A comment by CERRE Academic Co-director Professor Nils-Henrik M. von der Fehr, May 2022
The rise in energy prices has put retail markets under considerable stress. The most obvious implication is the increase in consumer bills, but more fundamentally retail markets have been shaken in their foundations. Contracts have been broken, retailers have gone bankrupt and governments have rushed strong measures to support the market and compensate those who have been adversely affected.
This unprecedented increase in energy prices was impossible to predict. Therefore, it may seem unfair to criticise anyone for being ill-prepared, be it consumers on variable-price contracts, retailers that had not hedged their exposure to wholesale prices or regulatory authorities that were unprepared for a market failing to deliver what it was supposed to.
It may also be too early to draw conclusions about the need for changes to retail market design. Surely, we will be better prepared when the next shock comes: consumers will be on fixed-price contracts, retailers will hedge their positions and regulatory authorities will have better tools for handling market failures and protecting vulnerable consumers.
Nevertheless, enough time has passed to draw preliminary lessons. Some retail-market elements seem to have worked as intended while others did not. In some markets, the overall design appears consistent, while in others it does not. By comparing experiences across retail markets, we can learn how different designs performed under the test.
This is not to suggest that there exists one ideal retail market design. European countries differ so much – in terms of energy mix, market structure and political aims – that it is unlikely that any one design would be ideal for all countries. Nevertheless, lessons can be learned across countries that may help improve the design of individual markets.
In France, the retail market has been almost entirely shielded from the impact of higher wholesale prices. The “Bouclier tarifaire” (tariff shield policy) limits the increase in consumer prices to 4 per cent from February 1, 2022. The policy is underpinned by extending EDF’s obligation to supply competing suppliers at regulated prices from 100 to 120 TWh per year. In addition, the government has essentially removed the tax on final electricity consumption. As a result, annual electricity bills should only increase by an average of €38 for households and €60 for industrial consumers, instead of the €330 and €540 initially forecasted by the French Energy Regulatory Commission. The policy is expected to cost EDF an estimated €6-7 billion in revenues, while the government will lose approximately €8 billion in tax revenues.
In contrast, in Norway, the increase in wholesale prices was allowed to pass through directly to end consumers. Most consumers are on spot-based contracts – i.e. contracts where retail prices are directly linked to hourly wholesale prices – and so immediately felt the impact of the price spike. Industrial consumers on the other hand, especially those in energy-intensive industries, are typically on fixed-price contracts with generators. While Norwegian electricity prices have tended to be lower than elsewhere in Europe, they have now reached levels that had never been seen before, with average prices (excl. taxes and network tariffs) in December 2021 almost ten times as high as in December 2020 and about five times as high as the average of prices in December months over the period 2016-2020. The government, which benefits from ownership of a large part of the hydro-dominated generation capacity, as well as a specific hydro resource tax, responded by halving the electricity tax and introducing a rebate scheme, whereby household consumers are refunded 80 per cent of electricity prices above 70 øre (7 euro cent) per kWh. The scheme is administered by distribution companies and financed by government transfers.
Unlike in Norway, where contracts allow retailers to pass on increasing wholesale prices to their customers, retailers took a severe hit in the Netherlands. Several smaller retailers, who had based their business model on buying at spot and selling at fixed prices, went bankrupt. Customers who saw their retailers disappear were reallocated to other retailers but at contracts reflecting current market conditions. Due to the relatively low (regulated) penalty for breaking retail contracts, the market for long-term, fixed-price retail contracts has dried up as retailers fear consumers will switch to more beneficial contracts once wholesale prices fall. As a result, consumers are faced with variable-price contracts that fully reflect wholesale prices. The government responded by reducing the energy tax, amounting to an annual gain for households of about €400.
In the UK, competition in the retail market, which in the run-up to the crisis was fierce, has largely been suspended. Of a total of around 70 retailers, almost 30 exited the market between January 2021 and January 2022, affecting 4.7 million customers. The exits were due to a maturity mismatch between annual retail and monthly wholesale contracts. The impact was heightened by the default price cap (which binds 22 out of 28 million homes) and the regulatory compensation scheme in the event of bankruptcy. The default price cap subjects all retail tariffs to a maximum price during any six month period. The cap in place from 1 October 2021 to the end of March 2022 allowed for only a 12 percent price increase (the subsequent increase from 1 April 2022 fully reflected the underlying rise in wholesale prices). The bankruptcy regime makes no provision for raising prices for customers facing a bankrupt retailer. Instead, the regulator guarantees payments of higher costs to retailers taking on these customers and socialises the losses on all consumers. The government has responded by extending the discount to poorer households, giving a one-off reduction in bills of £200 to all consumers (both of these measures will eventually be funded by surcharges on consumer bills), and a one-off Council Tax reduction of £150 (funded from general taxation).
There is no doubt that many consumers were ill-prepared for the rise in energy prices. What is less clear is whether they had taken a calculated risk or were misled into being excessively exposed to price rises. For example, Norwegian consumers, who mostly rely on spot-based contracts, are not unaccustomed to fluctuations in prices across seasons and between years driven by the availability of hydro resources. They also have easy access to other types of contracts including fixed-priced contracts for up to three years. Some observers have argued that consumers have been misled by “experts”, including the Norwegian Consumer Council, who have advised that spot-based contracts have been cheaper than other types of contracts. While not contesting the fact that over time, spot-based contracts have performed better, the critics argue that when concentrating on average prices, one may forget the benefit of being insured from high prices. In any case, the Norwegian consumers’ bet paid off: they were bailed out by their government.
What consumers certainly would have had difficulty foreseeing was the lack of preparedness of their retailers. Retailers often rely on sourcing energy on short-term wholesale contracts, thereby exposing themselves to margin risk. When the wholesale market turned up, many of them paid the price in the form of bankruptcy. Unfortunately, their (lack of) hedging strategies also had consequences for others; in the Netherlands, it was the customers of the failing retailers that bore the cost of having to enter into new and less favourable contracts; in the UK, much of the cost of failing retailers was socialised on energy consumers as a whole. Retailers with a closer maturity match between their retail and wholesale contracts, or which, through vertical integration, had access to their own energy resources, have fared better.
Regulators seem to have been unaware of the implications of having large parts of the retail sector being more or less fully exposed to variable wholesale prices. In the UK, regulatory authorities had encouraged consumers to switch to new and cheaper retailers, hailing the loss of market share of traditional retailers as a success. Surely, more could have been done to stress test retail business models and warn consumers about the risk they were taking when signing up to retailers with very risky business strategies. The situation was much the same in the Netherlands, where the problem was further exacerbated by the lack of any safety net for customers that saw their retailers disappear. In Norway, government authorities have been more concerned about what consumers pay than what risk they are exposed to.
The French model has shielded both retailers and their customers more or less completely from the increase in energy prices. A consequence of the muted price signal is that there will be little to no consumer response to what is effectively a scarcity in the availability and supply of energy. Moreover, by letting generators such as EDF cover much of the cost, the incentive and ability to fund new investment is undermined. The Norwegian tax reductions and rebate to consumers also have the effect of limiting the incentive to save on energy, but here the price of generation was not distorted. In the UK, the default cap meant a temporary but not permanent delay in the increase of retail prices, and the measures for relieving the impact of higher energy bills have been implemented outside of the market.
Challenges and opportunities
Recent events have highlighted the challenges of designing well-performing retail markets. On the one hand, one would like consumers to have access to energy at affordable and stable prices. On the other hand, one would also like consumers to be flexible and respond when the availability and supply of energy is scarce. More specifically, one would want to facilitate a change in consumer behaviour that increases the efficiency with which they use energy and enhances the energy transition.
This is a balancing act. It is not possible to both keep retail prices low and stable and encourage flexibility and energy saving. It is also not possible to induce a change in behaviour without exposing consumers to the costs of their actions. And, in order to raise the revenues that will be necessary to fund the energy transition, prices will have to reflect the actual costs of renewable energy. A good retail market design must balance different considerations, where the balance may well depend on the specificities of individual countries.
It is possible to encourage demand flexibility by exposing consumers to short-term price variations while at the same time locking in a significant part of their energy costs at fixed prices. It is also possible to protect vulnerable consumers through the general tax and support system rather than through interventions in the energy market. And it is possible to ensure that retailers take full responsibility for their strategic choices rather than passing the cost of their mistakes on to their customers, or to others for that matter.
The current crisis provides an opportunity for exploring these possibilities.
*With thanks to Catherine Banet, Chloé Le Coq, Michael Pollitt and Bert Willems for their contributions, and to the energy regulators and corporates who participated in the CERRE Retail Markets Workshop on 23 March 2022. All of the views expressed in this paper are those of the author only and should not be taken to represent the views of any other party with whom he is associated.