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  • The Energy “safeguard tariff cap”: Learning from the payday loans price cap Posted on 18 May 2017

    The Conservative Party’s manifesto, published today, promises to introduce a “safeguard tariff cap” to help customers on the most expensive tariffs in the energy market.

    Price caps are normally reserved for markets where there’s an inherent lack of competition, such as water supply where there’s no choice of provider for consumers. Before the Conservative Party’s proposed price cap for energy suppliers, the last one introduced for a generally competitive market was the Financial Conduct Authority’s (FCA) price cap on high-cost short-term credit (HCSTC), or payday, lenders.

    The HCSTC market is small - far less than 1% of the UK’s consumer credit sector - but politically charged. Although most users of payday and other loans with interest rates above 100% per year are quite happy with the products, a small minority of customers have found themselves running up ruinous debts.

    When the FCA took control of consumer credit in 2014 it was initially reluctant to impose price caps on the industry. Instead it implemented a series of conduct rules that required lenders to do more to assess the affordability and suitability of loans and to work with debt advice agencies to allow those with serious problems to pay back what they could afford. It was only after a change in the law in 2013 required the FCA to “secure an appropriate degree of protection for borrowers against excess charges” (a measure instigated in the House of Lords the previous year) that a price cap was proposed.

    The payday price cap is complicated - possibly unnecessarily so. It caps the interest rate lenders can charge (to 0.8% per day), default fees to £15 per loan, and the total cost of the loan including interest and all fees to 100% of the amount borrowed. Overall, the mechanism appears to have been effective in remedying the worst excesses of the market, working alongside the FCA’s other measures. The market is smaller with lower defaults and fewer complaints. The cap has put an end to stories of desperate consumers with thousands of pounds of debts after having initially borrowed only small amounts. Fears that it could drive business ‘underground’ to illegal loan sharks seem not to have been realised. 

    Despite the apparent success of the policy, our analysis suggests that the cap has had an unintended consequence. It has made lending over very short periods - days or a few weeks - unprofitable. Even with a very lean operation, lenders are unlikely to be able to make a loan without incurring cost of at least £30.  With the 0.8% per day limit that makes many small loans to tide people over until their next payday inherently unprofitable. Instead, lenders now have every incentive to push longer loans of three months or more. 

    Fortunately, there is a self-correcting mechanism here. Lenders earn little or nothing more for loans of over around 7 months compared to shorter periods. This is when the total cost of loan price cap of 100% of the amount borrowed kicks-in. Even so, the cap appears responsible for a considerable lengthening of the average loan period in the HCSTC sector.  Had the FCA only implemented the 100% cap on total interest and charges, it seems this could have remedied the problem of consumers running up high debts, without leading to longer, and therefore costlier even at the capped interest rate, loans. This approach might not, however, have clearly met the legal obligation on the FCA to act on “excess charges”, so the FCA’s hands may have been tied. A lesson from this for an energy price cap is that the objective needs to be very clear and simple and the mechanism designed to achieve just that objective. 

    For energy, the Conservative’s concern appears to be the unfairness of a system that penalises customers who either do not switch supplier at all, or switch to a fixed rate and then are automatically transferred to a standard variable rate after the end of the fixed rate period. The annual difference between the lowest and highest tariffs offered by a supplier can be over £500 for many households.

    As has been suggested by John Penrose MP, and supported by Stuart Jackson, Chief Financial Officer of Octopus Energy, a price cap to remedy that problem need not be concerned about actual prices charged. Instead, it could simply limit the percentage difference between the highest and lowest rates a supplier charges its customers. This would also have the advantage of avoiding the need for a legion of new staff at the energy regulator OFGEM.

    Price caps are major interventions into generally competitive markets and it is right they should be used highly selectively. A lesson from the UK's HCSTC price control is that capping relative and not absolute prices can protect vulnerable consumers without unnecessarily disrupting what is generally a competitive market.

    This blog is based on my work for Apex Insight’s new report on the HCSTC market, see https://www.apex-insight.com/consumer-credit-market/

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