Households across Great Britain received some rather grim news on Friday, when Energy regulator Ofgem announced the household energy price cap for England, Scotland and Wales will rise again in October. At that time, the BBC reports, “The typical gas and electricity consumer is likely to see their bill go up by £139 to £1,277 a year.”[i] Further analysis in The Guardian points out that for many households, energy costs will therefore be the highest in a decade, and it profiles several families for whom this presents hardship.[ii] We surely empathise with this, and we think it also illustrates one of the biggest ironies surrounding official price controls, like the energy price cap: They often have the opposite of their intended effect. In our view, this is a core concept for investors, as understanding price controls’ unintended consequences can improve overall economic analysis (and, by extension, investment decision making).
The current price controls, enacted in 2019, are mostly a bipartisan effort. As several commentators reminded readers on Friday, energy price caps originally appeared in Labour’s election manifesto in 2017 before becoming official government policy under Conservative Prime Minister Theresa May. We reiterate this not to point fingers, but because it illustrates what we think is a crucial point: No political party is inherently beneficial or detrimental to the economy and equity markets. Both parties have passed policies investors might consider good or bad for businesses, and sometimes the parties borrow ideas from each other. This is why we think investors benefit most from a party-blind approach, focusing on policies rather than personalities or partisan ideologies.
In theory, price controls aim to prevent prices from rising much. In the early 1970s, policymakers in the US and UK used them broadly in hopes of curbing accelerating inflation. It didn’t work, as a large array of research and our own historical analysis shows. Inflation rates accelerated throughout the decade as rising costs forced policymakers to repeatedly raise and eventually abandon the price controls.[iii]
The saga of the energy price caps, in our view, illustrates why price caps and accelerating inflation coincided in the 1970s: The cap inevitably rises as businesses’ wholesale costs increase, potentially by more than prices would have if normal market forces were allowed to determine them. Now, that is impossible to measure, as it lacks a what-if scenario, known in science as a counterfactual. But what has happened in UK household energy is instructive, in our view. In explaining the increased cap, Ofgem cited energy suppliers’ rising costs. Usually, a business will raise prices only as much as needed to preserve profits when prices rise—in our view, competition prevents them from doing more than that. But in a system with capped prices, raising prices only enough to offset costs can be risky for businesses, as both future costs and the cap are unpredictable. The solution, for many businesses, is to increase prices as much as the caps allow, giving them wiggle room in case costs rise further before the next cap increase. Industry analysts have found this to be the case amongst UK energy suppliers: Changes to their tariffs since 2019 indicate they are treating the price cap as a target rather than a prescribed maximum.[iv] In our view, this explains why measures aimed at curbing prices have instead resulted in the aforementioned decade-high household costs.
We also think price caps have had a secondary effect: reducing competition. Ofgem encourages households to avoid price increases by switching their supplier in order to take advantage of favourable rates offered to new customers. This has incentivised companies to sweeten those deals as much as possible. The largest energy suppliers have enough clout to do this without running at a steep loss, but upstarts don’t have this advantage. As a result, at least 20 British energy suppliers have gone out of business since 2019 began.[v] Without competition, there is even less pressure on large energy suppliers to keep prices in check, as households have little alternative but to pay up.
As painful as this is for millions of British households, we don’t think it is a broad economic negative. Our analysis of economic history shows higher energy costs can affect where people spend their money, but it generally has little impact on how much they spend. Growth in gross domestic product (GDP, a government-produced measure of economic output) depends simply on total spending. Similarly, we don’t view these price caps as a negative for the broad UK equity market, as they are confined to one relatively small sector, Utilities. We do think they are a headwind for that sector, but we also don’t think global Utilities companies are positioned to lead global markets right now, so UK-specific headwinds seem secondary. (Our research shows Utilities usually lag broader markets during periods of economic expansion.)
But we do think this saga is worth remembering. Price controls have a way of going in and out of fashion, and experience tells us they will likely have broad political appeal at some unforeseeable point in the far future. If and when politicians of any party argue price controls are the solution to accelerating inflation, remember this scenario. In our view, reasonable research over economic history shows price controls are more likely to worsen inflation than address it.
[i] “Energy Bills to Rise by at Least £139 for Millions of Households,” Simon Read, BBC News, 6/8/2021.
[ii] “‘My Heart Sank’: How Lifting Energy Price Cap Will Hit the Most Vulnerable,” Jillian Ambrose, The Guardian, 6/8/2021.
[iii] Source: FactSet, as of 6/8/2021. Statement refers to Consumer Price Indexes (CPI) in the UK and US. CPI is a government-produced measure of consumer price changes across the broad economy.
[iv] “Energy Price Cap – Pros and Cons,” EnergyScanner.com, April 2021.
[v] Source: EnergyScanner.com, as of 6/8/2021.
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