Retail competition in electricity markets — expectations, outcomes and economics

Retail competition in electricity markets — expectations, outcomes and economics

ARTICLE IN PRESS Energy Policy 37 (2009) 759–763 Contents lists available at ScienceDirect Energy Policy journal homepage: www.elsevier.com/locate/e...

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ARTICLE IN PRESS Energy Policy 37 (2009) 759–763

Contents lists available at ScienceDirect

Energy Policy journal homepage: www.elsevier.com/locate/enpol

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Retail competition in electricity markets — expectations, outcomes and economics Stephen Littlechild Judge Business School, University of Cambridge, Trumpington Street, Cambridge CB2 1AG, UK

a r t i c l e in fo Article history: Received 2 September 2008 Accepted 4 September 2008 Available online 21 December 2008 Keywords: Electricity markets Competition

1. Introduction Mr Defeuilly (2009) argues that the introduction of retail competition into electricity markets gave rise to great expectations that it failed to meet, and that this was primarily the fault of Austrian economic thinking. The main purpose of this note is to explain why both of these propositions are incorrect. A few further comments challenge his subsequent suggestion that the competitive process in electricity is so constrained by the limitations of consumer decision-making and electricity technology as to cast doubt on the policy of opening the retail market to competition.

2. Expectations The author says that ‘‘the introduction of competition into retail electricity supply gave rise to great expectations. However, to date its performance has been less than stellar’’. He says that ‘‘the expected situation did not always materialize’’ and even in Great Britain (GB), Sweden and Norway ‘‘competition in these retail markets is not performing as it was expected’’. He concludes that ‘‘the introduction of competition did not yield the expected results’’. The author does not document what these expectations were. In my experience, initial expectations in GB were very low, and the subsequent outcome has far exceeded these expectations. Let me give a few indications of this by explaining how the concept of DOI of original article: 10.1016/j.enpol.2008.07.025 E-mail address: [email protected] 0301-4215/$ - see front matter & 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2008.09.089

retail competition was developed and received, and contrasting expectations and outcomes in terms of customer switching. (1) Chile was a forerunner of electricity reform. Amongst other things, it made provision for a few large customers (over 4 MW maximum demand in 1980, reduced to 2 MW in 1982) to be supplied by an individual independent generator via access to the transmission and distribution systems. In the UK, the Energy Act 1983 also made provision for such common carriage. But quite apart from the difficulty of using Chile as an exemplar in the 1980s, neither Chile nor the Energy Act envisaged retail competition across the board as an alternative to regulation of electricity supply. (2) The first published discussions of UK privatisation were very brief. They focused on whether and what sectors to privatise and urged consideration of competition and restructuring at the wholesale level.1 (3) To my knowledge, the first suggestion of retail competition in electricity was in an unpublished paper by Michael Beesley and myself in November 1983.2 I discussed the electricity part of this paper with some industry contacts in December 1983, and then expanded it into a separate paper

1 E.g. Littlechild (1981); Beesley and Littlechild (1983); Eggar et al. (1984). Joskow and Schmalensee (1983) analysed electricity deregulation, restructuring and wholesale competition in the US, but did not explore retail competition. 2 The paper, entitled ‘‘Privatisation and Monopoly Power’’, was an outgrowth of some research that we had done for HM Treasury in August and September 1983. Its aim was to explore the possibilities of privatising the ‘natural monopoly’ industries identified in our July 1983 paper. After outlining some general principles, we applied the analysis to two industries: electricity and airports. I wrote the section on electricity, Michael wrote the section on airports.

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on electricity privatisation.3 Amongst other things, the papers proposed to separate the electricity Area Boards into distribution networks plus competing private retailers that would buy and sell power over the distribution networks. This would make new use of common carrier obligations on the distribution networks.4 The aim was to ensure that the increased efficiencies in generation (that we expected would flow from competition and new entry in the wholesale market) were passed through to retail customers as a whole without having to rely on regulation. In the run-up to electricity privatisation, there were further published economic analyses of the appropriate way to privatise, mainly focused on restructuring.5 I do not recall whether I discussed retail competition with the authors, but none of them mentioned the concept. In October 1987, I was invited to advise the new Secretary of State on electricity privatisation. I raised the possibility of retail competition. I was told by the senior civil servant involved that only a customer as large as ICI (the largest electricity consumer in the UK) might be interested in buying directly from a generator, and neither generators nor distribution companies would want to bother with seeking out smaller customers. The Government’s White Paper in February 1988 emphasised restructuring to create competition in generation. With respect to retail competition, the most I was able to achieve was the insertion of two sentences. ‘‘Adjacent distribution companies could find themselves competing to supply large users near their common borders. And larger users will also be able to buy electricity direct from generators, bypassing the distribution companies but using their distribution systems for ‘common carriage’ of the electricity’’.6 Around 1990, shortly after I had been appointed GB electricity regulator, I visited the United States and met one evening with Bill Hogan and Paul Joskow. I told them of my concept of retail competition via common carriage. I thought this concept would appeal to that competition-oriented country. ‘‘It won’t catch on’’, they said. ‘‘The larger customers already get a good deal from special tariffs and the smaller customers won’t be interested. During the privatisation process, views within the Department of Energy as to whether or when to allow retail competition fluctuated from ‘not at all’ to ‘large customers only’ to ‘all customers immediately’ and then back again. The Government’s eventual decision was a graduated franchise, with the market opening in three phases 1990, 1994 and 1998. This was to allow the Area Boards to sign mediumterm contracts with the generators back-to-back with coal industry contracts. Retail competition (at least beyond the largest customers) took second place. One of the most senior Regional Electricity Company (REC) chairmen was given responsibility for coordinating company arrangements for retail competition. I told him that I could envisage residential (called domestic in the UK) customers choosing their own electricity supplier, perhaps selecting

3 ‘‘Restructuring and Privatisation of the UK Electricity Supply Industry’’, January 1984. 4 ‘‘At present this facility [common carriage under the 1983 Energy Act] is somewhat of a dead letter, since supply by private generators is negligible. But suppose that the entire CEGB were restructured into several private generating companies, as proposed earlier. The 1983 Act becomes quite crucial, because it would allow any customer to purchase electricity direct, rather than from the Area Board in whose territory the customer resides.’’ (January 1984, para 48). 5 E.g. Vickers and Yarrow (1985); Henney (1987); Sykes and Robinson (1987). 6 Privatising Electricity, Cm 322, London, HMSO, February 1988, para 42.

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from entries in the Yellow Pages telephone book. ‘‘It will never happen’’ he said firmly, ‘‘It will never happen’’. In March 1990, just before Vesting, the draft licences granted by the Government listed out each company’s large customers. A company had to apply to the regulator to have its licence extended every time it wanted to sign a new customer, and to publish its application for others to comment on. If the regulator approved the request, the regulator had to notify the public electricity supplier in whose area the customer was located. It was evidently not envisaged that changing supplier would be a frequent occurrence.7 When the first tranche of the retail market opened in 1990, nearly 30% of the large customer sites changed supplier on the first day, mainly to one of the two large generating companies. They accounted for just over 40% of the largecustomer sales. The RECs that lost the customers were flabbergasted. They had not expected anything like this. The proportion rose to about 80% of large-customer sales by 1999. When the second tranche of the retail market opened in 1994, about 25% of the medium-sized customer sites changed supplier immediately, accounting for about 30% of these sales. The proportion rose to about 60% of mediumuser sales by 1999. The third and final tranche of the retail market opened up in 1998/99. It might have been expected on the basis of experience that about 10–20% of the small industrial and commercial customers would change supplier initially, and that this proportion would gradually rise over time. I do not recall much comment about or measurement of this sector. The possible situation with residential consumers was highprofile but unknown. The residential gas market had been gradually opened since 1996, some of the RECs had entered that market, and about 10% of these gas customers had switched supplier by mid-1998. But entrants into that market were able to purchase wholesale gas at significantly lower prices than the long-term contracts to which the incumbent British Gas was committed. British Gas had indicated an intention to enter the electricity market, but most of the RECs said that, unlike the situation with larger customers, the traditional regulated profit margin in electricity supply was too low to make competition worthwhile, either for suppliers or for customers. At the Office of Electricity Regulation (Offer), we did not know whether or when any competing suppliers would enter the residential market, or with what kinds of prices, and even if they did enter whether any residential customers would be interested enough to respond. For that reason, I considered it prudent to retain a price control. To reflect recent cost reductions, this control considerably reduced the incumbent price, which thereby reduced the scope for competition. Offer made no public predictions. My private view was that if, after a period of time, less than 5% of residential customers chose another supplier then it would be difficult to justify the expense of opening the market, but if the proportion eventually reached 10%, then we could defend the decision. I do not recall hearing any expectations of higher proportions than that. In the event, the proportion of residential customers changing electricity supplier reached 15% within about six months of the market being fully open. Thereafter, the

7 I have explained elsewhere (Littlechild, 2000) how, as regulator, I soon changed that process to eliminate the need for such requests.

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proportion of residential customers with a non-incumbent supplier continued to rise at a remarkably steady rate. After less than ten years, over half of these customers are with another supplier. This is far beyond any initial expectations of which I am aware. (18) I cannot speak for other countries, but I doubt whether there were greater expectations in those countries that opened their markets early.8

3. Customer switching The author examines some particular aspects of performance to assess how far retail competition succeeded. The first aspect is the extent of customer switching. The author’s Table 1 lists switching rates for 19 countries in 2006, presumably for residential customers, ranging from 47% down to 1%. (These are actually the proportions of customers with non-incumbent suppliers, i.e. they are stocks rather than flows.) He observes that ‘‘globally, customers are not very disposed to change supplier’’. However, as he rightly acknowledges, ‘‘markets with low switching rates are often suffering from several hindrances: regulated tariffs below market prices or switching barriers of various kinds’’. This is particularly true in almost all the US markets that are nominally open to competition (except Texas) and in much of the EU. It is misleading to present GB, Sweden and Norway as ‘‘the exceptions’’.9 There are seven markets where regulated tariffs or switching barriers do not apply, and all were characterised by relatively high percentages of switched customers in 2006: GB 47%, Victoria 45%, Texas 36%, South Australia 34%, Sweden 32%, Norway 28% and New Zealand 27%.10 Competition is developing in some other markets too, including New South Wales (about 30% by November 2007) and the Netherlands (28% by first quarter 2007).11 The percentages in particular areas are greater than these national averages imply. For example, the figure was 60% in one area of GB against a national average of 47%, and in Norway the national average of 28% covers a range that goes up to 69.5% in one region.12 The proportions are still rising over time. For example, as of June 2008 the percentage in New Zealand had increased from 27% to 32%, in Texas from 36% to 44%, in South Australia from 34% to 47%, and in GB from 47% to 52%.13 8 For example, ‘‘Demands regarding metering and the costs involved mean that most household consumers over the coming years will choose not to participate directly in activities on the new electricity market.’’ The New Swedish Electricity Market, A summary of the reform, Ministry of Industry and Commerce, Stockholm, 1996, p. 25. 9 The author seems to set aside Texas, Victoria and South Australia on the grounds that retail competition there has been artificially fostered by unduly high regulated minimum price levels. This is incorrect. In Texas the regulated Price To Beat (PTB) was a minimum price, but this was for only three years, and for five of the six suppliers the initial PTB was set 8–9% below the previously current residential rates. (Texas PUC, News Release 7 December, 2001) The PTB price control was removed in January 2007. In Victoria and South Australia, the price controls did not preclude the incumbents from offering lower contract prices. 10 Percentages from the author’s Table 1 plus data from New Zealand Electricity Commission for October 2006. 11 The Utility Customer Switching Research Project classifies GB, South Australia and Victoria as Hot markets (over 15% of customers switching per year) and Norway, Sweden, the Netherlands, Texas, New South Wales and New Zealand as Active markets (between 5% and 15% of customers switching per year). (The other markets are classified as Slow or Dormant, or not yet open.) World Energy Retail Market Ranking, third ed., July 2007. The fourth ed, October 2008, now classifies 22 countries as active (4 Hot, 6 Warm Active, 5 Active, 7 Cool Active). 12 Ofgem (2007) Fig. 7.2, von der Fehr and Hansen (2008) p. 23. 13 NZ Electricity Commission; Texas PUC Report Card, Market Share Data; 2006/07 Annual Performance Report: Performance of South Australian Energy Retail Market, Essential Services Commission of South Australia, November 2007, Table A1.3 and The Essential Update - Statistical Update, Essential Services Commission of South Australia, October 2008; Ofgem (2008) Fig. 3.4.

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As the author recognises, these figures refer to the percentages of customers that are with particular suppliers at a particular moment in time. They underestimate the total number of customers that have switched at any time in the past. It is thus hardly accurate to say that ‘‘customers are not very disposed to change supplier’’. Where retail competition is allowed to develop, customers are remarkably disposed to change.14 As the author acknowledges, these figures also underestimate the extent to which customers are active in the market because they do not include customers who have switched to a different contract with the incumbent supplier. For example, in Norway, 28% of customers had chosen another supplier in 2006 but by first quarter 2007 over 50% had chosen a product other than the traditional variable price tariff.15 In South Australia, by June 2008 47% of customers had chosen another supplier and a further 22% had switched to a contract with the existing supplier, making a total of 69% of customers exhibiting active choice. It should also be understood that the residential market is less than half of the total market. Industrial and commercial customers typically consider switching supplier annually (or signing a new contract with an existing supplier after a tender or beauty contest). Retail competition for such customers is now so commonplace, and accepted as appropriate, that it no longer attracts comment.

4. Other aspects of performance The author says that ‘‘despite high switching rates, competition in these retail markets [GB, Sweden and Norway], is not performing as it was expected’’. He gives four examples, apparently drawn from his own expectations rather than from those who opened the markets. None of them stand up to scrutiny. (1) He predicts that switching dynamics should rise over time with the dismantling of barriers and the development of learning effects, but says that we do not observe this. However, if he refers to the rate of switching in any particular year (the flow) then many factors might be expected to influence that, not least the extent of any changes in prices and expectations about future prices. If he refers to the cumulative extent of switching over time (the stock), then this has steadily risen over time in all the competitive markets. (2) He predicts that switching costs should decrease over time leading to an increase in the number of active consumers and a convergence of prices to the cost of entry, but says that we do not observe this because prices are not converging as proved by the continued differential between the incumbent price and the best available offer. However, as just noted, the evidence is that there is an increase over time in the number of active customers. A persistent divergence between any particular supplier’s price and the best price in the market is not evidence that market prices generally are not tending to the costs of new entry — rather, it is a feature of any competitive market in the real world. Only in the unreal world of a perfectly competitive equilibrium are all prices the same. 14 Regulators testify to this. In Victoria, for example, the Australian Energy Market Commission observes that ‘‘Customers are demonstrating a clear willingness to participate in the competitive retail market.’’ Review of the effectiveness of competition in electricity and gas markets in Victoria, Second Final Report, 29 February, 2008. 15 Similarly, in Finland although only 11% of customers had changed supplier in 2005, another 19% had changed terms with their existing supplier. Littlechild (2006) Table 9.

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(3) He observes that new entrants were typically of two types: newly created companies and incumbent companies from other sectors (gas) or other geographical zones, and that the first type did not succeed. Whether this is true of all the competitive markets is questionable. However, since an aim of opening the market was to discover what types of organisation are best fitted to supply electricity, it is not clear how this finding, even if true, is inconsistent with previous expectations. (4) He says that years following the opening of competition were characterised by a great deal of experimentation, mainly done by new entrants, but that new channels of retail supply (via the internet) and joint offers (dual fuel and energy with telecoms) did not pass the market test. This is bizarre, since the internet is critical in making and comparing offers to residential customers and the author himself instances dual fuel as ‘‘truly entrenched’’. He says that the innovations that appear to have become truly entrenched are more limited in scope and seem unable to give an entrant long-lasting competitive advantage. Since he seems to accept the extent and importance of these innovations16, this sounds a bit like asking what the Romans ever did for us. However, to the extent that the characterisation about ‘not providing longlasting competitive advantage’ is true (which is debatable), it seems equally applicable (or inapplicable) to the retail sector generally. In short, the expectations about performance that the author identifies are not in general those of the designers of retail competition, nor are the subsequent outcomes inconsistent with initial expectations.

5. Economic theory and competition The author refers to the ‘‘less than stellar performance’’ of retail competition as ‘‘owing primarily to the theoretical concepts underpinning this reform, which draw heavily on the Austrian school’’. He says, ‘‘This misestimation is due to the partial relevancy of the economic arguments providing their rationale. The introduction of competition was largely inspired by ideas originating from the Austrian school.’’ Certainly I was influenced by Austrian thinking on competition as a discovery process, as explained in the paper that the author cites.17 The author sets out some of the benefits that retail competition should provide, according to this approach. These include reducing market imperfections, discovering new products, stimulating alertness of consumers and stimulating competition in generation. Retail competition has actually achieved all these things in those jurisdictions where it has been allowed to develop. Contrary to the author’s perception, the Austrian view would not seek to specify precisely what the outcome of the competitive process would be, in terms of prices, outputs, products, customer switching, number or type of competitors, effect on market structure, etc. The central aim was to set the competitive process 16 ‘‘The combined sale of electricity and gas (dual fuel), the enlargement of menus of contracts (duration, payment type, origin of the electricity including clean energy products, pricing options) and the development of some value-added services (demand monitoring, advice and energy efficiency options), using new technologies, such as web-based auditing and energy management software). These innovations certainly expand consumers’ choices, provide consumers new and innovative tools to manage and monitor their demand and foster competition between electric retail suppliers.’’ 17 Littlechild (2002). Marshall and Robinson (2008) point out that the concept of competition as a discovery process is nowadays explicitly endorsed by UK competition authorities.

in motion, especially by removing barriers to entry where competition had previously been prohibited, and thereby to discover the most preferred products and most efficient suppliers. A further reason for introducing retail competition was to remove or reduce the scope for the regulator and/or the government to use electricity pricing for political convenience. In that, too, it has succeeded, in contrast to other countries that have not fully embraced retail competition.18 Preventing, limiting or deferring price increases may be politically popular in the short-term, but cannot be claimed to be efficient. The author then argues as follows. The discovery of information should lead to a progressive elimination of price anomalies and to convergence of prices towards the marginal cost. However, we observe that price differences between suppliers persist on electricity markets, even years after the introduction of competition. The Austrian approach implicitly assumes that consumers make fully rational decisions and choose the supplier that best meets their preferences. They respond perfectly (or at least satisfactorily) to the incentives and information transmitted by price signals.

Unfortunately, the first proposition here is only half the picture, and the subsequent characterisation of the Austrian approach is almost the opposite of the case. It was precisely because Austrians were not satisfied with neo-classical assumptions of fully rational decisions and perfect responses that they emphasised the concept of competition as a discovery process. And while this would indeed lead to a progressive elimination of price anomalies if nothing else changed, in practice market conditions are constantly changing (input prices, technologies, customer preferences, products and policies of rivals, etc). The competitive process tends to equilibrium, but the equilibrium point is itself changing, as a result of the competitive process working in other sectors. (Hence Kenneth Boulding’s frequent analogy of the dog chasing the rabbit.) The author provides a useful review of some recent research in behavioural economics and on electricity switching decisions. This work provides important insights into consumer decisionmaking and thereby into the nature of competition. I agree with the author that, in this respect, the electricity retail market is not an exception. Recent empirical work is valuable for its insights into how consumer decisions are actually made and how competitive markets develop from scratch, not for any alleged findings that the retail electricity market is not competitive. As regards economic theory, these insights seem more consistent with the Austrian tradition than with traditional neoclassical economics. They enrich our understanding of the market process rather than demonstrate limitations of the Austrian analysis. 18 A recent example: ‘‘British families could find themselves subsidising households in France after the French government ordered a 2% cap on electricity price increases on Wednesday 6 August, the Times reported on Thursday 7 August’’. EDF will not be allowed to increase French prices by more than 5%. Cornwall Energy Associates, Daily Bulletin, 7 August, 2008. ‘‘Of the four electricity tariffs available to consumers, tarif bleu (small businesses and domestic consumers) rises by 2%. This increase is less than the rate of inflation (CPI is currently running at an annual rate of 3.6%). Medium-sized businesses on the tarif jaune will see a 6% increase while for large industrial businesses, tarif vert increases by 8%y The increases, though, result in energy prices that are still well below those found on the open market. For example, electricity in France can be bought on the wholesale market for h88/MWh, while a TRTAM consumer [intensive user] will only pay between h60 65/MWh delivered, saving around h20/MWh plus the cost of delivery.’’ John Hall Associates, Energy Review, 2(17), 21 August, 2008.

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As regards competition in the electricity market, it will be interesting to see whether the market process is indeed characterised by ‘‘a persistent segmentation between active and inactive clients’’. Do customers really act differently in the electricity market than they do in other markets? Or are all markets characterised by such a persistent segmentation? Would there not be a significant proportion of customers that have not switched butcher or baker, supermarket or bank, in the last five to ten years?19 Evidently additional comparative research would be helpful.20 In his final section, the author looks at the impact of technology. He presents a rather comforting view for large incumbent companies21 and a remarkably central role for equipment suppliers.22 There is no doubt that technology affects the precise nature of the competitive process, and it is helpful to explore this. But I fear he underplays the role of retail competition23 and the consequent innovations in pricing.24

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In the short-term, no doubt some classes of customers may be worse off as a result of a shift from regulation to competition, or may benefit less than others. This is true whatever the market. Such consequences need to be carefully considered by the regulator and appropriate steps taken to address the situation. But is it seriously argued that it is more efficient in the longer term to prohibit or discourage retail competition than to allow and facilitate it? Is this an argument that would be seriously advanced in any other sector of the market economy?

Acknowledgements Without implicating them in what I have written, I appreciate helpful comments from Paul Joskow, Eileen Marshall, Alan Moran, Colin Robinson, Steve Smith and Catherine Waddams. References

6. Conclusions The author’s central argument, in a nutshell, is that retail competition delivered less than expected because it was based on an Austrian economic analysis that failed to take into account the realities of customer decision-making processes and the technological characteristics of the electricity industry. He is led from this to question whether ‘‘retail competition leads to an improvement in the overall efficiency of the electricity market’’, and whether ‘‘the opening of retail electricity markets was a gain. I have tried to show that retail competition, where it has been allowed to develop, has in fact delivered more than initially expected. Advances in our understanding of customer decisionmaking processes are not inconsistent with Austrian economics (which may not be the case for standard neo-classical economics). It is helpful to try to understand how and why the retail electricity market has developed in the ways it has, including the role that technology may play. This may help to avoid judging the actual competitive market against an unattainable theoretical ideal. 19 Over the last five years, the proportion of people switching electricity and gas provider (both 54%) is second only to car insurance (61%) and above home insurance, fixed line telephone, mortgage, mobile telephone, credit card, savings account and personal current account (ranging from 46% down to 13%). Ipsos Mori Consumer Survey carried out for the OFT, July 2008, Fig. 4.3 in Ofgem, 2008. 20 One correspondent remarks, ‘‘Opening the energy markets has enabled (and the political environment has encouraged) microscopic analysis which is much more difficult, perhaps virtually impossible, in other markets.y But we have little idea whether (a) the level of consumer errors in electricity is common in other markets; and more importantly (b) whether it matters in terms of disciplining the markets. Hence the usual academic call for more research happens to be strongly justified in this arena, if only we could do it convincingly.’’ 21 ‘‘The electricity supply sector is a steering example of a stable industry, organised around large incumbent companies implementing cumulative innovation processes.’’ 22 ‘‘Second, innovative processes in the electricity sector are largely propelled by equipment suppliers rather than by the electrical utilities themselves.’’ 23 For example, retail competition has driven industry restructuring in Australia. In the UK, it has pressured companies to exit those businesses where they have no comparative advantage and enabled them to expand where they do have advantages. (I am told that Centrica’s home service business covering boilers and electrical repairs is now valued at nearly 60% of the value of its supply business.) It has required cost reductions and new IT investment that could not have been achieved by regulation. 24 A colleague comments ‘‘Try telling the 4m UK customers on fixed price deals (something I doubt any regulator would ever have had the confidence to sanction given wholesale market volatility) that competition has been bad for them. And just do a thought experiment on what regulation would have been like given recent wholesale volatility–either price re-openers every 6 months or cost pass-through with no real discipline on retailers to do anything to manage wholesale price risk and no choice for customers.’’

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