Energy prices and profits

February 25, 2010 11:41 AM

Wind_2.h2 Today British Gas has announced record profits.  That will anger many ordinary taxpayers who are struggling with high energy prices, even after the recent cut.  Energy companies do deserve the public's ire, but the story is a bit more complicated than it might appear.

Taxpayer funded campaign group Consumer Focus should be helping the public understand why their prices are so high and working to bring that burden on families down.  Unfortunately, their quote is utterly useless and makes no attempt to actually understand the situation:

"However, campaign group Consumer Focus called for "immediate and significant price cuts across the market".

"Energy companies have no excuses for not cutting bills for their customers. It is clear the problems in the energy market are profound and that it requires fundamental reform," said Consumer Focus deputy chief executive Philip Cullum."


There are some short term factors driving energy prices.  They fluctuate with the international price of gas.  And energy companies don't just buy the gas on the day they supply it, at that day's price, but through contracts in advance, so the pattern of retail and wholesale prices won't always match up.  Organisations like Ofgem need to keep an eye on whether the market operates fairly.

But the bigger, longer term upward pressure on energy prices isn't a result of that natural operation of the market, or any market failure, but of government policy.  BERR estimate that government policies are already responsible for 14 per cent of domestic electricity prices.  The Government have accepted ambitious EU targets for a huge expansion of renewable energy by 2020.  Those targets are being enforced by a policy called the Renewables Obligation which requires energy companies to source a certain, rising portion of the electricity they supply from renewable sources.  In order to meet the targets, Britain is expected to have to rely on extremely expensive offshore wind.  Building all those turbines and the other investment needed to meet a range of environmental targets without crashing the grid is expected to cost Britain €161 billion by 2020.  That is more than Germany (€72 billion), France (€56 billion) and Italy (€23 billion) combined.

All that investment isn't coming from public spending financed by general taxation, but it doesn't come for free either.  Energy companies, and their investors, will expect a return just like any other business or investor would.  Given that they are relying on government subsidies, which could be withdrawn if they are unlucky, it is quite a risky investment so they' need a good rate of return for it to make sense.  Citigroup Investment Research - who have performed the most reliable investigation of this issue - expect that they will need to meet a hurdle rate of 9.2 per cent before tax.

So in order to pay for the investments required by government policies, energy companies need to make higher profits.  That means higher prices.  Citigroup think it will mean prices and profits doubling.  Energy companies do deserve their share of the blame for this sorry
state of affairs, they have endorsed the renewables agenda in the hope the higher profits will be worth the political backlash, but the real culprits are the politicians who put the targets and policies in place.

The only answer is to scrap the renewable energy targets.  They are an incredibly expensive way of cutting emissions.  Without the targets, the energy sector will continue to get more efficient by increasing the use of ever more efficient gas and coal plants and even installing more nuclear power.  We explored the policy changes needed in more detail in this report.

Wind_2.h2 Today British Gas has announced record profits.  That will anger many ordinary taxpayers who are struggling with high energy prices, even after the recent cut.  Energy companies do deserve the public's ire, but the story is a bit more complicated than it might appear.

Taxpayer funded campaign group Consumer Focus should be helping the public understand why their prices are so high and working to bring that burden on families down.  Unfortunately, their quote is utterly useless and makes no attempt to actually understand the situation:

"However, campaign group Consumer Focus called for "immediate and significant price cuts across the market".

"Energy companies have no excuses for not cutting bills for their customers. It is clear the problems in the energy market are profound and that it requires fundamental reform," said Consumer Focus deputy chief executive Philip Cullum."


There are some short term factors driving energy prices.  They fluctuate with the international price of gas.  And energy companies don't just buy the gas on the day they supply it, at that day's price, but through contracts in advance, so the pattern of retail and wholesale prices won't always match up.  Organisations like Ofgem need to keep an eye on whether the market operates fairly.

But the bigger, longer term upward pressure on energy prices isn't a result of that natural operation of the market, or any market failure, but of government policy.  BERR estimate that government policies are already responsible for 14 per cent of domestic electricity prices.  The Government have accepted ambitious EU targets for a huge expansion of renewable energy by 2020.  Those targets are being enforced by a policy called the Renewables Obligation which requires energy companies to source a certain, rising portion of the electricity they supply from renewable sources.  In order to meet the targets, Britain is expected to have to rely on extremely expensive offshore wind.  Building all those turbines and the other investment needed to meet a range of environmental targets without crashing the grid is expected to cost Britain €161 billion by 2020.  That is more than Germany (€72 billion), France (€56 billion) and Italy (€23 billion) combined.

All that investment isn't coming from public spending financed by general taxation, but it doesn't come for free either.  Energy companies, and their investors, will expect a return just like any other business or investor would.  Given that they are relying on government subsidies, which could be withdrawn if they are unlucky, it is quite a risky investment so they' need a good rate of return for it to make sense.  Citigroup Investment Research - who have performed the most reliable investigation of this issue - expect that they will need to meet a hurdle rate of 9.2 per cent before tax.

So in order to pay for the investments required by government policies, energy companies need to make higher profits.  That means higher prices.  Citigroup think it will mean prices and profits doubling.  Energy companies do deserve their share of the blame for this sorry
state of affairs, they have endorsed the renewables agenda in the hope the higher profits will be worth the political backlash, but the real culprits are the politicians who put the targets and policies in place.

The only answer is to scrap the renewable energy targets.  They are an incredibly expensive way of cutting emissions.  Without the targets, the energy sector will continue to get more efficient by increasing the use of ever more efficient gas and coal plants and even installing more nuclear power.  We explored the policy changes needed in more detail in this report.

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