As the price cap falls below the EPG, is the energy market set to re-open?

On 25 May, Ofgem announced the new price cap level that will apply from 1 July. The cap level is to fall from £3,280 now to £2,074 for a typical dual fuel household. Of course, consumers currently benefit from the Energy Price Guarantee (“EPG”), which has limited bills to £2,500 per year assuming an average consumption level. This reduction in the price cap will see it falling below the EPG, and raises the prospect that the market might re-open with suppliers offering fixed price deals, leading to a return to competition and switching.

Despite this welcome reduction, households will still be paying more than double the £1,042 they were paying in the Winter of 2020/21. There is a widespread expectation that prices will remain at roughly this current level for the next couple of years, which is causing concern to energy poverty charities and intensifying calls for a social tariff.

Price cap falls significantly but further reductions are unlikely and prices may yet rise again

The reduction in the price cap is overwhelmingly due to the reduction in wholesale costs which have fallen significantly since mid-December. The price observation period for the new cap period beginning on 1 July was mid-February to mid-May during which time prices fell by around 45%. Cornwall Insight is forecasting that the cap will remain broadly at the current level for the next two quarters.

However, current gas and electricity forward curves, indicate risks. Both gas and electricity forwards are trading higher, by successive months, until early next year, when they decline again. This reflects two aspects of the fundamentals: the first is seasonal – prices are almost always lower in the summer than in the winter because demand is lower. The GB gas market is typically well supplied in summer, and is normally exporting to the EU in order to remain in balance, due to a lack of domestic storage capacity. In winter, this reverses as demand rises. Electricity prices tend to follow gas prices.

The other aspect of the fundamentals relates to the wider gas balance across Europe. A mild winter allowed the EU to enter the summer gas injection season with above average inventories, but lower prices make it harder to compete with Asian markets for LNG – JKM spot prices are above the European benchmark now for the rest of the year making it more profitable for US sellers to sell into Asia than Europe.

“Europe can’t be complacent as only 40-45% of its winter LNG demand is contracted, narrowing the buffer versus demand upswings or potential disruptions,”
– Patricio Alvarez and Joao Martins, analysts at Bloomberg Intelligence

Imports from Russia continue to be minimal, limited to flows through Ukraine and Turk Stream. Nord Stream continues to be inoperable, and the Yamal pipeline has not returned to east-west flows despite suggestions it might late last year.

Although Japanese LNG demand is falling as the country continues to bring its nuclear power stations back into service (there are now ten up and running), elsewhere in Asia gas demand is rising. India is pressing ahead with the large-scale implementation of LNG import infrastructure, while the Philippines and Vietnam are ready to begin commissioning several LNG terminals this year. Thailand and Bangladesh are trying to secure additional volumes from the market. Chinese demand is also recovering after covid, increasing by 16% in the year to March, although there are some doubts as to the strength of this recovery. While not all of these countries will have the financial fire power to outbid European buyers, the additional competition will put upward pressure on prices.

This means that there are risks to Europe’s gas supplies heading into next winter which could see prices rise significantly. Analysts at Goldman Sachs suggested they might treble by the winter:

“While this lower-than-expected rebound in European gas demand buys Europe more time, it doesn’t solve the market deficit we see lending support to prices next winter and in summer 2024. Even if industrial demand remains sluggish this summer. This is not a guarantee that storage will be comfortable throughout winter, as there is only so much capacity to store gas ahead of heating season,”
– Goldman Sachs research

So far in the price observation window for the next price cap starting in October, prices have continued to fall, but the period has barely begun. Should prices rise, including through the summer – the August and September contracts are both trading above July which is not encouraging, and as expected the October, November and December contracts which suppliers are using (or their equivalent forwards) to hedge the next price cap are all also higher.

In addition, there will be changes to the price cap methodology from October, including a likely increase in the EBIT allowed from 1.9% to 2.4% of the full price cap level, which will add about £10 per year to the average bill. Of course the press has jumped on this as a negative, complaining that “Ofgem wants your energy supplier to make more money”, but the increase is modest and necessary. Ofgem believes that increasing the EBIT margin will be positive for consumers as it will reduce the chance a supplier will fail and therefore the chance consumers will pay the socialised costs of those failures. Although other regulatory changes are also designed to reduce the risks of failure, it is certainly true that when profit margins are low, suppliers struggle to accumulate the reserves needed to see them though difficult periods.

As prices are expected to remain relatively high is a social tariff the answer?

There have been widespread calls, including from Ofgem, for the introduction of a social tariff for energy to protect vulnerable consumers, with many people also noting that the price cap was originally intended to be a temporary measure until “the conditions for effective competition in this market are in place”

“The introduction of a social tariff for energy would be a significant step in the right direction. The funding of it will be a policy decision for the government but if we can get this right and deal with the root cause of the affordability crisis, some of the difficult issues around fitting prepayment meters should no longer be necessary,”
– Chris O’Shea, Chief Executive, Centrica

Age UK recently wrote a Parliamentary Briefing calling for the government to directly fund a 50% energy bill discount for those in “greatest need”, saying this must:

• include automatic enrolment for eligible households
• be universal across suppliers
• sit alongside existing consumer protections
• be accessible for all customers struggling with their energy bills

It said this should apply regardless of how energy is paid for, what type of fuel is used for heating, and whether the household has access to the welfare benefits system. Age UK believes this discount should be paid for through taxation rather than bills to avoid the current situation with other benefits such as the Warm Homes Discount, where people who only just fail to qualify for the support pay for it to be extended to others, thereby making energy less affordable for themselves. The charity also wants households on this tariff to be exempt from standing charges.

According to Age UK, 7 million households are currently in fuel poverty ie more than a third of the country’s 19.4 million households. That represents a significant challenge for any social tariff scheme, and underlines the importance of not trying to fund such a scheme through bills, since it would likely push more households into poverty. Age UK pointed out that Belgium has a social tariff which benefits 20% of its population, where household have a one third discount on their bills – yet the scheme it is proposing for the UK is both more generous and more wide-reaching, and would be difficult to afford.

A paper by the University of York for the Child Poverty Action Group suggests that if the objective is to mitigate 50% of fuel stress it would be necessary to extend mitigation to 70% of households. Previous studies by the University had explored two options for delivering a social tariff: a fixed £x discount in £ terms on bills (eg equivalent to abolishing the standing charges/prepayment premiums), or a fixed discount in £ terms on the bills of low-income consumers (but the question is where to draw the line). In this study, it considered a third option, reducing bills for lower-income households by a percentage which declines as income rises. This is similar to a previous suggestion I have made of tiered support, where households receive different levels of support depending on their income levels. My suggestion was to link it with income tax bands as this would be relatively quick to implement, but I recognise that it has limits relating to households with more than one wage-earner.

The study found that in principle, this approach would help to bring the fuel poverty rate down from 20% to 9% at an additional cost of £24 million per week (which translates to £1.25 billion per year) to taxpayers. However, it goes on to say that “operationalising such a system requires a reliable way for the government to identify low-income households, which is not straightforward”, which also reflects the downsides of my proposed solution – I came up with a model that had obvious drawbacks but was at least well defined. The York study does not attempt to offer a means of making the necessary household selections.

Of course, even a selection based on income tax brackets would miss people with specific needs such as those who have average incomes but very large energy bills due to the need to run medical equipment in the home. But these are a minority of people who are likely to be in regular contact with health authorities, so a medical certification system could be added so that people having such medical needs could receive a certificate from their doctors that would allow them to benefit from the social tariff.

However the idea of a social tariff does not have universal support, with some critics pointing out that it narrows the idea of vulnerability to purely financial considerations. This is indeed true – vulnerability, as I have often said before, encompasses much more than just poverty. Disability, poor literacy and numeracy, and digital exclusion are all other major causes of vulnerability, and there are temporary causes as well such as ill health or bereavement. I understand this very well, since I live with a disability and have recently suffered a bereavement (one of the reasons the blog has been quiet recently) but although I do not consider myself to be vulnerable it is certainly true that these things take a lot of time and energy, leaving less time and energy for other things. Personally, I’m not interested in changing my supplier, but I am now thinking about whether it might be time to look at fixed rate deals, but that means finding the time to look at the options and do something about it.

As the energy market re-opens, if Ofgem up to the challenges ahead?

After 1 July, the Energy Price Guarantee will no longer be lower than the price cap, so most people will go back to paying a market price for their energy. There is also an expectation that fixed priced deals will also be offered again by suppliers, providing a basis for competition. So there is an expectation that the market may begin to revive, but the question is by how much? At the start of the energy price crisis in late 2021, I questioned whether Ofgem was meeting its statutory duties under the price cap legislation, specifically in relation to ensuring the cap is set at a level which:

• creates incentives for holders of supply licences to improve their efficiency;
• sets the cap at a level that enables holders of supply licences to compete effectively for domestic supply contracts;
• maintains incentives for domestic customers to switch to different domestic supply contracts; and
• ensures that holders of supply licences who operate efficiently are able to finance activities authorised by the licence.

Of course, Ofgem is of the opinion that these objectives are merely guidelines and that ignoring any or all of them is at its sole discretion. However, the regulator has been strongly criticised for its regulation of the retail market, and although it was rarely stated explicitly, if it had followed these objectives, some of the problems might have been avoided.

Later this year, Ofgem expects to increase the EBIT margin suppliers can earn. This is helpful, but probably does not go far enough – suppliers need to earn decent profits to enable them to build reserves ahead of future market volatility, and to provide a cushion to support innovation (without which suppliers are likely to continue to be risk averse with their business models). However, the idea that suppliers should earn any profits let alone more profits is deeply unpopular, partly because energy has become so expensive – something for which suppliers cannot be blamed – and partly because other energy companies, in particular oil and gas producers, have earned record profits in the last couple of years.

But the solution to expensive energy is not to cut supplier profitability. If there is a genuine consensus that suppliers should not earn profits then the industry should be nationalised – this is unlikely to be in the best interests of consumers, but it is the only logical approach if people want energy to be treated as a social good. The alternative is to reform the market. Sensible reforms would be to strengthen prudential regulation to reduce the risk of supplier failure, but to reduce other aspects of the regulatory burden, in particular the non-supply activities imposed on suppliers. I continue to be of the view that green levies should be recovered through general taxation, that the Warm Homes Discount should be rolled up into the benefits system, and that the Energy Company Obligation should be the responsibility of local government. The smart meter rollout should be completed by distribution network operators. And the price cap should be abolished, freeing suppliers to set their own prices on whatever basis they see fit.

By reducing the regulatory burden and allowing suppliers to become profitable, the market will become attractive for new entrants with genuinely new business models. Consumers will have wider choice, with options to chose based on price, or based on different types of value-added services. Protection of the fuel poor should be the responsibility of the government, through a tax-funded social tariff, which provides a basic amount of energy at cheap rates (with sensible exceptions for people with health-related high energy needs). This basic tariff would be a simple, unique, price-based offer – there would not be multiple variations as expected in the rest of the market.

I also continue to believe that the retail energy market should be regulated by the Financial Conduct Authority under the supervision of the Treasury. I have little confidence that Ofgem could design the necessary regulatory reforms. Ofgem has a very wide remit, and despite being one of the largest energy regulators in the world by headcount, it struggles to deliver its various mandates because it has too much to do. High staff turnover does not help. Neither does its persistently hostile tone towards suppliers.

As market fundamentals improve there is scope for a proper retail energy market to develop. Can Ofgem rise to the challenge?