By George Barham (BSc Economics & Finance)
[This essay was written for the Government, Welfare and Policy third-year undergraduate module. Students were tasked with writing a blog-style essay on a topic linked to a group poster project. Topics were chosen by students and reflect their own interests. The essay gave them experience of writing content in an engaging style for a non-expert audience. What you see below is one of this year’s top-marked blog-style essays. Christa Brunnschweiler]
As the clock struck midnight on the 31st of March, April Fool’s Day commenced. But on this usually jolly day, there were no jokes to be had. Multiple scheduled price increases such as Council Tax, VAT on pints and National Insurance hit consumers on a day coined “Bleak Friday” (BBC, 2022). Among these, average annual energy bills rose to £1,971 for 22 million households, forcing an estimated 2 million people into fuel poverty. So where is the saviour to protect the vulnerable?
Here enters the Ofgem Energy Price Cap (EPC). This solution arrived in January 2019 to fix the “broken” UK energy market. The cap was only intended to last until the end of 2020, but after consideration, the UK government has allowed it to stay beyond 2023. Conservative party advocates claimed, “the cap could save people up to £100 a year” (Vaughan, 2017). But 4 years on, the EPC faces difficulties, and the energy market appears more battered and bruised than ever. So, the question we must ask is: Has the price cap really protected us after all?
A brief recap on the Ofgem Energy Price Cap first: The EPC is the maximum amount a utility company can charge an average customer in the UK per year for the electricity and gas they use (Hughes, 2022). The aim here is to stop companies from making excessive profits, ensuring customers pay no more than a “fair” price for their energy. The Summer 2022 EPC review by Ofgem saw it rise by 54% from the 1st of April, which equates to a bill hike of £694 for the average consumer.
But why are bills rising?
As shown above, companies base their prices on the costs they incur for providing electricity and gas, as well as additional profit on top (1.77%). The catch? The EPC must adjust to match these increasing costs, and therefore, it doesn’t always make energy prices affordable. Let’s look at these costs in detail.
Wholesale costs refer to the prices that suppliers pay for gas and electricity from the market. It makes up the largest cost in the price cap (54%) and increased by a whopping £549 (+104%). The key driver here is due to more demand and less supply of electricity and gas than usual. Post-lockdown economic growth has spurred demand for gas in Asian and South American nations. China saw an 18% growth in LNG demand in 2021, and this should continue to grow (Heringa et al., 2022). If that wasn’t enough, the UK experienced its coldest winter since 1922 (Copernicus, 2021). Increased demand for heating led to dwindling gas storage levels. And with the UK having just 11TWh of storage capacity, compared to other nations such as France, who has 51TWh of capacity, this put major upwards pressure on prices (Gas Infrastructure Europe, 2022).
Other factors have put pressure on supply, such as poor wind energy generation; delays to North Sea maintenance works; gradual closure of the Groningen gas fields (Alvarez and Molnar, 2021); sanctions on Russia, and finally, the closure of Nord Stream 2 – a pipeline that could have doubled the flow of gas to Germany each year (Sommerlad, 2022). Unfortunately, this demand-supply imbalance has led to sharp spikes in gas and electricity prices in the UK and seeing as companies are “price-takers”, Ofgem has to pass this cost on to the consumer.
Next up are Network costs, which are faced when building, maintaining, and operating the infrastructure that carries energy to UK households (Capstick, 2022). They are second to wholesale costs, contributing 19% of the EPC and increasing by £103 (+39%). Ofgem tells us that the driver of this increase is the recovery of Supplier of Last Resort levy costs. Other energy companies have taken on 2 million customers from suppliers that have gone bust recently, costing approximately £2 billion. Suppliers can recoup this from the market, but this adds £68 to everyone’s bill. In total, more than 30 energy suppliers have gone out of business or been put in special administration since the beginning of 2020, affecting 4.3 million domestic customers and leaving the UK with just 26 suppliers remaining (Ofgem, 2022). Those remaining have acquired the small firms and concentrated their market share:
But why did these suppliers fail?
The short answer is the price cap. The EPC was decided in August 2021, but soon after, the situation deteriorated. Suppliers such as Utility Point were particularly vocal – stating that the cap was set £200 below the cost of supplying energy. Even Ofgem’s CEO recently recognised that regulation played a part in the supplier failure (Ofgem, 2022). He also hinted that further price increases are likely to happen later this year. One estimate by Cornwall Insight stated that bills could go up by a further £629 in the October review (Lowrey, 2022).
Theoretically, price spikes are generic features of electricity markets, and they are required to cover supplier costs. However, price caps interfere with suppliers’ ability to adjust for these shocks, and implementing these caps are found to deteriorate the total welfare in the market (Erten and Sirin, 2022). So, despite being introduced to “protect” consumers from significant bill rises, it appears the only effect has been to delay wholesale price increases to the future and cause numerous suppliers to fail. These failures lead to less competition and lower service quality going forwards. Ultimately, the consumer pays the price regardless.
So, has the price cap succeeded?
In short, no. A model by Energyscanner found that the cap increased volatility in prices when it was first introduced – with spreads between the cheapest deal and a basket of standard tariffs increasing (Energyscanner, 2021). As Ofgem define “unfair” prices as the difference between the average tariff and the cheapest on the market, this would imply a failure to achieve its main objective.
The EPC also reduces the incentives to switch suppliers. When it works correctly (reducing the spread in prices), some consumers are lulled into a false sense of security, relying too heavily on the price cap, and not shopping around when price differentials are at their peak. Alternatively, when it doesn’t work (increasing price spreads), some people do switch, but those who don’t lose out to a greater extent, as they are capped to a higher price. In terms of competition in pricing – the spread between the cheapest and most expensive SVTs (Standard Variable Tariffs) of the Big 6 has decreased by a factor of 59 since the EPC was introduced. In addition, it is certainly the case that for the GB prepayment meter price cap, prices have tended to bunch around the cap, which further suggests a decline in competition between the main players (Hardy, 2019). Consumers now have less options to shop around for better prices. It’s not all about cheaper energy though. A survey by Choose magazine found that smaller suppliers had better customer service (Brown, 2022). So, with large suppliers on the rise, customers may have more trouble communicating with their providers in the future.
What can be done to remedy the situation?
In the short term, Chancellor Rishi Sunak has since announced the Energy Bills Rebate – a £150 council tax rebate for houses in bands A to D, as well as a £200 government-backed loan scheme to reduce bills (Gov.uk., 2022). But this barely makes a dent in the £700 burden to households and is well below the £20bn demanded by the energy industry.
In Europe, the Commission plans to mitigate high prices with minimum gas storage obligations to ensure security of energy supply, as well as collective purchases to reduce prices (European Commission, 2022). Given the UK’s strategic gas reserves last just 5 days if fully deployed, it would be a good idea to increase these to help deal with future price shocks as well (Burton and Ying, 2021).
In the long term, it’s time to scrap the cap. The gap between the wholesale prices that we’re basing the EPC on and when the price cap starts is simply too long. Ofgem has announced that it will be reviewing whether to update the energy price cap more frequently in the future due to the “unprecedented rise in wholesale market prices and volatility”. This change would come into effect in October if agreed upon (Knight, 2022). But why stop there? A dynamic market without the EPC could adjust much more quickly than the 6-month waiting period – avoiding many unnecessary supplier failures (and thus charges) for consumers.
Instead of broad sweeping legislation, we need to assess who are the acceptable and unacceptable victims of competition. Energy price caps have historically proven themselves to be difficult to implement, as seen in California (Wolak, 2003). Instead, targeted policy using smart meter data may allow more specific identification of vulnerability (Brown, 2022). Building on initiatives such as the VENICE programme (Western Power Distribution, 2022) can help policymakers to target investment at vulnerable communities and engage the fuel poor in the transition to Net Zero emissions.
All taken together, these recommendations would improve the efficiency of the market by allowing prices and profits to dynamically adjust, and it would also improve equity as the most vulnerable customers could be targeted with specific legislation to alleviate financial burdens. Of course, we can’t predict whether removing the EPC will raise prices for consumers, but it will allow them greater choice in their decision making.
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