Politics above economics in the energy market hurts consumers

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June 11, 2014 by Paul Goldsmith

This should be an article about economics. However, it has an unavoidable political dimension. What is going on in the energy industry at the moment is partly about the tacit collusion of the big six firms that provide 98% of our energy. But there is also the issue of the politically advantageous but economically almost illiterate intervention of Ed Miliband and the Labour party last September. I’m sure, in fact I can almost say I know, that Miliband meant well when he announced his intention fix energy prices for two years while he ‘sorted out’ the energy market (see more on that by clicking here), but I’m not sure he meant for consumers to not see their energy prices fall even though there is such an important reason for those prices to do so.

46% of Household energy bills are made up of wholesale costs, which is the cost of buying that energy in the first place before distributing it to your homes. Energy firms have little to no control over their wholesale costs, as they are connected to demand and supply in a variety of marketplaces. This is why fixing prices at a certain point in an industry with so little control over their major cost is so dangerous…if those costs are going up. But fixing prices at a certain point in an industry with so little control over their major cost goes from dangerous to completely counter productive…if those costs are going down. Which they most certainly are.

The forward prices for the coming winter are 16% lower for gas and 9% lower for electricity than last winter. The mild winter in the UK and Europe has left record levels of gas in storage, pushing down prices. Spot prices – when firms buy energy for next day delivery – have fallen even more sharply. These tend to be used by smaller suppliers who have more flexibility owing to their smaller market share. Spot gas prices were down 38% in early June compared with the same time a year ago. This left prices at their lowest level since September 2010. Spot electricity prices were 23% lower than a year ago, taking them to their lowest level since April 2010.

Yet no UK energy firm has shown even the slightest inclination to lower their prices. This has brought it to the immediate attention of Ofgem, the regulator of the energy industry (which was privatized in the 1980s, having been a nationalised industry run by the state for many years). In a competitive market, a sustained reduction in costs would encourage suppliers to cut prices for customers, as they would be worried about losing customers to other suppliers, Ofgem said in a letter sent to energy suppliers that they published yesterday (which I have pasted below this article). But bills aren’t falling, and this, according to Ofgem – could “reduce confidence in the energy market.” Which is an ironic use of language, given that one of the main reasons household bills aren’t falling is because the energy market itself has been given so much reason to lose confidence in the motives of the political establishment.

Over the past year, since Miliband’s announcement about fixing energy prices for two years should Labour enter government in 2015 (which they may well do), the energy companies have been doing what is in the best interests of their shareholders in that uncertain situation – which is doing a spot of “forward-buying” – which means agreeing a long term price for energy which gives them the same certainty over their costs that they are going to be forced to have over their prices. This is an economically sensible decision, forced upon them by political uncertainty. This has, for instance, allowed SSE to announce that their prices will be fixed for the next 2 years and British Gas to announce the same for 1 year. If their costs are now fixed, they aren’t getting the benefit of the price falls in wholesale energy, so there is nothing to pass onto consumers. That, I’m afraid, is the price of putting politics above economics.

Yes, some energy firms are probably benefiting from those falls in wholesale prices, but they also know from experience that consumers prefer to have ‘smoothed’ price fluctuations to help their planning – meaning that if the consequence of large falls if costs fall a lot is large rises if costs rise a lot they would prefer those falls and rises to be less either way. Ofgem are just doing their job – but they are thinking purely economics. Sadly, in my view, the politicians have got in the way, and when politics is put in front of simple economic, nobody wins.

Ofgem letter in full:

Wholesale Costs

I am writing to you today in relation to the significant falls in wholesale gas and electricity prices we have seen over the past year or so.

In a competitive market, I would expect the threat of losing market share to encourage suppliers to pass on sustained reductions in wholesale costs as savings to consumers as soon as possible. If that is not happening, it could be seen as further evidence that competition is not working for consumers as well as it should be. A concern that savings were not being passed on to customers was one of the reasons why we have proposed a referral of the energy market to the Competition and Markets Authority for investigation.

I should stress that pricing decisions are entirely a matter for individual suppliers. Each supplier will of course have its own strategy for purchasing energy, which will determine the impact of falling wholesale prices on its business. However, the downward trend in falling wholesale prices seems clear and should reduce wholesale costs increasingly over time.

Given the need to rebuild consumer trust in the market it is important that suppliers explain to their customers these changes in the wholesale market and what impact they will have on their pricing policies. I would welcome an explanation of how you are doing this.

Yours sincerely,

Dermot Nolan, Chief Executive Officer

 

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