CMA Interim Report Part 2 – Wholesale energy Market Focus

Issues affecting electricity generators and the energy market as a whole.

Below is the second of our blogs linked to the Competition & Markets Authority (CMA) Energy market investigation – summary of provisional findings report, published on 7 July. It is worth prefacing this post thus: The CMA looks at all things through the prism of whether market competition is working efficiently to deliver lower costs to consumers. It naturally frowns on interventionism and focuses its ire on reforms which are likely to pass on greater costs to already hard-pressed energy consumers.

A quick reading of our last blog post uncovers the fact that the Big Six know that up to 70% of their customers hardly ever switch to other suppliers. As a rule they charge these loyal customers a good deal more than new customers for not doing so.

The CMA looked at average unit revenues earned by the Big Six and a number of independent suppliers from 2012 to 2014 which showed that ‘rollover tariffs’ charged (the one you pay after you come off the introductory deal) were 29-36% higher than retention tariffs for electricity customers and 25-28% higher for gas over the same period. So retailers appear to be exploiting the fact that many of us don’t take the time to run price comparisons and switch regularly to secure better deals.

They are also earning more revenue per unit of power through exploitation of customer disengagement: average revenue per KWh earned by the Big Six from customers on Standard Variable Tariffs (SVTs) was around 10% higher for electricity and 13% higher for gas customers.
We also know from the report that average domestic electricity prices rose by around 75% in real terms between 2004 and 2014 while domestic gas prices rose by around 125% over the same period!

But the assumption that the Big Six are ruthlessly exploiting their market dominance and the natural stickiness of customers does not stand up to scrutiny if you look at their financials. During the 2009 to 2013 period wholesale electricity costs remained flat while supplier’s EBIT margins fluctuated. For gas, there was an even percentage increase in wholesale costs although EBIT margins increased significantly after 2009 (more on this later). According to the report the Big Six’s profitability in the 2009 to 2013 period indicates that returns were “in line with or below cost of capital”.

“Our provisional view is that the profitability analysis does not provide evidence that overall, the Six Large Energy Firms earned excessive profits from their generation business over that period or that wholesale market prices were above competitive levels.”

So far so surprising! It leaves the question: ‘What exactly is going on if retail prices are rising so rapidly while wholesale prices are not and suppliers’ EBIT is far from tracking these retail price rises?’ Where is all the additional money going?

According to the report, the single biggest cost item for both electricity and gas is the cost of the wholesale energy itself (that’s 45-55% of the cost of supplying electricity and gas to domestic customers); while 20-25% is attributed to network costs. The remainder is due to costs associated with retailing (including making a profit margin) – responsible for between 15 and 20%; and costs of associated with social and environmental policies that energy suppliers are required to deliver on behalf of the government. These costs are higher for electricity (15%) than gas (5%).

The CMA’s interim report focuses on the effectiveness of the wholesale and retail energy markets but frankly not much else. As we dealt with the retail market content last time this post looks at the generators and the wholesale energy market. CMA’s views and opinions are summarised below:

+ The CMA gives the thumbs up to the 2001 move away from a central dispatch system known as ‘the pool’ to the self-dispatch-based New Electricity Trading Arrangements (NETA)/British Electricity Trading and Transmission Arrangements (BETTA) reforms.
+ Although the CMA does level some criticism at a reform which stopped locational pricing (pricing based in location of generation – effectively pricing in the cost of distribution including loss of energy during the process of moving electricity and gas more effectively).
+ But in this report it does green-light the recently Ofgem-approved reforms to the system of imbalance prices under the Electricity Balancing Significant Code Review (EBSCR). It rubber-stamps single pricing for imbalances on the grounds that it thinks this is positive from a competitive point of view as it eliminates the ‘inefficient penalty’ that has previously been imposed on companies that find themselves in ‘helpful’ (i.e. they produced too much power in a given half hour) imbalance at any given time.
+ It also favours the Capacity Mechanism which has been put in place by the DECC to help ensure sufficient investment to meet future energy demand. As we know National Grid has now held its first Capacity Auction to secure agreements from generators to provide capacity when called upon to do so at times of system stress.
+ By contrast, the DECC-driven Renewables Obligation (RO) comes in for criticism in the report because it has, in the CMA’s view, increased the burden on energy bills so that Renewables Obligation Certificate (ROC) payments are estimated to reach nearly £4 billion per year by 2020/21 or 20% of domestic electricity bills in that year.
+ However, the CMA does think Contracts for Difference (CfDs) have been a positive replacement for RO as the main mechanism for incentivising investment in low carbon generation.
+ So how to CfDs work? Under CfDs, generators are paid the difference between the strike price (which is fixed in real terms) and a ‘market reference’ price. CfD payments are due to increase steadily, reaching about £2.5 billion a year by 2020/21. The CMA supports the DECC’s view that using CfDs to insulate low carbon generators from fluctuating wholesale energy prices will encourage investors to accept a lower level of support per MWh of generation.
+ However, understandably the CMA hates the Final Investment Decision enabling for Renewables (FIDeR) scheme under which offshore wind projects were awarded contracts on a non-competitive basis. It estimates consumers will pay substantially higher costs for energy from these sources amounting to £250-310 million per year for 15 years, equivalent to 1% increase in retail prices. It also doesn’t like the fact that DECC can award CfDs directly to parties through a non-competitive process in the future under new powers given to it by the Energy Act 2013.
Vertical Integration (VI) is also not ruled to create an adverse effect on competition (AEC) - it is noted that the Big Six are if anything moving away from further VI anyway.

It seems to us that although the CMA interim report addresses efficiencies in the wholesale electricity market very well, it does not seem to address concerns which are now widespread about the effectiveness of the wholesale gas market. There are increasingly loud allegations of price fixing and some alleged evidence of non-competitive practices operating there.

The Chairman of the Energy and Climate Change Select Committee and Tory grandee Tim Yeo has been leading the charge on this issue. However, his concerns about the efficiency of the wholesale gas market will have to wait for inspection by another Dunstan Thomas Energy blog post.

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