CMA publishes updated issues statement in energy market investigation

On 18 February, the Competition and Markets Authority (CMA) published an Updated Issues Statement as part of its investigation into the GB energy market. The document summarises the CMA’s thinking based on the evidence it has received to date and highlights those issues that it considers are likely to represent the focus of its investigation in the period up to the publication of its provisional findings in May/June. The main changes in emphasis are around the significance of the rules and regulatory framework governing wholesale electricity and the broader regulatory framework including the current system of code governance. The CMA is inviting responses to the Updated Issues Statement by 5pm on Wednesday, 18 March 2015.

Updated theory of harm 1: The market rules and regulatory framework distort competition and lead to inefficiencies in wholesale electricity markets

The main change since the initial Issues Statement is that the CMA’s investigation into the wholesale electricity market is no longer limited to the effects of low levels of liquidity and opaque prices. The CMA has identified a number of areas where its initial view is that the market rules and regulatory framework could potentially distort competition and lead to inefficiencies in wholesale electricity markets, most notably that:

• there may be a risk of the imbalance price reforms overcompensating generators, given potential interactions with the Capacity Market;
• the absence of locational pricing of constraints and losses may distort competition; and
• a risk that a lack of competition in the CfD allocation mechanism may mean that CfDs are not allocated to the most efficient projects or at least cost to energy consumers.

Drawing on the analysis set out in the Working Papers, the Updated Issues Statement considers the impact of, firstly, current Market Rules and the proposed modifications under the Energy Balancing Significant Code Review (EBSCR), and secondly, the two major planks of the DECC’s EMR: the Capacity Market and CfDs.

Market Rules and EBSCR

The CMA first reviewed the principle of self-dispatch arguing that given the increasing liquidity of within-day markets and proposed reforms to cash-out prices, the principle of self-dispatch did not give companies sufficient incentives to vertically integrate in a way that could potentially distort competition.

The CMA then provided its views on fundamental reforms to the system of cash out prices under the EBSCR and argued that the move to a single price for imbalances would be positive for competition. However, it will seek further clarifications on criticisms in respect of PAR1 (a move to pricing imbalances according to the average cost of the most expensive 1MW of balancing action taken). The CMA also raised the concern that there was no need for the RSP (reserve scarcity pricing) component in cash out prices, given the introduction of the capacity market.

Finally and most notably, in reviewing the market rules the CMA’s main concern was about the absence of locational prices for constraints and losses. The CMA said that there were “clear arguments” that the absence of such prices was likely to adversely affect competition within and outside electricity markets, and involve efficiency loss. It also welcomed further evidence on the likely efficiency gains, distributional effects and transitional costs associated with a move to locational pricing.

The Capacity Market and Contracts for Difference

The CMA considers that the design of the Capacity Market appears broadly competitive, although it was still reviewing detailed aspects of design. For example, the CMA is considering the interaction between the introduction of the Capacity Market under EMR and the introduction of ‘reserve scarcity pricing’ (RSP) under EBSCR. RSP is being introduced in order to encourage adequate investment in generation, potentially allowing for a cash-out price in times of system stress of up to £6,000/MWh. The concern is that this may lead to an overcompensation of generators, if generators fail to take into account the impact of these potentially large but uncertain payments in their bids for providing capacity. The CMA is also considering representations put to it that providers of DSR are not able compete with generators on an equal basis, since generators facing high capital costs are eligible for up to 15-year capacity agreements, while DSR providers are eligible for only one-year agreements (even where they face high capital costs). The CMA also intends to investigate further the design of penalties for failing to provide capacity and whether the mechanism for recovering the costs of the Capacity Market provides efficient signals to suppliers of the value of capacity at peak times.

As regards CfDs, the CMA considers that that there are relatively strong efficiency arguments for replacing ROCs with CfDs; perhaps the most important being that under CfDs competition can be used to set the strike price. However, the CMA has some concerns that some elements of the allocation process may restrict the use of competition in setting the strike price. Dividing the CfD budget into three separate pots runs the risk that projects from one pot may be displaced by more expensive projects from another. Further, the fact that potential bidders for CfD contracts still have the option of seeking support for their projects under ROCs until March 2017 risks placing an effective floor on bids for CfD contracts, reducing the effectiveness of the competitive process.

Updated theory of harm 2: Market power in generation leads to higher prices

The CMA’s modelling has suggested that the major generators do not appear to have the ability and incentive to increase profits by withdrawing capacity in generation through the exercise of either the unilateral or coordinated market power.

Updated theory of harm 3: Vertical integration

The CMA addressed the concern in relation to opaque prices and low liquidity in wholesale electricity markets by stating that current levels of liquidity appear to be sufficient to allow independent suppliers and generators to trade in the same way as the “Big Six” suppliers. The CMA’s initial assessment also suggested that vertically integrated firms did not have the ability or incentive to engage in “consumer” or “input” foreclosure and thus harm the competitive position of non-integrated firms.

Updated theory of harm 4: Energy suppliers face weak incentives to compete on price and non-price factors in retail markets, due in particular to inactive consumers, supplier behaviour, and/or regulatory interventions

The CMA’s initial views on retail theories of harm are at an earlier stage of development than those relating to wholesale electricity and vertical integration. To date, the main focus of its work on retail markets has been on gathering data and evidence – in particular, collecting and cleaning data from suppliers and conducting an extensive survey of just under 7,000 domestic customers across Great Britain

In its initial observation on the nature of competition in domestic retail energy market, the CMA noted that over the last three years the gross margins that the “Big Six” earn were higher for customers on standard variable tariffs (SVT) that for those from non-standard tariffs. It will investigate further whether or not there is a higher cost associated with customers on standard tariffs, as purported by some suppliers.

The CMA stated that there were a significant number of inactive domestic energy consumers who could make considerable gains from changing tariff and/or supplier, so in the next phase of the investigation it would focus on what prevented those consumers from doing so.

The CMA considers that the evidence it has received to date appear to be consistent with the hypothesis that the Big Six energy firms have unilateral market power (UMP) over their SVT customers. The CMA has observed that the Big Six have consistently charged higher prices for the SVT for gas and electricity compared with non-standard tariffs, which provides some support for the view that these suppliers can segment the market and price discriminate. It has not yet taken a view on the strength of arguments that the Big Six attempt to keep their SVT customers disengaged, so as to retain them on high tariffs.

The CMA has carried out an assessment of whether the public price announcements of the Big Six are likely to provide a route for tacit coordination over the SVT. Whilst yet to reach any conclusion, it has conducted an analysis of the public price announcements of the Big Six over the last ten years, reviewing in particular: the date of any public announcement, the date of implementation and the date the supplier started notifying customers. “Significantly”, it has found no evidence to date of announced pricing plans changing in response to subsequent announcements made by rivals, either by altering the price or by changing the date on which the new prices came into effect.

The CMA has also identified a number of elements of the regulatory regime that could have a potential impact on retail competition. It intends to investigate further the heavily criticised prohibition of regional price discrimination implemented via Ofgem’s SLC 25A, the impact of retail market review measures, the significance of higher costs imposed by social and environmental obligations, which have fallen disproportionately on electricity rather than on gas, and the impact of smart metering roll-out.

Updated theory of harm 5: the broader regulatory framework, including the current system of code governance, acts as a barrier to pro-competitive innovation and charge

A clear cross-cutting theme that has emerged from the CMA’s investigation to date relates to the impact of regulation on competition in energy markets. Several parties have expressed a view that elements of the codes system risk affecting competition either through distorting incentives, increasing barriers to entry, or stifling innovation. The CMA now considers the issue to be sufficiently important to warrant consideration under a separate theory of harm.

At this stage, it has identified two separate issues that it wishes to investigate further

• whether the number of codes in electricity adds to barriers to entry and/or expansion
• whether the current system of industry code governance acts as a barrier to pro-competitive innovation and change.

It also wishes to consider to what extent the nature of industry participation in current governance arrangements tends to favour the interests of incumbents over new entrants, smaller suppliers and consumers.

Next steps: The CMA invites responses by 5pm on Wednesday 18 March 2015. Further information and background papers can be viewed on the CMA’s website.