This week, there are lengthy queues outside petrol stations in Britain, as desperate motorists try to secure fuel for their cars. The companies that supply petrol stations say there is a shortage of lorry drivers to transport fuel from the refineries and that the government needs to offer visas to foreign drivers to meet demand. The government, not wanting to accept that its policy on immigration – linked inevitably to the way it managed the UK’s exit from the EU – is the source of the problem, says that there is no shortage of fuel in the country. Unsurprisingly, as soon as government ministers deny that there is a shortage, some drivers assume they are lying and head to the petrol stations to fill up. Many others, seeing growing lines of cars, waiting at the pumps, worry that they will lose out unless they join; so, they do. Whether or not there was a serious problem a few days ago, there is certainly one now.
Queues of irate drivers waiting impatiently to buy petrol makes for good television and newspaper coverage, which has temporarily displaced the story of the other, more serious energy crisis from the headlines. Natural gas is a major source of energy for the UK, with more than four out of five households reliant on gas for heating their homes and around a third of wholesale electricity produced by burning gas. Prices have risen dramatically over the past twelve months, for example, the ICE’s NBP Natural Gas Index has risen from 33.5 to 213. Whether this price spike will be temporary is unclear, but it has become a political problem for the UK because of the way in which energy prices are regulated.
Household energy bills in the UK are capped, so that households are on standard tariffs should not pay more than a certain amount each year, set by the regulator. The current ceiling has just been raised from £1,138 to £1,277 per annum, an increase of just over 12%, but at these prices gas companies are effectively being forced to sell fuel to consumers at below the current price in the wholesale market. Some firms will have bought supplies in the forward market when prices were lower, and other firms will have sufficient financial reserves to sell gas at a loss for a few months. However, nine smaller companies have already gone out of business this month and more will follow soon unless they receive government subsidies. When a small energy company fails, the larger companies are required to pick up their customers to ensure that no household goes without energy, which means that these customers – numbering just over 1.5 million households to date – are almost certainly transferred onto a higher tariff, at the level of the ceiling, but they will still be paying below the market cost of the fuel, thereby adding to the financial pressures on the larger companies.
Unlike the petrol shortage, the higher price of natural gas is likely to persist for some time, as global demand for energy continues to grow and the supply of renewable energy remains too small to meet this additional demand. (The problem is not confined to gas: oil prices hit a three year high, at over $80 a barrel, yesterday). If there is a cold winter in the northern hemisphere this year, gas prices might stay high for another six months or more. It is not clear how many of the UK’s energy companies can remain solvent while selling energy to consumers at below the market price for half a year, which suggests that either the regulator will be forced to allow producers to pass on the true costs of energy to consumers – which will be politically unpopular and in addition will likely cause a spike up in inflation, which might force the central bank to raise interest rates, generating further public anger – or the regulator runs the risk of pushing most energy companies into bankruptcy, leaving the market controlled by a very small group of large suppliers. Neither option appeals, but the former seems preferable.
Why does the UK find itself in this unpleasant dilemma? The price cap on domestic energy prices was introduced by politicians to please voters. Historically the UK’s energy markets had been dominated by a small number of national energy companies, often formerly state owned such as British Gas. Although consumers were able to switch to other providers – either because they were offered cheaper tariffs by new market entrants, or as in my case, to buy electricity wholly from renewable sources – many stuck with the standard tariff from supplier they had used for many years, and often paid higher rates for their energy as a result. The government decided that it would force the large energy companies to lower the bills of all their customers by imposing a cap on annual fuel bills, which started in 2019. It is just the sort of populist policy that plays well in the UK: the government presents itself as standing up to the greedy corporate executives running big business, by cutting costs for “hard- working families”. Rather than encouraging people to use less energy, by making their homes and appliances more efficient, and to switch to green energy wherever possible, we have instead fixed the price of energy to consumers, thereby reducing the financial incentives to lower carbon consumption. As Greta says, blah, blah, blah.
Now, consumers are going to have to pay more, and the market for domestic energy supply, which was gradually diversifying, will become more concentrated. These consequences were entirely foreseeable, but the politicians paid no attention, preferring to claim credit for a short-term populist fix than to act responsibly for the longer-term. This example is hardly unique. In the non-executive work that I have been involved with over the past decade I have come across two other examples where politicians tried to appease the public by imposing price caps, thereby making the problem they were trying to solve much worse than it had been.
During the time I was chair of the board of a London based micro-credit provider, there was a flood of stories in the media about the very high cost of short-term credit provided outside of the mainstream banking system. As the major banks retreated from the riskier segments of the personal credit market (a consequence of the regulator telling them to de-risk their balance sheets) a campaign grew, led by a mix of left-wing politicians, church leaders, and third sector organisations, that called for the government to regulate the credit markets more aggressively by imposing a price cap on the cost of loans. This is not a new idea, and the problems associated with capping the cost of credit have been well described by the leading English philosophers of the age: Francis Bacon in the sixteenth century, John Locke in the seventeenth, and Jeremy Bentham in the eighteenth. Unfortunately, my modest contribution to the debate in the twenty-first century was to no avail. The cap was introduced, together with various other reforms of the market, and within three years all the major sub-prime credit providers have either been forced to close or have switched their attention to other products and markets. The result is a major shortage of supply of (legal) credit for those who suffer exclusion from mainstream finance providers, which has made many of the poor worse off than they were before. Since most of those who campaigned for the price cap were not themselves customers, this highly undesirable outcome, the opposite of what was intended, has attracted little media attention.
When I was the deputy-chair of the board of a London university, the government changed the system of student finance, removing direct government support for universities and replacing it with higher tuition fees. Previously, students had paid £3000 per year and the government had paid the balance of the teaching costs. Now, students pay the whole amount, which they could borrow from a loan company that the government set-up, with the annual cost capped at £9000. Since there was only one provider of finance, and the interest rates and repayment terms on the loans were set by government, there was no possibility of competition around price or customer service from the lender. In addition, almost immediately every university worked out that if you charged less than the maximum for any course, it would be perceived as an acknowledgement that your courses were second-rate. It was judged, correctly I think, that students would rather pay £9000 than £7500 to ensure their friends, family, and future employer all believed that they studied on a good course. Despite claims by the government that they were introducing market mechanisms into the higher education sector, there are significant barriers to entry for providers of tuition (which is probably a good thing), there is a monopoly for loan provision (almost certainly a bad thing), and there is no serious market in course pricing (which is ridiculous). The only way to achieve price variability is to remove the cap, allowing Cambridge to charge £20,000 per annum for a law degree and the London School of Economics to charge £30,000 for a finance degree. It seems highly unlikely that the price cap will come down, since the government cannot afford to pick up the extra funding costs and the universities are struggling with falling income because foreign student numbers have dropped due to Brexit and Covid.
The moral of this story is that when there is some form of market failure in customer service or pricing, imposing a cap on prices is almost always the wrong way to fix the problem. It is popular in the short term because it looks as if the government is on the side of the consumer. But since governments cannot control the real costs of providing gas, credit, education, or most other goods and services, the main effect of the price caps has been to penalise service providers, giving them an incentive to allocate their capital and entrepreneurial energies to other parts of the economy.
Markets where prices are capped tend to become stagnant markets because innovation is less likely. In any marketplace for products or services, early innovators (that is the companies who find a way to produce product x cheaper than their rivals, or who produce a better product for the same price as x) initially make excess profits, but over time other companies copy them and profit levels return to normal. In the long run the consumer benefits from permanently lower prices and better goods, but competition allows only temporary excess company profits. The reverse is also true: where regulation prevents innovation through controls on prices or products, companies miss out on temporary excess profits, but consumers suffer permanently from higher prices and worse products.
While you sit in your car, hoping that the petrol station does not run out of fuel before you get to the front of the queue, it is worth reflecting that however popular a price cap might appear when it is introduced, in the long-term it will cause more problems than it solves. Giving consumers the power to choose is almost always a better option than fixing the prices producers can charge.