Articles Britain

Theresa May’s problematic pledge to cap energy prices

The case for a cap on energy prices has arisen after the ‘big six’ energy companies raised prices by up to 15% earlier this year, even alongside low and falling wholesale prices. Although these have been justified by the energy companies as the result of being forced into generating renewable energy, it has not been perceived in that light by the general public, making the pledge to cap energy prices a powerful political tool.

The energy sector is an oligopoly, with the ‘big six’ suppliers providing about 98% of all household energy and gas. This industry also has high entry costs, high costs of switching suppliers, and is characterised by limited price competition and increased non-price competition. This means that although the energy suppliers may compete with each other with giveaways as part of their tariffs, such as British Gas offering free and quick boiler repairs, prices are unlikely to fall in a competitive manner.

A price cap would prevent the energy suppliers from raising their prices without any loss in their customer base, due to the high costs and hassle of switching energy supplier, and therefore would benefit the consumers as long as their nominal incomes rise faster than the price cap allows energy prices to rise. With the stagnation of wages in the UK (basic pay in the three months to April 2017 was 0.6% lower than a year ago) this energy cap takes on heightened importance, as if the price rises go on unchecked, consumers’ standards of living would quickly be worsened.

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However, a price cap theoretically causes all sorts of problems. As shown below, in free market equilibrium, demand equals supply at q* and p*. However, once a price ceiling is introduced, the energy suppliers only wish to supply q1 units and the consumers wish to consume q2 units.

With the price cap, there is a shortage of supply of size q2-q1. In the energy industry, this would manifest itself in terms of blackouts and some remote regions not being served: the extra costs of serving those regions would be above the marginal cost of supplying those regions. One such example of this is the California electricity crisis of 2000 and 2001, in which blackouts were partially the result of a statewide price cap of $150 per megawatt per hour, causing US$40-45 billion in economic damage. Furthermore, having a low price cap could reduce the ability of new firms to enter the market and undercut incumbents, due to the price of energy being closer to the cost of providing it.

Of course, these effects would only take place if the initial equilibrium price is such that the energy suppliers are not making supernormal profits. in the UK the suppliers are in a non-price competitive oligopoly: dependant on how severe the price cap is, even with the price cap, the suppliers may be able to make a profit on every unit of energy that they supply while satisfying all demand at the equilibrium price.

There are many alternative policies which also need to be considered, as they could fix the market permanently instead of being a temporary fix. If the energy companies are being truthful, then lowering the costs of green energy through either heightened investment or even just subsidies for green energy producers would remove the excuse that the ‘big six’ use. A better solution would to be to take action in order to make it easier to switch supplier in this market. The Competition and Markets Authority has pointed out how infrequently consumers in the UK change supplier, and the abnormal costs of the process. Therefore, through forcing the suppliers to simplify the tariffs that they offer and to offer fewer, consumers may be able to see a better deal for themselves, and switch to a rival supplier. This would once again making the market more price competitive and putting a halt to price rises when wholesale costs are falling.

The energy market in the UK is in need of a shakeup. However, the energy price caps promised by both Mr Corbyn and Mrs May are not the best way to go out about it, and many other options must be considered before any action is taken.

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