Most of the time, “the economy” is an abstract thing – a confection of statistics such as GDP growth, the unemployment rate or the pace of investment. Very occasionally, it cuts straight into people’s lives, directly affecting their wellbeing and sense of security: during a recession, a devaluation crisis, or an episode like the onset of the Covid pandemic.

A spell of sharply elevated inflation is another such time, particularly when the inflation is so concentrated upon one highly visible item – the cost of energy. From my experience advising the Coalition government (2010-14) and May administration (2017-19), UK citizens have never become wholly accustomed to the cost of electricity and gas not being a matter for the government. But energy costs are, unavoidably, the government’s business. One of the key “cut through” moments of the Coalition period was in 2013 when the then leader of the opposition, Ed Miliband, vowed to freeze energy prices. Shares in energy companies fell, ratings for the opposition rose, and energy policy became an urgent policy priority.

The price rises Miliband meant to address were small compared to what the UK faces now. For most of the last decade, government forecasts for gas prices were between 60p and 100p per therm (levels criticized by some for being too high, thereby flattering the case for renewable alternatives). Since mid-2021, they have climbed well above 150p and stayed there, with occasional spikes to 250p and even 450p in December. The impact on energy suppliers’ costs has been extreme, particularly those that failed to hedge to a sufficient degree and were therefore exposed to the full force of those price changes.

Customers have been protected either through fixed price contracts with those companies, or by the cap imposed on the “standard variable tariff” (SVT) that most people default onto. I was part of the Downing Street team that worked to produce legislation for an energy price cap, in the face of criticism that government intervention in markets is always risky. Many critics would see the multiple corporate failures of the past few months as strong vindication of that view.

The price cap is recalculated every six months, and the next such moment (the calculation in February, the price change in April) is likely to see an eye-watering increase of almost 50% in the typical household energy bill. For customers – like me – who had hitherto enjoyed a low fixed-price contract with one of the now-failed companies, the rise is likely to be much higher. Even if people distinguish the decisions made by the regulator, Ofgem, from those of the government, there is no doubt that April’s price rises will be seen as a political matter. Calls are becoming louder for the government to find ways to soften it. So how fair is it to blame regulation and energy policy for the price rises about to hit UK households?

It is far from ideal for there to have been so many company failures in energy supply.

This is in part a reflection of high levels of new company entry into the market in recent years, reflecting a deliberate policy to reduce reliance on what was once called the Big Six. New entrants’ share of the market rose from 3% in 2017 to around 30% in 2019, and by 2018 there were 70 companies competing to supply households.[1]

However, most of these companies gained customers by offering very attractive starter deals, with the hope that they would revert to a very profitable SVT when those deals expired – a strategy condemned by some as “tease and squeeze”. The introduction of the SVT cap was intended to address the perceived abuses of that approach, as high standard prices were seen to disadvantage vulnerable, less engaged customers less likely to shop around for better deals or notice when their tariff changed. 

Long before the current crisis, there had been a number of company failures, perhaps reflecting the imposition of the price cap. In normal times, Ofgem’s “supplier of last resort” programme performed perfectly well in transferring the customers of failed companies to a willing competitor. However, payments still owed for renewable contracts are spread across the surviving companies, a justified cause for complaint. This problem becomes more and more extreme as company failures rise.

Blaming the price cap misses the target

But it is wrong to blame the price cap for current mess in the energy market. Its existence was a known fact when companies set about creating their trading strategies in 2020 and 2021. Of course, had companies been free to jack up their SVTs as quickly as the gas price rose, more might have remained solvent, but only at the cost of passing these steepling costs onto some of their most vulnerable customers. It is true, however, that a more regular review of the level of the cap would have been appropriate in light of such sharp movements in the gas price.

It is fairer to criticize the rose-tinted optimism towards what retail competition can achieve for household energy prices, which itself justified the encouragement of such hectic new company entrance half a decade ago. A glance at any breakdown (see Ofgem’s website [2) shows that most of the bill is made up of fixed and unavoidable items: network costs; social and environmental elements; tax; and wholesale costs, which are largely set in a market that retail companies have to accept as a given. The amount left – operational costs and the company margin – is pretty small, meaning that the underlying gap between the best and worst company is not going to be much more than a few percentage points.

Above all, it is quite right to criticize a system that allowed companies to operate with so little equity to cushion themselves against shocks. In Downing Street I recall one Big Six executive complaining bitterly about companies “that can set themselves up with a mobile phone in a shopping aisle”. Ofgem took action in 2019 after a spate of failures, tightening requirements “to weed out those that are underprepared, under-resourced and unfit.” In retrospect, they might have gone much further, although it is difficult to envisage what it could have put in place to prevent substantial failures in 2021.

Other claimed solutions to the energy price crisis do not survive much scrutiny

Britain might have benefited from there being more energy storage, but the price of the gas stored there would still have largely reflected global conditions and therefore high international prices. As former energy official Adam Bell has pointed out, to fully insulate the country against such fluctuations would have required an unfeasibly large amount of storage. [3] Such storage has to be paid for in normal times – it is insurance, and all insurance commands a premium.

It is also true that faster installation of wind energy might have helped, given the sharp falls in the price of offshore wind. But wind is intermittent, like solar, and so requires the provision of backup capacity (usually gas) on the system too. The marginal price faced by retail companies will still be highly determined by that gas price. Furthermore, by far the loudest complaints about energy policy in the last ten years were that too much wind, not too little, was being installed. [4]

Another frequently-heard suggestion is for certain fixed costs, like those for environmental and social obligations, to be taken off customer bills and paid for by the government. But whatever the technical merits, this merely shifts the cost from the household in one form (energy customer) to another (taxpayer).

UK households used to pay roughly £30bn for their energy needs. The sharp rises of the past six months raise that figure to something closer to £40bn. The complicated system that sits between the generators at one end and the kettle at the other could no doubt be improved, but that cost cannot be made to disappear. Somehow or other, the UK has to pay it, and the question of exactly how is just pure politics.

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  1. https://www.ofgem.gov.uk/publications/state-energy-market-2019
  2. https://www.ofgem.gov.uk/energy-advice-households/costs-your-energy-bill
  3. https://twitter.com/Adam_Grant_Bell/status/1445322637446631432
  4.  See The Economist, “Rueing the waves”, 2014 and the experts quoted there: https://www.economist.com/britain/2014/01/04/rueing-the-waves

 

Original source – The Institute for Government

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