New customer support schemes will need very careful management

1 October 2022, marked a momentous day for the British retail energy markets, indeed for the nation as a whole. On that Saturday the Energy Price Guarantee (EPG) commenced for household customers and the Energy Bill Reduction Scheme (EBRS) for businesses.

Not since March 1990 have ministers had so much direction over the prices paid for electricity and gas by the vast majority of consumers. Back then, the largest users broke free of prices driven by a centrally-set Bulk Supply Tariff to negotiated contracts. In the intervening years, retail markets for gas and power fully opened and price controls were lifted, only for a process of re-regulation to begin from Ofgem’s 2008 Energy Supply Probe to a Default Tariff Cap we have had for households in one form or other since 2017.

The reasons for the incremental interventions to date have been national, mainly concerns about the fairness of pricing from a consumer perspective. The EPG and EBRS have been triggered by international factors, namely the surge in European wholesale energy prices accompanying the Russian invasion of Ukraine. But as we discuss in here, whatever the reasons for their coming, how and when they might be managed – let alone removed – looks like a major challenge.

Vast majority of households will be subject to Energy Price Guarantee

The two interventions go with the grain of their respective markets. The EPG effectively sets a Default Tariff Cap-like charging schedule aimed at £2,500/year + VAT for the typical medium user as defined by Ofgem. Without the intervention, the Default Tariff Cap would have increased to the equivalent of £3,549/year + VAT for Ofgem’s typical medium user. The EPG is to be in place for the next two winters, and the coming 2022-23 season households will also benefit from the measures announced by then Chancellor Rishi Sunak back in May. These payments will reduce most consumers bills by £400, with more available for groups of vulnerable consumers, cited as having a cost of £15bn.

There are many complexities to be navigated but, from the supply side perspective, money equivalent to supporting the tariff rates will be provided from the UK state based on consumption information held by profile class by the respective market operators. The government has also said that the two schemes are based on equivalent wholesale costs, with the differences between the figures cited below for fuels between the two schemes, due to the treatment of policy costs.

Extending the Default Tariff Cap risks a sub-optimal energy hedging strategy for households

Even without the EPG we would be asking some fundamental questions about what we want the retail market to achieve. The UK Government wants to introduce legislation for the Default Tariff Cap to continue after next year, and has done so in the proposed Energy Security Bill. As drafted, the Bill would allow the extension of the cap for two years at a time by the Secretary of State where they “conclude that the conditions for effective competition have not been met for domestic supply contracts.” The Bill has no longstop date, “reflecting the need to remain flexible and keep the cap in place until the conditions for effective competition for domestic supply contracts are in place”. If we are right and wholesale prices are set to remain at historically very high levels for much of the decade, not only will there be huge pressure for the current bill relief schemes to continue, but very likely we will also be in a world where the Default Tariff Cap continues to apply. The cap was confirmed as applying for another year in August by Ofgem.

We expect the risk premium in the forward curve to remain very substantial, due to the increased potential for unexpected events to disrupt gas supplies into Europe, especially as those volumes will typically be flowing from much further away. If this is so, we would expect questions about whether forcing domestic suppliers to hedge (and then be subsidised) according to a single, very blunt hedging strategy is the most prudent use of their money as well as that of consumers and taxpayers. It is not a great leap to suggest different buying mechanisms or even buyers, especially if a Great British Energy-like entity is involved in investing in renewables. OVO Energy has gone further and recommended that a new Future System Operator’s role “should be expanded to allow for the long term procurement of the nation’s primary energy needs guaranteeing physical supply and providing price stability”.

Need for clear governance and defined responsibilities

Even before we consider who should continue to be eligible and exactly how we should pay, there are significant risks of unintended consequences and very expensive costs from adding the EPG to a scarcely functioning Default Tariff Cap. The EPG, and to a lesser extent the EBRS, have set consumer expectations of the most it is reasonable for them to pay. So long as markets remain above their levels, there will be huge pressure for them to continue, with potentially huge costs.

We seem to have decided that the purpose of the retail market is no longer to deliver choice, efficiency and innovation but, with significant state help, to limit the distress driven by increased international competition to secure gas supplies. This situation may be prompted by an international emergency, but if applied over a longer period time it will have significant consequences for the national energy market. While more efficiency on the demand side needs to be encouraged, we could well see the market inherently smaller and more unstable if those that cannot afford energy switch off and those that can opt out with their own generation and storage. We need to be careful that people do not leave the grid in either of these circumstances because of the blind imposition of a purchasing strategy that cannot cope when markets fear structural shortages.

Spending such large amounts of taxpayers money is necessary to keep social and economic life going this winter, our politicians have decided. Now that decision is made, it will require good governance and joining the dots to avoid as many unintended consequences as possible. Tough decisions will be required, especially if wholesale prices prove very much stronger for very much longer, and good information needed on which to base them.

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