In the UK there is currently a political rumpus about our over-priced electricity and gas supply. It would be hard to imagine a more broken by design market structure than the energy market our politicians have concocted for us. And yet the price freezing “remedies” proposed by the Labour Party opposition seem even worse (see the Californian example).  I think we do however have realistic options for structuring the market in a way that ensures genuine price competition to provide consumers with a better deal and allow energy companies to invest appropriately to ensure future supply.

In the UK we have a system where  companies compete to supply electricity and gas over shared supply grids. Consumers each choose which electricity generator and gas supplier to pay. The consumers use the electricity and gas from the common transmission pool and the suppliers get paid to contribute the electricity and gas used by “their” consumers. Obviously the only consideration for the consumer is cost since the electricity and gas is all the same and is taken from a common pool. In principle every consumer would choose the same cheapest supplier if costs were transparent- BUT costs are not transparent. The dysfunctional set up ensures that companies actually compete on the basis of bamboozling consumers. A  bewildering and constantly changing array of different tariffs (that combine or separate gas and electricity supply and charge various amounts for different quantities) ensures that consumers typically inadvertently choose more expensive suppliers. Rather than investing in efficient energy generation, the suppliers are induced to invest in marketing campaigns to increase brand awareness and loyalty in consumers. This sorry mess is overseen by the regulators Ofgem who supposedly ensure a correct “balance” between “fairness” to consumers and profitability for the suppliers.

The system was designed following a goofy blind faith that consumer choice and competition, however construed,  would inevitably provide a good system. Stepping back we can see that in this instance consumer choice is a mute concept. What is needed is pure, pared-down, price competition. The way to ensure that is by directly linking retail prices to wholesale prices established by uniform-price auction. Uniform-price auctions are known as the most competitive way to set energy prices (the uniform-price auction method may also be familiar to you as the way US Treasury debt is issued). In such auctions, npower say could place a bid at £x to supply 10 GW of electricity whilst E.ON might bid at £y for 20 GW etc. The cheapest bids would be filled first until the entire market had been portioned up. Consequently companies that bid too high a price would end up not getting the market share they sought. The same price would be paid to all of the successful bidders and the price would be set by the bid at the margin that only got partially filled. Auctions could cover a series of time frames such that some of the market was sold just covering the next hour, some the next day, some the next two years, next ten years or whatever. As much of the market as possible would be covered by the long term contracts so as to keep overall prices more stable and to facilitate the financing of any necessary new capacity.  All consumers would pay the same as each other per unit of power at any given time. Collection of payment from the consumers would be conducted centrally much as energy transmission is today; it would be a service provided to the energy suppliers by a separate company.

Retail prices would be constantly fluctuating much as retail prices for say diesel constantly fluctuate today. The current price would need to be made public on a continuous basis. It would be an amalgamation of the various long term and short term prices covering that moment.  For the vast majority of consumers, exposure to the raw cost would get them the cheapest power for each billing period. However, just as some transportation companies today use financial hedging to avoid variations in their fuel costs, consumers with special circumstances (such as commercial consumers with cash flow issues) could pay finance companies to provide a swap to a fixed rate that was known in advance.

We would then have a system where market share went to those companies that were able to provide power the cheapest rather than to those companies with the catchiest TV adverts and most charming/aggressive telephone sales teams. Currently new entrants to the market are thwarted by the dominant brand awareness garnered by the “big six” energy companies. Under the system I’m proposing no advantage whatsoever would be gained by having a brand that was a household name. Suppliers could then focus on ensuring efficient supply rather than marketing and none of our energy bills would end up going towards TV adverts, sports sponsorship and door to door or telephone sales pestering.

Electricity markets are notoriously vulnerable to manipulation. This vulnerability arises because electricity can not be stored; demand is exceedingly price insensitive in the short term and creating extra generation capacity is relatively slow. Consequently if a market participant commands even a seemingly modest share of the market, the phenomenon can arise where withdrawing generation capacity during periods of peak demand increases profits because the remaining capacity becomes so much more profitable as prices spike up. Regulators need to be exceedingly vigilant to make sure that no company or coordinating group controls more than a few percent of the market. It is vital to recognize that such market fragility may remain latent until precipitated by a crisis as occurred in California in 2001. There is no place for complacency.

Another key consideration is how to ensure that appropriate electricity generating technologies are used to meet environmental and energy security concerns. Perhaps renewable energy could be given precedence over fossil fuel energy such that all provided renewable energy was bought and fossil fuel generated electricity just made up the (large) shortfall in capacity. The auction could directly set the price for the fossil fuel generated electricity whilst the renewable energy was paid for at a fixed premium above that auction price. The need for renewable energy  and energy conservation (which I personally fully recognize) is anyway a somewhat separate debate from this.

Related stuff on the web:

Uniform-Price Auctions in Electricity Markets -Crampton and Stoft

Energy bills: Where does my money go -BBC

Understanding energy prices -Ofgem

The energy market explained- Energy UK

Electricity Market Reform: policy overview -Department of Energy and Climate Change

The Retail Market Review – Findings and initial proposals – Ofgem

Our dividend obsession -SSE

The California Electricity Crisis: Causes and Policy Options -Christopher Weare

MPs to quiz energy chiefs on price hikes -Express

Revealed: How Big Six energy firms conceal their profits -Independent (link added 09Nov2013)