Price caps on energy – what next?

Price caps on energy – what next?

May 19, 2017

The UK energy industry is accustomed to a more capricious policy environment than most. This election it faces a Hobson's choice between a Conservative party promising price caps and a Labour party promising price caps and nationalisation.

The details on how this proposed cap will work are still unclear. But it will be on the standard variable tariff (SVT), which we are told 70% (and we believe 60%) of UK energy customers currently pay. The SVT is the default tariff customers are charged when they don't actively choose anything else. It is significantly more expensive – sometimes 25% more - than many of the fixed tariffs on the market.

According to both major parties, the big difference between the SVT and other tariffs is unjustified and reflects an abuse of market power by the major companies.

For the "Big 6" energy companies and their European owners, anchored by a legacy cost structure, this is not good news. If effective, the cap will significantly reduce the industry's overall revenue and profit. Possibly by the £1.4 billion the competition regulator's recent inquiry found they were overcharging by in 2016.

Modelling the effects of a price cap

Roland Berger has modelled the effect of a price cap on UK energy retailers. Based on this analysis, we distinguish between three different types of companies, each of which will be differently impacted.

  1. The first group is "Independents". These companies have never had a high number of SVT customers as part of their business plan, so will only face a modest fall in (already wafer thin) margins.
  2. The second group, the larger and luckier part of the major energy suppliers, is characterised by high exposure to SVT customers and high profit margins. They will see profit margins decrease significantly but will remain profitable. Their focus will be on reducing costs.
  3. However, the real impact of the price cap will fall on the remaining, unluckier major energy suppliers, who are significantly exposed to SVT customers but don't have significant margins to cushion the impact of the price freeze. We predict these suppliers will become loss making and will seriously consider leaving the domestic energy supply market.

Clear winners and losers

As these companies represent a significant share of the market (perhaps 30% of customers) a decision to exit will have major impacts on the industry, with clear winners and losers.

In the short term, the small energy suppliers – especially those focused on offering low prices - will be the biggest winners. With their low prices, good customer care, and lean, digital business models they are amongst the most enthusiastic supporters of price controls. At present a quarter of all consumers who switch find their way to these newcomers and, while cash flow issues associated with this rapid growth may sink the unwitting few, they are best positioned to capture the customers shed by the exiting majors.

Niche businesses that support the independents will prosper from this growth. We foresee a one-off windfall of £100m for the price comparison websites alone.

The other big winner, of course, will be the 60% of apathetic customers currently on SVTs. If the cap is effective they will see a significant fall in their energy bills, though ironically they appear, by definition, to be the people least likely to notice.

The losers, apart from the SVT-exposed energy companies and their employees may well be the more proactive 40% of consumers currently on fixed tariffs. Many companies, both small and large, currently use the higher margins from SVT customers to cross-subsidise their fixed tariff. This subsidy would shrink, perhaps requiring major energy suppliers to increase their fixed tariffs to breakeven in their domestic supply business. Low margin independents could follow these price rises, with a sigh of relief.

More broadly, the energy sector as a whole will be significantly disrupted by the exit of some of its major players. This is likely to have knock on effects into other important policy areas. Smart meter installers, for instance, should be attentive to this risk.

While the energy sector is accustomed to being the punching bag of the British polity, at a certain point the bag may burst. And that will affect everyone.