Friday, 27 September 2013

What will an energy price freeze achieve?

Ed Milliband's announcement that he will freeze energy prices for 20 months after the next election if Labour wins has received many different responses. Consumers groups love it, the energy companies hate it and their share price has dropped which suggests investors are worried. What do I think?

Wholesale energy prices are volatile. In the last year gas prices on the UK market (UK NBP) have varied between about 1.7 and 2.6 p/kWh (converted from 8 and 12 $/MMBtu) [1]. The peak was in March/April when the late spring meant stocks were running very low; demand is seasonal but supply isn't and the UK has limited storage capacity. Gas trading is largely limited to where the pipelines go; on the short term day-ahead markets, the UK price dropped by 14% for a few weeks earlier this year because of maintenance on pipelines connecting to Germany. Some gas is traded by ship, cooled and pressurised into liquid form (LNG), but this market is dominated by Asia which pays high prices, typically 3.4p/kWh at the moment (16 $/MMBtu). Looking at the charts [1] over the last few years it looks like gas prices have gone up at least 20% but according to OFGEM statistics the wholesale cost of gas has hardly changed in that time [2]. I can't make sense of this.

Well never mind the markets - the key point is that the energy companies are making big profits, more than a few years ago. From the OFGEM data, the margin (rolling net profit over bill) for a dual fuel bill is now 5% and even higher for separate bills: 6.7% for electricty and 8.6% for gas. This is a very nice margin for a mature business.

If the profits are excessive, that means that competition between the companies is not working very well. The only way competition is going to work is if customers are prepared to switch. 59% of gas customers have switched at least once (because they are not with their 'home' supplier) and 63% of electricity customers [3]. However, to make the markets work we need to be prepared to switch often. This is never going to happen while it takes 5 weeks to do so [4].

A price freeze is not going to fix the markets - it might keep our bills down for a while but if the markets aren't working now they still won't be working after the freeze unless something else changes. We need to make it easier to switch, not freeze the prices.

Will the price freeze mean the lights go out?

From my experience with taking startup companies into public ownership, investors like the balance sheet to be predictable. If you say you will make £1,000,000 profit and you make £800,000 they will want to know why. If you make £1,200,000 they will still want to know why your predictions are wrong. This is because if you have made more profit than you expected this quarter, maybe you will make less next quarter. It means their investment is risky. Investors won't take big risks unless the rewards are high - big dividends or strong growth in share value. If the energy companies have unpredictable wholesale prices and are unable to make adjustments to the retail prices then their profits will be unpredictable and that makes them more risky - so it is no wonder the share prices have dropped.

If their business is risky they will also have to pay higher interest to borrow money which means that they will find it hard to invest. However, we desperately need investment in electricity supply. Never mind the problem of cutting carbon emissions, there are many old oil and coal plants that have to be decomissioned in the next few years and we need new capacity to replace them (see Energy crunch time for the UK from January this year). If we don't, then well maybe the lights in our homes won't go out but some of those industrial customers who are contracted to switch off if asked may have to do just that.

[1] Quarterly Report on European Gas Markets - Second Quarter 2013 (
[2] SMI update 18/Sep/2013 (OFGEM)
[3] Quarterly energy prices Sep 2013 (DECC)
[4] Call for one-day energy switching (Telegraph Sep 2013)
[5] Digest of UK Energy Statistics 2013 (DECC)

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