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Energy market referred for competition investigation

Energy pylons Print publication

27/06/2014

Reference

Following the State of the Market Assessment (reported in March), the Office of Gas and Electricity Markets (Ofgem) consulted on whether to refer the energy market for an in-depth investigation by the Competition and Markets Authority (CMA) and on the scope of the reference. The consultation elicited responses from 28 organisations and 78 consumers. Nearly all of them supported a reference to the CMA, even if they disagreed with the assessment of the state of competition in the market.

Ofgem has now made a formal decision to refer for investigation the market for the supply and acquisition of electricity and gas, covering supply to domestic and small business customers.

Key features of the energy supply market

In making the decision to refer, Ofgem identified key features of the market and questions for the CMA to address. These build on the conclusions reached in the State of the Market Assessment.

Weak customer response

Ofgem considers that customer response is not driving competitive pressure, for example through switching, and that this has been a feature of the market for “some years”. Part of the reason for the reluctance for consumers to switch, according to Ofgem, is the number of tariffs and difficulty in making comparisons. Ofgem points to the lack of transparent information, exacerbated by consumer distrust of suppliers, which has been prompted by “poor supplier conduct”.

Ofgem has asked the CMA to examine whether weak customer response harms competition in the retail market and, if so, how can it be improved to make competition work better for consumers.

Vertical integration

Ofgem identifies vertical integration as an important feature of the electricity market. The six largest electricity suppliers directly own around 70 per cent of generation capacity and all but one (British Gas) own capacity equivalent to their domestic supply needs. (This is less of an issue in the domestic gas market.) Ofgem recognises that vertical integration can bring benefits, offering security against volatility in the wholesale market and potentially lowering consumer prices, but also highlights the potential downsides. These include the creation of barriers to entry in supply if new entrants face difficulty accessing wholesale products at competitive prices and vertical integration also may discourage retailers from adopting a different retail strategy from that of their competitors.

Ofgem accepts that working out whether the benefits of vertical integration offset the attendant downside is hard to tell. It therefore requests the CMA to consider whether vertical integration is in consumers’ interests and whether its benefits outweigh the potential harm to competition.

Barriers to entry and expansion

Ofgem identifies barriers to entry as a key feature of the market that restricts competition. As well as the effects of vertical integration, it lists other barriers to entry:

  • credit and collateral costs, such as signing up to industry codes
  • regulatory barriers and industry system requirements, such as the need to comply with complex licence conditions and industry codes
  • incumbent supplier pricing strategies, by which incumbent suppliers can target cheaper tariffs at more active consumers
  • reputational risks, with potential entrants suggesting that political scrutiny and the industry’s poor reputation were acting as a deterrent to market entry.

Ofgem has asked the CMA to consider how and to what extent barriers to entry and expansion harm competition and whether, and if so how, those barriers can be reduced.

Continuing incumbency advantage and market segmentation

Ofgem believes that many consumers have never participated in the more competitive parts of the market, which leads to some market power for suppliers. This has a knock-on effect on price competition, so that customers end up paying higher prices.  More competitive parts of the market, where customers are more actively engaged, tend to see lower prices.

Ofgem has asked the CMA to investigate whether the incumbency advantage harms competition and, if so, how the effect of this can be mitigated to the benefit of all consumers.

Possible tacit coordination

Ofgem considers that there is evidence of tacit coordination between suppliers.  It refers, in particular, to aspects of price announcement behaviour among the largest suppliers.  It notes the suppliers “are winning customers more slowly, their price announcements tend to be more aligned and their profitability has shown signs of converging and increasing as prices rise more than costs”.  Ofgem has recently written to the largest suppliers asking them to explain to consumers the impact of falling wholesale prices on their retail prices.

Ofgem has requested the CMA to investigate whether tacit coordination exists in the market and, if so, whether it is harmful to competition and the interests of consumers.  If so, Ofgem asks what can be done to make competition work better?

Outcomes for consumers

Ofgem suggests that there is little evidence of any increase in levels of consumer trust in suppliers and that consumer complaints are currently at their highest level in five years. However, Ofgem has been unable to conclude whether profits are excessive.

Ofgem has therefore asked the CMA to investigate what market outcomes say about the level of competition and what is the appropriate measure of profitability and whether profits are excessive.

Less problematic areas

Some aspects of the market are not being referred for investigation as there was no evidence of competition problems. These are:

  • transmission and distribution
  • interconnection and gas storage
  • wholesale gas markets
Regulation and future changes

Ofgem is also asking the CMA to take the following into account in its investigation:

  • third-party intermediaries, such as switching sites
  • difficulties in the switching process
  • consumers in vulnerable situations
  • transparency

Ofgem acknowledges that the market is changing and the CMA investigation will need to take into account smart metering, Electricity Market Reform and EU integration, which will all impact the retail market.

Impact on energy suppliers – and what to expect in the near future

What is a market investigation and how long does it take?

A market investigation is an information gathering and analysis exercise to assess if/why a market is not operating well and what, if any, action can be taken to address concerns. It involves the engagement of principal operators within the market and other interested parties, including trade associations and charities. Ultimately it is consumer-focused.

The CMA normally takes 18 months to carry out its investigation. The CMA may extend this by six months if it considers that there are special reasons why the investigation can’t be completed (and the report published) within 18 months. There is a further six-month period to implement any remedies (extendable by a further four months).

What happens next?

The energy market investigation will commence immediately. The CMA will shortly appoint independent panel members to the Investigation Group and publish a timetable setting out a schedule for the various stages of the investigation. The appointed Investigation Group act as the decision-makers and are chosen from the CMA’s panel members, who come from a variety of backgrounds, including economics, law, accountancy and/or business.

Many operators in the market will shortly receive a First Day letter. This may include:

  • details of the proposed investigation timetable
  • an invitation to an initial meeting with the CMA and/or an invitation to make an Initial Submission (to give views on the market and the state of competition)
  • a request for “Off-the-Shelf” information (see below)
  • an invitation to contact the CMA for the CMA to arrange a site visit.

Off-the-Shelf information, which may be formally requested by the CMA, is categories of existing documents held by parties to the investigation (i.e. it does not extend to documents specifically created for the investigation). The document request covers a wide range of aspects of the participant’s business, including:

  • details of the corporate background and corporate structures;
  • accounting and management information for the preceding five years, including annual filings, management accounts, business plans and relevant board minutes; and
  • supplier and competitor contact details.

The CMA will also publish an issues statement early in the investigation, which will set out the scope of the investigation and the questions it will be looking to answer, and invite submissions in response to this.

These steps are just the start of the process, which will be detailed and comprehensive.

What remedial action might the CMA take?

If the CMA decides that there are one or more features of the market with adverse effects on competition, it must take such action as it considers reasonable and practicable to remedy, mitigate or prevent the situation and any detrimental effect on consumers resulting from it. This can include measures to improve cost transparency and comparability for consumers, recommendations to abolish current or to implement new regulatory measures, price caps and even structural reform, such as ordering the divestment of vertically integrated businesses (in this context, potentially separation of energy generation businesses from retail distribution i.e. sales to customers).

For its part in regulating the sector, Ofgem has also been heavily criticised by some – Labour has proposed abolishing Ofgem if it comes to power. It is interesting therefore that Ofgem also expects the CMA to look at the regulatory framework and how it has been applied by Ofgem. It may be helpful to Ofgem to have the situation reviewed by an independent (and non-political) specialist body.

If your business is likely to be affected by these findings, or may wish to take advantage of potential market opportunities, Walker Morris can help. We have proven expertise in advising on market studies and investigations, including currently acting before the Competition and Markets Authority on the in-depth inquiry into payday lending. We work together with in-house regulatory specialists and with the leading economics consultancies and have significant experience of external engagement with competition authorities, sector regulators and other stakeholders on sensitive and complex competition issues.

For more information please contact the authors.

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