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Investigations of the energy markets: concerns and implications

On 27 March 2014, Ofgem announced its proposal to make a Market Investigation Reference (MIR) to the Competition and Markets Authority (CMA) in respect of the markets for the acquisition and supply of gas and electricity. The aim of the MIR would be to establish whether particular features of the market are having an adverse effect on competition (AEC) and, if so, what can be done to increase the effectiveness of competition in the market. 

Ofgem has previously expressed concerns as to a perceived lack of competition in UK energy markets and measures have previously been put in place to try to enhance competition. However, Ofgem's State of the Market Assessment (the Assessment) published on 27 March indicates that it still has concerns as to the state of competition in the relevant markets, and some of the issues may have worsened. 

The Assessment has identified various features of the energy market that may be adversely affecting competition. The features it has identified are: Consumers are failing to engage in the market which leads to low switching rates, little consumer pressure on suppliers and higher prices; the Big Six continue to hold a very high market share which makes it difficult for smaller suppliers to penetrate the market, which in turn this means that smaller suppliers are unable to provide the high levels of collateral necessary to function effectively on wholesale markets. Prices and profitability are both rising among the Big Six which has led to concerns that competition may not be functioning effectively. 

In light of the above, Ofgem considers that a MIR is necessary but is required to consult with interested parties before deciding whether to make one. As such, it has published a Consultation to which responses are requested by 23 May 2014. 

If a MIR is made, the CMA will undertake an 18-month investigation of the market and may make various orders designed to remedy or mitigate any AEC(s) it identifies. 

What issues are causing concern?

The Assessment identifies several features of the market that could be causing an AEC. Ofgem considers that the combination of these features leads to poor outcomes for consumers, such as rising prices, low switching rates and low levels of customer trust and satisfaction. We look at each of these features in more detail below. 

Lack of consumer engagement

The Assessment found that consumers were unwilling or unable fully to engage in the energy markets and were thereby prevented from exercising effective consumer choice. The number of different deals available and the complexity of the tariffs may make it difficult for customers to understand what is out there and what is best for their needs. Rising energy prices are constantly in the media and in 2013, 43% of consumers said that they did not trust energy suppliers to be open and transparent. The perception is that consumers are losing trust and confidence in the energy market and failing to engage, which means there is little consumer pressure on suppliers to incentivise them to continue turning out the best deals for their customers. 

Furthermore, there is seen to be a lack of awareness among consumers of their ability to switch provider, which contributes to low switching rates. Although only 10% of all energy consumers are unaware that they can switch, 62% of consumers have never switched supplier (though some have switched to a new tariff or payment method from their current supplier). Without the threat of consumers switching and the corresponding consumer pressure, large suppliers are free to set higher prices for their customers. 

TLT Comment: Suppliers small and large have very recently been faced with implementing comprehensive changes to their domestic and micro business customer offerings and communications through the Retail Market Review (RMR) which was specifically designed by Ofgem to deal with the number and complexity of deals available and providing clear information to consumers. These changes only came into effect at the end of last month. They cannot yet have had the desired impact and so, unless Ofgem is already admitting the ineffectiveness of these changes, we presume Ofgem is concentrating on the other features it has identified as justification for the MIR. 

Weak competition

There are two aspects of the energy markets that have led Ofgem to conclude that weak competition could be a feature of the market; the high market shares of the Big Six and the possibility of tacit coordination.
 
Unilateral market power 

The Big Six have over a long period held a high market share between them; currently 95% of the electricity market belongs to the Big Six. The individual electricity market shares of the Big Six have fluctuated between 11% and 25% over the years, and Centrica continues to hold 40% of the domestic gas market with the remaining five suppliers holding between 10% and 16% each. 

Ofgem also considers that there may be incumbency advantages. The geographical patterns that existed before the energy market was privatised still exist and "sticky" customers are often unwilling or unable to switch from their previous incumbent supplier. These customers are often charged higher prices by their suppliers, whilst more active customers are able to access better deals. Ofgem is concerned that this could lead to more vulnerable groups of people paying higher prices for their energy, although, as above, this was a feature that was meant to be addressed through RMR.

Tacit coordination

Ofgem did not find any evidence that the Big Six suppliers are colluding to coordinate their actions. However, it did suggest that tacit coordination may be taking place. This is where companies establish a coordinated course of action without having to communicate. It is said that it can come into play where companies know each other so well that they can anticipate each other's moves and adapt their own plans as such. 

Although Ofgem does not present a view as to whether there is, in fact, tacit coordination between the Big Six, it suggests that some of the available evidence could be consistent with tacit coordination. In particular, it references that price announcements among the Big Six tend to be at similar times and that profitability has increased for all the largest suppliers in recent years. Tacit coordination can restrict competition as it prevents there from being any discernable difference between suppliers which means consumers are less inclined to pressure their suppliers. 

Barriers to entry and expansion

New entry and expansion are both essential to keep up competitive pressure on market participants. The Assessment indicates that barriers to both may exist. The regulatory process and associated costs of supplying energy represent a larger burden for small suppliers with smaller customer bases. Similarly, small suppliers that have already managed to get a foot in the door can be put off large-scale expansion by the costs of complying with environmental and social policy schemes. 

In order to trade on the wholesale market, suppliers need strong credit ratings, which are harder to build up for smaller, younger companies. As a result, smaller suppliers may be forced to provide high levels of collateral. This requires access to working capital that they are less likely to have readily available. 

Ofgem is concerned that low switching rates and consumer trust may make it difficult for smaller suppliers to win market share, and potential new entrants could be put off by the negative media surrounding the energy market and subsequent reputational concerns. 

Vertical integration

Vertical integration is more a feature of the electricity market than the gas market and refers to the situation where an electricity supplier also owns generation capacity and can operate at different levels of the supply chain. All of the Big Six suppliers are vertically integrated and arrange their supply chains accordingly, which makes it easier for those suppliers, when compared to their non vertically integrated competitors, to adapt to fluctuations in wholesale prices. They are also likely to have stronger credit ratings and have to post less collateral because they can make direct trades internally or offset the collateral they need to post with the collateral posted with them. 

Ofgem suggests that this could act as a barrier to effective competition, but the Assessment also acknowledges that vertical integration can also have benefits to consumers. Ofgem recognises that the CMA will have to bear this in mind if a MIR is made. 

Rising profits

The Assessment also uncovered evidence that prices are rising faster than costs despite the fact that it is not clear that cost efficiency is improving. Between 2009 and 2012 the combined earnings before interest and tax of the Big Six rose from £3.1 billion to £3.7 billion, and profit went from £233 million to £1.1 billion. 

Though Ofgem does not suggest that suppliers are earning an excessive profit, it does raise the possibility that these suppliers may have had an opportunity to earn high profits which could mean that competition might not be functioning effectively. 

What happens next?

The Consultation is now open to receive responses from interested parties and any responses are requested by 23 May 2014. Once the Consultation has closed, Ofgem will review the responses and must make a decision as to whether or not to exercise its discretion to make a MIR. This decision must be made in accordance with Ofgem's principal objective to protect the interests of existing and future energy consumers. 

Ofgem aims to publish its decision in summer 2014 and if it does decide to make a MIR, it will publish a decision letter outlining its reasons. It is clear in the Consultation document that Ofgem considers a MIR to be in the interests of consumers and therefore we consider it likely that a MIR will be made, though Ofgem will take consultation responses into account. 

The CMA will then have 18 months in which to complete the MIR followed by a further 6 months to implement any remedies it considers necessary. 

If the CMA finds that there are one or more features that are causing an AEC, it must take all action it considers reasonable and practicable to remedy, mitigate or prevent the AEC and any detrimental effects on customers that have resulted from that AEC. The CMA's powers in this respect are wide-ranging and the actions it could decide to take include:

Accepting undertakings from organisations involved;

Making an order restricting the conduct of an organisation;

Ordering general obligations to be performed;

Ordering the supply and publication of information;

"Breaking up" energy companies by ordering the sale of parts of their businesses; and

Modifying the conditions of Electricity and Gas Licences, for example in relation to the customer/account thresholds for participation in additional regulatory requirements (e.g. the Energy Company Obligation).

How can you make your views heard?

The Consultation document is available to read and download via the link on the right hand side of this article. Any responses are requested by Friday 23 May 2014 and should be sent to the address outlined in the document. 

If you have any concerns or queries about how the MIR might affect your organisation, please contact Bill Hull, Partner or Miles Trower, Partner.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at April 2014. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

TLT LLP is a limited liability partnership registered in England & Wales number OC 308658 whose registered office is at One Redcliff Street, Bristol BS1 6TP England. A list of members (all of whom are solicitors or lawyers) can be inspected by visiting the People section of this website. TLT LLP is authorised and regulated by the Solicitors Regulation Authority under number 406297.

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