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Economics

Study Notes

Economics of an Energy (Fuel) Price Cap

Level:
AS, A Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

This study note looks at the debate over the decision by the UK government to legislate to bring in a cap on the bills that energy suppliers can charge to household customers. The cap came into force in January 2019.

What is the Energy Price Cap? (Source: OFEGM)

Key issues

An energy price cap raises many important micro and macroeconomic issues including:

  1. Affordability of energy for families especially lower income households at risk of fuel poverty
  2. Policies likely to be effective in driving improvements in energy efficiency thereby helping the government to meet ambitious targets for reducing carbon emissions
  3. The scale and extent of competition (contestability) in the UK retail energy industry
  4. Whether the industry should be taken back into state ownership (it was privatised and then liberalised in the mid to late 1980s)
  5. The future for energy sources such as coal and renewables

Background statistics

Gas and electricity currently provide around 80-85% of UK fuel consumption. Coal is now less than 1 per cent.

The gas and electricity industry is an oligopoly. Although there are now 69 active suppliers in the industry, the Big Six energy companies have more than 80 percent of the market.

Households spend - in total - over £30 billion a year on energy for their homes

In 2015, 2.5 million people lived in households defined as in fuel poverty - i.e. where more than 10 percent of annual income was needed to maintain a reasonable household temperature.

Big Six: Control 81% of gas supply and 80% of electricity

  • Centrica
  • EDF
  • E.ON
  • N-power
  • SSE
  • Scottish Power

Challenger suppliers in market (over 60 smaller firms)

  • First Utility (now owned by Royal Dutch Shell plc
  • Cooperative Energy
  • Octopus Energy
  • OVO Energy

The make up of a fuel bill

The composition of a fuel bill is approximately as follows (Source: OFGEM and Parliament Research):

  • Wholesale cost (purchasing the energy) 37%
  • Network costs (supply transmissions, distribution and metering) 26%
  • VAT 5%
  • Supplier profit margins (5%)
  • Other costs - including the impact of government climate change policies
Fuel bills in the UK: Source: https://www.ofgem.gov.uk/publications-and-updates/infographic-bills-prices-and-profits

Arguments for an energy price cap

  1. Cap protects consumers from over-charging due to market power of the Big 6 suppliers who make high profits
  2. High fuel bills hurt lower-income families who are at greater risk of fuel poverty
  3. Price cap will encourage energy suppliers to increase their productive efficiency (lower LRAC) to improve profits
  4. The cap can be temporary & lifted if competition improves

Arguments against imposing an energy price cap

  1. Price cap might hurt competition by reducing profits and lowering the incentive for new challenger firms to enter industry
  2. Price tend to gravitate towards the cap so average prices for customers might actually increase rather than fall
  3. Fall in profit will mean less investment in renewables – operating profit of energy suppliers is only 5%
  4. Better long-run strategy is to focus on nationwide housing insulation programme to improver energy efficiency

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