Introduction can occur bilaterally or on exchanges

Introduction

Policymakers
have struggled to secure greater levels of liberalisation and have attempted to
attain an all-embracing policy to improve the price margins, reduce emissions
and ensure the security of supply, ever since the privatisation of gas and electricity
in Great Britain (Witcomb
et al, 2016). Among the
following objectives, the security of energy supply did not disappoint as there
has been no significant incidents that threatens this in recent years. Nevertheless,
unsettling news in correspondence to the affordability of energy as the rise in
domestic prices have surpass inflation over the past ten years which leads us
to the questionable profitability levels of firms (Witcomb
et al, 2016). In addition to that, the service quality provided has
also declined. This essay will discuss the market structure, price discrimination,
competition, profits and market power, and also government policies.

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Market structure

The
physical supply chains for gas and electricity are widely similar as electricity
is transported to customers via high voltage transmission lines and low voltage
distribution lines whereas gas is transported to customers via high pressure
transmission pipes and low-pressure distribution pipes (Witcomb
et al, 2016).The difference between transmission
and distribution; transmission is meant for long distances and high voltages/pressure
around the country whereas distribution is for lower voltages/pressures into
homes and businesses (Webxsol, 2018). Energy
suppliers work as the middle man as they buy energy in the wholesale market and
sell it to the consumers who have an array of suppliers to chose from. Electricity
and gas wholesale markets have similar characteristics; contracts can be
arranged over multiple periods ranging from a number of years to on-the-day
trading markets, trading can occur bilaterally or on exchanges (Witcomb et al,
2016).The retail market is the most common point between gas
and electricity as they are often sold together by retailers through ‘dual fuel’
tariffs (Witcomb et al, 2016).Up to 31st of January 2016, there were 28
million domestic electricity consumers and 23 million domestic gas consumers,
in addition to that there were 20 million dual fuel customers, 8 million single
fuel electricity customers and 3 million single fuel gas customers (Witcomb
et al, 2016).The Six Large Energy Firms
(Centrica plc (Centrica), EDF Energy plc (EDF Energy), E.ON UK plc (E.ON), RWE
npower plc (RWE), Scottish and Southern Energy plc (SSE) and Scottish Power)
are the former monopoly suppliers of gas (Centrica) and electricity (EDF
Energy, E.ON, RWE, SSE and Scottish Power) to Great Britain customers (Witcomb
et al, 2016).A little under 90% of the
energy supplied to the domestic consumers in the Great Britain is by the Six
Large Energy Firms which also generates around 70% of total electricity generation
in Great Britain (Witcomb et al, 2016). In retail, there are currently 34 suppliers selling
both electricity and gas and the largest suppliers to domestic consumers
outside the big six are: Utility Warehouse, First Utility and Ovo Energy, which
are collectively known as the ‘Mid-tier Suppliers’ (Witcomb
et al, 2016).Breakdown of the costs
incurred to the consumers are; wholesale energy (40-50%), network costs (25%),
retailing (including profit margin) is 20% (CMA 2016a). Social and environmental
policies (obligation costs) are higher for electricity (15%) compared to gas (5%)
(Witcomb et al, 2016).

Price discrimination

Based
on the Competitions and Market Authority (CMA) report, price discrimination is
able to surface as market power is given to the six large suppliers due to the
lack of customer response; “pricing their standard variable tariffs materially
above a level that can be justified by cost differences from their non-standard
tariff” (Witcomb et al, 2016).There have been multiple objections to this analysis
by some suppliers which argued that they did not engage in price
discrimination, whereas other suppliers acknowledged that it occurred (Witcomb
et al, 2016).RWE in particular has voiced
out that this particular pricing model was embraced throughout the industry and
not only did it not raise any competition concern, it was often considered to stimulate
competition (Witcomb et al, 2016). “RWE also
said that the CMA had failed to demonstrate why this raised any competition concern.
Price variation and price discrimination were features of many competitive markets
and from an economic point of view were often considered to be
efficient/pro-competitive” (Witcomb et al, 2016).The CMA has therefore acknowledged that stimulating
competition via discounted introductory offers are common practice in other
markets (Witcomb et al, 2016).Although, the CMA’s findings show that in the retail energy
markets, price discrimination is not able to compete away the profits involved,
as on average, customers have been paying prices that are above the competitive
level (Witcomb et al, 2016). Price discrimination is definitely used in a broad
spectrum of competitive markets, although it is not necessarily evidence of
market power. For example, firms cannot sustain itself given that price is equal
to marginal cost if there are economies of scale due to fixed cost as there
would be less competition (Littlechild, 2017). This will then lead to price mark-ups above marginal
cost hence indicating elasticities of demand (Baldwin
& Cave, 1999). “Services where demand is relatively responsive to price
should generally have a lower than average proportionate mark-up, while
services where demand is relatively unresponsive to price should have a higher
than average mark-up over their marginal costs. This enables common costs to be
recovered in a way that reduces to a minimum the harmful effects of distortion
in output caused by a mark-up over marginal cost.” (Baldwin & Cave, 1999). This
then suggests that in order for firms to recover their fixed costs in an
efficient way, lower mark-ups are charged to more responsive customers compared
to less responsive customer, as opposed to charging every customer the same
price. Uniform pricing is not viewed as the normal attribute of equilibrium of
competitive pricing whereas discriminatory pricing is (Baumol 2006). “…wherever
the demand curves are not horizontal and wherever it is possible for the firm
effectively to prevent consumers in separable groups with different demand
elasticities from reselling products to one another. …wherever such pricing is
feasible, effective competition makes it discriminatory pricing mandatory…”
(Baumol 2006). Price discrimination should not be banned as it can lessen
competition and help firms incur higher prices to consumers in general (Vickers
2009).

Competition, profits and market power

Figure
1 depicts a Supply and Demand curve. Price Pc and quantity Qc are located where
the supply and demand curve intersect. The supply curve is the industry’s costs
curve in which firms are (Littlechild, 2017). Pc represents the price at the “competitive
level”. Competition is when suppliers take market price as given (Littlechild,
2017). For the last unit produced, it is associated with the highest cost producer
in the market and competitive markets do not imply zero profit for all
suppliers and all units produced in the market. Firms with higher efficiency
will be able to enjoy lower costs compared to more inefficient firms and
therefore earn above-normal profits. In the long run equilibrium, marginal
firms will earn zero economic profits whereas firms with lower costs will earn positive
economic profits (Lind & Walker 2003). In comparison, figure 2 depicts a
market identified by market power, in which firms are able to limit output
while increasing the price at the same time. Pm is the given price set by the
firm with high market power. The area A in figure 1 is bigger than area A in
figure 2 which is due to the decrease in quantity(Qm) provided. Although, now
the area B is now excess profit for suppliers. both high cost and low-cost
suppliers are able to enjoy excess profits (Littlechild, 2017).  In general, the vital task or a regulator or
competition authority is to determine whether a market is basically competitive
(Figure 1) or displays market power (Figure 2). A typical approach is to
calculate the profits and profit rates, or return on capital employed, of the major
suppliers in the market and is then compared with normal profit rates to assess
whether there is true excess profit and also the respected level (Littlechild,
2017). Profit reflecting superior efficiency (producer surplus, area A) and
profit reflecting market power must be distinguishable as this will affect the
understanding of market phenomenon and could influence policy. As an example,
to identify whether price discrimination is competitive or reflects market
power may be affected by the price level; if it is above competitive level in
which there will be true excess profit. In the short term, limiting output bin
order to achieve excess profit is economically inefficient because there are consumers
who are willing to increase output from Qm to Qc. As the competitive price
increases, the consumers are required to pay more than they should in order to
receive the same amount of output.

Government policies

Given
that an increase in competitive nature is required in order to replace inefficient
firms with efficient firms, the government should implement price caps. In order
for firms to generate the amount of profits that they currently do, the would
require them to operate in a more efficient manner to reduce their costs. The Draft
Domestic Gas and Electricity (Tariffs Cap) Bill will allow energy regulator
Ofgem the authority to cap standard variable tariffs. Around 12 million households
are using the same form of uncapped default tariff which can cost op to
hundreds of pounds a year (Bbccouk,
2018). However, this price cap will not take effect before winter.
Consumers will then have to pay the uncapped default tariff as the peak usage
of energy in a year is during the winter time. Business and Energy Secretary
Greg Clark said that the customers of the big six energy suppliers were “overpaying
to the tune of £1.4bn a year” (Bbccouk, 2018). This is then
rebutted by director of energy switching firm Flipper and former Ofgem board
member, Steve Smith, stating that the cap can do more harm to competition and
will result in many customers end up paying a lot more (Bbccouk, 2018).
In order to the price cap to be more effective, it should have been implemented
before the winter time so the consumers can save earlier compared to
implementing it after the peak energy consuming season. This will then aid to
the consumers that are less responsive and will be able to better regulate the
firms with strong market power in the industry.

Conclusion

The
inefficiency of firms has lead to the higher prices charged on less responsive
consumers. This has given the firms market power to limit output and increase
prices above competition level. Regulators are able to determine the
competitive, price and market power in order to influence government policy. A price/tariff
cap is an effective way to prevent organizations from overcharging and
protecting the consumers from paying too much. Although, it should be
implemented before the peak energy consuming season in order to maximize consumer
saving on overcharged prices.

 

 

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Bibliography

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