An alternative model for the energy supply business

In the last two weeks Kathryn Porter, who writes at Watt-Logic (www.watt-logic.com), has published two detailed, and extremely useful, analyses of the financial state of Octopus and Ovo. For readers not familiar with the UK retail energy market these are the two “challenger” energy suppliers that have taken a significant share of the energy supply market from what were known as the Big Six suppliers. They have grown partly by innovative and aggressive marketing, and partly by taking over energy suppliers which failed or wanted to exit from the market.

I strongly recommend that you read Kathryn’s articles if you have some understanding of the detailed financial analyses carried out by City analysts. For those who want the abbreviated story, the essence of her conclusions is that the energy supply businesses of both groups are in a financial hole. In the case of Octopus, its get-out-jail card is selling a part of its technology business (Kraken), which is – or may be – the golden nugget within the group. Ovo’s problems may be more serious as the balance sheet of its energy supply business has a large negative equity value. There is no obvious get-out-jail card, so that in one way or another Ovo may have to raise a large amount of equity to survive.[1]

In this article I am not going to rehash ground already covered well by Kathryn. Instead, I will examine what lessons we should learn for the UK’s model of energy supply. In the years immediately following privatisation of the gas and electricity industries, energy supply was handled by distribution companies. Large business users were allowed to choose their own suppliers and gradually the lower limit of the definition of “large” was reduced to include most medium and large enterprises.

Between 1998 and 2002 the retail market – for households and small businesses – was opened for competition between energy suppliers with a transitional price cap. What emerged was an industry dominated by 6 major suppliers, all of which had substantial generation businesses. From the perspective of energy suppliers, a retail customer base was seen as a hedge against the volatility of wholesale market prices. After this transition, Ofgem considered that retail competition in the energy market was a success judged by the average proportion of customers who switched their supplier in a year.

However, from 2008 onwards there was an increasing volume of complaints that the energy market “was not working”. This led to investigations by Ofgem and then the Competition and Markets Authority (CMA) which claimed, on questionable grounds, that market failures were causing up to £2 billion annually in customer harm. Reviews focused on (a) customers with Pre-Payment Meters, most of them the poorest and most financially insecure customers, and (b) Standard Variable Tariffs which were paid by customers who did not haggle with their existing supplier or change supplier every year. Both groups tended to be non-switchers, either because they were regarded as unprofitable by suppliers or they were disinclined to spend the time required to haggle or switch suppliers. Hence, Ofgem’s obsession with switching.

Since regulatory changes did not reduce the level of political unhappiness over energy prices, in 2017 the Conservative government introduced legislation to force Ofgem to set energy price caps. These limit the average prices that energy suppliers can charge different groups of customers. Inevitably, the result has been to greatly reduce market competition. This has become little more than feel-good marketing.[2]

The unacknowledged elephant in the room that lies behind the high level of political complaints, both during this period and subsequently, is the major real increase in energy bills that has occurred since the mid-2000s. Initially this was linked to a doubling in the market price of gas from 2004 to 2014, which was largely a consequence of a critical change in the structure of the UK gas market from about 2005. From 1970 until 2005, the real market price of gas tended to fall as production of natural gas from the North Sea grew rapidly and exceeded domestic demand, so the UK became a significant net exporter of gas to the rest of Europe.

However, in 2005 the balance of trade in gas reversed and the UK became a net importer relying primarily on supplies from Norway with other supplies from the Continent, indirectly linked to gas from Russia, playing a smaller role. This change meant that gas prices in the UK had to increase to cover higher transport costs and, later, the costs of LNG imports from the rest of the world. Unfortunately, the effect of switching to reliance on imported gas was reinforced by an increase in the general level of European gas prices.

Since 2010 the impact of this change in the structure of the gas market has been increased by the imposition of levies to fund policies to support renewable generation and to promote energy efficiency. Consequently, the margin between market and retail prices has grown steadily larger. For a combination of political reasons (for the government) and market theology (for regulators), there has been strong resistance to the idea that energy prices should be unbundled to show, for example, the composition of what customers pay.

In some European countries it is standard for energy bills to show the amounts paid for (a) purchases of energy at wholesale prices, (b) network charges, (c) policy levies, and (d) taxes. There is greater transparency in the UK now than in the past because Ofgem is required to publish a detailed breakdown of how it sets energy price caps. Still, that is for nerds like me. If you ask the typical politician – or the median voter – why energy bills are so high, their answer will be that it is all due to the high levels of gas and electricity wholesale prices. This perception is extremely convenient for policymakers who want to shift the blame for the consequences of their decisions.

The crucial question is whether all energy customers are willing to pay for the services that regulators and politicians think they should have. In essence this is about risk management and who should bear the costs of price variability. The mental model adopted by Ofgem is that customers want certainty about what their monthly energy bill will be, preferably for a period of 12 months or longer. Hence, energy suppliers are required to offer contracts with fixed tariffs for at least 3 months ahead and they are encouraged to offer tariffs that are fixed for 12 or even 24 months ahead. In addition, energy suppliers are expected to smooth the level of monthly payments due to random or seasonal variations in consumption.

All of this imposes costs on energy suppliers. They must hedge aggregate purchases for between 3 and 12 months. Many unhedged energy suppliers were bankrupted by the sharp increase in energy prices from Spring 2021 onwards. Since energy suppliers don’t want to act as lenders to smooth payments, they accumulate substantial customer balances by overcharging in months when consumption tends to be low and running down these balances during the winter.

The operations of energy suppliers are complicated by the fiasco of the rollout of smart meters, so that over a third of customers must either submit meter readings manually or be charged for estimated consumption. In addition, the management of the national meter databases has been awful ever since privatisation, so the reputation of energy suppliers is consistently undermined by billing errors in complicated cases or when customers switch suppliers. These problems have been worsened by foolish regulatory decisions by Ofgem based on dogma rather than common sense and practicality.

None of this provides a good context for advocating an alternative model of energy supplier. On the other hand, the combination of price cap regulation plus the increase in the share of customer bills determined by policy levies, transmission and distribution charges, and taxes has greatly reduced any scope for competition and innovation in the energy supply market. With very limited exceptions, the differences between energy suppliers are those between Tweedledum and Tweedledee – purely marketing fluff. At the margins, some suppliers offer innovative products – notably Octopus – but most copy each other to attract narrowly limited segments of the market – e.g. the current focus is on electric vehicle owners.

One reason why we should challenge current assumptions about energy supply is that many countries in Europe have adopted different models. One key element is the adoption of smart meters, which are rare in Germany but nearly universal in Italy, Spain, France, Benelux and Scandinavia. In most countries where the penetration of smart meters is high, energy suppliers have been pushed or choose to promote two types of tariff, either alone or in combination.

One type is time of use tariffs. These vary from two or three period tariffs (peak, middle, and off-peak) to dynamic tariffs which are directly linked to wholesale market prices. Even in Ireland, which is perhaps most like the UK, multi-period tariffs are becoming standard. In the UK, what were known Economy 7 tariffs required special equipment but anyone with a smart meter could take advantage of a multi-period tariff if they were properly publicised. Energy suppliers have dipped their toes in this market by offering special EV tariffs. If regulatory and political barriers were removed, they might become the norm as they are in Italy and Spain.

The second type is market-linked tariffs. These need not be dynamic tariffs which vary every hour (or half-hour) with the wholesale price. In Italy, for example, electricity prices are adjusted monthly in line with the value of the PUN (uniform national price) derived from the wholesale market in a manner prescribed by the regulator. Similar arrangements apply for natural gas and LPG. Energy suppliers compete on their daily supply charge and their mark-up on the PUN, which together cover their administrative and other supply costs. Network charges and policy levies are separately itemised in energy bills. Other countries from Austria to Scandinavia have similar arrangements.

The energy price cap and associated regulatory policies impose costs on energy consumers that are neither efficient nor transparent. While some consumers may be happy to pay for the cost of hedging that is built into the price cap, others may prefer to pay lower tariffs and accept a degree of price volatility. The belief that the price cap provides protection against price spikes of the kind that occurred in 2021-22 is just nonsense. Such changes are always passed through to customers sooner or later. If they were not, the energy supply chain would simply disappear via bankruptcies or withdrawals from the market.

Current arrangements serve two interest groups. First, undercapitalised energy suppliers who are able to use customer deposits as working capital. If such deposits were ring-fenced or put in escrow, as in other sectors, these suppliers would require a large increase in capital, whose cost would be passed on to customers. That cost is still present, but it is socialised via regulatory arrangements that transfer the costs of bankruptcies on to all suppliers and, thus, all customers.

The second interest group are those who want to hide the extent to which energy prices have been driven up by policy choices funded by levies on electricity consumption as well as by increases in network charges.

Abandoning the energy price cap would be too radical a step for many policymakers. However, encouraging or even requiring all energy suppliers above a certain size to offer multi-period tariffs linked to market prices would introduce a degree of competition into the energy supply market that is missing at present.

As a part of that change, all energy suppliers should be required to provide a monthly breakdown of what they are being charged with clear separation of wholesale costs, transmission charges, network charges, policy levies and taxes, and the energy supplier’s own costs. Fuller information is not the answer to the defects of the energy supply market but it is a necessary first step in the direction of greater competition and, ultimately, major reforms.

[1] As full disclosure, I was an Ovo customer in the past and am currently an Octopus customer on their dynamic Agile tariff. The IT technology developed by Kraken and used by Octopus has clearly been an important part of their success in the market. Still, as Kathryn Porter has explained, they have been undercapitalised to finance their rapid growth as an energy supplier. This is a familiar story among entrants to the energy supply market.

[2] It is frequently claimed that the large energy suppliers make “excess profits” with Centrica (British Gas) as the primary target for such accusations. Regulatory investigations have consistently rejected such claims. Many of the claims reflect an easy journalistic and political assumption that the cost of capital is zero or very low. The energy supply business is both risky (as the many bankruptcies among new entrants demonstrate) and requires substantial capital for hedging and cash flow management. SSE, never a company to ignore an opportunity to make money, chose to sell its energy supply business to reallocate capital to its network and renewable generation businesses. This provides a concrete example that energy companies may not view the profitability of the energy supply market in the same light as commentators with minimal understanding of the business.