Ofgem Economics: Simple Tariffs

Ofgem have announced that Energy suppliers must simplify their tariffs. Under the new proposals Ofgem will set a fixed standing charge and the supplier will determine a unit rate.  This blog entry will explore that decision.

Consumer Irrationality

One of the key problems that Ofgem has been working on for a number of years is the customer switching rate. 40% of people have never switched supplier and of those that have, only a fraction will switch supplier on a regular basis. For a classical economist this is perplexing indeed. Why would someone pay more for a commodity than less? Switching supplier can be done within 20 mins on the internet and save hundreds of pounds a year, yet most people won’t switch in any given year.  For Ofgem, who would need constant switching in order to create an effective market place, they need to know why people don’t switch. The answer lies in a branch of economics called Behavioural Economics. 

Behavioural economics is all about why people behave in a suboptimal utility maximising way, or in other words, why people are not rational.

In the case of power and gas, the tariff structures can be confusing and complicated. There are lots of different types, fixed, trackers, online and standard. Also, the tariffs are calculated in different ways. Some offer different unit rates for trenches of consumption whilst others offer a standing charge and a variable rate. Some have different rates for day and night, while others have day, night and a seasonal price. In all this confusion it is little wonder that consumers can make suboptimal decisions

When a consumer face a great deal of complexity and uncertainty they are likely to make wrong economic decisions. This is because their rationality is said to be bounded. That is, people want to be rational, however due to lack of information or limited computation ability they might not necessarily achieve it. For a regulator this might be a case to intervene in the market.

Ofgem has recently announced that it wants all suppliers to simplify their tariffs and have set out a standard to which all retail energy suppliers must follow. This will mean the removal of several types of tariffs and there will be fewer products available on the market. 

Whilst tariff simplification will help the problem of Bounded Rationality, there are limitations to the efficacy of these changes.

Status quo basis

The reason why people are not switching may be in part due to Bounded Rationality, but it is most likely it’s to do with their Status Quo Basis.

In the 1990s in two US states, as a part of a law reform of car insurance, policies were made void and their consumers were offered two types of new car insurance. One allowed them to sue for medical damages and the other, which was cheaper, did not. If no decision was made then they would default to whatever the state nominated as the default policy. Both States adopted different default insurance, and in both states most consumers went with the default category.

The same is true with electricity and gas supplies. Most people when they move into a new home will continue with whatever supplier they inherit.

When it’s possible to save hundreds of pounds for less than 20 minutes work, it is not rational to keep with the status quo. In this respect simplifying tariffs will have no effect on those who simply stick with the status quo.

For argument sake let’s assume that simpler tariffs will increase switching rates and help the market become more efficient.

Rocket and Feathers

Improving market efficiency will provide new challenges for an Industry Regulator in an Oligopolistic market.

If all consumers switched to the cheapest tariff available to them, it would change the behaviour of the firms in the market. If a supplier knew that a price increase would result in all customers leaving, then they would think twice before doing so. Equally if the supplier reduced its price and became the cheapest, it would gain all the customers. Obviously the other suppliers would not allow this to happen and so would respond immediately. Since the supplier knows that the others would respond to any price decrease, it does become logical to lower their tariffs and prices tend to become stuck. Prices can become particularly stuck in the downward direction, with a price decrease there is a sacrifice of revenue and profit. What would be the point of cutting prices and not gaining any customers?

Prices can shift up however when costs jump. If one large player is bold and raises their prices in response to increasing costs, the others will cautiously follow. So long as all major firms are obedient in their prices movements all firms can enjoy decent margins. This effect is known as Rocket and Feathers, Prices rocket up in response to costs but floats down when costs fall.

Ofgem realise this and are continuously producing market reports which try to evaluate the competitiveness in the market. So far in all of the market probes, apart from a few bad practices, show the market is competitive. Margins, until recently, have been reported as small and prices are low compared to that on the continent. Ofgem want more small suppliers in the market to deter the Big 6 from making huge profits. In fact, Chris Huhne tried to blame the Big 6 for deterring entrants with their overly competitive prices (after criticism the Big 6 gladly stopped this pricing policy).  However neither Ofgem or the government need be concerned, as small suppliers will become attracted to the market should the profitability increase.