14 Apr 2016
(By David Deller) In an , I provided an initial reaction to the . This blog post considers the underlying assumptions that appear to have provided the ‘envelope’ for the remedies that the CMA considers suitable and proportionate. I critique the CMA’s reasoning in three core areas: (i) the size of interventions that could be justified by the estimates of harm; (ii) why the headline harm estimates are likely to be overestimates; and (iii) the limited evidence for concluding that smart meters are a panacea to low consumer engagement. After such a lengthy investigation it is disappointing to see such weaknesses in reasoning.
The estimates of harm could support radical interventions
The CMA’s detriment estimates are very large, with the highest quoted figure being £2.5bn in 2015 alone. It is sensible to treat the detriment estimates with some scepticism (see next section), but if one took an ultra-conservative view of the figures, would substantial interventions still be justified? The short answer is yes.
Consider the CMA’s lowest detriment estimate of £660m per annum, an intervention with an ongoing cost of £60m per annum would still have a positive net present value in the following situations:
- Actual detriment is only 10% of the estimated detriment and the intervention resolves all of the detriment, or
- Actual detriment is £660m, but the intervention only resolves 10% of the detriment, or
- Actual detriment is £660m and the intervention has a 10% chance of resolving the entire detriment.
The next question is what could £60m per annum purchase in terms of regulatory activity? To provide some context, in 2014-15, the total gross operating cost of Ofgem was £87m and Ofgem’s permanent headcount was 896. I am not advocating an expansion of Ofgem by two-thirds(!), but this example clearly shows that ongoing running costs are unlikely to provide strong grounds for excluding particular remedies. Of course the CMA should maximise the NPV rather than simply ensure it is positive, and the costs imposed by regulations on firms and consumers need to be considered, but, if the CMA believes its detriment estimates, very large interventions could be justified.
But the headline estimates of harm are overestimates
The CMA’s preferred detriment estimates (an average of £1.7bn per annum over the period 2012-15) are based on comparing prices of Standard Variable Tariffs (SVT) against a ‘competitive benchmark price’. One needs to be ultra-conservative regarding such estimates for two reasons.
Firstly, there is no guarantee that the equilibrium price when all consumers are ‘engaged’ will be equal to the current ‘competitive benchmark price’. It seems highly questionable that a market with a range of prices would converge on the lowest currently observed price – such a price may not even be viable once the market adjusts.
Secondly, it is wrong to consider all of the difference in price between SVTs and the competitive benchmark as a realisable welfare gain and therefore consumer detriment. Some of the difference in price will be offset by the costs of consumers newly engaging in the energy market. These costs relate to the time and cognitive effort required to identify the best deal for the individual consumer (search costs) and then the time (and possible payment of exit fees) to complete the switch (switching costs). That relatively few individuals switch suppliers in the energy market can be interpreted as showing that substantial costs to switching exist and that in many cases these costs are greater than the expected savings quoted to consumers.
Unlike the CMA, the Financial Conduct Authority (FCA) does calculate the costs of consumer engagement in a consultation paper considering measures to increase consumer engagement in the general insurance market. The FCA’s cost benefit analysis quantifies both the cost to consumers of engaging with the market and the cost to firms of handling calls from consumers enquiring about different deals/switching. The annual cost of consumer engagement is estimated at £13.1m and the annual cost to firms of increased call handling is estimated at £3.9 million.
Furthermore, if consumer welfare and profits are given equal weight, any increase in consumer welfare from reduced prices, conditional on the quantity consumed remaining fixed, is simply a transfer from firms’ profits. For interventions that increase consumer engagement to deliver a true welfare gain it is necessary that the lower prices resulting from higher consumer engagement also increase the quantity consumed. Given the widely discussed issues of fuel poverty and under-heating of homes, the welfare gains from increased energy consumption are potentially significant.
Smart meters do not justify the exclusion of radical interventions
The CMA relies heavily on the assumptions that smart meter roll-out will be completed by 2020 and that it will be transformational in increasing consumer engagement. These are central to the CMA’s argument that most remedies are temporary and that remedies must be rapidly implemented. Both assumptions are questionable, and it would be more reasonable to treat smart meters as introducing considerable uncertainty regarding the energy market.
The CMA argues that “fully functional smart meters are likely to have a substantial, positive impact on both competition and engagement”, yet this conclusion appears to be based on little evidence. The CMA itself reports that “There is limited evidence on the impact of smart meters on engagement in domestic retail energy markets – and our review of the international experience of smart meter roll-out….did not identify any studies that have specifically addressed this question”. The evidence the CMA reports to justify its positive conclusion seems to be simply a set of descriptive statistics regarding smart meter users’ greater understanding/information regarding energy bills and supply choices relative to ‘dumb’ meter users. As evidence, these descriptive statistics can be questioned on a number of grounds. Perhaps most significantly, smart meters are optional, so the statistics may simply reflect differences between the type of people who opt for smart meters and those who don’t, rather than recording the impact of smart meters themselves.
While taking the Department for Energy and Climate Change’s smart meter roll-out timeline at face value, the CMA highlights that even within this official timeline the suppliers’ obligation is simply “to take all reasonable steps to ensure that a smart metering system is installed on or before 31 December 2020”. Similarly, the CMA notes that for the 3.5% of households requiring “alternative home area network” solutions the timetable for receipt of a working smart meter is “currently unclear”.
Nevertheless, the CMA places great emphasis on rapidly implementable remedies. The CMA argues that “Given the scale of the detriment we have identified, we believe that it is vital to ensure that our remedies are implemented as rapidly as practicable. To assess the effectiveness of the proposed remedy package….we have considered the timescales over which these remedies are likely to be implemented.” While it is correct to implement proposed remedies as rapidly as possible, to suggest that the size of detriment means that remedies that can be rapidly implemented are per se more attractive is highly questionable. The correct method to assess the relative merits of different interventions is to assess their full costs and benefits over their lifetime i.e. to compare their net present values. The CMA’s approach risks selecting interventions that deliver rapid improvements over those that give greater benefits over the long term. Implicitly, this emphasis on speed potentially introduces a bias towards smaller rather than larger interventions.
Lastly, it is not automatic that significant interventions are incompatible with smart meters. Italy, often held up as a model of a successful smart meter roll out, currently combines smart meters with a single buyer model, which is a market structure similar to an .
The assumptions that lie behind the CMA’s proposed remedies appear critical to the reasoning that radical alternatives to the current operation of the domestic retail energy market are not proportionate or feasible. Unfortunately, these assumptions are built on weak foundations.
Paragraph 59, page 14, ‘Energy market investigation: Summary of provisional decision on remedies’, Competition and Markets Authority (CMA), 10 March 2016
Including initial setup costs would reduce the NPV, but these setup costs would need to be large to offset the qualitative conclusions of the example.
See pages 43 and 77 of ‘2014-15 Office of Gas and Electricity Markets (Ofgem) Annual Report and Accounts’.
Paragraph 58, page 14, ‘Energy market investigation: Summary of provisional decision on remedies’
This reasoning assumes that consumer engagement is always required. Alternative mechanisms, such as opt-out collective switching or price regulation, may reduce/remove the need for consumer engagement.
‘Increasing transparency and engagement at renewal in general insurance markets’, Financial Conduct Authority (FCA), Consultation Paper CP15/41, December 2015
Table 2, Annex 2, ‘Increasing transparency and engagement at renewal in general insurance markets’. In calculating these figures the FCA does employ one questionable assumption, that all consumers have the same costs of engagement. In the energy market there are clear engaged and unengaged groups, suggesting that the unengaged face (or at least perceive) search and switching costs which are much higher than those experienced by the engaged.
Since this quantity change is not quantified in the FCA’s cost benefit analysis, the result for its proposals is a negative net present value.
Paragraph 4.77, page 200, ‘Energy market investigation: Provisional decision on remedies’
Paragraph 4.75, page 200, ‘Energy market investigation: Provisional decision on remedies’
Paragraph 4.76, page 200, ‘Energy market investigation: Provisional decision on remedies’
See page 9 of Deller, D., M. Hviid and C. Waddams (2016), consultation response to the CMA’s ‘Energy market investigation – Provisional decision on remedies’, available at:
Footnote 262, page 201, ‘Energy market investigation: Provisional decision on remedies’
Point (d), paragraph 4.80, page 201, ‘Energy market investigation: Provisional decision on remedies’
Paragraph 4.88, page 203, ‘Energy market investigation: Provisional decision on remedies’