Competition and regulatory law experts Andrew Hockley and James Marshall outline the scope and potential risks associated with the energy sector competition review framework jointly published by UK competition authorities. They also consider some of the regulatory risks associated with the ongoing political scrutiny of the energy sector.
This review could be the first stage in a more detailed competition review of the sector and ultimately lead to structural reform within the sector. However, a more immediate concern is the prospect that the current political scrutiny of the energy sector intensifies in the lead-up to the next election in combination with ongoing regulatory intervention.
Competition Review Framework: key focus and some potential outcomes
On 19 December 2013, Ofgem, the Office of Fair Trading (OFT) and the Competition and Markets Authority (CMA) announced the much anticipated framework for how they will assess competition in the energy sector (Competition Framework). This follows the Prime Minister’s announcement on 23 October of an “annual competition audit” of the energy sector (see our previous blog post for more detail).
The Competition Framework identifies the focus of the review, which will:
- examine the role and strength of the ‘Big 6’ energy suppliers;
- assess the nature, scope and vitality of competition in the sector;
- identify barriers to new entrants wishing to compete with the existing suppliers;
- examine how the vertical integration of suppliers affects competition; and
- assess whether profit levels at different parts of the supply chain are competitive.
The review will be published before the end of March 2014. It will draw on Ofgem’s energy sector knowledge and expertise, as well as the OFT’s wide-ranging experience of assessing competition in a range of different markets. The CMA will take over from the OFT in April 2014 and will be the UK’s lead competition and consumer body (see previous Blog Post here). Possible outcomes include an in-depth CMA Market Investigation Reference, ongoing Ofgem scrutiny and/or recommendations for legislative intervention.
At this stage, it seems likely that Ofgem’s review will be the first stage in a detailed competition review of the sector. This could lead eventually to structural remedies to address any concerns identified. However, any such reforms would likely only happen after a detailed analysis by the CMA, which may not conclude until the second half of 2015. Arguably, the greater immediate risk comes from the ongoing political scrutiny of the energy sector.
Cost of living and competition: Ofgem and the energy sector in the spotlight
The competition review comes amidst increased political scrutiny of the energy sector driven primarily by the Labour Party’s focus on the “cost-of-living crisis”. On 2 January, the Labour Party claimed that consumers have been overcharged up to £4 billion over the last three years because wholesale market opacity allows downstream suppliers to pay too much for wholesale energy. Ofgem has reiterated its commitment to wholesale market transparency and reform, including a requirement that the Big Six energy suppliers publish the price they will pay for wholesale power for up to two years ahead (Ofgem press comment available here). Ofgem will consider further the link between wholesale and retail prices as part of the competition review and will likely ensure that its analysis addresses Labour’s allegation directly.
Most recently, Labour announced that it would introduce an “Annual Competition Audit of Britain’s economy” if it wins power at the next election, with the aim of tackling “the cost of living crisis through greater competition”. The CMA and other regulators (including Ofgem) would work with consumer groups to “identify broken markets and priorities for action”. The energy sector was again singled out for attack. Labour accuses the Big Six energy suppliers of overcharging consumers and criticises Ofgem’s failure to rectify flaws it has identified in the domestic supply markets.
Although Labour’s proposals for additional ‘competition audits’ would only take effect if it wins the next election, Ofgem will clearly be under pressure to deliver the ‘right’ outcome from its current review of competition.
What does the Energy Competition Framework contain?
The Competition Framework published in December identifies two principal review stages:
Defining a “hypothetical well-functioning energy market”. This will provide a comparator against which Ofgem will assess the actual conditions of competition in the UK energy sector. Ofgem will employ both short-term and longer-term indicators of a well-functioning market in order to determine whether the UK’s current market is failing in comparison. The indicators include levels of consumer engagement, trust and service; levels of suppliers’ cost and margin pressures; whether dynamic rivalry exists; and the opportunity for successful new entry and business models.
The review will then employ five theories of harm to assess whether effective competition exists:
- Unilateral market power – the review will examine current and historic market shares for the ‘Big 6’ to determine whether one or more suppliers has market power to act independently of its rivals;
- Weak competition between suppliers – the review will examine factors such as market structure, new entry, information transparency, and market behaviour and outcomes over time to determine whether the conditions for tacit or explicit coordination may exist;
- Barriers to entry and expansion – whether potential barriers may mean incumbents face insufficient competitive constraints. Potential barriers include high costs, possible structural barriers (e.g. vertical integration), weak demand for new entry due to consumer disengagement, and switching and regulatory barriers;
- Vertical relationships – whether vertical integration (i.e. either structural or contractual control of both key upstream inputs/assets such as generation and downstream retail supply), may restrict competition. Ofgem will focus on pricing and profitability throughout the supply chain, as well as potential cross-subsidisation of different products;
- Weak customer response – Ofgem’s Retail Market Review has recently introduced a variety of changes intended to increase consumer engagement and switching levels¹. The competition review will examine whether other factors also weaken customer response;
- Profitability – whether prices for retail energy are “above competitive levels”. Ofgem will focus on the profitability of energy supply and generation for the ‘Big 6’ by looking at relevant comparators and cost of capital. This analysis will support Ofgem’s overall competitive assessment.
What are the principal risks for energy suppliers?
The review could find that competition is not working effectively and that further intervention is required. Possible forms of intervention could include:
- Market Investigation Reference and possible mandatory remedies: Ofgem could refer one or more markets for the supply of retail energy to the CMA for a Market Investigation Reference. This would involve a detailed 18-month investigation to determine whether any feature(s) of the market prevents, restricts or distorts competition. If the CMA concludes that the market is not operating competitively, it has extensive powers to seek remedies. These could include forced or voluntary divestiture of assets (e.g. vertical separation), additional behavioural or information requirements, recommending legislative intervention etc.
- Recommendations for further intervention: Ofgem could also make recommendations to the Government to, for example: (i) introduce greater regulatory powers for Ofgem and/or the CMA; (ii) intervene directly through legislation to require, for example, vertical separation; (iii) introduce a fixed or ‘loose’ price or profitability cap; or (iv) provide formal support for new entrants. While a more likely outcome may be a full Market Investigation Reference, the possibility of recommendations to Government cannot be ruled out.
- Intensified political scrutiny: the political reaction to the review is uncertain. However, Ofgem has been subject to considerable criticism from both the Government and opposition. The Prime Minister has stated that he “believe[s] in intervening in the energy market”² and the Government will reduce the cost of bills by reducing environmental levies and introducing a rebate scheme. Meanwhile, the Labour leader has pledge to freeze retail energy bills for two years if he wins the 2015 election, in addition to promising further regulatory scrutiny and intervention. Given the continued focus on the ‘cost-of-living’ debate, it is possible that the review may not appease any political appetite for further intervention in the sector in the 12 months leading to the next election.
Ofgem will carry out the review through engagement with key stakeholders. The review will be published before the end of March 2013, shortly before the CMA replaces the OFT.
Various other reforms will continue alongside the review. These include changes to retail supply tariffs and procedures following Ofgem’s Retail Market Review, Ofgem’s ongoing examination of price reporting in the gas market, and the introduction of the Electricity Market Reform during 2014 under the Energy Act 2013 (which passed into law on 19 December 2013).
The pace and frequency of energy sector reform, combined with ongoing regulatory and political review is unlikely to lessen in the short to medium term. Indeed, it seems more likely that political scrutiny will increase leading up to the next election in May 2015. The competition review and ongoing political pressure on the energy sector seems likely to add to the general climate of uncertainty for all market participants over the coming months.
¹ Ofgem Retail Market Review, full details available on the Ofgem website here. Changes include restrictions on fixed-term contract renewal and unilateral variation of bills. From 31 December 2013, retail suppliers will also be subject to a tariff cap and will have to provide enhanced information to facilitate customer switching.
² A Market Investigation Reference may be made under section 131 of the Enterprise Act 2002 where the relevant competition regulator “has reasonable grounds for suspecting that any feature, or any combination of features, of a market in the United Kingdom for goods or services prevents, restricts or distorts competition”. A single-market reference may consider any structural feature or conduct in the market. A cross-market reference (of two or more markets) may only be made in relation to any conduct within the market.