regard to an efficient supplier being able to finance their activities when determining the level of the cap.

The draft Bill has been designed to minimise any potential impact on investor confidence.  For example, responsibility for setting the level of the cap – and for recommending whether it should remain in place – will rest with Ofgem, the independent expert regulator. Ofgem is well-placed to form an independent judgement on what level of the cap will best balance the objectives we have set, including ensuring efficient suppliers are able to finance themselves. Ofgem will be required to develop a transparent methodology for the price cap. Moreover, the draft bill clearly establishes the price cap as a time-limited measure aimed at addressing a particular element of market function.

Closing

The Government has been clear in its view that the retail energy market is not currently working effectively.  As the Secretary of State said when he gave evidence to the Committee on 1 November, it ought not to be the case that every consumer every year has to go through a process of defending themselves against what the CMA has found is an excessive price. This draft Bill would bring about a necessary safeguard against this unfairness until the conditions for effective competition are in place.

Margot James MP

Minister for Small Business, Consumers & Corporate Responsibility

29 November 2017