Littlechild assessment: Did the UK watchdog get it wrong?

Energy affordability and the benefits of competitive markets have been under intense scrutiny in recent years.

Concerns about affordability led to a major inquiry into the retail market by the UK’s competition regulator, the Competition and Markets Authority (CMA), as well as locally by the Australian Competition and Consumer Commission, among others.

With parallels to Australia, the CMA’s assessment was seen as an indicator that the UK domestic retail energy market was not working properly with less engaged customers seriously disadvantaged. It ultimately led to price re-regulation via price caps in the UK.

But did the UK watchdog get it wrong in their assessment and was the consequent response warranted? These are the questions thrown up by a recent paper[i] by Stephen Littlechild, the former Director General of Electricity Supply and Head of the Office of Electricity Regulation.

Adverse effect

The CMA’s review[ii] was triggered by earlier concerns about rising energy prices which led to the UK’s Office of Gas and Electricity Markets (Ofgem) requesting the CMA look at “weak customer response” among issues it wanted investigated. The authority ultimately found that this factor had an “adverse effect on competition”, which allowed six large former incumbent retailers to engage in “price discrimination” against less engaged customers and to make excess profits and/or operate inefficiently. The CMA estimated that customers in general were overpaying by up to GBP2 billion.

The big headline numbers, unsurprisingly, stoked media demands for price controls. As was seen in Australia, this public concern about electricity prices along with claims of “rip-off energy tariffs” and “loyalty bonuses” became the main justification for government to push price regulation. In the UK this was in the form of a Tariff Cap Act with caps coming into effect in January last year for most residential tariffs. This was six months before price re-regulation was introduced through default market offers in Australia.

Different approach

Professor Littlechild finds that the exceptionally high detriment pointed to by the CMA did not indicate an exceptional lack of competition – instead, it merely reflected a different approach undertaken in the investigation, which contrasted with previous competition reviews. He argues that unless the regulated price cap is regarded as having other uses, such as enabling what would otherwise be illegal coordination of “fair” prices to higher-cost vulnerable customers, there is now a significant challenge of how to remove it.

The difference in approach and outcomes identified stemmed from:

• The weight placed on a “weak customer response” in the market and an assumption that customers could and should have acted differently;
• Comparison against a hypothetical benchmark “that effectively but implausibly assumes that, if only customers had been more engaged, all suppliers would have been as efficient as the most efficient suppliers”; and,
• Adding an inefficiency cost to the conventional excess profit calculation, which in one case amounted to nearly three times the excess profit.

Weak customer response

The CMA found there was weak customer response because many customers had not switched to the smaller, lower price retailers despite energy being an homogenous product and customer service levels being at least as good that offered by other retailers.

Professor Littlechild describes as “implausible” the CMA’s assumption that the absence of weak customer response would involve perfect knowledge and lack of loyalty to particular retailers.

“Whether it is appropriate to define a benchmark on what a market would have been like if people were different is debateable ... But if … one were to accept the CMA premise, that suppliers are able to price higher because customer response is weaker (or less informed) than it might be, this raises the question what would constitute ‘normal’ or ‘reasonable’ customer response?”, the paper notes.

Real life information that became available from customer engagement trials, known as Collective Switch, run in 2019 by Ofgem[iii] suggests what a normal or reasonable customer response might be. As part of these trials a number of large retailers were required to offer some long-standing customers - those assumed to be disengaged - a collective deal. The outcome was 25 per cent of customers switched retailer, while the bulk chose not to change even though they knew there were lower priced deals available and they were supported to switch.

Assuming a normal or reasonable customer response involves 25 per cent of customers would switch would impact and cut the level of customer detriment identified substantially, given the bulk of consumers are also assumed to prefer their current supplier.

Hypothetical benchmark

The level of detriment identified was not based on an estimate of excess profit. It involved the CMA comparing the average price charged by large retailers against a benchmark price assumed to be charged by a hypothetical retailer, that is “a supplier that is a combination of the supplier that we have identified as being the most competitive in the markets”[iv]. The benchmark was based on two of four mid-tier retailers (Ovo and First Utility).

On average the tariffs of the bigger retailers were assessed to be about 9 per cent higher than the benchmark. The authority found that its calculated customer detriment was similar to the annual profits of the six largest retailers and stated that this reflected their “inefficiency”. The paper notes: “This meant that, at the calculated competitive price, these suppliers would not merely lose their excess profits, they would actually make losses unless they could increase their efficiency.”

The paper also questions whether the benchmark used breached the competition authority’s own guidelines which say the market could be judged against a “well-functioning market”, i.e. one that displays the beneficial aspects of competition, but not an idealised perfectly competitive market”. Yet the competition conditions specified by the CMA “were quite idealized”.

The result, according to Professor Littlechild, reflected CMA comparing the actual prices of the large retailers with a “guess at what just two of the much smaller mid-tier suppliers would charge if they were not exempt from costly environmental obligations and if they had reached an efficient scale and if they were in a steady stage and if they were not loss-making and if instead they were earning a normal return on capital”.

Excess profit plus

The CMA also used an indirect approach which involved assessing the profitability of the big six and particularly whether their return on capital exceeded their cost of capital and whether their costs were higher than estimated for an “efficient” retailer. It then added the two estimates (excess profits and average inefficiency cost) to establish a cost of customer detriment. This was a departure from normal practice and essentially included an assumption that a benchmark “well-functioning market” would be characterised by all suppliers operating at or near efficient cost.

Conclusion

While the CMA’s investigation flagged exceptionally high customer detriments, Littlechild states that it did not indicate an “exceptional” lack of competition, while the different approach it adopted with its focus on weak customer response was an Achilles’ heel. The paper highlights the challenge of accurately assessing competition and the need to get a proportionate response.

The paper concludes that the approach isn’t helpful for future policy because it misrepresents the nature of competition and overstates the reasonable extent of market power and customer detriment and encourages inappropriate and “counter-productive” government and regulatory intervention.

The UK investigation highlights the difficulties in estimating customer detriment by reference to an efficient cost benchmark, “but even in competitive markets, firms will have different costs for different reasons (e.g. because they have different products or customers with different costs to serve, or they may provide different level of customer services, or investments are made at different times with different technologies available, etc)” according to the paper.

The paper also suggests that to arrive at a proper assessment of the market more weight should be placed on conventional criteria such as barriers to entry or expansion or customer switching rather than a calculation of customer detriment “at a moment in time”. And for the UK energy market none of these seem to have been a problem.

[i] The CMA’s assessment of customer detriment in the UK retail energy market, University of Cambridge Energy Policy Research Group Working Papers, June 2020

[ii] Energy Market Investigation, Competition and Market Authority, 24 June 2016

[iii] https://www.ofgem.gov.uk/publications-and-updates/ofgems-collective-switch-trials

[iv] Energy Market Investigation, Competition and Market Authority, 24 June 2020