Climate change means energy policy matters long term. But recent events are a reminder that the sector can still stumble over immediate contingencies, and as government navigates between price caps and supplier failures there are lessons to learn about the fragility of competition in regulated markets.

Gas market volatility is to be expected, but the UK is particularly exposed

Natural gas prices have spiked very considerably in September 2021, [1] and the UK has found itself particularly vulnerable. International markets have been hit by high demand from Asia and constrained supply from Russia. At the same time, national supply has been hit by a fire in Kent and low wind levels. [2] It is the perfect (lack of a) storm.

The UK’s exposure to the spike has been exacerbated by suppliers’ financial weakness, combined with reductions in storage capacity that were known to be risky at the time. [3] With hindsight, the government and Ofgem, the energy regulator, may have paid insufficient attention to these issues, and they should now stress test the sector’s resilience for the future. [4]

The UK still has considerable domestic gas production capacity as well as reliable supply lines from countries such as Norway, so the price spike does not imply a material risk of supply failure. But producers charge market prices and maintaining supply will be expensive. The question is how that cost should be distributed between government, consumers and suppliers.

It is reasonable for government to maintain protections for domestic consumers

UK domestic consumers are protected by an energy price cap set by Ofgem. This maximum “fair” price per unit of fuel is intended to be well above the provider’s cost, allowing for a profit margin.[5] Updated every six months and already fixed for the period from October to March, it does not reflect the recent wholesale price spike and leaves some suppliers unable to charge enough to cover their current costs.

Wholesale price volatility is a key risk domestic energy suppliers face and the price cap – including its semi-annual method of calculation – is well-established and transparent. The cap is based on the average price of buying forward contracts in the previous February to July, meaning suppliers that did not buy ahead took a calculated gamble. [6] On the other hand, hedging is expensive, particularly against extreme spikes. So in the competitive energy market government has nurtured, suppliers that don’t hedge have a competitive advantage in good times.

The stated aim of the cap is to protect “sticky” consumers, who tend not to switch providers, from excessively high default tariffs in an increasingly fragmented energy market. It is not intended to mitigate high prices across the board or even to combat price volatility. [7] On this basis, suppliers might have hoped for more help from government, but the cap has not previously been reduced between scheduled review dates and current concerns over the cost of living mean raising the cap from its current level now to help suppliers would have been hard to justify. It is true that energy suppliers’ business models became riskier due to the pandemic, but that is true for many and government cannot pick up the tab for this indefinitely.

Future competition in energy markets will depend on how such decisions are interpreted

Energy markets will see more, not less, government involvement in future as climate change becomes more pressing. If government wants ongoing competition in domestic supply, it will need to articulate the benefits of that and work hard to sustain it. The potential benefits may in fact be limited because retail energy suppliers control only a modest proportion of their costs, which consist primarily of wholesale and network costs.[8] But assuming government does want to maintain a competitive market, then clear expectations of all parties – including government – will be essential. In a highly regulated environment, competition cannot be furthered just by requiring regulators to promote it: how government behaves under pressure matters too.

Ofgem’s supplier of last resort process – arguably a partial substitute for closer regulation of suppliers – has already been invoked to transfer customers of six failed suppliers to other providers in September 2021, with three more pending appointment. [9] This is a significant achievement for the regulator, but if Ofgem’s process cannot service all failures in the coming months government may still have to finance some struggling providers. If this is needed, it should do so only briefly and on commercial terms after private sector alternatives have been exhausted.

Government is justified in standing behind Ofgem as it holds suppliers to the letter of the price cap formula, but this must be seen to derive from Ofgem’s consistent regulatory approach rather than from a government policy choice to prioritise consumer protection in response to the wholesale price spike. If government wanted to support consumers – to address the cost of living crisis, for example – it would need to do so in other ways (ranging from winter fuel payments to investment in supply resilience or home insulation, for example). If suppliers or their financiers believed government was prone to interfering in the price cap for extraneous policy reasons, only the large multinationals that can weather such political risks might remain in the market and promoting competition could become extremely difficult.

Looking ahead, this implies that any future change in the price cap formula would need to be driven by Ofgem’s regulatory priorities, and not by wider government policy, to be consistent with an ongoing competitive market in retail energy supply. Setting a more interventionist precedent might not only stunt competition in energy but could also unsettle market participants’ expectations in other regulated UK markets, reducing government’s wider ability to encourage competition in such markets in future.

 

  1. BBC, ‘Gas prices: Why are they so high and what is the energy price cap?’ BBC, (no date) retrieved 29 September 2021, www.bbc.co.uk/news/business-58090533
  2. Lynch R and Wallace T, ‘Inside Britain’s energy crisis – and how to fix it’, The Telegraph, 20 September 2021, retrieved 21 September 2021, www.telegraph.co.uk/business/2021/09/20/inside-britains-energy-crisis-fix/
  3. Thomas N, ‘Closure of biggest UK gas storage site draws criticism’, Financial Times, 16 August 2017, retrieved 21 September 2021, www.ft.com/content/564a1ec0-8288-11e7-a4ce-15b2513cb3ff
  4. Osborne A, ‘Ofgem needs to be more plugged in’, The Times, 21 September 2021, retrieved 21 September 2021, www.thetimes.co.uk/article/ofgem-needs-to-be-more-plugged-in-kzr2qrksg
  5. Ofgem, ‘Check if the energy price cap affects you’, Ofgem, (no date) retrieved 29 September 2021, www.ofgem.gov.uk/information-consumers/energy-advice-households/check-if-energy-price-cap-affects-you
  6. Ofgem, ‘Record gas prices drive up price cap by £139 – customers encouraged to contact supplier for support and switch to better deal if possible’, press release, 6 August 2021, www.ofgem.gov.uk/publications/record-gas-prices-drive-price-cap-ps139-customers-encouraged-contact-supplier-support-and-switch-b….
  7. Ofgem, ‘Check if the energy price cap affects you’, Ofgem, (no date) retrieved 29 September 2021, www.ofgem.gov.uk/information-consumers/energy-advice-households/check-if-energy-price-cap-affects-you
  8. Ofgem, ‘Infographic: Bills, prices and profits’, Ofgem, 26 August 2021, retrieved 29 September 2021, www.ofgem.gov.uk/publications/infographic-bills-prices-and-profits
  9. Ofgem, ‘How you’re protected when energy firms collapse’, Ofgem, 26 September 2021, retrieved 1 October 2021, www.ofgem.gov.uk/news-and-views/blog/how-youre-protected-when-energy-firms-collapse

Original source – The Institute for Government

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