WIREDGOV

Blog posted by: Griffin Carpenter (November 14, 2013)

From promises of an energy price freeze to attacks on environmental levies, the debate around our soaring energy bills is becoming ever more focused on the details. But the fact is our energy system is built on broken economic principles.

When our electricity and gas supply was privatised during the hype of free market liberalisation in the 1980s and 1990s, textbook neoclassical economics prophesised a new era of empowered consumers, competitive firms, and low prices. On the demand side, consumers would be able to switch frequently and seamlessly between suppliers in response to price changes. On the supply side, competition between many players would lead to efficiency improvements. The reality has been something quite the contrary.

Confused consumers

First, there is a major lack of shopping around in our energy market. Few people change suppliers and this number has recently hit records lows. Is it that we’re all satisfied with our providers? The public polls suggest not, as the Big Six struggle with customer satisfaction and the industry as a whole consistently ranks as the lowest in this category. With 900 different energy tariffs to choose from, a more likely reason for our supplier loyalty is that we’ve become paralysed by the range of options and complexity of deals out there. Conventional economics says consumers can never have too much choice, but consumer behaviour in our energy market suggests differently.

Second, the neoliberal idea of the rational consumer or “economic man” clearly doesn’t hold water. Evidence shows that our energy choices are often based on biases and can even increase our energy bills.  We pay too much attention to short term headline figures like switching fees to the detriment of long term savings. Energy suppliers are well aware of this, and price their tariffs accordingly, with the result that 33-40% of the consumers do not move to cheaper tariffs when they switch. (If they make it that far – energy companies even have win-back teams to pursue any consumers who do attempt to switch with promises of cheaper short term tariffs.)

Stagnant suppliers

On the supply side, rather than energy providers entering and exiting the industry as believed under market liberalisation, we’ve had an oligopoly of energy suppliers for over a decade: the Big Six. Together they provide around 98% of all UK households’ energy. No company without links to the period before liberalisation has been able to gain a foothold in the market, showing the powerful role of incumbency. Of additional concern is that the share of the market for each of the Big Six has remained remarkably static with each supplier dominating a specific geographical area.

What’s more, the Big Six have shown little sign of efficiency improvements. Contrary to the promises of market liberalisation, competition is not driving convergence in the operational efficiency of the suppliers and not driving efficiency savings, thus we’ve seen little downward pressure on bills.

Finally, the original vision of market liberalisation failed to discern the effect of factors such as lobbying, the heavily vertically integrated structure of the market and the connections between the energy industry and positions of political power. The sad thing is, until we have more transparency in the sector, neither can we.

Building on quicksand

The most recent data shows that on average the Big Six energy firms are making profits of 5%. But the discussion on what the appropriate level of profit is somewhat beside the point. The issue is that firms are responding as standard businesses to the system they find themselves in, and that this system was designed on flawed economic principles.

All in all, if the students at Manchester University challenging the teaching of conventional economics need a case study in broken economics there can hardly be a better example than the UK energy supply market. As politicians decide on reforms to address the grave issue of fuel poverty they would be wise to give the set of conventional economic principles they are working with a serious mucking out and design a system that better aligns with how consumers and suppliers operate in reality.