Since the announcement on 27th March 2014 and consequent extensive press coverage it will not be news to readers that Ofgem is consulting on a market investigation reference (‘MIR’) to the Competition and Markets Authority (the ‘CMA’, being the successor to the Competition Commission (“CC”) in this regard) as it has greater powers to deal with any adverse effects on competition observed in the energy market.

There is every expectation that a reference will now be made. That it may have an extensive impact on the energy sector in a number of ways is clear. What is less obvious but nonetheless important is whether there may be an impact on environmental regulation and if so, how this is likely to be approached. To answer this, it is helpful to turn to the process of an MIR first.

The MIR process in outline

For anyone familiar with competition law and specifically the UK regime, the following will not add much. But the audience of this newsletter is broad, and not everyone is expert in this field - indeed, given the small number of MIRs actually made and undertaken by the CC (the powers passing now to the CMA), actual experience of the regime resides in relatively few hands.

So, for those not familiar with the MIR powers, here are a few comments on the context and the process:

  1. First, an MIR made by Ofgem was virtually inconceivable until recently. MIRs have almost universally been made by the OFT: the sectoral regulators with such powers concurrent to the OFT’s (effectively all the main ‘economic’ regulators – Ofgem, Ofcom, Ofwat, the ORR et al) have been loathe to use them (the limited exception is the somewhat peripheral issue of the ‘rolling stock leasing’ market referred by the ORR in 2007 and the reference as regards BAA’s ownership of airports referred by the CAA). Typically, economic regulators have wanted to keep the markets they regulate away from the kind of detailed scrutiny by another independent competition authority that an MIR entails. Not least, there is the potential for (implicit or other) criticism of what it has itself done (or failed to do).
  2. The above is not surprising given the nature of the MIR regime (which has received relatively minor tweaks only in passing from the Competition Commission to the CMA): an MIR is a lengthy (now 18 months, extendable to 2 years) investigation, potentially followed by a remedies phase which may also be lengthy and include incredibly ‘intrusive’ powers.
  3. While one may well assume the ‘big six’ are most obviously going to be under scrutiny, an MIR does not, in terms, focus on particular parties. Any member of the sector/any party having an effect on the market may be considered or required to give information. And government regulation may come under scrutiny including (and importantly for present purposes) regulation promulgated by DECC relating to environmental regulation.
  4. The ultimate decision makers in an MIR will be independent and highly qualified (and experienced) people, supported by experienced and well qualified staff. This ‘robustness’ has always been a strength of the MIR process. If they believe that environmental measures (from ECO to Feed in Tariffs and the Renewables Obligation) are distorting competition, they will say so – and may either make direct amendments to the operation of the market to remedy this, or (perhaps more likely) suggest amendments to the various schemes. Ultimately, indeed, this may include not only secondary legislation promulgated by DECC, but potentially even certain aspects of Ofgem’s duties under primary legislation.

Some points of conflict between environmental measures and competition

It is too early in the day to make predictions as to outcome. However, it has been regularly recognised by industry experts (including economists and lawyers) that the core ‘competition’ duty of Ofgem has been ‘watered down’ over time, by imposing sometimes competing duties in relation to the environment. At its most basic level the conflict may be expressed as follows: while a properly functioning market will lead to an optimal allocation of resources (for instance, the ‘generation mix’ that would meet the needs of the market at the lowest cost), interventions aimed at ensuring a higher level of renewables (or, indeed, meeting specific CO2 targets) ‘distorts’ this, ultimately giving benefits to low carbon technologies at a cost to consumers of gas and electricity. These ‘interventions’ have been hard wired into both the duties placed on Ofgem, and through secondary legislation in respect of schemes (such as ECO, FITs and ROCs).

The above characterisation of the problem is not however the whole picture: economic theory recognises that markets (and hence, pure competition) do not naturally factor in external costs (such as pollution or other environmental costs). So, schemes which accurately and efficiently address this issue of ‘externalities’ may have a sound economic basis.

A preliminary view

The real territory for dispute in this area is not likely to be as simple as the binary question about whether environmental costs should be factored into the regulation of energy markets or not: the answer here is that this is a legitimate aim of government policy and legislation (and indeed economic theory regarding the pricing of external costs). Rather, the focus will be on whether there are elements of the current schemes which operate to the detriment of competition (have an ‘adverse effect on competition’ in the language of the MIR process) and/or which could be structured in a manner less likely to distort competition.

And it is here that one can spot real issues, both with current schemes and future pricing mechanisms (such as Contracts for Difference). To take an obvious current example: smaller energy suppliers (those with under 250,000 customers) are exempted from a range of environmental measures (and therefore costs); for instance the ECO scheme. The aim is to reduce barriers to entry, and thereby to encourage competition – and this has been effective, with 10 new ‘small’ suppliers entering the market in the past 4 years. However, it is also a barrier to growth: a supplier that is close to the limit will face a massive additional cost once taking on customer number 250,001, as the benefit of the exemption is then lost. And that additional cost may make it impossible to compete with the larger companies (who, some argue, benefit from owning their own generation – i.e. they are ‘vertically integrated’). Hence the observed strategy of some, but not all, small suppliers to stay small.

One might expect the CMA to find that this situation is well intentioned, but flawed in design: there are other ways of reducing barriers to entry that don’t have the obvious consequences of the route taken (at the very least, even a ‘tweak’ so that the benefit of exemption phases out as a company grows would be far less of a barrier to growth, in particular if combined with other measures such as increasing electricity wholesale availability other than by vertical integration).

So, to make a prediction at this very early stage: the CMA will be unlikely to be able to (or want to) avoid the interaction of environmental measures (and targets) with issues of competition in the relevant markets. There is also some obvious ‘low hanging fruit’ for change. At a minimum, therefore, one might expect changes to some of the environmental schemes. However, there is a distinct possibility that the CMA goes further: this already complex field (energy regulation) has been beset with both a multiplicity of environmental schemes (aside from licence obligations, there are over five currently in place aimed at reducing carbon emissions or reducing demand), and regular changes to the schemes. Some of these (notably the CESP scheme and the Green Deal) have been/are perceived as failures. It is a rather obvious question to ask whether a properly constructed CfD scheme, with a single and simplified ‘demand side’ scheme (along the lines of ECO) might not lead to less regulatory burden (so facilitating entry/expansion and encouraging competition) and longer term certainty (again facilitating competition, as investment can be made on a predictable footing).