The Energy Price Freeze – What Will it Actually Do?

Rob Natzler & Tommy Peto

So what will a price freeze actually do? Not very much, it seems. Neo-classical economic theory suggests that a sudden supply-side shock[1] could lead to blackouts if prices are frozen. A crisis in the Middle East or a decision by Russia to turn off the gas taps could lead to a sudden spike in the international price of fuel. If British energy companies aren’t able to raise their prices to cover their increased costs, they’ll start making losses, and may well decide to throw in the towel. Even if they are able to get authorisation from the government to raise prices despite the freeze, in a neo-classical world of efficient markets and instant price changes the delay may be long enough to cause a temporary period of blackouts nonetheless.

Only prices in the energy market aren’t instantly flexible. Energy companies are required by law to warn all customers of a future energy price rise 30 days in advance of it being carried through. Neo-classical economists may argue that this statutory requirement leads to inefficiencies, but it means that the imposition of a price freeze has little impact on the ability of energy companies to adapt to a huge and unexpected supply-side shock.

It’s hard to imagine that any price freeze system wouldn’t have a ‘knock-out clause’ in case of emergency. By the far the most likely is a requirement for companies to acquire government permission before raising their prices. Under the current system, companies would either need to wait 30 days to raise their prices, or would have to persuade the government to repeal the statute which insists upon the minimum. A price freeze system where the government of the day need not raise Parliamentary support before permitting sudden rises is going to be no slower than one in which Parliamentary support is additionally needed. It may even permit a faster response to sudden supply-side shocks, so that the price freeze system reduces the chance of blackouts.

It is true that a government running a price freeze system might be more suspicious of pleas by energy companies for emergency price increases than one under the current system. This is both unlikely and avoidable, however. Unlikely, because a massive and unexpected supply side shock of the sort we’re talking about is unlikely to go unnoticed by the government. Avoidable, since an incentive structure scheme where energy companies who make profits having misled the government into breaking the price freeze suffer confiscation of profits plus a fine will ensure all energy company pleas are made in the sincere belief of a crisis.

But what about investment? Well, it’s unlikely to fall as a result of the price freeze. Energy companies standardly offer a fixed-rate deal for periods of time longer than the 20 month period Milliband is insisting on[2]. Whilst they will get hit by needing to offer this package to all of their customers, it is fair to presume that they will choose to raise their prices either immediately following the election or immediately after any Labour victory.

This makes the price freeze essentially a gamble between Milliband and the energy companies as to whether their guess of the market price for 2015-17 is going to be accurate. If wholesale energy prices rise, consumers win; if wholesale energy prices fall, the companies make more money than they would have otherwise, and consumers lose out. In either case, when you consider the 30-year lifetimes of energy projects, the 20 month blip price freeze period is highly unlikely to deter investors.

Of course, all this is assuming that there are investors still choosing whether or not to invest in projects due to come online in the 2015-17 period, by no means a certain assumption given the average historical time to complete a new energy project since 1995 has been just over four years[3]. In fact, this category seems to represent only a small sub-set of investors, with most investment decisions being made currently being those whose returns will be won post price freeze. So the price freeze policy effects only a small sub-set of the returns on a small sub-set of investment decisions – a far cry from the claims of mass blackout resulting from investment flight some of the more alarmist political commentators have been claiming[4].

That’s not to say that Milliband’s policy isn’t going to hit investment, however. Following the 20-month price freeze period, he’s planning on introducing a new energy regulator designed to increase levels of competition in the energy market by holding the small number of large, vertically-integrated firms that currently make up Britain’s energy suppliers more accountable. Depending on the model you use, a less oligopolistic energy market may lead to either higher or lower returns to investment, so we can’t say for certain what the pro-competitive reforms will do[5]. The Select Committee for Energy and Climate Change called for them back in July[6], however, so energy companies should probably assume some kind of change is inevitable regardless as to who wins the election.

What we can say, however, is that current uncertainty as to exactly what form the new ‘consumer-friendly’ pro-competitive regulator will take is likely to deter investment. A new regulator means new rules, and new builds may stall until those rules are known, as investors shy away from betting that their project is going to meet all the new regulatory standards. That’s not to say that their investment will go elsewhere – investors lacking contacts and know-how in foreign energy markets or alternate sectors have no incentive to trade out in the short-run – but that some aspects of new projects may have their construction time increased as investors hit a pause button and ‘wait-and-see’.

The flip side of this is that investors may see some parts of the energy sector as a better source of investment in the interim. A new regulator may be harsher on standards for coal or CCGT power stations, but is unlikely to come down hard on new green energy builds. Technology in the renewable sector is developing at a rapid pace, and Milliband’s history as Energy Secretary under the last government saw a large number of pro-green taxes on polluting fuel sources being introduced. Investment on polluting builds may or may not stall due to uncertainty as to how the new regulator will view them, but investment in green energy may actually increase as its short-run prospects relative to other methods of energy generation actually improve due to higher levels of investment certainty[7].

That said – and this is worth saying – overall investment is still likely to fall. A new regulator may also mean a deterioration in the returns to investment following 2017. Whilst this isn’t a definite, some investors may want to reconsider their options until the market situation becomes clearer. This relatively minor hiatus in investment is extremely unlikely to lead to either blackouts or a failure to meet green targets, but may well lead to price rises in the short run as the supply of energy temporarily fails to rise in tune with increasing demand.

The irony of the situation is the Ed is being branded a socialist for proposing a pro-market reform by instituting a tougher regulator. Meanwhile, the option of returning to pre-2002 price controls on a permanent basis remains as yet unmooted.

[1] A sudden demand-side shock is obviously also a possibility; however, over the 20 month period proposed by Ed Milliband it stretches the imagination to think of a situation where domestic energy needs increase so much faster than expectations as to drive fixed-price energy suppliers out of business.

[2] Indeed, Npower were briefly advertising a deal to freeze their prices from 2013-2017 under the slogan “Why wait for Ed?”

[3] We hasten to add that this is an estimate cobbled together through looking at the histories of all post-1995 power station conversions and new builds – if there’s an industry expert who can give us a more precise figure for future builds in the 2015-17 period, that would be much appreciated!

[4] One further argument is that investment flight may occur as Milliband’s policy indicates a government who are ‘market-meddlers’ and so may interfere in the energy markets in the future. This just doesn’t cut mustard in this instance, however – price controls in the UK existed as recently as 2002, and Milliband’s scheme is laid out for a finite period of time and with the clear justification of solely being to tide us over to a new regulator. Insofar as we don’t already have a reputation for being prepared to meddle in energy (and very few countries do not), it’s unlikely this policy is going to give us one, or make our existing one worse.

[5] Schumpeter and Arrow have differing opinions on the way competition through investment might play out in a more competitive oligopolistic market.

[7] However, this aspect of our conclusion is largely speculative.

4 thoughts on “The Energy Price Freeze – What Will it Actually Do?

  1. I may be completely wrong but do you think it’s possible that the well above price rises here are the energy companies hedging against this policy coming into effect in 2015? At the moment a Labour government looks reasonably likely and as a result the energy companies are increasing prices now in order to try and give themselves a buffer against no price rises for 20 months. If this is a fair assumption is the problem with the price rise not the fact that the lights will go out but that it is self defeating? Surely we would have been better off with 5% rises for 4 years then 10% rises for two and then no price rises for two.

    • That sounds like a fair bet, yes. We’re seeing price rises at the moment; we may well see another round closer to the election as well, particularly if the chance of a Labour government rises over the coming year.

      Our point in the article above is that, whilst the price freeze may well turn out to be self-defeating from the point of view of consumers, from the point of view of the overall economy its impact seems to be negligible.

      There’s a wider debate to be had on whether a more competitively regulated energy market will increase the welfare of consumers or diminish it, but that can be had another day (and is linked to the whole policy rather than just the price freeze element of it).

  2. This policy seems to based on the misconception that energy companies are overcharging consumers. As this infographic shows unless we really believe that energy companies should make 0 profits their really isn’t space for a price freeze. I agree that an independent regulator is needed but I think the headline policy is actually the wrong one

    • I wouldn’t be so quick to either conclusion. (And I’d actively disagree with the conclusion that energy companies will make 0 profits under the policy).

      Reading the Select Committee report, the concern isn’t that energy companies are necessarily overcharging consumers. It’s that they MIGHT be.

      The profit margins/investment levels of the Big Six are difficult to discern due to the opaque company structure. Different divisions have different turnovers and different subsidiaries; some run profits and some losses; some are based offshore and some in the UK. Not to upstage the infographic, but the data table here (taken from 2011) summarises the confusion behind the scenes much more effectively –

      So the argument for the policy comes more from a desire to tidy the sector up and bring it closer to free market conditions than from a misconception of overcharging. Ultimately, no-one knows if people are getting overcharged – and that’s the problem.

      As for the idea that the price freeze is going to force firms into making 0 profits, we deal with that in the article. In summary, however, firms can raise prices now to hedge against a 20-month freeze. As both Sceptical and the article notes, this might actually lead to higher energy company profits: it’s extremely unlikely that it’ll lead to drastically lower profits.

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