In of firms in the energy market and

In the
UK, there are 6 major suppliers; these are SSE, Scottish Power, Centrica, RWE
npower, EDF and Eon, which altogether have a market share of 82% (Ofgem 2017).
However, there are as many as 54 active suppliers of energy in the UK (EnergyUK
2017). Therefore, the market structure in the energy sector is an oligopoly. An
oligopoly is a market that is dominated by a few firms. The UK classifies an
oligopoly as a five firm concentration of more than 50. The market structure of
the energy market has led to various problems in the production and consumption
side, and this essay will discuss these.

One
problem that is currently being faced in the energy market is tacit collusion,
which is leading to higher prices. The big firms have been accused of
tacit collusion in the past, with critics claiming that there has been evidence
of tacit collusion due to the size and timing of price increases, and Ofgem has
investigated for evidence of collusion with the big energy firms (Macalister
2014). A game
theoretic approach may be used to illustrate why the firms undergo tacit
collusion. The below model shows a very simplified version of the strategies
and corresponding payoffs, and as we only assume 2 firms in the market, isn’t
representative for the energy market, but still provides useful intuition on
behaviour of firms in the energy market and how strategies by energy firms are
affected by strategies of other firms.

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                                                                                  EDF

Payoff/Expected Profit
(£million)

High Price

Low Price

High Price

£4m, £4m

£-1m, £6m

Low Price

£6m, £-1m

£1m, £1m

 

                       Eon

 

Let’s
assume that initially both firms were charging a high price. They would both
gain profits of £4 million. There is clearly incentive for one of the firms to
undercut the other by charging a lower price, which would result in them
getting £6 million profits now, this is £2 million better off from before. The
firm that was undercut would now be operating at a loss at £1 million and in so
they would lower prices themselves as well in order to be better off by gaining
a £1 million profit. This means that both firms would have £1 million pound
profits, and are hence both worse off than before. This game could go on forever, and eventually a price war
would break out which would lead to both firms being worse and worse off. The
intuition behind this simple model can be applied with the big 6 firms in the
energy market where if we assume that the firms cannot coordinate in any way
then if one firm, say British Gas cuts their prices then the other 5 firms are
likely to follow and cut their prices. As it is fair to assume that energy
consumption won’t increase drastically even when prices decrease, a price
decrease from all firms would mean that all firms lose out. To avoid this from
happening, tacit collusion is used, which means that prices stay high.

Another issue in the energy market
is high barriers of entry. High barriers are an issue in most industries but in
the specific case of the energy market, one of the main barriers to entry is
due to high levels of vertical integration that is needed for a energy firm to
be able to function properly. This claim is backed up by findings of an
assessment conducted by Ofgem that claimed that vertical integration and high
barriers to entry was one of the reasons of low competition in the energy
market (Ofgem 2014). The structure of the big firms is characterised by a high
degree of vertical integration between the different production stages, shown
by the fact that the six larger suppliers all own energy infrastructure such as
power stations and supply businesses (Ofgem 2014). For a potential entrant to
enter the energy market successfully, it must be able to secure access to
energy infrastructure, from the production stage all the way to the supplying
of customers. However, this is costly to obtain, which results in start up
costs for entrants being extremely high, and therefore acts as a deterrence for
new firms who want to enter the energy market. As the big 6 firms who are
established in the industry know this, they have low incentive to act in a way
that suggests competiton, for example by keeping prices low or producing efficiently
and thus prices stay high and the big 6 firms don’t produce as efficiently as
they could.

The
market structure and the firms behaviour in the energy market is such that
consumers are bound to lose out due to higher prices. British Gas increased
electricity prices by 12.5%, which came into effect on 15th
September 2017, meaning larger bills for more than 3 million consumers (Kollewe
and Elgot 2017). Furthermore, a study by the Competition and Markets authority
found that altogether; consumers were paying £1.4 billion in excessive prices
(Hall 2016). This evidence clearly points to consumers losing out. This can be
shown by utility theory and indifference analysis. It is fair to assume that a
reasonable proportion of income is spent on energy; this is shown by the graph
below:  (Ofgem 2017)

 

 

 

 

 

 

 

 

 

The data
from 2015 suggests that the average household spends about 4.3% on their income
on energy, which this number increasing to around 9.8% for the households in
the lowest 10% for income. The 2017 figures are unlikely to be much different
to the 2015 ones.

Access to energy
such as electricity and gas is essential for households, especially winter time
where heating is needed, so a price increase is unlikely to lead to energy
consumption falling drastically for the average household. so less income will
have to be spent on other goods, and so the utility a household can gain
reduces. Therefore, households are going to consume at a lower point on their
indifference curve, hence they lose out.   
 

IC1

 

 

 

 

IC2

                                                                                                             

BC2

BC1

 

                                                                                             

This
diagram above can be used to illustrate this. Originally, before the price
increase households would be consuming at the indifference curve IC1. The price
increase shifts the budget line inwards from BC1 to BC2, and now the consumer
is consuming on the indifference curve IC2, which is shifted to the left, so
now consumer utility is less than before.

Consumers
may lose out further in the long run. Recently SSE and Npower, two of the big 6
firms recently proposed to merge, and they are likely to serve about 11.5
million consumers if successful (BBC News 2017). There have been concerns
raised about the merger, for example a cross-party group of MP’s have addressed
concerns that this merger would damage competition and be a bad deal to
consumers (Ambrose 2017). Theoretically it is easy to see why. It has been
feared that if the merger goes ahead then British Gas and the merged firm will
have a cumulative market share of 50% (BBC News 2017). This means there is a
bigger problem in the big firms abusing their market power and charging higher
prices for consumers, so consumer utility falls further due to even less income
being spent on other goods.

Even
though price increases is likely to mean consumers lose out, another factor
that is leading to consumers losing out is asymmetric information and consumers
having a lack of knowledge of prices in the energy market. All of the big
energy firms have a large proportion of customers that rarely or even never
engage in the market, also known as “sticky” customers. This means they are
unlikely to switch suppliers despite higher prices or even potential for
significant savings by switching suppliers due to a lack of information for
those customers who don’t engage in the market. In the energy market, 58% of
consumers fall in this category (Utility Aid 2017). Therefore, the big firms
can afford to charge higher than the equilibrium price for “sticky customers”,
and make cheaper deals for more active customers, as the majority of consumer
behaviour is unlikely to change despite the higher prices. Furthermore, it is
shocking to note that according to an Energy Saving Trust public opinion
tracker UK Pulse, only 7% of young people understand bills, and 40% unable to
identify that energy is measured in kilowatt hours (SEHBAC 2017). This clearly
shows that not only do some consumers don’t engage in the market, some don’t
even understand energy bills, which indicates a lack of knowledge for consumers
in the energy market.

Currently,
there is clearly market failure occurring here in the energy market, due to
factors such as imperfect information, and a degree of government intervention
may be needed to correct market failure. One such intervention would be price
caps on the Standard Variable Tariffs for the consumers on this tariff, and
this method of intervention was announced by Theresa May (Vaughan 2017). This
would help to an extent prevent the big firms from charging super high prices,
as there would be a ceiling price to which the firms cannot exceed. The energy bills of 11 million households will be
capped for as long as five years, which the Conservatives have claimed could
save people up to £100 a year. This means that these households would
have more money to spend on other goods, and therefore their indifference curve
shifts to the right. As a result, their utility increases.

Another
method the government could use is focusing on improving consumer information
on energy bills, by improving understanding on how much energy households are
consuming, as well as improving consumer information on prices across the whole
energy market. To improve understanding on how much energy households are
consuming, the government can spread information about smart meters provided by
British Gas to enable consumers to understand how much energy they are
consuming and how much they are paying for their energy. Furthermore, to
improve consumer information on prices across the whole energy market,
comparison sites such as uSwitch which compare prices and deals across the
whole energy market would be effective. This would mean that consumers have
better knowledge of energy prices across the whole market, which would allow
them to make a better comparison and hence a well-informed decision on whether
they should switch suppliers, which would help address the problem of
asymmetric information. Therefore, firms will have an incentive to cut prices
and improve efficiency; otherwise they will lose customers, which in theory
should help improve competition and address the problem of a lack of consumer
information in the energy market.

Another
strategy could be for the government not to intervene yet, and see how the
energy market continues to function. The reason why this is a feasible strategy
is because of the recent proposed merger between SSE and Npower. Although there
have been concerns that this merger should be blocked due to the fact it may
reduce competition, it could actually have the opposite effect. This view was
shared by a spokesperson of SSE, who claimed that the merger would “improve
competition by offering customers a completely
new model combining the resources of established players with the agility and
innovation of an independent supplier”, which would “offer better value for
consumers” (Vaughan 2017). This suggests that competition would improve by the
merged firm providing better quality services and so other firms will have to
improve quality of their services. It is still uncertain whether this recent
merger will even go ahead, and if it does whether it would reduce competition
further or even improve it, and if consumers would gain or lose out in the long
run. Therefore, non-intervention by the government until there is sufficient
evidence that the merger is harming competition may be a sensible idea.

In my opinion, the method of intervention that the government
should implement is price caps. Although it isn’t a perfect method to completely
correct market failure, there are several issues facing the UK energy sector,
which means that some government intervention is needed as it is clear that
leaving the market to correct itself won’t work. Price caps would at least
address the problem of tacit collusion and consumer utility, therefore it may
help correct market failure in the energy market. Furthermore, methods to try
and improve consumer information is likely to take a very long time before it
has any visible impact due to the large amount of UK consumers that don’t
engage in the energy market. However, it is worth noting that no government
intervention is fully guaranteed to correct market failure, and maybe a
combination of different methods of intervention may be more effective.