Non-discrimination Clauses: Their Effect on British Retail Energy Prices.

• Author: Waddams Price, Catherine

1. INTRODUCTION AND HISTORY

   The year 2008 marked a change in the British energy regulator's attitude to the residential retail market. While it had previously pioneered and championed competition in this sector, it became increasingly concerned with the fairness of the competitive process, seeing the competition glass much more as half empty than half full. We explore the effect of this policy shift on the industry by identifying changes in the way that the major suppliers to the retail market have set their prices. The debate continues to be driven by political and consumer concerns, and to be fuelled by political intervention, ranging from ex cathedra statements by the prime minister that he would ensure that everyone was on the cheapest tariff in the market (Cameron, 2012) to the promise of a seventeen month price freeze if the Labour party is elected in 2015 (Miliband, 2013), and counter moves from the government to remove taxes which fund energy efficiency measures from prices (Osborne, 2013).

   Until 1996, each residential consumer in Great Britain was served by two monopolists-a national gas supplier, British Gas (1) (known as Scottish Gas in Scotland), and one of fourteen regional electricity suppliers. The retail energy markets were opened between 1996 and 1999, and each of these previous monopoly suppliers entered each others' markets. At the same time electricity distribution networks were separated (2) from retail operations (gas networks had been separated from gas retail through the creation of Centrica in 1997). A process of consolidation through takeover and exit led by 2002 to the emergence of five major successors to the electricity incumbents, each previously the monopoly supplier in two or three regions, and British Gas. These firms dominated supply, with other entrants gaining less than 1% of the market over the next decade, and with no long term survivors amongst these entrants, who were taken over or exited the market. The regulator reduced barriers to entry after some years, and by early 2014 there were several new entrants, whose joint share of the market had grown to 5% (Ofgem, 2014), the largest for many years. Nevertheless supply continued to be dominated by the five previous electricity incumbents and the former gas incumbent, known collectively as the Big Six. Analysis of energy prices from these firms at the time when the last price caps were removed from the retail sector (4) in 2002 showed that while parts of the market were competitive, incumbent mark-ups remained, suggesting considerable consumer inertia; and price variations did not reflect differences in costs for consumers using prepayment (pay as you go) meters, indicating considerably less well developed competition in this sector (Salies and Waddams Price, 2004). The removal of price caps on incumbent suppliers coincided with the end of a period of consolidation in the industry which culminated in the establishment of the Big Six. In the three years following that consolidation the surviving companies chose price structures which effectively separated the market, with some offering tariffs particularly attractive for users of large quantities, and others offering tariffs which were better for users of small amounts of electricity (Davies et al., 2014). These appeared to evolve from the repeated interaction of the companies in the regional electricity and national gas markets rather than from any explicit collusion; they are consistent both with innovation in the market and as an effective way of softening "head-on" competition between suppliers. The very rapid increase in wholesale energy costs after 2005 seems to have destabilised this tariff pattern.

   However one pattern which continued in these later years, and which resulted in substantial regulatory intervention, was the persistence of an 'incumbent mark-up' of around 10%, similar to those identified by Salies and Waddams Price (2004) when the price caps were removed in 2002. In its 2008 Energy Supply Probe, the regulator identified such price differences between regions as a symptom of competition concern and a major problem for fairness; they introduced a new license condition (25A, which we refer to as the non-discrimination clause, or NDC), to prevent companies charging higher mark-ups to consumers in their home regions than in others. (5) The regulator pursued this policy on the grounds of fairness, and a concern that vulnerable consumers were more likely not to have switched, and so be paying higher prices (Ofgem, 2008), despite acknowledging potential damage to competition (Ofgem 2009). The regulator was also motivated by complaints from potential entrants from outside the industry that the heavy discounts offered by major players out of their home markets acted as a barrier to entry to smaller players without a home base where they could charge higher prices to recoup their costs. Following representations from the Big Six, the large players were allowed to compete through special offers to attract new consumers, so long as these were temporary; as predicted, (6) such special offers resulted in a proliferation of tariffs, and concerns that consumers, particularly vulnerable groups, might not fully understand the temporary nature of those offers, which were generally replaced by higher 'default' tariffs when they expired..

   The 2008 supply probe also introduced other measures to improve competition and remove barriers to switching, including an annual statement to prompt consumer awareness, tighter rules on mis-selling of energy and restrictions on how far companies could prevent switching by consumers in debt. However after accumulated evidence that the market had been damaged by the NDC (Hviid and Waddams Price, 2012; Littlechild, 2012) the regulator reversed its decision to renew the clauses in 2012, but announced continued vigilance in this regard and introduced a number of other constraints on tariffs to simplify choices for consumers. In this paper we examine the evolution of electricity price movements of one major tariff type between 2005 and 2013, focusing on the interaction between different firms in the market. Energy expenditure almost doubled between 2005 and 2013 (from about [pounds sterling]250 to [pounds sterling]450 a year in real terms (7)) and prices have recently become the focus of considerable political attention (Miliband, 2013; Cameron, 2012). We find that the pattern by which firms set their prices changed at the time of the NDC, consistent with concerns that this intervention has adversely affected the nature of competition in the industry. This supply side change has been mirrored by falling consumer engagement in the market, with switching rates halving between their peak in 2008 and 2013 (Department of Energy and Climate Change, 2014a (8)). The next section presents descriptive statistics on price changes in the residential market and explains the data and their limitations. Section 3 uses causality tests to identify price leadership, and section 4 discusses the policy implications and concludes. 2. TARIFFS AND DATA Since 2005, the level of retail energy prices has risen in real terms, but with some decreases as well as increases. This rising trend in prices is shown in figure 1 for each of the main suppliers, using an unweighted average across all regions of the annual bill of a direct debit electricity consumer on the standard offline tariff (i.e. the main tariff published for that payment method, rather than one attracting special conditions (9)), using a medium quantity of electricity. (10) At the end of December 2013, 55% of residential consumers paid by direct debit, of whom about 65% were on standard tariffs of the kind reported here (Department of Energy and Climate Change , 2014b). Each of these Big Six suppliers is similar in terms of turnover and structure, all with both generation and retail operations in electricity supply (though only British Gas is vertically integrated in gas). Of the 26.7 million domestic electricity accounts in December 2007, the market shares of the Big Six ranged from 12% (Scottish Power, incumbent in only two regions) to 19% (Scottish and Southern Energy, incumbent in three regions) and 22% (British Gas) (Ofgem, 2008 p. 32). No small entrant survived throughout the period of analysis, and at the time of the Energy Supply Probe in 2008, four such entrants shared less than 0.3% of the market accounts, though their share had grown to 5% by 2014 (Ofgem, 2014).

   Figure 2 shows these data grouped according to type of supplier in each region, namely incumbent (which varies between regions), cheapest and median offer from among the rest of the Big Five (i.e. other than the incumbent and British Gas) and British Gas. To distinguish between these companies and smaller firms who have entered the industry from outside, we label these large companies with regional electricity incumbency regions as 'majorsaway' when operating outside their home areas; and identify the best majoraway as the one which charges least for the medium consumption level on the standard offline direct debit tariff. The gap between the average incumbent and median majoraway bills before 2008 illustrates the background to the regulator's introduction of the NDC. The regulator had found that in the period leading up to 2008 suppliers had charged around ten per cent more in incumbent areas (where consumers stayed with it as default provider unless they switched provider) than in other areas (where the majoraway had to tempt consumers away from the incumbent provider in that region). Of course the identity of the cheapest (and median) majoraway varies both between regions and across time periods, and identifies the best challenge to the incumbent at any one time.

   Figure 2a shows the convergence of prices following the imposition of the NDC in 2009, and these reductions in differentials are illustrated in more detail in...