With the nip of winter in the air, the announcement of price increases by Britain’s largest natural gas and electricity firms raises the perennial debate about the competitiveness of energy markets. In a surprising intervention, the Chancellor urged the energy companies to “look again” at the cost of energy and to consider whether price increases are really necessary, while the Prime Minister signalled an intention to force energy companies to offer their ‘lowest tariffs’ to customers.

Two recurring themes have been prevalent in the debate. One is the suggestion that even if energy companies did not agree to across the board price increases, the practical effect of them increasing prices, at a similar level and in close proximity, is the same as though they had so agreed. Yet there are many (non-collusive) explanations for apparent parallel behaviour. The other theme is the contention that the market isn’t working, as reflected by a tendency for firms to act more quickly to increase prices in response to rising wholesale costs than to reduce them when costs are falling, otherwise known as the ‘rockets and feathers’ effect.

Britain’s Office of Gas and Electricity Markets (“Ofgem”) has published proposals following a lengthy ‘Retail Market Review’ to require energy companies to offer simpler and more transparent tariffs, for instance by capping the number of tariffs options and eliminating complex ‘multi-tier’ tariffs. It has not found any evidence of cartel behaviour.

Energy pricing dynamics

Recent figures released by Ofgem indicate that average energy bills for a dual fuel domestic customer have risen by around 50% in the past five years. The Ofgem analysis suggests several factors have driven the increase: (1) wholesale costs, which account for around 50% of the retail bill, have faced upward pressure due to rising fuel costs; (2) increases in other costs (including increased network charges and VAT) have added over £100 to average bills since 2007; and (3) energy suppliers’ margins have risen by over £100, albeit from a negative (and apparently unsustainable) value in 2007.

Whatever the reasons, the increase in bills (now expected to average over £1350 for a typical dual fuel customer according to Ofgem) and recent price increases has focused regulatory attention on the industry.

Parallel behaviour and competition law

The proximity of price increases across the major energy suppliers has resurrected concerns that conditions in the market are such that there is a situation tantamount to ‘tacit collusion’ where each party adapts itself to the behaviour of other players, even if they are not explicitly agreeing prices. When apparently parallel cycles of behaviour emerge in the absence of evidence of direct agreement, this raises a question of how to detect this, and how under U.K. law should it be controlled, regulated and sanctioned (if at all). It is convenient to remind of the U.K. legal principles that determine whether there is a violation of competition law in the absence of direct evidence of agreement.

Chapter I of the UK Competition Act 1998 (Chapter I prohibition) prohibits agreements, decisions and concerted practices between or amongst undertakings or associations of undertakings which have as their object or effect the prevention, restriction or distortion of competition within the UK and which affect trade in the UK. The Chapter I prohibition is modelled on the corresponding EU competition prohibition against cartels in Article 101 of the Treaty on the Functioning of the EU. Conduct may amount to a “concerted practice” even where the parties have not explicitly adhered to a common plan defining their action in the market but knowingly adopt collusive actions which facilitate the co-ordination of their commercial behaviour.

First, infringement can be based on indirect evidence if an overall pattern of guilt emerges and which is corroborated by the actual conduct of the undertakings on the market. In Suiker Unie the EU Court set down the conditions which need to be satisfied to prove a “concerted practice.” The criteria of coordination and cooperation do not require the working out of an actual plan, but should reflect that each economic operator must determine their market behaviour independently. However, the Court noted also that the requirement for independence does not deprive economic operators of the right to adapt themselves intelligently to the existing and anticipated conduct of their competitors, but rather strictly precludes any direct or indirect agreement between operators which influences their conduct in the market.

Second, indirect evidence must be seen in context and in conjunction with all the other direct and indirect evidence. The EU Court has stated (in Limburgse Vinyl Maatschappij NV and others v Commission) that: “…items of evidence should be regarded not in isolation but in their entirety […] and individual items of evidence cannot be divorced from their context”.

Third, mere parallelism (of price variations) is insufficient to prove an infringement. In Dyestuffs the EU Court observed that:“…[a]lthough parallel behaviour may not by itself be identified with a concerted practice, it may however amount to strong evidence of such a practice if it leads to conditions of competition which do not correspond to the normal conditions of the market, having regard to the nature of the products, the size and number of the undertakings, and the volume of the said market” (emphasis added).

Fourth, the experience of the European Commission demonstrates that it tends to be very difficult to support a cartel infringement decision imposing penalties relying exclusively or to a large extent on economic evidence. The only case which relied exclusively on indirect evidence in the form of economic studies was annulled by the EU Court. The Woodpulp II decision was decided by the European Commission in 1984 and asserted that it was not possible to explain the price increases with conscious parallelism as may be observed in oligopolistic markets. The EU Court ruled that, contrary to the decision of the European Commission, the market had become transparent for innocuous and natural market structure related reasons and that the parallel price movements could be explained by normal oligopolistic interdependence.

Finally, previous experience has shown that where the European Commission has sought to rely largely on indirect evidence, such evidence will not be persuasive before the Court where the parties can put forward plausible (not anticompetitive) explanations that render unreliable the finding of a concerted practice. The result is that the suspected undertakings “do not necessarily have to go as far as to show that the […] assertions are wrong, but merely have to show that they are unsafe or insufficiently proven”.

Economics perspectives

From an economic perspective, it is not easy to determine whether market outcomes are the result of tacit collusion as opposed the normal competitive outcomes of imperfectly competitive markets. Both outcomes could in principle lead to prices above costs. While the rationale of collusion would be to sustain profits above those which would be earned under the stable oligopoly outcome, there is no easy benchmark to apply to test for this. Comparisons with similarly structured markets elsewhere are unlikely to yield robust conclusions, due to differences in market and regulatory conditions. The timing and parallelism of price changes also do not generally provide conclusive evidence of coordination, since under competitive conditions changes in market-wide costs would tend to be passed through to consumers.

Economics does, however, provide some insights into the conditions that may support tacit collusion, which allow the plausibility of coordination to be assessed and, where appropriate, refuted. In Airtours, the General Court found that a credible coordinated effects case requires that (1) producers be able to reach an agreement over price; (2) producers are able to sustain that agreement; and (3) the arrangement is not undermined by outside factors such as new entry or buyer power. The standard of proof in cartel cases is very different from that in merger enforcement. Broadly, in the EU mergers can be prohibited if they are likely to lead to a significant impediment to effective competition; whereas collusion itself can only be punished if there is unambiguous evidence that an infringement has taken place. However, the criteria set out by the General Court provide a guide for analysing the likelihood that a market may support collusion and how changes in the market rules affect this likelihood.

It will be recalled that Ofgem has not found evidence of a cartel. Absent evidence on coordination, the increase in prices seen in the electricity markets, for example, could also be explained by a market characterised by normal competition in which customers become more likely to switch when prices increase. Under such conditions, suppliers may be (1) more inclined to raise prices rarely because this precipitates customer switching; and (2) less inclined to lower prices because it is unlikely to result in more demand in the short run. However, when faced with complicated tariff structures and uncertain future demand for electricity, consumers may find it too costly to continually evaluate alternative tariff plans.

Ofgem’s scrutiny of energy markets

Against this background, on 26 October 2012, Ofgem published its latest proposals for reform of the retail energy market. That same day, it also published its consultation on the detail of its proposals for the reform of the non-domestic energy market.

Under the banner ‘Simpler, Clearer, Fairer’, the main elements for reform of the domestic market will be: (1) to ban complex multi-tier tariffs, with only a simple standing charge and pence per unit being permitted; (2) to limit the number of tariffs offered to customers; (3) to require disclosure of the cheapest tariff available, possibly across the whole market in the case of vulnerable customers; (4) to provide an easier basis of comparison across suppliers; and (5) to default to the cheapest tariffs at the end of fixed term contracts.

The aim behind the proposals is that the simplified tariff structure and increased transparency may induce more consumers to switch to better price plans since this reduces research costs and makes the benefits of switching more readily visible. In principle, this would appear to make it more profitable to offer customers lower prices, since the lower price is more likely to be offset by higher volume. Conversely, this would also make it less attractive to raise prices.

However, support for the proposals is not unequivocal. The introduction of simpler tariffs and less tariffs can make it considerably easier for firms to monitor each other’s pricing, making deviations easier to detect and thus less attractive. Moreover, the obligation to reveal to customers the lowest available tariff reduces the incentive to offer such tariffs in an effort to attract new customers, potentially easing competition.

Conclusion

It is very difficult to determine the existence of collusion on the basis of market indicators such as profitability or timing of price increases. Structural changes in the market aimed at reducing the likelihood of collusion may be possible, but would potentially increase investor uncertainty and cost of finance. Ofgem appears to be taking the less costly route of improving transparency with a view to raising consumers’ ability to choose competitive tariffs. On the other hand, the measures may prove counterproductive if the increased transparency weakens firms’ willingness to compete, for example because of obligations to put a firm’s own customers on the most advantageous tariff. The ultimate effect clearly remains to be seen. Ofgem invites comments on its proposals by 21 December 2012.

* Derek Holt is a director and economics consultant at AlixPartners in London.

This article is based on a version first published in the November edition of Competition Law Insight and is reproduced here with kind permission.