Energy prices September 11 2012, 0 Comments

Npower announced today that it is following the lead of British Gas, the UK’s dominant gas supplier, by announcing that it is increasing both its electricity and gas prices by 9.1% and 8.8% respectively. This follows British Gas’s price increase of 6%. Consumer watchdogs immediately criticised the energy supplier’s decisions, pointing to the lack of competition in the energy market. The companies themselves have argued that increases in wholesale energy prices are beyond their control, while some of the price rise will be used to cover major investment programmes as energy suppliers attempt to become more efficient in order to meet the government's Certified Emissions Reduction Target to cut domestic carbon dioxide output. British Gas also pointed out that consumers could purchase a price ‘fix’ for up to two years.Energy price rises are more bad news for the inflation outlook as energy makes up around 15% of the CPI inflation basket. Long term, North Sea gas supplies are becoming exhausted, which means that the trend is clearly upwards. However, many observers are pointing to the general lack of competition in energy supply, which is dominated in the UK by the ‘Big Six’, as perhaps the single most influential factor in the current round of price increases. Economists are, indeed, likely to see this as further confirmation that energy suppliers operate interdependently - a tell tale sign of oligopoly. Some may even argue that the energy companies are guilty of operating a complex monopoly – a charge that the suppliers themselves would vigorously deny. Since the energy market was deregulated in the 1980s pricing models have been developed to explain, predict and control energy prices in what are, essentially, highly volatile commodity markets. However, the sharing of ‘pricing models’, which are complex but usually derived from simple ‘cost-plus’ pricing principles, is strongly suggestive of anti-competitive behaviour. Most multi-factor pricing models used by energy suppliers are published and openly available to all competitors. Moreover, the kind of price leadership witnessed this week is, clearly, further evidence of ‘follow-my-leader’ tacit collusion.

However, such tacit collusion is almost impossible to regulate against. Simple game theory can shed some light on energy pricing decisions. Pricing behaviour can be likened to a repeated game involving a few influential players, where the high risks of price competition encourage a more co-operative strategy. A simple solution to this ‘type’ of game is to agree some rules of co-operation, such as employing identical or similar pricing models, or to tacitly agree a price leader. The effect of this is to discourage competition by exerting a strong influence on each player’s individual decision making. In this case, if all energy suppliers increase price on a regular basis - be it as a result of increases in wholesale prices, or to fund future investment - the game slowly but surely evolves into one of implicit co-operation rather than competition. No single energy supplier dare risk reducing price in case it triggers a tit-for-tat price war. Conversely, if all suppliers raise their price in concert, the perception among consumers is that there is little choice but to pay up. While comparison websites, including uSwitch, provide useful information at the margin and make the retail market more transparent, the number’s switching supplier is relatively small. Knowing this, price rises remain a low risk option for energy suppliers. Of course, if the game always results in an identical outcome the suspicion of regulators will be raised, so price reductions will be built into the pricing models. At least, this is the view that many share.

Price indexing can also be regarded as an attempt to take some of the competitive risks out of the market. For example, the major gas suppliers to Europe, including Russia, Algeria, Norway and Qatar all index link their gas prices to oil prices – further evidence of a pricing system that does not necessarily reflect specific market conditions for individual energy types. Despite the weak global economy, high oil prices have clearly contributed to energy price inflation outstripping general inflation levels across Europe.

Not surprising then that Ofgem, the UK energy regulator, has been the subject of recent debate on all sides of the political divide, with the smart money on a complete overhaul of energy regulation after the next election.