Tales of the unexpected

Tariff Simplification

The proposed standard tariff format

Utility Weeks’s reporting of OFGEM’s latest move to try and ensure that consumers get a better deal from UK energy retail markets highlights one proposed reform in the area of tariff simplification.

The article in Utility Week stated that:electricity

 “Ofgem wants to restrict the number of tariffs for standard products from each supplier, to just one per payment method. It would standardise the format of the tariffs, with suppliers allowed to compete on just a single "per unit" price.”

I presume that OFGEM’s logic  is that simple and standardised tariffs make price comparison easier and therefore make it easier for consumers to make the right choice.

A classical economist would argue that this simplification of market function and reduced cost of complexity will feed through to lower consumer prices through the application of market forces.

The law of unintended consequencesutilities

As ever, the road to hell may be paved with good intentions as the Law of unintended consequences comes into play.

Forcing through such a measure may well have the opposite effect. What we may actually see is reduced customer switching, increased prices and super profits being made by energy retailers. Worse still we might well see this policy leading to lower energy efficiency in society and increased carbon emissions.

An examination of the energy system can lead us to see how the counter-intuitive outcomes can easily come about.

Let us imagine a world in which only a single standard price format is allowed.

In this world price comparison websites close down and their pro-active marketing campaigns cease. Given that in the UK energy markets we have the highest level of consumer switching (between 15 and 25 % per year) in comparison with any other energy market in the world and indeed possibly in comparison with any other industry in the world the level of customer switching can only go one way when this stimulus vanishes – and that is down.

This in turn reduces supplier costs since the cost of acquiring new customers to replace those that churn is one of the largest industry costs. In addition supplier administration costs will also reduce due to the simplification of tariff management and billing processes.

However, this will not feed through to reduced consumer prices because of the changed behaviours of the players in this new simple world. No longer will suppliers be thinking through how they wish to price for different segments of the market  it will be a simple  case  of just looking at the published unit price of competitors and broadly matching it. No point significantly undercutting since the others will then just match you. Much better to take higher prices and lower churn and enjoy the market of “accommodation”.

Please note there is no suggestion of complicity between players here – simply that the logical independent decision making of players dictates these behaviours.  

Another feature of this world is that we have a standard fixed standing charge in the industry set by OFGEM.  This could be zero however this runs counter to the fact that some of the cost structures of the industry are fixed per customer so for the purposes of this scenario I have assumed there is a positive standing charge.

So what happens……..

Large users who would previously have enjoyed a high standing charge and very low unit  rate  will find their tariffs rising as the standing charge drops and unit rates rise. It will have to drop since OFGEM will want it set at a level which does not put a high burden on low use vulnerable households. This means prices for all medium and higher volume users will rise. Given the reduced level of prompt to switch (the price comparison website extinction) and the logical pricing behaviours of the players price levels will simply rise.

So for suppliers this may well be good news since rising prices and reducing costs means higher profits.

Clearly for the regulator this will be bad news and a lot of head scratching trying to work out why market reforms that seemed sensible have created the opposite outcome to that planned.

Finally, we currently live in a world where suppliers are contemplating how to price the electricity to be used in the appliances which  enable a switch from hydrocarbon to a low or zero carbon alternative. The two most prominent of these are heat pumps (ground and air source) and electric vehicles. Adoption of these technologies makes these households high energy users. Given that high energy users are penalised in this scenario what we will see is a lower take up of these technologies than would otherwise have been the case. Hence lower energy efficiency and higher carbon emissions.

And it gets worse.

In order to reduce peaks in demand , and hence the need to bring on, or even build “brown” power stations the industry will under the current regime bring in innovative time of use tariffs. In this standardised world however this will not be possible since it goes against the mantra of simplification. The consequence is rising peaks , more “brown” station use and hence higher emissions, more investment in generation and networks which in turn means higher costs which will feed through to consumers due to the changed player behaviours described above.

All in all the “Simplified tariffing  approach ”  is not simple – it is simplistic.

The complex dynamic nature of the energy system means that rather than delivering consumer benefit it has the potential to do great damage to both consumers and the environment.

Published by: Enstra Consulting

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