Electric shock: the Government struggles to address the energy market crisis

The energy market crisis is suddenly big news. It is impossible to open a newspaper or turn on the television or radio without hearing stories of rising bills and supplier bankruptcies. Energy is no longer a footnote in the business pages, with some outlets now running rolling commentary on the market. Yesterday I was on my way to give a presentation to a group of investors about energy price trends and in the time it took me to get there, two more suppliers had failed. Now suppliers are actively and publicly deterring customers from joining, and not just by raising prices. Blub has terminated it’s refer a friend scheme and Ovo has removed its fast quotation function from its website.

The current crisis is not only hurting suppliers (and consumers of energy), it is also impacting switching and price comparison providers. Price comparison company Compare the Market has suspended its switching tool due to there being too few tariffs being offered by suppliers. Several other price comparison sites have stopped offering deals, but are less up front about it, while today, energy switching service Flipper has ceased trading.

Supplier failures lead to increased market concentration

Six energy companies have ceased trading since the start of September, after Hub Energy (6,000 domestic customers) failed in early August:

• MoneyPlus Energy (9,000 domestic customers) and PFP Energy (80,000 domestic and 5,000 non-domestic customers) both failed on 7 September;
• People’s Energy (350,000 domestic and around 1,000 commercial customers) and Utility Point (220,000 domestic consumers) both ceased trading on 14 September;
• Avro Energy (580,000 domestic consumers), and Green Supplier Limited (255,000 domestic customers and a small number of commercial customers) both failed yesterday.

E.On was the Supplier of Last Resort (“SOLR”) for Hub, while EDF Energy was assigned to Utility Point’s customers. British Gas was appointed SOLR for MoneyPlus, PfP and People’s Energy. A SOLR has yet to be announced for Green or Avro, the latter being the largest supplier to fail by some margin. As a result of its SOLR activities this year, British Gas has gained over 440,000 new customers.

Bulb, the 7^th largest supplier, and minnow Igloo are both rumoured to be in distress and may be the next to close, while Ofgem has written to five suppliers, including Igloo, issuing them with provisional orders to make the payments necessary to meet their Feed-in Tariff (“FiT”) levelisation obligation. The amounts owing are:

• Igloo – £316,582
• Colorado Energy – £261,406
• Symbio Energy – £146,239
• Neon Reef – £37,351
• Whoop Energy – £3,780

Market concentration is likely to rise further since Ofgem is overwhelmingly more likely to appoint one of the larger suppliers as SOLR to the newest failures not least because in these markets it is hard to find people wanting to acquire new customers.

Why are suppliers failing?

The Government is consistently repeating its mantra that “badly run” suppliers are failing. This is pretty unfair for the most part – any business is going to fail eventually if its costs rise rapidly and it is prevented from passing those costs to consumers.

“The government will not be bailing out failed companies, there will be no rewards for failure or mis-management. The taxpayer should not be expected to prop-up companies who have poor business models and are not resilient to fluctuations in price. We must ensure that the energy market does not pay the price for the poor practices of the minority of companies and that the market still maintains the competition which is a feature of today’s current system,”
– Kwasi Kwarteng, Secretary of State at the Department of Business, Energy and Industrial Strategy

However, this messaging is not persuading the press and therefore the public. News outlets are explaining that wholesale prices are rising and talking heads are laying out how it simply isn’t normal for a government to prevent businesses from increasing prices in response to higher input costs. Despite the Government stating that the crisis is temporary, Ofgem has stated that higher gas prices may well persist beyond the near-term, as have many analysts, and the press is relaying all of this to a worried public.

The Express reported the interview of Dale Vince, the founder of challenger supplier Ecotricity by Emily Maitlis on the BBC’s Newsnight programme today:

“The cap is one of the fundamental problems today….But at the same time, normally a business where its input cost goes up, it puts up its retail price to keep yourself whole. These companies are prevented from doing so by the Government’s price cap. It is a very unrealistic measure and it’s going to force dozens of companies out,”
– Dale Vince, founder, supplier Ecotricity   

He went on to discuss the issues with the SOLR process, saying that the difference between the price cap and market prices generates a deficit of about £400 per customer (presumably on an annual basis). Since 1.5 million customers have lost their supplier, that means SOLRs need to take on £600 million of additional cost, which no-one will want to do.

Sky News has an explanation on its website about hedging and how many smaller suppliers can’t afford the “insurance-like” costs, and also says that suppliers have “razor-thin margins”.

At this point the Government needs to read the room and stop pretending that mis-management is to blame for the supplier stress, and that this energy market crisis is a short term problem. Neither is true.

Why the price cap is flawed and should be removed

Energy supply is not a high margin business, but the Government appears to believe otherwise. Suppliers do not make large profits (and have not done so for a long time) despite the Government’s successful attempts to persuade the public that rising bills are the result of supplier profiteering rather than the truth: that 23% of electricity bills are a pass-though of green taxes, and that a portion of network costs (c22% of bills) is a result of the costs of integrating subsidised renewable generation into the electricity system.

In it’s impact assessment for the price cap, the Government said that:

“The objective of this intervention is to protect domestic energy customers from unjustifiably high prices, which have resulted in £1.4 billion in annual detriment, until the conditions for effective competition are in place.”

The document goes on the say that the Competition and Markets Authority (“CMA”) has found that  “on average the customers of the six largest energy suppliers were paying around £1.4bn a year more than they would in a truly competitive market over the period 2012 to 2015”. I analysed these claims and found that they were untrue based on a study of the Consolidated Segmental Statements the Big 6 suppliers were required by Ofgem to product and which had to be validated by their auditors.

Stephen Littlechild, Emeritus Professor at the University of Birmingham, and Associate of the Cambridge Judge Business School shares this view (albeit for different reasons):  

“I argue that the cap was a mistake: there was no such detriment and there are valid reasons for customers not changing supplier…. There was no customer detriment of £1.4 billion – £2 billion: the CMA used a mistaken calculation, inconsistent with economic theory, with previous competition authority practice, and with its own Guidelines.”

Littlechild was previously Director General of Electricity Supply between 1989 and 1998, so he knows something about the energy markets. His paper is worth reading as he provides a narrative describing the history of competition in the market, and how the actions of the Government and Ofgem have actively undermined this. I have summarised his description of the market in the box below. He then explains why the CMA’s claim of £1.4 billion of excess profits was flawed:

In its review of the energy market, the CMA attempted to quantify the detriment associated with its analysis that the market was un-competitive by determining the prices that would be seen if the market was fully competitive market.

In 2014, the CMA’s predecessor, the Competition Commission carried out a similar analysis of the cement market in which it ranked the existing companies in order of increasing unit cost, noted their maximum capacities, and then calculated the competitive price as the unit cost of the marginal plant – that is, the cost of the highest-cost plant needed to meet demand. Customer detriment was measured by excess profit – the extent to which market prices exceeded that competitive price. This was in accordance with standard economic analysis. 

However the CMA assumed that the competitive price in the retail energy market was the unit cost of the lowest-cost plant available in the market, and it defined the competitive price as the price that would be charged by “a hypothetical construct, a ‘supplier’ that is a combination of the suppliers that we have identified as being the most competitive in the markets”. This seems to refer to two new entrant companies with lower costs than most of the other companies. However, this “hypothetical construct” is essentially what the CMA Guidelines call “an idealised perfectly competitive market”, which the Guidelines say explicitly will not be used as a benchmark.

I criticised the CMA’s conclusions from a different perspective – that the audited financial results of the Big 6 did not indicate they were making anywhere close to £1.4 billion in profits in their retail supply businesses, and the only way such profits could be evidenced would be if the companies were mis-allocating supply profits as generating profits, which were higher. They may have been doing this, but the correct response would have been to require them to report their activities in accurately rather than impose an industry-wide cap.

Also, the Big 6 have changed significantly since this time and for the most part are no longer vertically integrated. Had vertical integration provided material benefits to these companies, presumably they would have remained vertically integrated, but since only two of them still combine supply and generation and only one of these has conventional generation in its portfolio, the it is reasonable to conclude that vertical integration does not provide any significant competitive benefit.

Had the CMA followed a more conventional approach to its analysis (and its own Guidelines) then the amount of excess profits would have been assessed at around £170 million per year – an order of magnitude smaller than the £1.4 billion claimed – and that this finding would be consistent with the impact of Ofgem’s simple tariffs policy which had led to higher profits (see box below).

In other words, had the CMA followed its own Guidelines it would have found that it was the actions of Ofgem which had led to excess supplier profits, and since the CMA had already identified the issue with the simple tariffs policy and Ofgem has withdrawn the restriction, the problem had already been remedied. Even with its massive over-estimate of the customer detriment the CMA did not believe a price cap was appropriate. Unfortunately the reported numbers were so large that it hit the news, and the cap became politically popular.

Talk of “windfall taxes” may make things worse

Business Secretary Kwasi Kwarteng told MPs that the Government is “looking at all options” when asked if Britain could follow Spain’s lead in introducing a new tax on energy companies’ windfall gains. The obvious question is what is considered to be a windfall gain in this instance.

The British market is far more fragmented than the one in Spain, and British policymakers have a better reputation for regulatory stability than their Spanish counterparts. In the past, policy changes that have been applied both retrospectively and retroactively in Spain harmed the country’s reputation and deterred investment in the country’s energy sector, as well as sparking litigation against the Government.

It could be argued that renewable energy developers have benefitted from windfall profits, due to generous subsidy arrangement, but I highly doubt the Government will try to claw any of that back now, particularly with COP 26 on the horizon. Upstream gas producers might be earning windfall profits, but after years of low gas prices during which they continued to invest in the sector, preventing them from benefitting when prices rise would have a chilling impact on investor confidence. It would also impact the ability of these companies to pay dividends, and since many of these companies are listed on the stock market, that means that ordinary investors would suffer, including pension funds.

“What we’re seeing now is that the UK needs gas. A windfall tax may make it difficult for companies such as ourselves to continue making the level of investment we’re planning in the next few years,”
– Mitch Flegg, chief executive, Serica Energy

Nuclear power producers are able to sell their electricity at high prices without facing higher fuel costs, but the nuclear fleet it falling apart at the seams and these additional profits would be better spent investing in plant improvements to increase availability over the coming winters and mitigate the looming capacity crunch. Taxing this additional income away would also harm confidence in the sector at a time when the Government would really like to see viable proposals for new projects coming forward.

CCGTs have been earning good money in the Balancing Mechanism (“BM”), but have had to pay higher prices for their gas. Taxing away their additional profits from balancing activities would likely see them requiring higher prices in the capacity auctions. Auction prices have risen in the past few rounds, reflecting the narrowing capacity margins and the additional income required by the aging fleet of power stations to be maintained in good working order. As with the nuclear fleet, these investments are sorely needed, and taking from these generators now in the form of additional taxes only to give back more later through higher capacity prices makes little sense.

Coal power producers have also been earning well in the BM, and as they are slated to close over the next few years, they could be seen as an easy target. Except we still need them and it wouldn’t take much for them to sell out of their existing capacity contracts and close early, which would be a disaster. Given the parlous state of the nuclear fleet, the Government should really be considering delaying their closure until at least 2026 when Hinkley Point C is due to open, not pushing them out of the market earlier.

The other relevant point is that many companies have hedged their gas price exposures both on the producer and consumer side – a well hedged producer isn’t earning windfall profits because it will be paying out on its hedges. Typically, upstream gas producers finance part of their operations with asset-backed loans known as “reserves-based” or “borrowing-base” lending. Often a condition of this type of lending is that a portion of the output is hedged in order to secure the cashflows required for debt service.

This means that it would be very difficult to define what constitutes a windfall profit. And since the current situation is driven by global market dynamics, many of the companies profiting from the situation are foreign – as The Guardian put it: “HM Treasury can hardly send an invoice to Gazprom or Qatar”.

Windfall taxes would be difficult to structure fairly and are likely to have significant adverse consequences which could impact investor confidence in Britain’s energy markets for years to come, turning a short-term crisis into a long-term disaster. They are best avoided.

What should consumers do in the face of rising bills?

Out of interest I looked at some price comparison sites to see what deals might be available. Compare the Market has suspended its service, and while uSwitch appears to be offering deals, none were available for any of the addresses I entered. Go-Compare is also not offering deals. The cheapest deals I could find were all standard variable tariff deals ie those that are subject to the price cap. There were no cheaper fixed price deals available.

On MoneySupermarket, the cheapest fixed price deal was 2-year tariff at £245 /year higher than the SVT. Two suppliers had deals at this price level and then the next cheapest was a 2-year deal that is £416 /year higher. On Money Saving Expert, the cheapest deal was £316 /year more expensive for 2 years fixed (but they couldn’t actually offer it), and the next cheapest was a staggering £1,344 more expensive for 1 year!

SimplySwitch announces proudly on my results page: “Switching now will save you up to -£354.46 a year!” which was for 2 years fixed – the next cheapest was a 1-year deal was with the same supplier at £629 more expensive.

The conclusion from this is that the best option for consumers is to be on an SVT, although whether suppliers will actually accept new customers onto SVTs isn’t clear.

What should the Government do to address the crisis?

Policy Exchange has this week suggested five potential policy actions for the Government:

An emergency price freeze, which it did not recommend as it would potentially deepen the crisis and lead to the Government having to re-nationalise a chunk of the industry;

Bill rebates either by subsidising bills or removing the environmental and social policy costs. In 2014-15, the Government gave customers a rebate of £12 each per year to reduce the impacts of environmental and social policy costs which cost the Government £620 million over the two years. Unfortunately the current increase in wholesale prices means the rebates would need to be in the order of £200-£300 per year or more, which would cost £5.6 – 8.4 billion per year. Given other pressures on public finances, this is unlikely to be feasible, so a loan-type structure might be better where the Government could reduce energy bills by £200-300 next year and recover this cost over five years through a consumer levy of £40-60 per customer per year.

Deferring investment in energy networks, renewables and energy efficiency which are paid for though energy bills would also save money for consumers in the short-term although delaying them might make them higher overall. Policy Exchange suggests that cuts to new renewable projects might increase energy bills as current wholesale electricity prices are “significantly higher than the cost of new offshore wind farms”. I’m not sure that this logic holds since part of the current problem is lack of wind which cannot be solved by building more wind farms. Rather than suspending these costs, the Government should move them from energy bills into general taxation – as the poorest consumers typically do not pay income tax, this would tilt these costs towards those who are better able to afford them, while targeting relief at those on low incomes.

An emergency cut in carbon prices, which is now feasible since the UK left the EU ETS. Unfortunately, carbon costs make up a relatively small portion of energy bills, so the impact would be relatively modest. This would also risk damaging the UK’s reputation internationally and undermine the ambitions for the COP26 climate conference in November.

Increasing the Warm Homes Discount (“WHD”) is Policy Exchange’s preferred option as it would be targeted to those who need it most. Unfortunately the WHD is funded by all suppliers and administered by suppliers with 150,000 domestic customers or more. This option is not suitable in my view as it requires an increase in supplier costs at a time they are already struggling with costs and cost recovery.

I propose a different approach.

The VAT reduction would be offset by the fact that rising wholesale prices mean the tax receipts on the energy bills of industrial and commercial consumers will be much higher than the Government had budgeted for, making the measure more affordable. This option also has the benefit of being quick to implement.

Finally, the price cap has to go. It should never have been introduced in the first place, and it is now forcing suppliers out of business which will create new costs for either consumers or taxpayers depending on how these failures are managed. It is also clear that no-one is buying the Government’s line about suppliers being responsible for their own difficulties, so it’s time to face reality and take meaningful, credible action.

The alternative is maintaining the status quo, and seeing the market shrink back to maybe 6-10 suppliers, major overnight price increases for people whose supplier has failed, state funding for the SOLR process, and a constant stream of bad news about chaos in the energy markets.