Energy Market and Energy Price Cap: Part 3

Summary of the proposed changes

On 26th February the Government has introduced the Domestic Gas & Electricity (Tariff Cap) Bill before the House of Commons. The Bill will require Ofgem to set an absolute cap on standard variable and default rate tariffs.

This change is intended to reduce an average energy bill by £100 for additional 11 million households across the UK, which are not currently affected by the existing energy price caps.

The price cap will apply until the end of 2020, as due to EU regulations any government interventions have to be time bound. Based on Ofgem recommendations the cap might be extended until 2023 on an annual basis. Ofgem is set to review the cap’s level on six month basis to reflect the estimated cost of supplying energy.

“Green” tariffs may be exempted from the price cap.

Impact

Market structure

Since 2012 the Big 6 lost almost 20% of their market share to the small and medium size suppliers (see Figure 6)

The price cap is set to only further this process. This is due to a number of conditions, combination of which is not dissimilar to the ‘perfect storm’.

Fifty eight percent of the Big 6 customer base is on a standard tariff (see Figure 7). The reduction of the price of the standard tariff by estimated 8%, increasing costs of the government obligations and legacy IT systems as well as the earlier price cap of the prepayment tariffs, mean decrease in profitability on a per customer basis.

The largest suppliers may respond in two different ways.

Some may choose to increase prices of their fixed tariffs — by estimated 5% — to offset decreased customer LTV. This will lead to the closing price gap between the standard and fixed tariffs and continual exodus of their customer base to the smaller suppliers. Due to an estimated decrease in the switching rates, this process may slow down from the current 5% a year to 3.5% a year. This strategy may help preserving profit margins for at least near future at the cost of the supplier’s market share.

Others may follow a different strategy and attempt to keep their fixed tariffs competitive in order to preserve their current customer base. This will most certainly require aggressive cost cutting — British Gas recently announced its intention to cut 4,000 jobs — and sacrificing level of service and innovation. Although in the short term this may benefit the bottom line, in the longer run this may only accelerate the customer base attrition.

This seismic change may result in a further market consolidation or some supplier choosing to exit a retail market altogether.

The outlook is less gloomy for the smaller suppliers however. Historically they have been benefiting from the lower policy cost obligations and modern IT stack. In practical terms, this means less than a percent reduction of the price of the standard tariff and healthy price differential still capable of attracting Big 6 customers.

Decreasing switching rates and consequently increasing competition may lead to an increase in the customer acquisition cost, which presents a greater problem to the smaller suppliers.

Interestingly, the intensified competition between smaller suppliers may benefit price comparison websites as some may choose to start paying commision to the said websites in order to acquire customers.

Other suppliers may try to cater to preferences beyond price, environment or ethicality in the pursuit of greater differentiation.

It is important to note, that smaller suppliers much more than incumbents exposed to the volatility of the energy prices on the wholesale market.

Thus, a combination of the increasing customer acquisition costs and sudden price volatility on the wholesale market due to supply constraints or unforeseen increase in demand, may see some of the smaller suppliers exiting the market.

Conclusion

The proposed energy price cap marks the first significant change in the UK energy policy since the market liberalisation began with Margaret Thatcher’s decision to privatise British Gas in 1986. Albeit, the original vision of the “the citizen shareholder” fell somewhat short of the reality, the de-regulation did deliver savings to some customer segments of the energy market.

Now, the energy market is entering the next stage of its transformation. The perceived unfairness of the market that benefited more engaged at the expense of less engaged customers prompted the pro-free market government to intervene, which is an irony in itself.

For the better of worse this change will launch one of the significant market restructuring we saw since the privatisation of the energy industry. The incumbents’ business model is being disrupted from both sides: challenger energy companies and the state.

With a cautious optimism we may expect that this change will pave a way to the next wave of innovation, that will be brought about by long awaited time of use tariffs and the next day switching.

But one thing is clear — many boardrooms are on fire.