The UK was historically respected globally as a leader in encouraging liberalised, competitive and efficient energy markets balanced by carefully designed regulation. So why do we have an energy crisis, with rapidly rising energy costs, suppliers going out of business and the spectre of a sharp rise in domestic energy bills from April? How much of this situation is of the country’s own making?
We need to consider separately the drivers of global energy prices, which we cannot control, and the design problems of our domestic market.
Energy prices are the result of global supply and demand, and coming into winter stocks of natural gas were below average in every region for two reasons: extreme cold weather events last winter drew down stocks; and then the pandemic temporarily affected energy demand, sent prices to very low levels and caused global energy investment to fall by around 20 per cent in 2020. Lower investment resulted in lower supplies and ability to rebuild stocks; then the economic rebound drove demand up quickly, with supplies not quite able to compensate. Between 35 per cent and 40 per cent of the UK’s power generation is still from natural gas and so our electricity prices are on the rise, too. These are global market forces that we cannot control and will take perhaps to the end of 2022 to settle down.
So what has gone wrong in the UK energy market? There have been five fundamental design mis-steps.
First, numerous new suppliers were encouraged to enter the market to drive competition, but with almost no requirements to have the necessary financial resources to manage the risk. Wholesale energy prices can be extremely volatile and energy suppliers are expected to use hedging to manage price risk. In addition, when you sell someone energy, you do not know how much they will use. That depends on the weather. So they need the financial strength and capabilities to manage both price and volume risk.
Then, there was a disproportionate emphasis by the regulator on encouraging customers to switch, driving a focus only on price as the differentiator between suppliers. To attract customers using only price, some new entrants began selling fixed-price energy at negative margins. Combined with the minimal criteria for financial strength, this should have been seen as a warning signal of a potentially unsustainable model, but instead the associated switching was lauded as a success.
Third, safety-net measures were introduced to protect customers if a supplier went bust. Supplies were guaranteed and financial losses arising from commitments to customers were spread across the market. This encouraged risk-taking with limited downside by the customers and the energy companies, with the cost of any failure largely borne by everyone else.
Fourth, despite evidence from other countries of the unintended consequences, the government decided to introduce the energy price cap to limit energy bills and protect certain customers. This reduced supplier profit margins to extremely low levels and added a further difficulty in managing risk, especially if prices were to rise sharply.
Finally, the significant and growing costs of environmental policies to encourage the transition to a lower-carbon energy system were charged through customers’ bills rather than through general taxation. These costs alone run to over £4 billion per annum for consumers. Such an approach is regressive, disproportionally affecting those least able to afford it.
These design factors have resulted in significant upward pressure on bills and an asymmetric exposure to any sharp rise in wholesale energy prices, which we are experiencing.
Unsurprisingly, this has led to market failures of ill-equipped suppliers, but with only temporary insulation of consumers by the price cap mechanism. The next price cap level from April will be dramatically higher. Should ministers intervene?
Calls for poorly equipped energy suppliers to be protected from bankruptcy should be resisted. The safety net mechanisms are in place to protect the customers and companies that fail knowingly participated in a complex and risky market without the necessary strength and capabilities. However, in some cases the losses could be so large that it may be necessary to provide bridging loans to encourage other companies to take on the customers of failed suppliers.
To help consumers with higher energy bills, the options are limited and they would all take the form of further temporary subsidies from the government.
The scale of the increase means the near-term focus should be on helping the vulnerable and those who can least afford the higher bills, but to keep the interventions simple to administer. The government should provide a rebate for part or all of the April price increase directly to those customers who are already eligible for the warm home discount and it should consider whether to expand eligibility.
Second, there is the option of temporarily removing the 5 per cent VAT in the energy bill but this is simply a form of temporary subsidy for everyone.
Third, for the longer term, environmental policy costs should be removed from the energy bill and be funded instead from general taxation. The costs of the energy transition will have to be borne by society, but the wealthier should bear them disproportionately.
Finally, as envisaged when it was introduced, the energy price cap mechanism should be reviewed and phased out, as it is a blunt intervention in competitive markets, introduces extra risk for suppliers and does not protect consumers against the natural pressures of wholesale energy costs.
The UK cannot control global energy prices, but instead of a well-functioning UK energy market with which to face this situation, we have the compound effects of layers of often-populist, short-term interventions which have resulted in some very predictable and avoidable negative outcomes — in short, something of a market failure by design.
Iain Conn is former group chief executive of Centrica