Debunking energy myths: energy supply is not a goldmine and life is tough for new entrants

The energy landscape is an increasingly confusing one for consumers – with new entrant suppliers going out of business, the introduction of price caps, and the on-going controversy over smart meters. The latest issue is the fuss suddenly being made about so-called “surge pricing” by which suppliers are apparently going to hike prices for consumers at times of high demand such as Christmas and Easter. Many of these problems have their roots in a number of myths about the industry that are believed by the public and in some cases by policymakers. In this short series of posts, I will explore some of these myths and why they are taking energy policy in the wrong direction.

Myth #1: Energy supply is a lucrative business with the Big 6 suppliers earning billions in excess “profits”

This myth has gained traction since the Competition and Markets Authority carried out an in-depth investigation into energy supply businesses and found that the domestic customer detriment due to overcharging by suppliers was around £1.4 billion per year over the period 2012-15 under once analysis approach, and around £720 million/year over the 2007-14 period using a different method.

“For far too long older people, hard-working families and those on low incomes have been subject to rip-off energy tariffs,”
– Theresa May, Prime Minister

As I have described before, this figure is inconsistent with the Consolidated Segmental Statements by the Big 6 – reports that are prepared by their external auditors based on guidelines issued by Ofgem, that must reconcile with the suppliers’ audited accounts. Aggregated data for the Big 6 suppliers are shown in the table above and indicate that the only way that over £1 billion of excess profits could be earned would be if reported profits in the non-domestic segments including generation were in fact earned from domestic end users (or the figures are completely wrong/distorted in other ways). This could be the case, but neither the CMA nor Ofgem has said they believe this is happening, nor taken any action to prevent it.

The latest bills breakdown published by Ofgem (also based on the Consolidated Segmental Statements) show that retail electricity supply is a loss-making activity for the Big 6:

Although margins on gas are healthy at 10%, the margin for dual fuel customers is 4.83%, which is reasonable but hardly a goldmine.

New entrants lured by the prospect of easy money find the going tough

The problem with this myth is that new entrant suppliers are encouraged to come and take market share from the Big 6, however setting up a functioning supply business is hard. Gas and electricity are largely commoditised, so new entrants must either identify a particular consumer preference such as local or green energy, or they must compete on price, but since margins are low (and negative for electricity) it is challenging to develop a successful low-cost supply model.

This is illustrated by the growing number of suppliers that are going out of business, most recently Iresa, which had faced a number of operating restrictions from Ofgem due to poor customer service and high levels of complaints, and finally closed its doors last month. So far this year, five small suppliers have exited the market: Brighter World and Future Energy both closed in January, followed in April by Flow Energy, and National Gas and Power, which supplied the non-domestic sector had its supply licence revoked in July after becoming insolvent.

The next failures are on the horizon with reports that Gen4U has had all of its trading contracts cancelled and has withdrawn its tariffs from the market, and Electraphase, which appointed administrators on 6 August.

Trying to force switching

Since the CMA identified low switching levels as a sign of market disfunction, Ofgem has been exploring ways in which switching can be stimulated for disengaged consumers. This has meant that suppliers will be required to share the data of such consumers to the Disengaged Customer Database (with all of the privacy concerns that go alongside such as scheme), and has been considering ways in which these customers can be incentivised to switch supplier, for example by allowing other suppliers to target them (which is highly likely to make both the original supplier and prospective suppliers breach the General Data Protection Regulation, so it’s hard to see how the scheme could be legal).

Consumer group Which? has also found that 80% of consumers are likely to either opt out or ignore any communications arising from the scheme, limiting its effectiveness.

“Consumers should vote with their feet. Switching suppliers will always help consumers to get the best deal,”
– Claire Perry, Energy Minister

In February, Ofgem trialled the “Active Choice Collective Switch” initiative, in which 50,000 inactive consumers were provided with a calculation of their savings if they switched to an alternative tariff determined by “an Ofgem-appointed consumer partner organisation”. The role of the consumer partner is to:

• negotiate a price competitive, ideally market-leading tariff;
• calculate the saving each customer could make and let them know what it is;
• provide online and phone routes to switch to the new tariff and/or conduct a wider search comparing tariffs across the market.

Ofgem is yet to report on the outcome of this trial, but the Sunday Telegraph reported this week that almost 13,000 customers were encouraged switch to a new entrant supplier that is “unable to pay its bills”. According to the newspaper, SSE sent over 176,000 letters to customers part of the trial, of which 12,917 encouraged customers to switch to Electraphase, which trades under the name E-phase, and which, as noted above, has recently gone into administration.

Where does this leave the competitive landscape?

While smaller suppliers are finding the market increasingly challenging, the Big 6 are also feeling the pressure, which is emerging in three ways:

• firstly, all of the larger energy suppliers (and many smaller ones) have been increasing their prices, most recently British Gas announced its second increase in its standard variable tariff this year;
• secondly, the larger suppliers are in the midst of various corporate re-structurings and/or mergers and divestments in order to better position themselves in the face of difficult market conditions;
• and thirdly, the larger suppliers are exploring new business avenues such as energy services, distributed energy and the connected home segment.

In addition, several larger non-energy companies are targeting the sector, and are more likely to be successful than the many smaller new entrants (that are also often start-ups).

Energy supply is a complex business, but few people understand this and why current energy policy is driving costs higher and service lower.

The basic energy supply business involves procurement of energy in wholesale markets (gas and electricity or the fuels for the generation of electricity for vertically integrated suppliers). This involves managing volume risk as well as price risk, since participants in the wholesale markets must maintain balanced positions every day for gas and every half-hour for electricity. Having an imbalanced position exposes the supplier to imbalance prices which cannot be hedged and which can vary from a few pence to thousands of pounds per kWh.

Suppliers must also pay a share of the transmission and distribution network costs incurred in the delivery of energy to their customers, which are growing due to the effects of de-carbonisation. Suppliers are also required to recover the costs of various environmental and social policies through bills, such as the costs of renewables subsidies, and the smart meter roll-out.

All of this makes the administration of the supply business highly complex, requiring sophisticated billing systems – something suppliers have generally done badly. Despite the complexity, this has been an own-goal which has allowed successive governments to place the blame on suppliers for rising costs, on the basis of their inefficiency and profiteering, rather than the pressure created by energy policy.

“This latest price hike is another slap in the face for energy customers who are already feeling the pinch and can’t see any real difference in the service they’re receiving. We would urge the nine million customers affected by the Big Six price hikes to take back the power by switching to a better deal, as they could save over £400 a year,”
– Alex Neill, Managing Director of Home Products and Services at Which?

The problems experienced by new entrant suppliers such as Iresa demonstrate the difficulties of running a supply business very well. Iresa positioned itself as a low-cost supplier in order to win customers, however it simply did not have the systems in place to cope with the customers it acquired, leading to large numbers of complaints and restrictions being placed in its operations by Ofgem. Eventually it simply collapsed.

It is tempting to conclude suppliers must either be large (due to legacy positions or entry from other markets), or very small with modest growth aspirations, neither of which looks like the sort of competition the Government seems to want in the industry.

Where next for retail market regulation?

There are now calls on Ofgem to tighten the rules for new entrants as the barriers to entry are considered to be too low, while at the same time, the Government believes the market is insufficiently competitive and has introduced a retail price cap as a means to prevent the Big 6 suppliers from exploiting their dominant market position.

The reality is that retail energy supply is not a lucrative business, and that while barriers to entry are too low, barriers to effective operation continue to be too high. Setting up the operational systems needed to service new customers is not cheap, and new entrants still struggle to manage price risk despite initiatives such as Secure & Promote making them vulnerable to swings in wholesale and imbalance prices.

The steps needed to fix this are unlikely to happen (such as recovering policy costs through general taxation rather than bills; and an end to the narrative from the Government that suppliers are profiteering at the expense of ordinary consumers), which places Ofgem in a difficult position trying to stimulate competition while ensuring that new entrants have adequate resources to operate effectively.

Ofgem will almost certainly introduce new licence conditions for suppliers, possibly around capital adequacy, and resourcing. This may stimulate some much-needed be consolidation among the smaller new entrant suppliers, as those that do not meet these new requirements will need to either find new investment or join with a larger supplier – failure to do so would lead to the withdrawal of their licence and the allocation of their customers to another non-Big 6 supplier.

Effective competition in the energy markets will not come from dozens of minnows, but from a smaller number of companies with the heft to challenge the Big 6 over the long term.