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Competition in Energy Markets – Assessment Framework

Image of electricity pylons and insulator discs Print publication

30/01/2014

Background

It is rare to hear someone argue that energy prices are low or even that they are just right. The usual mantra is that energy prices are too high, that the energy market is dominated by a few large companies and that these companies unfairly skew the market for their own purposes. Although there is no hard evidence of the latter, nevertheless the view persists and there are an increasing number of calls from the Government, from commentators and from the industry for a comprehensive review of the energy market.

In the five years following the introduction of competition into retail energy markets in 1999, the number of energy suppliers fell from 15 to six. As a result a perceived problem with the market is that the ‘Big Six’ (British Gas, N Power, SSE, Scottish Power, Eon and EDF) provide almost all household electricity and gas and control almost three-quarters of electricity generation in the UK. Many commentators point to vertical integration (where supply and generation are controlled by the same organisations) as a key barrier to new entrants into the energy market. Further issues for consumers are that the process for switching suppliers can be complicated and the lack of or type of information provided by large companies can exacerbate this problem.

Since 2008 Ofgem has undertaken two separate reviews of the UK’s gas and electricity retail markets and found in both reviews that features of the market such as high levels of market concentration with no significant “competitive fringe” and a lack of engagement by customers weakened competition between providers.

In March 2013 Ofgem published its final proposals for Retail Market Reforms (RMR), aimed at making competition work more effectively in the energy market and protecting consumers and small businesses.  These include simplifying domestic energy tariffs and introducing standards of conduct that require energy suppliers to treat small businesses fairly.  These reforms are currently being implemented.

Latest consultations

Following confirmation by Ofgem that it would report annually on competition in the retail energy markets, in October 2013 the government announced that Ofgem would work with the Office of Fair Trading (OFT) and the Competition and Markets Authority (CMA) (which is due to take over from the OFT on 1 April this year) to carry out this annual assessment. The assessment will consider how well competition in the markets for gas and electricity is serving the households and small firms in Great Britain. The first such “state of the market” assessment will be delivered by the end of March 2014 covering both the domestic and SME markets, Ofgem, the OFT and the CMA have now published a framework setting out how this assessment will be carried out.

The assessment framework

The first annual assessment will be published too soon to give consideration to the impact of Ofgem’s RMR  which are still being implemented.  The assessment will therefore only consider the extent to which these reforms can be expected to address any competition issues. Subsequent reports from 2015 onwards will be able to assess the impact of RMR and it is hoped that further guidance will be provided in summer 2014 in relation to how RMR will be reviewed separately. In addition, due to the timeframes for this review, the assessment will not be able to consider the impact of smart metering. It has been suggested, however, that smart metering may well offer consumers greater visibility and control of their energy use and therefore may prompt increased switching.

The framework covers three elements:

  1. A description of a well-functioning market and how competition should work to deliver desired outcomes
  2. An explanation of the broad categories of reasons why the competitive process may not be working as it should (‘sources of harm’)
  3. An explanation of how Ofgem, the OFT and the CMA will use data and information (‘indicators’) to assess the market and competition.

Indicators of a well-functioning energy market

The well-functioning market can be used as a model for comparison with UK energy market(s) to assess the effect on competition. This is not an idealised model of the market as such but one that sets out how the market should operate within the parameters of a ‘real’ market.  Competition is dynamic and therefore the features of a well functioning market will be subject to change.

The tables below (reproduced from the State of the Market Report – Assessment Framework (19 December 2013)) show the indicators of a well-functioning energy market in both the short term and the long term.

 

Short Term Indicators
Market Outcome Indicator
High engagement Switching levels (internal or external), consumer research metrics, switching drivers, switching elasticities
Good service Customer complaints information, consumer research metrics, number of consumers in debt, number of disconnections, debt repayment rates
Clear communications (e.g. bills, letters) Consumer research metrics
Pressure on supplier costs Cost efficiency, observable pricing strategies
Pressure on margins Profitability (per customer), margins (including for different market segments and small suppliers’ margins), value chain profitability

 

Long Term Indicators
Market Outcome Indicator
Wide choice of retailer, demonstrable ability to grow from new entry New entrants at each level of the supply chain, size and growth of recent entrants, entry costs, barriers to entry
Tariffs responsive to consumer needs Innovative tariffs
Sustained, significant, dynamic rivalry Changing shares in different market segments (regional, payment type, fuel, tariff type e.g. online), concentration ratios, new and different consumer acquisition strategies/corporate strategies, market entry, market exit/merger activity
New commercial/business models New entrants or existing suppliers responding to changing market opportunities, new ways of consumers engaging with energy, offerings linked to other services
High quality of service and consumer trust Complaints information, supply interruptions, consumer research metrics, switching experience (time & reliability vs. Industry standards)

Potential sources of harm and how these will be assessed

The authorities outline their proposed areas of focus:

Unilateral market power

A number of features of energy markets suggest that unilateral power may be profitable for energy companies.  For example, in some areas of the market consumers do not respond strongly to increases in prices by switching suppliers or reducing their demand for energy. To investigate whether unilateral power exists, the assessment will look at:

  • National and regional measures of concentration
  • Changes in market shares over time (taking into account changes in prices where possible)
  • The sensitivity of demand to price
  • Indicators of whether that power might be being exercised over time.
Weak competition between suppliers

There are potential issues for consumers if energy companies undermine competition by coordinating their behaviour. Coordination could occur in the energy market because the market is relatively concentrated and has stable supply and demand conditions. There is also segmentation between customer types and little differentiation between products. The assessment will look at:

  • Demand and supply conditions over time
  • The number of new entries
  • How differentiated the products offered are
  • The impact of regulation
  • Energy companies’ pricing strategies
  • Price and profit information
Barriers to entry and expansion

Barriers to entry or expansion can mean that existing suppliers do not face enough competition and consequently consumers can be left with reduced choice. Barriers to entry in the retail energy market include:

  • Cost related barriers
  • Strategic and structural barriers (for example, in relation to how existing suppliers compete)
  • Weak demand side barriers due to low levels of consumer engagement
  • Switching and regulatory barriers.
Vertical Relationships

The domestic retail energy market is currently dominated by six large vertically integrated companies and the assessment will consider:

  • Independent suppliers’ ability to access the wholesale energy market to buy energy and independent generators ability to sell energy
  • The extent of transparency, and the effect of a lack of transparency, of wholesale prices
  • How liquidity indicators have evolved over time
  • Profitability across the supply chain
  • The trading models and positions of vertically integrated companies.
Weak Customer Response

Where consumers do not engage with the market there can be a lack of ‘competitive discipline’ in relation to existing suppliers. Ofgem has already outlined in the RMR, market features that may make consumer engagement more difficult, for example:

  • A large number of tariffs with complex structures and discounts
  • Information provided by suppliers can be complex, incomplete or unclear
  • A lack of trust and poor supplier conduct leading to a lack of confidence on the part of consumers when participating in the market
Profitability

In addition, the assessment will look at profitability in relation to the sources of harm. It will consider individual profitability of the large vertically integrated energy companies, patterns of profits over time and between different companies, relative profitability between different customer groups, and existing costs patterns over time and between different companies.

Summary and next steps

Although stakeholders have already provided feedback on the proposals, Ofgem, the OFT and the CMA are looking for further feedback during January and February 2014 which will be taken forward whilst carrying out their assessment.

The first annual assessment will be published before the end of March 2014 and following that Ofgem, the OFT and the CMA will consider what the next steps will be. These could include specific reforms or even a market investigation reference i.e. an 18 month in-depth review to assess and to impose and propose remedies to tackle any features of the market which are adverse to competition. Powers to impose remedies are wider-ranging including (in an appropriate case) orders to divest business assets and/or imposing a price cap.

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