Feb 2010 25

Energy prices and profits5

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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  • http://profile.typepad.com/6p01156f88a0c8970c Graeme

    Whilst I take the point about what is effectively extra taxes, that’s not the full story.
    The other part of the story is as said by Consumer Focus – we’re being ripped off.
    Advance purchases of energy just doesn’t wash. Immediately the wholesale cost goes up, so do our bills, the converse is NEVER true. Do a graph of wholesale vs retail prices. You’ll see the gap widen.
    The problem we have is a weak regulator. Ofgen should have the remit of protecting the consumer, but has no teeth whatsoever, in fact it may as well go on the Quango bonfire.

  • John Barton

    As someone who does not belive in the windmill as a viable source of electricity. I just see the whole thing being driven by Germany where most of these hidious machines are made.
    We have pleanty of rivers which could be dammed with weirs to provide lots of small electricity producing plants with very little impact on the countryside or expense. Another advantage of using hydro is that it rarely fails and never in winter.

  • Jon Stack

    The renewables obligation, introduced by our government to fund uneconomic renewable energy schemes, is increasing each year, and is passed through in all our electricity prices. Rising prices are down to this government’s, and the last government’s, dismal inability to grasp even the basics of energy economics. We are all paying for it now and into the future and may well experience power cuts at peak times within 5 years because of this government’s ludicrous pursuit of renewable energy sources. For every wind turbine built, a power station is required to provide back up for when the wind doesn’t blow.So double up all the cost for all of us at least as a result. £160 billion of our money to be spent on this stupid policy by 2020. The investment banks are loving it.

  • andrew easom

    Gluttonous power companies free to fix prices without genuine regulation, in bed with a duplicitous government now creating more back door taxes.

  • Wayne Rooney

    Most of the funding for Consumer Focus actually comes from energy and postal companies (and ultimately energy and postal consumers) rather than taxpayers.
    While environmental obligations, as well as social obligations, grid charges, metering costs etc contribute to the final energy bill, the most significant component of the energy bill is still the wholesale commodity, at least 50%. (As an aside please don’t completely accept the energy companies’ arguments that it is too difficult and costly to invest. The GB market is still highly profitable).
    The main reason why bills are higher than they ought to be is because wholesale energy markets, especially the power market, are illiquid. While you are correct that significant volumes of gas (power as well) are purchased in advance it is the way this energy is traded which is key to understanding why prices are too high (It is also unclear whether the prices these contracts are locked into are fixed or whether they are indexed to other commodity markets including the wholesale gas and power price). The fact is very little trading occurs beyond 6 months for power, a couple more years forward for gas on wholesale markets. Most trading on wholesale markets take place on the prompt market to help fine-tune energy players’ positions. Most forward trading (remember the price of these contracts determine the price for end users) in fact takes place ‘off-market’, under the counter if you like. The reason for this is as follows:
    For power the vast majority of trading occurs within vertically integrated energy companies between their generation and supply arms. This activity strangles traded volumes from the wholesale forward market. As a result unreasonable risk premiums (not justified by supply and demand fundamentals) are added to impounded into traded forward prices as the price discovery process is unable to adequately take place (as there are very few bids and offers posted). The (claimed) increased cost to the utility is passed on to consumers and the power companies pocket the additional margin (profit oscillating between upstream and downstream businesses depending on the movement of the wholesale price).
    A similar situation occurs in gas through the use of long term structured contracts between gas Majors and gas suppliers.
    To compound this situation the lack of liquidity in forward wholesale markets forecloses the energy market to new entrants and prevents the organic growth of independent players in both generation and supply, resulting in reduced competition and higher prices. This process is further intensified due to a large number of ‘sticky’ consumers who don’t switch.
    As you can see it is quite a complex problem and as such is not really suitable for a media friendly press release. Before criticising Consumer Focus for being uninformed perhaps who could improve the TPA’s understanding of the fundamental problems in the energy market which result in higher prices for consumers.