Four steps to reform electricity supply

Another week, another bankrupt electricity Supplier; something clearly isn’t working in the UK’s electricity supply market. The regulator Ofgem is trying to reform the system, but is it worth considering a more radical evolution of Suppliers? 

It’s tough to find anyone willing to defend electricity Suppliers, not surprisingly looking at Ofgem’s name and shame table of penalty payments, including over £10m charged to British Gas in 2017. Potentially transformative changes are afoot in the sector, including Smart Meters, time-of-use tariffs, and increased competition. However, to make the existing system work we need more customers to shop around, and unfortunately most just aren’t interested in their electricity supply. At some point we will need to acknowledge this reality and work out how to get all customers onto fair tariffs.

By reformulating the default “Standard Variable Tariff” (SVT) as a “Smart Tariff” that directly passes through costs to customers, we can ensure that customers always receive a fair deal; at the same time we can leave room for innovation in customer experience and service, and innovation in providing fixed-price or other financial offers to engaged customers.

“Why don’t I automatically get the cheapest tariff?”

For many customers, disinterest and mistrust contributes to persistently low switching rates and the popularity of nationalising of the energy industry. One question often asked is: “Why don’t I automatically get the cheapest tariff?”

New auto-switching services esnure that customers are always on a good tariff, however the possibility of the switch going wrong or your smart meter “going dumb” remain. Auto-switching is a convoluted, if relatively effective, solution to a problem that many people think shouldn’t exist in the first place.

Reforming electricity supply

The overriding principle of any reformed tariff should be that Suppliers are only allowed to charge customers the costs that they incur, plus a maximum margin, as per the energy price cap that has been operating January 2019. However, the existing cap fixes prices for six months at a time, which means that Suppliers can rightly argue that they are incurring high “hedging” costs to fix prices over such a long period. By passing through the real-time electricity price to customers these hedging costs drastically reduce and transparency increases. Customers are also more likely to engage with their electricity usage, for example by scheduling heating and electric vehicle charging in low price periods or by buying “smart-home” products.

Ofgem recently published its own research into such a “cost pass-through” (CPT) model. The research found that customers would typically save around 5% per year on their energy bills, but would be exposed to greater price volatility. Whether or not the CPT tariff is beneficial to customers depends on how much they value fixed prices and, for vulnerable customers, their ability to pay in any periods with sustained price rises. 

What could a new “Smart Tariff” look like?

Ofgem’s CPT research gets us some of the way to a real-time “Smart Tariff”, where customers are by default on a fair tariff. How can we add to this proposal to make it deliverable and work for customers? My four principles for a new electricity Smart Tariff are:

1. Real-time electricity pricing plus a capped margin: the essence of the Cost Pass-Through model, with the Supplier “passing-through” each component of the electricity bill: real-time wholesale price, network costs, subsidy costs, and capped operating costs and margin

2. Insurance against extreme price spikes: a major concern with the CPT model is price spikes (up to 600 p/kWh compared to average prices of 10-15 p/kWh). Concerns over high prices are not unfounded, as customers in Texas recently found out. One solution is to provide insurance against high price events, similar to the Octopus Energy “Price Cap Protect” feature that caps prices at 30 p/kWh. Suppliers could be mandated to provide a price cap, or the Government (via Ofgem or BEIS) could provide/procure this insurance and pass-through the cost to customers. Particularly flexible customers including those with on-site generation or storage may want to opt-out of this protection.

3. Option for customers to buy fixed price deals, and protections for vulnerable customers: for the vast majority of residential and business customers a straight pass-through of prices, when combined with the price spike insurance outlined above, is unlikely to cause financial headaches. The most volatile element of the bill, the wholesale price, only makes up one third of the typical bill; if wholesale prices increase by 50%, residential electricity prices only increase by around 20%. Fixed price options should be offered to customers who want or need them, including:

• The poorest customers: the Government estimates that 10% of households are “fuel poor”. For these households a shock in electricity prices could cause serious harm, so it is appropriate to fix prices for these customers over longer periods.
• Large-energy users: businesses that have significant electricity costs, such as manufacturers and retailers, are likely to want to “hedge” their exposure to electricity costs. This is compatible with the Smart Tariff as a financial add-on that could be provided either by the customer’s Supplier or others.

4. Removing some social and environmental obligations from Suppliers: large Suppliers are responsible for delivering Government programmes including the ECO energy efficiency scheme, the Warm Homes Discount, and the Smart Metering programme. Given that we are encouraging more customers to switch, and therefore to be less loyal to their Supplier, it is worth considering whether Suppliers are still best-placed to deliver these schemes.

Pitfalls?

There are almost no new ideas in this proposal. The dynamic wholesale pricing plus protection against price spikes is provided by the existing Octopus Agile tariff; the capped operating costs and margin are part of the energy price cap; protections for the poorest customers exist and should endure; and we are due a review of the responsibilities for social and environmental obligations. 

The delay to the Smart Meter roll-out is probably the biggest hurdle to transforming default energy supply tariff, as well as valid concerns about the impact on the poorest customers and the disengaged. The good news is that if we get this right we will have fair default tariffs, increased customer engagement, smart-home innovation, and ultimately faster decarbonisation at lower cost.