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How the big energy providers survived; what comes next?

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Ofgem, the UK government’s energy regulator, announced last week (26th August) that the energy price cap would rise by 80% from the current price of GBP1,971 to GBP3,549 per year. Moreover, predictions made by analytics firm Cornwall Insights suggest that the new year could bring a further raise of more than 30%, bringing the annual total up to the region of GBP4,500 per year for an average household.

The principal reasons for the rise in energy price are well-known, and so do not need in-depth discussion here. The understanding that energy prices have increased so much, so quickly are a result of a post-lockdown return to normality and increase in demand, coupled with a reduction in supply when Russia cut its supplies of natural gas into Europe as a reaction to the war in Ukraine. Gas prices are decisive for electricity prices, because over the last year 42% of the UK’s electricity was generated by burning gas. Whether the price consumers pay for each unit of energy accurately reflects reality is a matter for discussion, but elsewhere.

Regardless of the causality, the result has been a massive uplift in energy prices paid by consumers in the UK and across Europe. The producers of natural gas and electricity took the opportunity to raise their prices so rapidly, that many retailers locked into long-term contracts were caught out, and this saw many smaller (more speculative) suppliers go out of business in 2021. Ofgem has been increasing the price cap to try and ensure the remainder do not collapse.

Level playing field

The price cap was introduced by the Theresa May administration in 2019 and was an attempt to protect consumers, who were loyal to their suppliers from having to pay higher energy tariffs than those who frequently switched providers to secure more favourable deals. Prior to this, energy companies were accused of profiteering from customers who had come to the end of their introductory energy deal by capping the maximum price that suppliers could charge customers for the energy they supplied.

Ofgem was keen to break the stranglehold of the big five (formerly big six) energy suppliers (British Gas (part of Shell) which supplies through Centrica LON:CNA, EDF Energy [EPA:EDF] of France, E.ON [STOXX:EON] of Germany, Scottish Power a subsidiary of Spanish energy company Iberdrola and SSE LON:SSE. It started opening up the energy market to new suppliers in 2010 and a flood of new competitors joined the market offering consumers a ‘fair price’ for energy.

This allowed consumers to shop around for energy suppliers and ‘switch’ to new suppliers regularly, in order to avoid the increase in prices that occurred when their incumbent annually reviewed their energy tariff and moved customers from a ‘promotional’ tariff to a standard tariff. Many customers were switching annually, and this encouraged more small operators to enter the market to hoover up the floating consumers.

Between December 2010 to mid-2018, the number of UK energy suppliers increased from 12 to 70 and by this time last year these new entrants to the market held over 40% of market share.

Purchasing Power

However, many new entrants were pricing their tariffs on wholesale prices available in the market at a spot time, or on a short-term three-month horizon. This meant that if and when prices rose, the tariffs they could offer would become less profitable, or even loss-making as the new suppliers were slave to the vagaries of the wholesale energy market.

As prices rose, the advantage went from the new entrants, to the companies that had deep pockets and were able to forward hedge wholesale energy. This saw the opposite effect of what the government and Ofgem were hoping for, as by being tied to the incredibly clumsy lever of the price cap the energy giants like Centrica were able to fix their purchases on a much longer-term basis than their smaller competitors and as gas prices rose the smaller companies who were forced into buying higher-priced, shorter-term contracts were unable to pass the price rises onto their customers and a wave of smaller energy firms collapsed.

Weak financial resilience

Ofgem has been criticised across the board for not doing enough to ensure that the energy sector was resilient to external shocks. The National Audit Office said in June that Ofgem and the Department for Business, Energy & Industrial Strategy had: “…by allowing many suppliers to enter the market and operate with weak financial resilience, and […] failing to imagine a scenario in which there could be sustained volatility in energy prices, […] allowed a market to develop that was vulnerable to large-scale shocks and where the risk largely rested with consumers, who would pick up the costs in the event of failure.”

From September 2021 to end of the year 26 energy companies went out of business. Since the start of the year a further five went out of business, and as autumn approaches the spectre of more failures intensifies. One of the highest profile companies to go out of business was Bulb which left 1.7 million customers without a supplier.

However, the survivors – mainly the bigger companies – have been reaping record profits. Centrica booked GBP1.34bn profits from the first half of the year, British Gas did announce today that it was going to donate GBP12m to support the most vulnerable households, but this is a drop in the ocean.

UK Finance Minister, Nadhim Zahawi said the price cap will affect even middle-income earners, earning up to GBP45,000 a year. The government has been criticised for not doing enough, quickly enough to deal with the impact the price cap will have on UK households – something that the Conservative Party’s leadership contest has affected, as the Exchequer and Incumbent Prime Minister were reticent to move on the matter as they did not want to “bind the hands” of the incoming PM.

Price Cap Capping

The debate is circling back around to the price cap itself, which many in the industry said is too inflexible and clumsy to reflect the global wholesale market. However, under the mechanism, which was designed to create a fair and equitable market, consumers are going to continue being hit by price rises – the next re-rating is due on 1st October.

The price cap was never meant to be a permanent solution – but successive administrations have not come up with a workable solution to replace it. Even the big five are suggesting that it be replaced by some kind of social tariff, that could protect the most vulnerable, at least until the market price stabilises.

However, as to when the market will stabilise, and what stability looks like is anyone’s guess. Until that point fuel poverty will remain a reality for many in the UK.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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