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Coffee House Spectator Briefing

Interview: Centrica CEO, Iain Conn, on the energy price cap

12 October 2017

8:21 AM

12 October 2017

8:21 AM

Theresa May had wanted Ofgem to introduce a energy price cap: it said this would require new legislation and today the Prime Minister will promise to create them by capping the Standard Variable Tariff. The case for the prosecution is simple: about 70 per cent of energy users are not on cheap tariffs, but the ‘standard’ variable tariff which is about £300 more expensive than the best deals.

Competition works for those who switch, but for those who tend not to (especially the poor and the elderly) the system is demonstrably not working for them. Centrica thinks otherwise and it sponsored a podcast, which we released yesterday, where I ask its chief executive, Iain Conn, about the market. The full podcast is here and an edited transcript below:

Q: Concerns about the market have been going on for years. There have been inquiries, reviews, angst, we’ve had a Labour manifesto proposing a price cap and then a Tory party manifesto proposing a price cap. The argument is fairly simple: the vast majority of energy consumers don’t switch tariffs, they are stuck on a rather expensive standard variable rate and the only way of bringing prices down for them is for the government to intervene. So given that price cap has got cross-party support, is it really such a controversial idea?

A: I think you need to look back in time and this market has come a hell of a long way.  It is probably the most competitive open energy market in Europe and there are currently 53 suppliers in the market. There are high switching rates: let’s call it 15 to 16 per cent.  So I would start from the place that the market is far from broken and actually it is working quite well. Are there things that could be further improved?  Yes, and is there a problem with the thing that’s called the standard variable tariff?  In my view, yes. 

Q: Those who don’t engage in the switching game are paying a penalty between £1.3 billion to £1.6 billion. So those who whatever reason don’t switch because they’re not in the habit, are – for want of a better word – being ripped off by about one and a half billion quid a year.

A: I will put it to you that some of those short term deals are lossmaking. Many of the companies who have entered the market currently don’t make any money. One of the things that one needs to watch out for is, is the current market actually sustainable? Some of these companies only make money by attracting customers on really cheap rates. Some of them are very much unsustainable and then when the customer is not looking, at the end of the fixed price period, the regulation allows them to default them onto this thing called the standard variable tariff. That’s how they make money.  The standard tariff is much higher than the acquisition contract, so they make money through the combination. 

Q: Let’s stay on the price cap. Your average bill is what, £1,100 a year?

A: Our average standard variable tariff is £1,101.

Q: Now the investigation by the Competitions and Markets Authority worked out that those who switched could save about £300. That’s quite a significant saving. But are you saying that that’s a false comparison because the lower rates are lossmaking? That the industry simply couldn’t get by on those rates?

A: It’s not a false comparison in the sense that those prices exist in the market and therefore people can, if they keep switching, take advantage of this dynamic in the market perpetually. You mentioned earlier this £1.4 billion that the Competitions and Markets Authority came up with. I have a huge respect for the CMA but we have a fundamental disagreement with this. £1.4 billion a year is more than the entire profits in the industry.  So if customers are being overcharged by that amount, the inference is that the expectation must be that everyone loses money supplying energy. That’s clearly not sustainable. 

The other way that the Competitions and Markets Authority came up with that number is through a highly theoretical idea that in a perfect market, the most competitive person doesn’t make any money and everyone else loses.  Now I’ve never seen a market like that in my thirty years in energy.

Q: But it’s not just the CMA that has concerns about expensive Standard Rate Tariffs. Paul Massara, the former Chief Executive of Npower said recently that free market competition had not encouraged most people to switch, as he put it ‘the markets haven’t worked and therefore you need to do something, the question is what is the right solution?’. Citizens Advice says price caps could ‘provide a solution to run away energy costs’. First Utility, one of your smaller rivals, says the price cap means time has finally been called on the Big Six’s behaviour. Quite a lot of people from the industry seem to agree with this analysis and seem to think that a price cap would promote competition.

A: I do agree that the market needs to be changed, I just don’t agree that the price cap is the right answer.  There are circumstances where we might even benefit from a price cap but I don’t think it would be a good idea for consumers.

What we need to see is an end, effectively, to this standard variable tariff. [A system where] at the end of that contract they don’t automatically get put onto the standard variable tariff, they automatically have to receive another offer from their supplier.  There are some very obvious things that we think can be done.

Also, a lot of people don’t know that the large energy suppliers are paying all of the government’s energy company obligations, all of the Warm Home Discount and we’re being encouraged to implement all of the smart metering roll out. That’s a change that also needs to be made to this market and just to put it in perspective, in the Electricity Bill next year the government mandates some policy and your average electricity bill will be £165. The electricity itself will be £134. We are very much in favour of transparency here, including bills that show how much of your bill is actually coming from government policy, how much is coming from transmission and how much is really coming from the suppliers’ profits. 

Q: You say if the price cap were introduced it would lead to an end to competition – a false sense of security because all the players would coalesce around a certain price point. Has that really been the experience when used elsewhere?

A: So price caps have been used in many countries, in Australia and New Zealand, in California, in Ontario, in Spain, Hungary. And in every single case, competition has fallen, prices have tended to bunch around the cap level and so customers end up ironically with less choice and in many cases average prices have actually gone up, not down. There are many commentators, including former regulators, who have also expressed this opinion very strongly.  You’ve seen it most recently in the UK with the pre-payment meter price cap which came in just earlier this year where on average the prices are now within £2 of each other and they have all bunched around the cap, with quite a few of them going up not down. So I think there are real unintended consequences.

Q: But for four million people on a prepayment price cap, the last price movement was downwards. So we are in a situation where the capped prices went down and the uncapped prices went up. So surely the moral of the story is: if you want prices to go down, caps are the answer.

A: It’s a neat argument but actually the regulated cap is a backward-looking assessment of costs and margins. What suppliers are doing is looking forward to the coming winter and next year and cost pressures mean that prices have had to go up.  We only put up our electricity prices because a lot of the policy costs in particular that are coming through are making the policy costs higher than the cost of the electricity itself. What makes the general public angry, and I can understand this, is commodity prices have actually come down and they have.

Q: We don’t have to go to California to look at price caps, there’s one in operation in Northern Ireland.  Now there the rate of switching is about the same as it is in the UK, about 15 or 16 per cent so doesn’t that indicate that a price cap, as exercised in Northern Ireland, has not led to a reduction in competition?

A: If the cap didn’t exist in Northern Ireland would there be more competition?  Absolutely.I’ll give you a much closer to home example of a price cap in action, it’s called university tuition fees and in setting the cap at £9000 it appears that ever university whether it’s Oxford or Cambridge or a less well known university, are all charging £9000 for very different products.  I’d argue that is the most obvious example of a price cap in action and I’m worried that the same thing is going to happen in energy.

Q: So your alternative solution then is to abolish the standard variable rate, to mandate all companies to basically give two year, three year contract and then oblige them to choose between a new tariff? If you do that doesn’t it imply more of your customers are going to be paying less for their energy and therefore Centrica’s profits would go down?

A: Well that is competition for you and we have to pay very close attention to our costs.  We’re under no illusions that the more we make this market work, the tougher it can be to operate in it. That is what a competitive market is all about, so I don’t fear that.  That is about true competition and we have to get our house in order.  We have taken huge amounts out of our cost base and the evidence is that British Gas’s standard tariff is now cheaper than 85 per cent of the market, that is not a place that we are known historically to have been.  I welcome the competition but absolutely it is going to drive us to get our house in order and bring our costs down.

Q: Since price caps started being mentioned as a likely political outcome, Centrica’s share price has gone down. This suggests that your investors believe that a price cap would mean less profit for Centrica. You were saying earlier that price caps might benefit big incumbents because you’d end up with a tuition fee situation where everybody clusters round a relatively high point, ergo that would mean relatively high profits. That doesn’t seem to be how your investors see it.

A: No investor, no market likes uncertainty and what happened with the Prime Minister’s announcement was simply the creation of a huge amount of uncertainty and although there was an announcement of a draft Bill, no one has seen the Bill yet.  The announcement was made before the regulator actually answered the government’s questions on what they think, what they want the regulator to say it should do with the market.  All of this has created uncertainty and that’s the principal impact on our share price.  I am sure some investors are worried about the sustainability of aspects of the portfolio and the business, I think that’s why you’ve seen the share price reaction, it’s uncertainty.  If I then come back to why are we advocating for different changes to price caps, it’s simply because I believe and we believe free markets ultimately benefit the customer.


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