The Energy Price Cap

A week after the energy price cap for the average household rose by 80 per cent, Matthew Oulton makes the case for abolishing the price cap, and suggests a more progressive system to replace it.

When Ed Milliband first suggested the idea of a price cap for energy companies, he was derided by the Tory press as ‘red Ed.’ Such a market intervention was made out to be the kind of ‘old Labour’ thinking that had been banished from the British political mainstream for decades. Less was made of the idea when Theresa May adopted it, and it is now a very important part of the UK’s institutional framework for the energy market.

However, even if it did originate from our side of the fence, the energy cap is bad policy, and a Labour Government should seek to abolish it.

The regulator for the energy market, Ofgem, has announced that it will review changes to the price cap on a quarterly basis, rather than merely twice a year. The change comes in the midst of chaos in the energy market, with global trends like the war in Ukraine causing sky-high wholesale prices. The energy price cap was never intended to cap prices for the average consumer, but rather to protect the most vulnerable customers who do not regularly change provider.

For most of the time the price cap has operated, it has functioned reasonably well. After all, when prices are stable, the cap protects the most vulnerable customers without influencing the overall market dynamics. Today, however, the impact of the price cap is far from positive.

There are a number of different reasons why it may be worthwhile to intervene in the energy market, and it’s worth thinking about them separately. Firstly, let us separate the question of the ownership and operation of energy in the UK from the question of helping consumers fund their energy bills. If the Government wanted to subsidise energy bills so that consumers can afford energy more easily, they can impose such a subsidy regardless of whether energy providers sit in the public or the private sector.

The reason it may be worthwhile to have energy sit in the private sector, then, is to engender competition between energy providers. Since energy production is not a natural monopoly – a situation in which up-front costs and other barriers to entry are so high that it is infeasible for a market to sustain multiple competing providers – competition is a viable prospect in the retail energy sector. To be clear, the market must be heavily regulated – we cannot have a situation in which the free market allows collapsing energy companies, with all the consequent consumer disruption, but Ofgem should aim to allow competition on the basis of prices as well as quality.

If the price cap should not be there to dictate the market dynamics of the energy firms, can it protect consumers from high wholesale prices?

Basically, no. In the short run a price cap will obviously shield consumers from price increases, but only by distorting the market. After all, when international wholesale prices increase, we don’t want consumers to be shielded. If energy becomes more expensive, consumers should pay more for it, so that they are incentivised to consume less. Obviously, this could cause problems if, as is the case at the moment, consumers cannot afford essential bills, but such an issue would be better addressed by providing consumers with more money in their pockets, rather than cheaper bills. Furthermore, if we are going to resort to a direct subsidy, which may have a beneficial impact on inflation, it should be targeted, not a blanket cap.

The next Labour Government, then, should abolish the energy cap and replace it with a tax credit system that ensures that, regardless of the wholesale price of energy, consumers can cope. Where a family’s bills increase, they should automatically receive the amount of money they would need to finance it, but they should not be compelled to spend it on energy (as they would be with a direct subsidy). Instead, we should allow consumers to switch spending away from energy and towards other goods if they prefer to. Such a change could be revenue-neutral in the long run, scraping back this money in the years where energy prices fall through an energy levy. In this way, Government could smooth the ability of consumers to pay their bills, but without causing overconsumption of energy.

Changes like this are, of course, fraught with political danger. A policy misstep could leave millions of families worse off. As a result, this change would need to be part of a wider package of reform in the energy market, with due care taken to ensure that everyone benefits, and that the public understand why and what was being changed. Policymaking like this isn’t glamorous, but it is necessary if Labour wants to change the country for the better if we are able to get into government.

There is then a separate discussion to be had regarding public ownership of energy companies. Again, it’s important to think separately about the different components of the industry. National Grid, a monopoly, should clearly be nationalised. In energy production, meanwhile, it might be sensible to nationalise fossil fuel providers, since their profits are created by ‘rent’ on natural resources, but not producers of renewables or nuclear. Unlike other ‘utilities’ where competition is impossible, there can be competition in the retail energy sector. As a result, Labour must be neither too hasty nor too ideological in proposing nationalisation. For now, ensuring prices are fair and incomes high enough to afford them should be the priority.

Price hikes in the energy sector are something we should get used to. Hopefully, diversification in our energy sources, including much more dependence on renewables, will render the present vulnerability to Russia less concerning, but transitioning away from fossil fuels will doubtless cause some unavoidable energy bills to rise. Sure, in the short-term we could try to treat these problems by regulating prices, the economic equivalent of taking heavy opiates to deal with symptomatic pain, but we should really seek to address their causes. If gas or electricity or petrol becomes more expensive, the price should rise, we just need to make sure the most vulnerable can afford it.

Matt is the Vice-Chair of the Economy and Finance Network. He is a recent graduate in Economics, soon to begin postgraduate study. He’s from Merseyside, Labour’s true heartland, and writes frequently on a range of economic and political issues.

His interests in Economics focus on microeconomic theory and Public Policy, and his politics are characterised by a near-pathological obsession with returning Labour to government. He tweets at @matthewoulton

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