17/10/17 – “Is Ofgem right to rely on switching to protect customers?”

Speaker: John Penrose MP

Tuesday 17th October 2017 – meeting notes

All-Party Parliamentary Group on Energy Costs

Is Ofgem right to rely on switching to protect customers?”

Chair: Lord Palmer

Lord Palmer opened the meeting by welcoming everyone to the 36th meeting of the group, and introduced the topic and the speaker.

John Penrose is the Conservative MP for Weston Super Mare and a former whip and cabinet office minister. He can be considered the prime mover in price cap policy. His powerful cross-party initiatives have delivered the confidence to the Government that price cap policy would have sufficient political support. However, his proposal was for a relative price cap and not the absolute price cap proposed in the current draft bill, which is said could throttle competition, and several other Conservative MPs have expressed strong reservations, so perhaps the debate about the nature of the cap is far from over. John has been very critical of the Big 6 and Ofgem, whose own proposal seems to rely on switching for consumer protection.

Lord Palmer then asked those present to introduce themselves, before handing over to the speaker.

John Penrose MP

The title of tonight’s meeting – “Is Ofgem right to rely mainly on switching to protect customers?” – was set some weeks ago. I think the answer to that is probably “no”, but as Lord Palmer’s introduction indicated, it is hardly the only question in town now, given what has happened in the last week (the publication of the draft bill proposing an energy price cap). So congratulations to the APPG for having the foresight to schedule this meeting at the end of what has been a very eventful week in the lifecycle of this campaign.

I will talk about switching and then broaden it out before questions and discussion.

By saying that I don’t think that Ofgem is right to rely mainly on switching is not to say that switching isn’t good – it clearly is – but the CMA, and Ofgem, and many others have rightly concluded that the market is clearly broken when it comes to serving the interests of consumers, and part of that answer has to be a range of pro-consumer reforms, and those reforms need to persuade consumers to behave differently. But it’s not just consumers who need to behave differently: the suppliers, and particularly the Big 6, need to change their behaviour.

Switching will be part of that. Making it cheaper, simpler, faster, to switch will not just increase the numbers of people switching but also broaden the numbers: getting more people to switch and not just getting the switchers to switch more often. The reforms also will include other things such as clearer bills, and so on.

The reason why I say that this isn’t enough is two-fold. Firstly, a recent CAB scattergraph shows the likelihood of switching compared with the potential saving. The shocking truth is that as the saving goes up, the switching goes down – the reverse of what we would expect. This illustrates just how broken the market is and how poorly consumers are being served.  We can’t leave things as they are: we need to do a whole series of pro-market, pro-consumer reforms of the kind that the CMA and Ofgem have already undertaken to do. Some say that all we need to do now is just wait for the market will take effect because the more consumers get ripped off, the more likely they are to switch, and we just need to wait for that to happen. Unfortunately that doesn’t reflect the reality of the evidence: broadly speaking that is just a recipe for inaction and for allowing more people to be ripped off for longer.

So what sort of things should we do? Yes, they should be the reforms that the CMA and Ofgem have recommended, but the fact is that there are 17 million households who are on default tariffs and suffering a degree of consumer detriment, calculated at something like £1.4 billion. Some of the energy companies have argued that this figure is wrong, but even if it is wrong by a factor of 2, it is still a very large amount and clearly we should be doing something about it.

The problem is that even if all those pro-consumer pro-market changes were made tomorrow (and they won’t be all made) they’ll still take a great deal of time and marketing money in order to kick in, and the time taken is measured in years and not weeks. That’s an awful lot of consumer detriment over a number of years until this problem is fixed, so we can’t just wait. We need something else in the short term, which is why I have been arguing for a price cap. I would argue that it is not only needed because of the perverse switching behaviour I’ve just mentioned, but also I would argue that it needs to have a sunset clause so that it bows out as the reforms kick in, and doesn’t just continue on for ever. As Ronald Reagan said, there’s nothing so permanent as a temporary government intervention.

The good news is that the Government has bought into at least chunks of this argument and they have accepted that we can’t just do nothing. They have accepted the idea of a price cap. 213 MPs across all parties signed up to this so there is a reasonable chance, even with a hung parliament, of getting something through. The draft bill just published has a price cap and a sunset clause, so that’s all good.

The part I don’t like is that the preferred option in the draft bill is for an absolute price cap rather than a relative one.

Just so that I can be clear about how I am defining these terms: with the traditional kind of cap, the absolute price cap, every six months or so a group of regulators get together and pick a number. That is the preferred option in the draft bill and it seems also to be the economically preferred option at at Ofgem as well. I find this somewhat perverse because I can’t find anyone outside Ofgem thinks that an absolute cap is a good idea. Ofgem originally took the line that a cap wasn’t appropriate or necessary, even though they had the power to impose one if they had wanted to, but now that they are being told there should be one, they’ve opted for the most distortive and heavy-handed approach possible. I find that odd.

My letter, signed up to by 213 MPs (although not all of them agreed with every single facet of what I was proposing) said that the challenger companies mostly prefer a relative cap. A relative cap is where the default tariff (the rip-off tariff and the worst one that anyone can be on) should be linked, or indexed, to a set percentage above each supplier’s best tariff.

Why is that better? Well, it’s better because at the moment the energy markets divide into two. Firstly we have the minority market, a highly competitive market where switching is operating as it should be with consumers moving between fixed term contracts all the time. Almost 50 suppliers are pricing and repricing all the time, launching new products, and being compared on comparison sites every day. It’s the closest thing we have to a properly functioning energy market and it’s not bad.

So if we can graft that competitive part of the market onto the uncompetitive rip-off default part of the market, by linking them with a cap, several things happen at once. First of all, you and I as consumers are protected to a degree: we know that we will not be unfairly penalised if (for example) we forget to switch, because there’s a maximum markup that can be applied to us. But we will also know that it will still be worth our while to switch because we can save more money if we do. And so, competitive behaviour is preserved

Also, from the suppliers’ side it creates a series of incentives too. If you look at most other products, coffee or cornflakes, for example, most of us don’t switch our brands that often, but we profit from the keen pricing that results from the manufacturers and retailers knowing that some people will switch.  So the non-switchers benefit from the behaviour of the switchers.

In energy markets the suppliers know that many customers won’t switch, the pricing model assumes that, and allows them to treat those customers in a different way. This is a first cousin to inertia selling, which is outlawed in other markets. With a relative cap, which prevents them from doing that, a link would be created between the switchers and the non-switchers, enabling the non-switchers to benefit from the behaviour of the switchers, in just the same way as they do in other markets.

Introducing a relative cap would go a long way to restoring faith in the market and improving brand image, and would allow customers to treat the market in much the same way as they do other markets, safe in the knowledge that if they don’t want to switch, or forget to switch, they will not be unduly penalised.

Consumers would, of course, elect to pay more if they wished: e.g. green energy, paper bills, good customer service, etc. but they would be paying more as a conscious choice and not because they’d forgotten to switch.

So, it’s all to play for in the bill at the moment

The final thing that I will leave you with is the thing that worries me: it is is not just the difference in caps, but also because we have a draft bill, this is a slow process. That means that there is plenty of opportunity for those who don’t like the idea of a cap to derail the whole thing, because it is a very slow process. Having got this far in the campaign, I will do my best to make sure that that doesn’t happen, and I hope that at least some of you will join me in working towards this.

Questions and Comments

Q: Is a price cap going to make Hinckley Point cheaper?

A: No, as it’s being built with guaranteed prices

Q: Will it make any part of the energy supply cheaper?

A: I think it will, but I think it will mainly apply to the Big 6 because they’re the ones with the big back books, and whose businesses most depend on milking the back book in search of margin, and particularly if we have a relative price cap they will find that a great deal harder in future, and they will therefore have to work on becoming more productive and efficient.  Some challenger companies tell me that they are more efficient than the Big 6 – not because they are doing anything better but because of other factors such as the absence of legacy systems that the Big 6 have to contend with. If we can put them under greater competitive pressure, not only will default tariffs be less of a rip-off for consumers but they will also have to become more efficient and more productive and compete with the challenger companies that don’t have the handicap of their legacy systems and so on.

Q: If you cap retail prices you put at risk other areas, e.g. security of supply, because that would leave one area that suppliers can find the money for investment elsewhere, which would be the business sector, which is also price-capped. Our worry is that this is yet another example of a policy layered on other policies, all trying to do different things, and we have ended up creating one of the most expensive energy supplies in the world with little to show for it.

A: Yes, you are absolutely right to point out the broader set of issues. I haven’t addressed those because I’ve been focussing on a retail issue, but, yes, I absolutely agree with you that there is not only a mess in the retail sector, there is also a mess in other parts of the industry. We need to pin some of our hopes on Dieter Helm and his forthcoming set of proposals. Given the short time he has been given to write it, I think we can be sure that it will be much the same as he has written in other places.

Comment: It won’t happen just yet but the inevitable consequence of all this is that the Government is going to end up having to set energy prices and nationalise things, because this is the end: there is no future for energy privatisation.

A: I think there’s a way back and Helm will help us choose that way back, because I think your characterisation of the mess that the sector is in is fundamentally correct. There’s a lot to fix.

Q: We represent 24 small retailers and we have a whole range of views across our membership about what this might mean. We are worried about the unintended consequences. Have you looked at what the consumer response to the cap might be? There’s a big worry that people will stop engaging because they feel that because there’s a cap there’s nothing further to go for. Also you spoke about the relative cap where you link the tariffs: some years ago in the early days of competition we had Ofgem interfering in prices where they did something referred to as out-of-area pricing for incumbents, and the prices didn’t come down universally – they coalesced at a high level. So where’s the guarantee that, with a relative cap even, that prices will come down and that people will still engage? The impact on competition is my big worry and I wonder if you have given this any thought or any analysis?

A: Extensive thought – which is why I prefer a relative cap, because as I’ve said, the majority of the market is profoundly uncompetitive. We are in a very bad place as things stand at the moment. Of your members, 11 of the challengers have given me quotes saying they’d prefer a relative cap, and in general, the answers that they are giving are that “we think this would be better for competition than an absolute cap” and “we think that this would still allow us to be creative and to be competitively dynamic in trying to take aim at the Big 6” (which is where most of their market share growth inevitably comes from). They seem to think this is the better answer.

There are a couple of arguments that either the anti-cap brigade or the pro-absolute cap brigade might advance. They may say that we just need to wait until people realise they’d be better off switching, but I think that the CAB analysis shows that in the past that has not been true and the likelihood of switching actually decreases as the size of the saving goes up, so I don’t think that that argument holds water in practice in this market. Classical market theory says that is should but I think this rather shows how badly broken things are.

The other argument you hear, particularly from the Big 6, is “If you introduce an absolute cap we will keep our default tariffs high and we will raise our competitive tariffs high in the switching market”. That rather strikes me as saying “If you give me a loaded gun and tell me that you’re going to introduce this tariff, I’m going to hold it to my head and blow my own brains out” because, broadly speaking, if they did what they threaten to do, the 40-odd challenger brands will be eating their lunch faster, because the threat means the supplier will stop competing in the competitive part of the market and will steadily lose share. If you are the CEO of any of the Big 6 and you announce that, then on day 2 you will start to come under heavy pressure from your investors, who will interpret it as announcement that this part of your business is on a terminal decline. Then you will be a brand damaged target for the consumer media as you would be the most evil of the Big 6 because you are just doing rip-offs of your back book. The brand damage that you would start to suffer immediately would be quite extreme, and you would also become a target for Ofgem because they would pick on you first. So I think it’s quite unlikely that that would be a supportable approach for many of the Big 6 for very long and it would only take one to break ranks for all the others to come under severe pressure. I’m sure representatives here from the Big 6 will tell me that I’m wrong and will explain why, but if a large proportion of challengers say that a relative cap is helpful to competition, and there are more of them than the last time Ofgen tried to do something (the geographical plan, which wasn’t the same but was a cousin of this) the dynamics will be very, very different this time.

So I suppose the long-winded answer is, yes, I have given it a lot of thought.

Comment: It only works if consumers do exactly what you want them to do, and my experience is that it’s not as easy as that.

A: I’m quite certain that consumers won’t do just one thing: they will all do different things – including things that none of us here in this room can predict – but I think that a relative cap presents more scope for consumers to do different things with different kinds of tariff and different levels of price points and competitive options.

Comment: I used to work for CAB and a lot of the analysis contained in the scattergram you referred to earlier was done during the days of doorstep selling, which accounted for approximately half of sales and which has now stopped. It stopped because consumers didn’t want it, and I think we should be careful with the interpretation of this because switching numbers went down not necessarily because differentials had changed, but because of changes in the whole strategy for selling.

We’ve been looking at switching figures over the past year and we’ve broken them down by parliamentary constituency and there are some areas where they’ve got really strong and healthy switching figures because there are things you can do to encourage switching. For example in Leeds the local authority has a policy where it churns social housing on change of tenancy, so there are things that you can do to target the people you feel should have the best deal, without necessarily taking irreversible action in what is essentially a competitive market.

A: I agree with you that there are other ways of doing this but I don’t want to give the impression that what we are doing currently is in any way enough. If we carry on as we are we will have many, many, many years of millions and millions of consumers paying too much for their electricity, and we will have let them carry on doing that, and will have comforted ourselves by saying “don’t worry, it will all come out right in the end”.

Yes, you are absolutely right that there is more to be done, and you are right that some things work better than others, but that’s not an argument for saying that therefore we shouldn’t do something big and profound.

Q: Can I explore this fundamentally broken principle? We now have 50+ suppliers and unprecedented levels of market entrants with different business models. I’m a switcher. There’s a consumer behavioural questions here. Consumers are not stupid and they will normally choose depending on price and other factors. At the moment innovation is quite rife in the sector, and we have faster switching on the horizon, which will drive engagement, and we also have unprecedented levels of investment in the energy sector around renewables and new products and services  . . . so, what is the concern? Is it that consumers are not being protected enough? Or is that the system is fundamentally broken, and consumers don’t have choice?

A: At the risk of sounding like a politician, I’m going to say both. But there is a reason why. You are right to point out that there is a properly competitive piece of this market now, and the fixed contract switching market is impressive, and much, much better than 10 years ago. The problem is not that though: the problem is with the default tariffs, which are not competitive, and which is where the rip-off is happening in those 17 million households who don’t switch. The problem we are having to grapple with is the very slow growth of the competitive switching section of the market.

The Big 6 have 80% of the market and their share decline in the default tariffs is in single figure percentages each year. At that rate it will take decades to get to the point where we don’t have very large numbers of households with a very large amount of consumer detriment. That’s why we need to do something else to accelerate that process and to protect as many of those people as we can for a temporary period, while we build on that competitive market.

Comment: Thank you, that’s helpful. As was said earlier, it’s about consumer behaviour, and I think we are tackling it from the wrong end. Consumers will feel protected and may not switch as a result of that. The other point I want to make is that the use of language such as “a fundamentally broken market” publicly, to consumers, may disincentivise them from actively engaging in the market. Talking this way may make consumers feel that there is no point in engagement.

A: Good points there. I don’t feel it’s enough though just to talk about changes in consumer behaviour, although that’s an important part of it. That will take years because there are 17 million of them and they won’t all change overnight. That isn’t enough on its own. There has to be a fundamental change in the behaviour of the suppliers too, particularly the Big 6, because I think there’s a moral flaw at the heart of the business model. Any market that says we’re going to make inertia pay, and rip off loyal customers, and do it in a way that encourages consumers to become less engaged because if they’re more engaged they’d be likely to switch and that makes them less profitable, and build it all into the business model, our customer profitability models, into our marketing activity. . . well, I think that’s one of the main reasons why the energy sector as a whole, through nobody’s particular fault because there was no evil intention, is now in a very bad place with some very badly damaged brands in it.

Therefore I think that the suppliers – mainly the Big 6 because of an accident of history – have got some very fundamental changes to make.

Final point – we can’t argue that calling out those flaws in the market is a bad thing because it might upset consumers. I think if we tried arguing that then, because of the scale of the detriment, politicians would be failing in their duty to the people who elected them, but also history would judge us rather harshly as allowing one of the rip-offs which is creating a country and an economy that doesn’t work for everyone.  At a time when there is measly productivity growth and measly wage growth, and has been for several years, if we collectively fail to take an opportunity to deliver a lower cost of living on one of the essentials of life, well, I think we will be judged extremely badly.

At this point Lord Palmer excused himself and left the meeting.

Q: Are we right to assume that the people who switch are effectively being subsidised by those who don’t? The Big 6 are arguing that their margins on the business are extremely low and in fact the costs of supply are rising. Is there a possible consequence that some of the people who generate will exit the market? And, if so, would that be a price worth paying to protect consumers who are effectively paying more because they can’t be bothered to switch for whatever reason?

A: I know that this might be slightly unexpected from a Tory advocating a price cap, but I am one of rather flintier free-marketeers in my party. I think you’re right that some Big 6 customers, where there is a large back book that can be used as a cross-subsidising engine, are benefitting from low take-on tariffs because they get lured in by an artificially low rate. That happens because the suppliers know that a proportion of them will forget to switch at the end of the offer and will go onto the default tariff. That is much less true of the customers of the other 40 suppliers, mostly because their back book is much smaller and therefore they don’t have the same internal incentives.

Secondly, I think that arguments about whether suppliers are making margins should not be paid attention to by policy makers. You can argue that if you have an oligarchy or a monopoly and they are making large profits then there’s a competition point, and the CMA or someone should get involved with that, but if you have a market with 40-50 competitors in it and some of them are making a profit and others aren’t, that’s fine.

On your final point about whether or not people will exit, who knows? I don’t think public policy makers should have a view apart from ensuring a smooth transition to alternative suppliers if and when someone does decide to exit the market.  On the question of whether anyone will exit, a) I don’t know and b) even if I did, I don’t think that should be something politicians should get involved in.

Q: The Big 6 are vertically integrated and they generate most of the country’s power. Do you think they are too big to fail in any way?

A: No is the short answer – certainly not retail operations. There has been nothing to stop them trading those parts of the business between themselves and others if they wanted to. There might be other factors affecting that vertical integration, but if it did happen, I can’t see the detriment provided it was done in a way that was ok for consumers.

Q: What if the margins for generating in this country became too low and it was just not attractive to invest in generation at all? In that situation you wouldn’t have someone to come in and buy their assets off them, because the assets would be loss-making.

A: Sorry, when you mentioned exiting I thought you were referring to the retail part of the market. If you are talking about further upstream, I’m not sure about the answer to that, and I think I’m going to refer back to the Dieter Helm review on it. But from what I can see, we clearly have a problem with capacity and contingency, flexibility of supply, etc. and that is an upcoming challenge regardless of whether people want to trade assets within the existing fleet or not.

So I guess you are probably right: I don’t know if any of them are too big to fail or not.

Q: Regarding the sunset clause. Obviously you need to have suitable conditions for the sunset clause to take effect. What would these be?

A: There are two ways to invoke a sunset clause – either by a predetermined date or by conditions achieved.  In the draft bill it’s a date, with an option to extend by 3 years. I think that’s probably simpler and safer and it allows for a policy decision and a parliamentary decision to prolong it. No one is clever enough to come up with conditions that would be both objective and right, so using a date, with an option of prolongment, is simplest.

Q: What’s to stop the extension being extended again?

A: The maximum extension is 3 years. At that point we should be asking, “Is the market fixed?” and “Is the cap having the intended effect?” If it’s an absolute cap I think that would be quite a high hurdle to clear but if it’s a relative cap I think the odds would be a great deal higher – but we would need to see evidence of the cap working before agreeing to extend it.

Q: If it ends up being an absolute cap would you still want to see it go ahead?

A: I don’t know. I’m very focussed on getting a relative cap. It’s a draft bill and I will be making submissions, and I hope we don’t get to that point.

Comment: I can solve this problem. All you have to do to solve this problem is to suspend the smart meter rollout, go for a digital industrial strategy for everyone, run a national competition for a smart agent you could solve the problem in a couple of years

A: So a massive sort of group switching agent?

Comment: You could have different agents offering different levels: either price certainty, which might be more expensive, or price variability which might mean something else.

A: I realise that your tongue is slightly in your cheek but there’s an important point underlying what you’re saying. A couple of thoughts: if you are a person who has never switched, and who doesn’t want to think about it, and is getting ripped off and hasn’t noticed or doesn’t care, and someone comes along and tells you that you’re going to be switched regardless . . . well, I think it is politically a very brave decision to take all those consumers and tell them that you are going to do good for them whether they want it or not. I think that that is a difficult thing to pull off, even though you are right that in terms of it reducing levels of detriment it would be a quick way of doing it on a macro-economic scale. But I don’t know how to do it without making a significant proportion of the 17 million affected households hate whoever does it to them, even though we save them money.

Q: Why do you think Theresa May chose to go with the absolute cap rather than the relative one?

A: I was very surprised and I don’t know. I don’t know whether it was her decision or Greg Clark’s decision, or whether it was on advice from Ofgem. I was surprised because a lot of people were in favour of a relative cap. Of the 213 MPs who signed up in favour of my campaign, I suspect Labour MPs supported it because the challenger companies told them that’s what they liked. Of the Conservative MPs, because we are a free market party, when faced with the choice between an absolute and a relative cap, I would expect them to come down on the side of a relative cap. But we will see where we get to, but I think I have not only got right on my side but I might even have some members.

The meeting closed at 7 pm.