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Energy Price Cap - Analysis and Evaluation Arguments


Last updated 17 Mar 2019

In this revision video we look at a sample answer for an EdExcel Paper 3 question on the micro and macroeconomic impact of an energy price cap.

Energy Price Cap - Analysis and Evaluation Arguments

KAA Point 1: Consumer surplus and fuel poverty

A price cap is a legal price ceiling in this example set by the industry regulator OFGEM. A maximum bill of £1,137 applies to 11 million customers paying dual fuel bills by direct debit from 1 January 2019. One microeconomic effectof a cap is to reduce the supernormal profits of some of the leading energy suppliers. The Big Six suppliers have substantial market power within an oligopoly and this cap may mean that they cannot charge a profit-maximising price for electricity and gas at an output where MC=MR. As a result, there will be an increase in consumer surplus (the difference between ability to pay and what is actually paid) and also a possible reduction in fuel poverty among lower-income households. Fuel poverty happens when a family needs to spend more than 10% of income to maintain an adequate heating regime. Price caps are designed to protect against over-charging and ensure that energy suppliers cannot charge an unfair rate on each unit of energy used.

Evaluation Point 1:

The micro impact of the price cap depends on how close it is to the average fuel bill for households and the coverage. E.g. the energy price cap only applies to customers who pay by direct debit. Some suppliers may raise the price of their other tariffs and othersuppliers may respond to the price cap by cutting operating costsand increasing productivity so that profit margins are maintained. However, most of the costs of supplying energy are not under their control e.g. the wholesale price of energy is set by the market and the government also sets a minimum price for carbon in the emissions trading scheme. If the regulator OFGEM increases the cap because of higher wholesale prices, the overall micro impact will be limited.

KAA Point 2: Aggregate Demand and GDP growth

Electricity and gas is used by millions of households and businesses so a price cap might have a significant macroeconomic impact. For example, capped energy prices might help to control the annual rate of inflation. This is because household fuel bills are a relatively heavily weighted item in the calculation of the consumer price index. Depending on has fast wages and earnings are rising in nominal terms, a fall in the inflation rate might lead to an increase in real disposable incomes for many households which would then contribute to an increase in consumer spending on other goods and services. An energy price cap might therefore contribute to increased retail sales and a faster rate of economic growth in the short term. Households might also be able to put a little more away each month to help build up their savings.

Evaluation Point 2: Possible drop in investment

However, although an energy price cap might lift consumer spending on goods and services, putting a ceiling on energy bills might have a negative effect on business investment which is also a component part of aggregate demand (AD=C+I+G+X-M). For example, the profit margins of energy companies are relatively low (less than 5 percent of operating cost). If their prices are capped, they might have less profit available to fund infrastructure spending to maintain and improve the energy distribution network. And lower energy prices might also reduce the profitability of investment in alternative forms of renewable energy such as off-shore wind, tidal and solar power. Some energy firms such as N-Power have announced big reductions in employment and a fall in the number of people employed in this sector could have negative multiplier effects.

Final reasoned comment

Overall, I feel that an energy price cap will have more of a microeconomic impact over the medium term. This is because there are many factors that affect consumer spending other than energy bills such as the level of interest rates and the rate of unemployment. However, the industry regulator OFGEM has set a price cap that is fairly high and it save the average household only around £75 per year. They have also said that the cap will be reviewed and changed up to two times a year depending on fluctuations in the international price of oil and gas. One might argue that the cap is an example of regulatory failure with the regulator operating mainly in the interests of oligopolistic energy suppliers rather than energy users.

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