Price caps are hard to do
By Alex Davies - Research Analyst
Both the Conservatives and Labour have included energy price caps in their manifestos. It is easy to see why the idea is in vogue. Energy companies have been accused of taking advantage of customers for many years, tempting in new customers with low fixed-term tariffs before switching them to much higher priced standard variable tariffs (SVTs), meaning only those willing to constantly shop around and change providers can stay on the lowest available rates. Unfortunately, price controls have been shown time and time again to hurt those they are meant to protect.
Economics 101 tells us that market-interventionist policies such as price controls are theoretically a very bad idea. In essence, when the price of something is limited to below the market-clearing rate, that product will tend to disappear from the market. By keeping prices artificially low, demand outstrips supply and scarcity increases. We can look to history to confirm this theory. The famous rent controls imposed in New York city following World War 2 Two increased demand dramatically but gave no incentive to suppliers to provide more housing or invest in what they already had, leading to enormous shortages in supply and declining conditions. Price caps on food and construction materials have had disastrous effects in places like Venezuela. The price of fuel in the USA was capped below the market rate in 1973 and the inventory quickly disappeared due to shortages. As Milton Friedman put it: "We economists don't know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers can't sell tomatoes for more than two cents per pound. Instantly you'll have a tomato shortage. It's the same with oil or gas."
There are likely to be all sorts of third-round effects to an energy cap that would ultimately hurt customers. The biggest of these would be reduction in competition, where small suppliers who truly benefit consumers by taking on the big boys simply become unsustainable, and new entrants into the market would be deterred. Suppliers may also raise prices in anticipation of the cap, or just raise the prices of their cheapest tariffs in order to make up the shortfall. Not only would these effects disproportionately hurt the poorest in society who are currently on the cheapest rates and pre-payment meters, it would reduce the incentive for people to shop around for the lowest prices and in turn reduce the incentive for suppliers to offer cheaper deals. Furthermore, a cap on prices would act as a cap on the upside potential of any investment by suppliers without altering the downside potential. This could lead to a reduction in much-needed investment into innovation, new technologies and energy infrastructure to make savings. Overall, the power of the big suppliers over the consumer would be increased.
Whilst we know that price controls are bad, there are different ways of doing them, such as with a relative price cap– a more interesting and marginally less scary proposal that has been advocated by Policy Exchange and promoted by John Penrose MP. The idea is that the cap is a limit on the differential between the highest tariff charged by a supplier and the lowest, ending the enormous price jumps that hit customers when they jump from fixed-term deals to SVTs. The policy may seem a smarter way of doing a cap, but it is a price control nonetheless and the third-round effects are simply more obfuscated. Again, we can look to history. Something similar was actually tried in 2008 when Ofgen banned the use of ‘unfair price differentials’ between tariffs, after determining that they existed within the market to the tune of £500m, and all sorts of bad things happened as a result. The price differentials were reduced primarily by suppliers increasing the prices of their cheapest tariffs whilst leaving the most expensive ones untouched. Ofgem at the same time introduced constraints on direct marketing and door-to-door sales, which saw a reduction in consumer engagement with the market – particularly amongst the poorest who relied on such tactics to find lower tariffs. Suppliers further mitigated the costs of the policy by introducing a whole host of new tariffs that baffled customers, reducing engagement even further. Overall, the rate of switching fell by 50%. The policy was scrapped in 2012, but many of its effects on the behaviour of both customers and suppliers linger on.
Unfortunately, neither party gives any real detail on how their caps would work and so it is difficult to properly assess the trade-offs involved. What we do know though, is that price controls have failed over and over again, and the parties are going to have to do something really clever if they want it to be different this time.
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