Energy and Climate Change CommitteeWritten evidence submitted by Which?

1. Introduction

1.1 Since the cost of energy is consumers’ number one financial concern,1 it is worrying that three quarters pay more than they need on expensive standard tariffs—a collective overpayment of £4 billion annually. While the factors and costs that determine prices are complex, the current market arrangements provide little assurance to consumers about the fairness of energy prices.

1.2 When the GB market was liberalised there was an expectation that all consumers would benefit from competitive prices. This has not materialised. Competition in the retail market is weak, with only 5–10%2 of consumers actively engaged,3 providing little incentive for suppliers or generators to be efficient and offer the lowest prices. Furthermore, the effectiveness of wholesale market competition is not clear due to a lack of transparency and information. Finally, there is little scrutiny of how government policy costs are attached to consumers’ bills, with considerable faith placed on the energy market to deliver programmes efficiently and cost effectively.

1.3 These factors are not only important for today’s prices, but also future energy bills since Electricity Market Reform relies on effective wholesale market competition to provide robust reference prices that will act as benchmarks for future generation.

1.4 The opportunity presented by the Energy Bill and Ofgem’s Retail Market Review to tackle retail market competition must not be missed. Action is also needed to ensure that wholesale markets become truly competitive and the costs of government policies are scrutinised rigorously. Without reform, consumers will continue to have little confidence in the fairness of the prices they pay and it will be difficult to convince consumers to support the £110 billion investment needed to decarbonise and renew the energy system.

2. What factors determine energy prices (wholesale prices, company operating costs, green levies, company profits etc)? What contribution do these factors currently make towards a typical household energy bill and how might this change over time? 

2.1 Consumers’ energy prices are constructed of six costs.4 Greater evaluation is needed of the effectiveness of the retail and wholesale markets and the cost of government programmes to their influence on the prices consumers pay.

2.2 Wholesale costs constitute over 60% of domestic energy bills.5 These have contributed to the substantial increase in prices in recent years and require particular analysis. These costs are derived from a complex set of interactions with suppliers sourcing energy through self-supply arrangements within vertically-integrated companies; purchasing it directly from a vertically-integrated or independent electricity generator/gas producer; or buying it from the wholesale markets.

2.3 The volume of energy that goes through each of these routes is not clear. Furthermore, it is not possible to know how much energy is traded over the wholesale markets. However, in 2010 it is estimated that equivalent of 6% electricity and 10% gas consumption volumes were traded over-the-counter (OTC) over wholesale markets.6 It is important to note that this trading influences the prices paid by suppliers wherever they source their energy from. Price information from the markets is limited but is often used to inform the transfer prices that dictate the cost of selling energy within a vertically integrated company7 as well as informing the direct contracts between suppliers and generators.8 These arrangements raise a number of concerns that are set out in 3.7.

2.4 The impact of government programmes on electricity bills has been relatively small so far. However, as low-carbon generation makes up a larger share of electricity and the EU ETS carbon price increases, the impact of support costs on prices and bills will grow.9 Since the majority of these costs are applied through electricity bills, people with electric heating—often the fuel poor—will be disproportionately affected.

2.5 There is significant uncertainty about the cost of the Energy Company Obligation (ECO) and its impact on bills. DECC estimates that the costs could range from £0.53 to £3.09 billion annually10—though there is no cap on the cost. If Green Deal finance is unattractive to consumers then ECO costs may increase as suppliers spend more to meet their ECO obligations.

2.6 Other government programmes also attach costs to consumers’ bills, such as smart metering. This is estimated to cost £11 billion and the main control mechanism on these costs is the retail market, which is acknowledged to be ineffectively competitive. As with ECO, there is no cap on the final price that consumers will pay for this programme.

2.7 Finally, while the cost of retailing energy should be a small component of consumers’ bills, ineffective competition reduces pressure on suppliers to ensure that their costs are as efficient as possible and also limits downward pressure on wholesale costs. This will remain a source of inefficient costs unless competition in the retail market becomes more effective.

3. To what extent (if at all) should the Government or the regulator intervene in the market to affect the prices consumers (or certain groups of consumers) pay for their energy? Should any changes be made to the Government’s current approach?

3.1 Competition driven by engaged and informed consumers is often the most effective mechanism to drive efficient prices. However, since the current regime is failing consumers, the Government and regulator must intervene.

3.2 The Government and Ofgem’s intervention via their tariff proposals contains a serious risk of allowing competition to remain weak since it will not improve the comparability of energy tariffs. Prices still cannot be compared at a glance and this will constrain competitive pressure on energy bills.

3.3 The Government should further amend the Energy Bill to introduce single unit pricing for energy tariffs. This should address the problem of consumer disengagement in a way that is less restrictive and more conducive to innovation than explicitly capping the total number of tariffs a supplier can offer.

3.4 Alongside this proposal, our recent report “The Imbalance of Power—The Retail Market” sets out a package of measures11 that offer the best chance to make competition work effectively. If these reforms are introduced and consumer outcomes still do not improve by 2015, then the wider structure of the retail market should be fully reviewed including consideration of a “fair price guarantee”.

3.5 A fair price guarantee does not equate to a return to a full price cap model for all tariffs. There are energy markets, such as in the US State of Illinois and Northern Ireland, where both regulated and competitive tariffs exist. These hybrid models can enhance rather than hamper competition, while ensuring the interests of consumers are protected. The regulated tariff acts as a price to beat for competitors, delivering choice for those that want it while ensuring fair prices for those who do not engage.

3.6 The Government should take backstop powers to enable the regulator to introduce a fair price guarantee for the default open-ended variable rate tariff. This would send a clear message that every effort must be made to improve outcomes for consumers. If effective competition does not develop, then the government will have the power to intervene swiftly.

3.7 Beyond action in the retail market, the Government must consider the steps necessary to ensure that the wholesale electricity and gas markets are transparent and competitive. As set out in 2.3, the fact that wholesale markets are dominated by uncleared OTC trading—with 80% of electricity traded and 70% of gas traded in this manner12—raises concerns. Uncleared OTC trading has similar vulnerability to manipulation as Libor—including no formal data collection—and accusations of this occurring have recently been made. This raises questions about whether contracts linked to OTC indexes are value for money. Furthermore, there are issues with the competitiveness of the wholesale electricity market13 and there have been allegations of manipulation in the gas market. As a result, questions must be asked about whether prices are as competitive as they should be.

3.8 The Government and regulator should also consider how the six major suppliers benefit from wholesale electricity and gas prices, as well as the way that their business structure has a wider impact on competition in the wholesale markets. These suppliers are part of larger vertically-integrated companies covering 98% of the retail market and 70% of total GB electricity generation capacity.14 ^, 15 This structure appears to present little incentive for companies to keep wholesale prices efficient, if it reduces the overall margin for their generation business. The vertically integrated structure also obscures the interactions between the most influential group of generators and suppliers, since their dealings are behind closed doors. This reduces the information available to external observers and raises questions of how costs are passed through to bills.

3.9 Given the role that wholesale markets play in encouraging investment and therefore their impact on future energy prices, the Government and regulator should consider what action is needed to ensure that price information is robust and that the markets are competitive. Which? called for the Government to establish an independent review to scrutinise the above issues following the six major suppliers’ price rises in October 2012. Such a review should identify the measures required to increase wholesale market transparency and competition.

3.10 This Select Committee inquiry should therefore explore the full range of actions available to the Government and regulator to deliver transparent and competitive wholesale markets. Which? believes that this should include consideration of a self supply restriction and the legal separation of the supply and generation divisions. The latter option could be informed by the approach taken by the regulator for distribution and network businesses that are owned by vertically integrated companies.

3.11 Our call for a review in October 2012 also argued that Government action is necessary to ensure that there is more robust scrutiny of the cost of policies. For example, the Government cannot simply pin its hopes on the retail market to keep a lid on the cost of smart metering. For ECO, a system must be in place to allow Ofgem to monitor how much is passed through to consumers in bills and to scrutinise these costs to ensure value for money.

3.12 Finally, the Energy Bill should be amended to ensure that a robust regime of scrutiny is put in place to protect consumers from the costs related to Electricity Market Reform. As previously recommended by the Energy and Climate Change Select Committee, transparency and scrutiny of the contract process must be written into the Bill to ensure that consumers are protected as far as possible. The Bill should ensure that the independent panel of experts has consumer representation and is responsible for scrutinising strike prices and that all strike prices are published before Contracts for Difference are signed.

4. How effective is Ofgem in ensuring consumers get a fair deal? Are there any areas for improvement?

4.1 Ofgem’s remit is to protect consumers through promoting effective competition. Competition was intended to be primarily price-focused, with additional customer service benefits stemming from it. Consumers were to be the engine of competition, choosing the cheapest offers without compromising on service. Yet, despite the fact that the price of energy is a primary financial concern, people appear powerless to take advantage of what limited competition the market offers.

4.2 For too long Ofgem has ignored the need for comparability, instead prioritising supplier claims of a need for complex tariff structures to recover different types of costs and deliver “choice” and “innovation”—two areas where suppliers have delivered little that is beneficial.

4.3 The limited competition that exists is played out in a small segment of the market where suppliers vie for the most engaged consumers with attractive fixed term deals. As a result, many people are effectively excluded from the most competitive deals, while accusations of loss leading are a common complaint from suppliers struggling to gain a foothold in the market.

4.4 Ofgem recognised these problems in the Energy Supply Probe in 2008, yet its review of the retail market has been ongoing for the last five years and its approach has changed markedly in that time. Whereas the Probe attempted to ban discrimination between different groups of customers, the Retail Market Review (RMR)—correctly, in our view—seeks to improve outcomes for consumers through more effective competition.

4.5 There is much to welcome in the latest RMR package. The focus on increasing wholesale market liquidity and transparency is of fundamental importance in ensuring independent suppliers and new entrants can mount a credible challenge to the six major suppliers. Furthermore proposals to simplify bills and other communications, improve the switching process, provide better reporting of complaints data and monitor the development of competition in a more meaningful way are welcome.

4.6 However, the tariff proposals will not allow prices to be compared at a glance, limiting competitive downward pressure on bills. Furthermore segmentation based on payment method or online account management will still be possible, meaning any competitive pressure that there is cannot be guaranteed to deliver benefits across all consumer groups.

4.7 Ofgem should amend their RMR proposals and finally enable consumers to play their designated role of driving effective competition to keep prices in check. This requires Ofgem to introduce unit pricing; limit segmentation by allowing one default tariff and make all tariffs available for all payment methods; review the case for national pricing; and improve the switching process.

4.8 Ofgem have attempted to improve the transparency of the link between the generation and supply arms of the vertically integrated companies through the introduction of market indicator reports, reporting requirements and an investigation into transfer pricing.

4.9 With regard to the wholesale markets, Ofgem has focussed on the ability of small suppliers to gain access to energy to challenge the major suppliers’ position. While the regulator acknowledges that reference prices must be improved, information and transparency has not been viewed as a vital element to improve confidence in the efficiency of wholesale markets. Ofgem should now address this. Unless information is available, it is difficult to see how the regulator will determine whether the markets are working effectively and whether consumers can be confident in the prices they pay.

5. Could it be possible to benchmark energy prices to provide greater certainty about whether consumers are getting a fair deal? If so, how might this be achieved in practice?

5.1 Benchmarks could be an effective mechanism to provide confidence in prices. Furthermore, a benchmark could be used as a robust basis for tracker tariffs.

5.2 Two options could be considered, a wholesale market index or a benchmark retail price, such as the fair price guarantee set out in 3.5. Both would require improvements to the transparency and robustness of the underlying wholesale energy market, as set out in 8.2. However, an international benchmark should be avoided since comparisons of international energy prices are often misleading and cannot be compared on a like-for-like basis.

5.3 Both the State of Illinois and the Northern Ireland hybrid markets have an effective benchmark retail price through a regulated default tariff. This allows consumers to benchmark the value of other tariffs and it is a price to beat for suppliers.

6. Could any other measures be put in place to ensure consumers are paying fair prices for energy and to provide consumers with greater confidence in this?

6.1 Ofgem’s RMR sets out a new set of measures of competition, which should give a truer assessment of the effectiveness of competition and whether consumers pay a fair price. If consumer outcomes have not improved by 2015, the hybrid model set out above should be considered, as set out in 3.5. This model could guarantee a fair price to all, whether they engage or not, through a regulated benchmark tariff and give more confidence in the value of energy tariffs.

7. Many consumers believe that energy company profits are the reason energy bills have been going up in recent years. Is this perception fair? Why is there so much uncertainty about the level of profits the large, vertically integrated energy companies are making? What could be done to improve clarity?

7.1 The major suppliers are part of vertically-integrated companies and able to move risk and margins around the company. This means that a supply business may look less profitable because the charges applied to that business are higher than would otherwise be expected. This is compounded by the fact that four of the large energy companies are international, so risks and margins can be shifted within the national and international dimensions of the companies. This has limited the usefulness of the new segmental information and there remains a lack of transparency and clarity.

8. How useful are Ofgem’s electricity and gas supply market indicators in monitoring the level of profits made by energy companies? Could they be improved?

8.1 Ofgem’s indicators are speculative projections of net margins on “typical” accounts based on estimations of expected wholesale and operational costs, as well as purchasing practices. The analysis reveals little more than was already known—that retail competition is weak and that companies may take advantage of this.

8.2 Building on the proposed new market indicators, Ofgem should monitor generation, production activity and margins; wholesale energy trading, including volumes of physical and financial trading; and the numbers of market participants. Ofgem should develop robust wholesale energy indexes against which movements of domestic tariffs could be monitored.

9. How useful are the segmental generation and supply statements that major energy suppliers are required to produce in understanding where companies are making their profits? 

9.1 While these statements are welcome, their usefulness is limited to a top-level assessment of where the margins and costs lie across the generation and supply businesses. The statements do not differentiate trading arms, they do not provide information on the different business structures or the ways that companies assign risks and margins to different business arms. The pan-European nature of four major suppliers adds an additional dimension as costs are not only moved within companies but also between national entities. As a result, limited insights can be drawn.

9.2 Ofgem should require a breakdown of trading activity. Further analysis of transfer pricing activity would enable a better assessment of the allocation of risk and margins between the supply, generation and trading functions in these companies.

February 2013