Wake-up call: Cost pressure in the GB energy market

This Energy Perspective was published in Issue 791 of Energy Spectrum on 10 January 2022.

 The current crises afflicting the energy supply sector, driven by rising energy input costs, are of economy-wide concern. The price of energy has always been an issue of significance for national economic competitiveness, inflation, monetary policy, and household affordability. There is nothing new in that. However, the scale of volatility in the market right now is historically unusual. Further, since at least 2010 changes to generation mix, combined with a distorted debate of who is actually responsible for the costs of decarbonising the power sector, has fundamentally changed the nature of policy. In recent years there has been a political and regulatory focus on the “outcome” of the price paid by the consumer through bills and managing this through suppliers. This reached its apogee with the introduction of a domestic tariff cap designed to neutralise rising energy bills as an issue in a general election campaign. Alongside we have had in-depth reviews, re-sets, and strategies aplenty. Most have been focussed on the rapidly shifting incentives on the generation and network side of the market, without resolving three very significant issues:

  1. Reforming the wholesale market so it will better respond to volatile gas driven balancing costs as we move away from fossil fuels over the next decade or so, whilst simultaneously catering for the predominantly low carbon, low short run marginal cost system of the future which we are well on the way to building.
  2. Developing a better understanding of the changing inter-relationship of wholesale prices with consumer costs, and how dynamic commodity-driven and net zero transition costs could shape the unit price of energy born by consumers over time.
  3. A concerted communication exercise that transparently explains to the public the muti-generational return on investment that underpins net zero, given that all political parties have pitched their election platforms on delivering this objective. This includes preparing people for the potential from time to time of facing higher costs in the near term, for a significant return in the long term.

Nightmares

“Market reform” programmes have lifted the lid on all three areas, but policymakers have often opted for expedience, parked detailed impacts on consumers in obscure documents (to the public), and instead focussed on building new instruments on top of the existing design. This has led to ever more complex arrangements and plenty of space for unintended consequences. At the same time, we have had the rather blunt imposition of the Default Tariff Cap. This appeared to be workable in a benign commodity market and was justified as a temporary measure. But it has become open-ended and has failed in the first contact with global commodity rises. Many predicted both would happen, including us back in 2018.

The rush to the cap highlights that managing the impact of rising energy costs on households – when it happens – has been seen as a problem for the energy market and its actors to solve through the energy market itself. Energy companies operating in a competitive market play a key role. They can contribute by driving down cost to serve, can smooth exposure to volatility through hedging, and can reduce costs through innovation. But they can’t reduce or manage market or regulatory induced costs that are outside their control. Nor do energy companies uniquely cause or can solely solve the problems variously arising in the welfare state, the economy or the funding of net zero. At the same time, the ramifications from energy costs spiralling significantly impacts the ability of the UK to achieve a nationally significant objective– the development of a stable and thriving net zero economy. We touched on some of these points in this piece on September 2021. It is paramount that the UK remains strategically on track for these objectives in spite of the current headwinds. Achieving that will rely on a wide-ranging approach. The energy sector can play its part, but it will involve the government recognising the role wider actors and broader policy levers can play to mitigate immediate risks and drive necessary long term change.

Alarm!

There are at least two distinct areas of immediate risk and cost that need to be addressed urgently:

Immediate supplier risks and costs

These are twofold a) dealing with the costs of failed suppliers to date; and b) dealing with the costs arising from global gas price rises interacting with the Default Tariff Cap method, This has driven a huge level of migration of customers from fixed-rate deals to default tariff deals and a consequent crash in switching. The timing lag between wholesale price rises and cap rises means that default deals are now the cheapest in the market. This unexpected shift in the delta between fixed and variable prices, and the resultant changing mix of supplier portfolios, is leaving all suppliers with much higher costs. These costs and risks are potentially very high and have emerged over the winter period. Whilst direct support for suppliers has not been forthcoming to date, the resulting accumulation of costs (which many suppliers would argue they cannot control or avoid) means such solutions may be urgent and more politically palatable now than in the autumn.

To cover these categories of cost some form of loan (whether through SPVs as per Ofgem’s consultation, or loans directly to suppliers from banks for the same purpose) may be the most efficient method and would have the advantage of being bounded in scope and time, whilst not instituting wider ranging changes to the current industry structure in a rush. It is rumoured at least two banks may be interested in principle in providing loans. The precise structure and security they need will guide whether this can be made to work, with some reports indicating that banks will require some form of government guarantee.

The failure of Bulb shows, large suppliers can fail. The supply company administration regime set up to deal with such eventualities transfers risks and costs to the state for a period before eventual recovery from energy consumers over time. The intervening costs of failure are not immaterial. We have no premonition that further large suppliers are going to fail, but if the risk is present that they might because of the interaction of wholesale price rises and the cap, then it would be better that such failures could be avoided in the first place. Loans have the benefit of being quantifiable liabilities and leave a viable competitive market behind in their wake. Whereas a special administration approach waits for failure to happen and could impose higher costs on consumers ultimately, whilst leaving a less than viable competitive market emerging from the aftermath.

Immediate household risks and costs

These are also twofold a) the impact rising energy costs will have on energy bills and b) the impact rising energy prices will have on wider household spending and tax receipts, general inflation in the economy and (because of possible Bank of England rates responses) household borrowing costs. For this second category, some of the options in this summary table that we produced over Christmas are relevant.

A key question is whether directing support to those households most in need through the complex cash flow plumbing of the energy market, either through existing or newly conceived means, is the most efficient means of assistance? Even the Warm Homes Discount isn’t as progressive as welfare-based measures given that the costs of funding payments are recovered from other bill payers with no regard to ability to pay. We would note that there are established welfare measures or general tax decisions that could see household relief that are not only well-targeted but also sees the costs of support spread equitably through the wider tax base.

The cold light of day

In any event there is a real danger that we focus too much on the short-term measures, and that these become long-term solutions by default. It is vital that thinking turns urgently to what that vision is for energy across the value chain, and that the time bought by some of the short-term interventions is used to develop this. This includes addressing the three largely unexplored challenges identified at the start of this piece. In our view, the government and regulator could reset the market to achieve the following three objectives:

  1. Achieving net zero:

a) The current events should not deter or defer the progress or commitment to the Net Zero Strategy, rather it should stimulate additive work that has been necessary for some time, and where various companies and institutions have already published a rich library of thinking and options.

b) For example, it should prompt some additional and strategically important work relating to the desired low carbon technology mix that make us more resilient to global commodity price movements. There should also be a specific strategy for how best to transition away from gas. This should include how we contract for gas in global markets and who does so, how we store gas and whether we have enough storage, and strike the right balance between indigenous and imported fossil fuel sources.

c) It should certainly accelerate a focus on evaluating alternative wholesale market design options to the current merit order/SRMC cost paradigm. We and others have written extensively about this subject.

d) We must accelerate and properly fund energy efficiency and wider demand side reforms. Both can reduce carbon emissions and the demand for gas whilst we transition away from this fuel over time.

e) The government should also accelerate thinking on how to fund investment under different policy schemes, as the model of loading costs into either electricity or (as some propose) gas bills is unlikely to be sustainable, equitable or acceptable to the electorate. Again, we and others have contributed ideas to this area and government were already turning their mind to this prior to recent events.

2. Encouraging competitive energy retail markets:

a) The Default Tariff Cap should be removed, not reformed. It will not really protect households from rising energy costs, rather it defers their exposure to them. On top, it has layered all kinds of turbulent costs and consequences for those suppliers trying their best to serve consumers against the cliff edge of dramatic and synchronised increases in bills. Suppliers who hedged in line with reasonable practice and the cap methodology will still have to pass wholesale rises through to consumers. Unless reformed ahead of time, the cap means that much of that pass through will happen all at once in April 2022 which will lead to a “shock and awe” consumer response. In addition, the cap has disincentivised the market from innovating generally (through margin pressure), but in risk management specifically by having to follow one Default Tariff Cap driven version of what good hedging looks like. That means suppliers may have ruled out approaches that may otherwise have seen better cost outcomes for consumers. It is not obvious that making the cap more dynamic would have protected households from rising costs either.

b) Regulation should ensure that the energy supply market is genuinely competitive. This has long been our position as this piece from last September punctuates. The shakeout of suppliers in recent years doesn’t mean the market is uncompetitive now, however, further exits could see us close to such a scenario. To the extent costs and risks have arisen for suppliers who hedged as many (including the regulator) would have regarded as appropriately, then proportionate support should be provided to avoid further exits, as it is far from obvious that they could have avoided these costs given market design.

c) Regulation should also focus on making companies financially and technically fit. Ofgem has dragged its heels in introducing financial resilience measures for the sector, taking as long as five years from first setting it as a priority. Many horses have bolted already, but that is not to say the measures are without merit. We have written many times on this issue over the years, including this piece from 2018.

3. Addressing impacts on consumers:

a) Even if competitive markets, comprising of strong companies, are very well regulated, prices can and will rise from time to time. A clear, well-articulated conversation should be progressed with voters (not just within the energy sector) on the time profile and likely levels of the costs and benefits of net zero. This should include the message that investment costs in net zero (and the costs of moving from fossil fuels) will mean that from time to time energy costs may need to rise. Such transparency has been sadly lacking to date. As a result, popular consent for continuing the transition may be fragile once costs begin to rise “unexpectedly” (at least in the eyes of the citizen). It is time for much greater transparency.

b) Government should also look at the way that energy input cost rises feed through into much wider household and business financial pressures and think carefully about the appropriate means of managing them. Energy input costs don’t just impact households through increased payment for energy directly consumed. They also drive increases in prices across the economy, wider inflation and ultimately household credit costs. These should not and cannot feasibly be mitigated through relief delivered through energy schemes. It is not obvious that this is attempted on such a scale in other sectors of the economy.

c) Instead, policy options should be developed that directly mitigate impacts at a household level, that avoid cash-channelling through the energy collections system. This may mean Treasury looking at flexible tax and welfare mechanisms that address the impacts of rising costs as they occur from time to time. In addition, migration of levy costs into general taxation is long overdue and should be progressed. We touched on these issues here.

We have no monopoly on ideas, and we are sure that there are many others who would propose a different suite of responses. But we would hope all can agree that we cannot simply intervene in an emergency without then rapidly addressing and resolving the factors that created that emergency in the first place. Otherwise, we shall lurch from winter crisis to winter crisis.

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