Scarce resource pricing: the benefits of the market while keeping basics affordable

Nigel Williams, 24 October 2013

Ed Miliband suggested freezing the prices. In a rare piece of back-seat driving, John Major suggested a windfall tax. David Cameron was equivocal about wearing a woolly jumper. It’s a good time for sharing ideas about how to keep warm this winter.

The jumper has more to recommend it than meets the eye. Much of Britain’s heritage was funded by proceeds of the wool industry. Capacity still exists, with potential benefits all along the production chain. Farmers produce the fleeces, which get spun and woven into yarn and fabric, then turned into clothes ranging from basic items up to suits and artisan knitwear. Wool even works to insulate lofts, as if the house is putting on a woolly hat. The suggestion is less welcome to someone already acting sensibly: wearing enough clothes for the season and in a fully insulated home but still with fingernails turning blue. Foodbanks are doing what they can for people that cannot afford to eat and they have the prospects of finding extra clients among people passing their food budgets to energy companies.

A windfall tax makes a moral statement about profiteering but adds an extra stage in the circulation of money. The state still needs to find a way to pass money back to anyone making difficult choices about keeping warm. As for freezing prices, the immediate consequences have not been great as energy companies get their retaliation in first.

Energy is a scarce resource. At a time of diminishing capacity, there are objections to almost every new source. People need a basic level of energy but high demand and restricted supply inevitably put upward pressure on prices.

Scarce resource pricing can work in a regulated industry, without overdoing the effect on competition. It sets a personal allowance, so much per adult, so much per child at their principal address, and requires that energy up to that allowance stay below a price set by the regulator. Above that allowance, prices can be left to market forces and competition, remembering that the price has to recoup any losses on the basic allowance.

Currently, many of the available tariffs work the opposite way. They have a standing charge. Reasonably, it pays for the costs of connection but it sends altogether the wrong market signal. Customers cannot avoid it even with insulation, jumpers and lowering the thermostat. The less energy they use, the more they are charged for each unit.

One major supplier gives estimates of average usage at 3,300 kWh of electricity per year. For purposes of illustration, if 2,000 kWh is as low as a households can control before deprivation starts to show, that is the level at which to regulate prices. If the lower price is set so that almost every household can afford that quantity of electricity, prices for using more can rise so that the company keeps the same average prices.

 Annual bills and unit costs at, below and above annual electricity consumption.

Under present arrangements, the standing charge ensures that making economies serves to put up the unit price, so that low users are pay more per kWh than high. The expressed wishes of Ed Miliband, John Major and others are that any subsidy should work the other way.

This illustration is for electricity. The same principles apply to gas.

The level of the regulated price is a matter for discretion. At 0.12p, the resulting marginal price of 23p/kWh looks high but still leaves the cost of average usage the same. That high marginal cost is what can drive efficiency improvements, cost-cutting, competition between suppliers, alternative means of provision and all the benefits of the market. At the very least, it is time to get rid of standing charges.