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Competition not intervention is key to reducing energy bills

Labour’s proposed energy price freeze exposes the need for politicians to be more honest with voters, writes Professor Michael Pollitt of Cambridge Judge Business School.

Energy

Professor Michael Pollitt

Professor Michael Pollitt

Energy policy has shot to the top of the political agenda in recent months following proposals from the Labour Party to freeze energy prices for 20 months if it wins power at the next election. As an academic economist, it is difficult to adequately describe the intellectual contempt that a policy that defies economic sense deserves.

While it is good that potential energy policies are put before voters, I believe there is a danger that many of the key points will get lost in the political battles. Any energy policy must address three issues: the affordability of energy; ensuring security of supply; and the environmental impacts of energy. The conflict between these three goals is known as the “energy trilemma” and all governments have to grapple with this.

The questions we need to ask of any set of proposals are therefore: how will this contribute to improving one or all of those three aspects, will it worsen them and, if so, is there an acceptable trade-off?

Fixing final energy prices is quite a common policy across the world and particularly in developing economies. The evidence against however is overwhelming: capping energy prices below cost leads to energy shortages, worsens energy security, pollutes the environment, fails to promote energy efficiency and creates energy poverty for those denied access to it.

In a liberalised and competitive market such as the UK, the government looks to private energy companies to help deliver those goals. If you cap prices, as the Opposition proposes, private firms will not invest in much-needed – but expensive programmes – such as low carbon energy and energy security. Either retail price caps will be imposed at such a high level that the cap is meaningless, or if the price cap binds, it will lead to shortages of investment that will damage energy security over the long term. A successful cap will also lead to over-consumption and wasted energy, with negative environmental impacts.

In contrast, in my view, there was not a problem with the competitive market until both politicians and the independent regulator started to mess about with it. Since 2008, interventions inspired by political concerns but promoted by Ofgem have acted to systematically raise prices and increase retail margins.

This does not necessarily however mean that the answer is to do nothing. If politicians really want to help hard-pressed households, they need to distinguish between reducing consumers’ energy bills and cutting the price of energy. To secure the benefits of a competitive market for energy, consumers should be exposed to the true cost of the last unit of energy that the consumer uses.

There will always be extra costs associated with ensuring energy security and meeting environmental targets. That does not mean you cannot actually help people with their bills. The issue is who pays for those extra costs – and politicians do have choices.

For example larger households could pay a higher standing charge while ensuring that all households were still exposed to the unit cost of the energy they use. Energy efficiency is very important and more work has to be done on ensuring it is better targeted at poorer households.

Another route is to take the fear out of receiving an energy bill. Options include switching to “micropayments” for energy by moving to weekly payments and making better use of what is probably the most sophisticated tax and benefit system in the world. By using the benefits system to pay all or part of energy bills directly, state support could adjust to energy costs quite easily.

There are not easy solutions – and the dishonesty that surrounds energy policy does not help. As developing country leaders have found, it is easy to get sucked into trying to do something about an issue that is essentially driven by international commodity prices. There are a limited number of interventions that are viable and which do not end up being grossly unfair and inefficient. Politicians need to stand back and consider what precisely they are seeking to achieve and what the constraints are.

Competition is a process worth nurturing precisely because the alternatives are so difficult to make work and the benefits are often not what we would expect. To ditch competitive retail energy markets now would be a deeply unfortunate reversal of economic progress in a sector, which has historically benefited from competition, and suffered so much from the lack of it.

There is no perfect solution that will solve the energy trilemma. Politicians need to be honest about what the costs of its policies are and who will pay for them. Currently none of the main UK political parties is as clear about that as they should be.


Michael Pollitt is Professor of Business Economics at Cambridge Judge Business School and Director of Studies in Management and Economics and Fellow of Sidney Sussex College.