Both major parties have announced policies to curtail markets, but are price controls really the best way to protect consumers?
After being included in both of the major parties’ manifestos, Theresa May announced a policy of capping energy prices at her parties’ conference in Manchester, whilst Jeremy Corbyn floated the idea of rent controls at the Labour conference in Brighton. Whilst price controls have always been a staple policy of the socialist-leaning left, to see a Conservative Prime Minister championing the free hand of the market and announcing an energy price cap in one speech is quite bizarre. Whichever side they may stem from however; price controls are bad policy.
It is easy to see why the idea is in vogue. Energy companies have been accused of taking advantage of customers for many years, tempting in new customers with low fixed-term tariffs before switching them to much higher priced standard variable tariffs (SVTs), meaning only those willing to constantly shop around and change providers can stay on the lowest available rates. Now, it looks like the government is preparing to set a blanket price cap on all SVT tariffs in order to protect customers and limit the dominance of the big six suppliers. Unfortunately, blunt price controls of this type regularly cause more problems than they solve.
Price controls are one of the only issues where you will find broad agreement from economists of every stripe, and we can look to history to confirm the theory.
Economics tells us that when the price of something is limited to below the market-clearing rate, that product will tend to disappear from the market. Keeping prices artificially low removes the incentive for suppliers to increase output whilst higher levels of demand are encouraged. The famous rent controls imposed in New York city following World War 2 Two increased demand dramatically but gave no incentive to suppliers to provide more housing or invest in what they already had, leading to enormous shortages in supply and declining conditions. Price caps on food and construction materials have had disastrous effects in places like Venezuela. The price of fuel in the USA was capped below the market rate in 1973 and the inventory quickly disappeared due to shortages. Energy price caps in California in the late 1990s led to rolling blackouts, the collapse of energy providers, market manipulation by companies like Enron and the declaration of a state of emergency. As Milton Friedman put it: "We economists don't know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers can't sell tomatoes for more than two cents per pound. Instantly you'll have a tomato shortage. It's the same with oil or gas."
There are likely to be all sorts of third-round effects to an energy cap that would ultimately hurt customers. The biggest of these would be reduction in competition, where small suppliers who truly benefit consumers by taking on the big boys simply become unsustainable, and new entrants into the market would be deterred. Suppliers may also raise prices in anticipation of the cap, or just raise the prices of their cheapest tariffs in order to make up the shortfall. Not only would these effects disproportionately hurt the poorest in society who are currently on the cheapest rates and pre-payment meters, it would reduce the incentive for people to shop around for the lowest prices and in turn reduce the incentive for suppliers to offer cheaper deals. Furthermore, a cap on prices would act as a cap on the upside potential of any investment by suppliers without altering the downside potential. This could lead to a reduction in much-needed investment into innovation, new technologies and energy infrastructure to make savings. Overall, the power of the big suppliers over the consumer would be increased.
The evidence shows us that when price caps are imposed, large swathes of customers feel less obligated to engage with the market.
There are different ways of doing price controls, such as with a relative price cap– a more interesting and marginally less scary proposal that has been advocated by Policy Exchange and promoted by John Penrose MP. The idea is that the cap is a limit on the differential between the highest tariff charged by a supplier and the lowest, ending the enormous price jumps that hit customers when they jump from fixed-term deals to SVTs. The policy may seem a smarter way of doing a cap, but it is a price control nonetheless and the third-round effects are simply more obfuscated. Again, we can look to history. Something similar was actually tried in 2008 when Ofgem banned the use of ‘unfair price differentials’ between tariffs, after determining that they existed within the market to the tune of £500m, and all sorts of bad things happened as a result. The price differentials were reduced primarily by suppliers increasing the prices of their cheapest tariffs whilst leaving the most expensive ones untouched. Ofgem at the same time introduced constraints on direct marketing and door-to-door sales, which saw a reduction in consumer engagement with the market – particularly amongst the poorest who relied on such tactics to find lower tariffs. Suppliers further mitigated the costs of the policy by introducing a whole host of new tariffs that baffled customers, reducing engagement even further. Overall, the rate of switching fell by 50%. The policy was scrapped in 2012, but many of its effects on the behaviour of both customers and suppliers linger on.
Suppliers and regulators have made progress in encouraging new entrants to the market and in getting customers to switch more regularly in recent years. Lazy policy risks undoing this.
Following the announcement of the policy, Centrica PLC’s share price fell to a 14-year low as investors priced in the possibility of new disruption to the market. According to a note from wealth management firm RBC Europe, earnings for the big six could be hit by as much as 25%, with profit margins for the group potentially slipping from 2.6% to 0.3%. This comes at a time when there is already considerable uncertainty in the market thanks to Brexit, and the government estimates £100bn of investment into power grids and plants is needed over the next decade to replace ageing facilities and reduce pollution. The announcement also undermines Ofgem’s ability to act as an independent regulator amidst existing efforts within the industry to address this issue by phasing out SVTs altogether, which EON has already committed to. The big six’s share of the market has slipped from 99% and just 4 million people switching providers each year three years ago, to an 80% market share and over a third of people switching today. Heavy-handed, blunt policies like blanket price caps could put this progress at risk.
There are a number of markets where high prices and lack of supply need to be tackled, energy and housing being the biggest on a national scale, but price controls are a sledgehammer where more delicate instruments are needed, and have exacerbated the problem they are deployed to address over and over again. If our politicians really seek to improve the access to these markets of some of the poorest in our society, they will need to be much smarter, and not repeat the mistakes of the past.