The price cap - time for reform?

The global gas crunch has thrown the UK’s price cap regime into sharp relief. It has already led to several suppliers going to the wall and is likely to lead to several more. However, it represents a key opportunity for reform of the UK’s antiquated supplier arrangements.

Firstly, some background. The current energy market arrangements date from the Utilities Act 2000 and the subsequent reform of the GB energy system into a tripartite structure: generators, who produce the power, transmission and distribution operators, who carry the power, and suppliers, who provide the interface between the rest of the system and the consumer. The role of the supplier in this regime is rather ‘thin’ – although they handle contracting with generators and hedge against fluctuations in energy prices, in practice they largely act as a cost pass-through vehicle for the rest of the system, and apply little downward competitive pressure unlike, say, a supermarket.

Absent any real value add, suppliers should in theory compete over their cost to serve which is primarily made up of the cost of the IT system they use to handle billing plus energy trading and their hedging arrangements. The former can effectively be bought off the shelf, which lies behind the explosion in supplier numbers over the last decade. Hedging arrangements normally take the form of long-term contracts to buy at a fixed price the commodity that normally sets the price of both heat and power – natural gas. But the focus of suppliers on the cost of these was historically limited: energy consumers are rather sticky and accordingly competition only really operates over a small portion of actually engaged consumers, who offer very poor returns given their focus on price.

The real value in the market lies in the ability to extract rents from consumers who are disengaged with the energy system and will accommodate price rises without seeking alternative provision. This led to dramatic differences between the prices offered to engaged consumers and to the disengaged. Following years of efforts to encourage consumers to actually engage in the market, in 2018 Government effectively threw up its hands in exasperation and implemented a ‘temporary’ energy price cap that came into force in January 2019. This established a margin above an average set of pass-through costs (network charges, wholesale energy prices and policy & taxation costs) that suppliers were permitted to charge consumers, slashing the rents available to them.

Despite prior warning from suppliers that this would reduce competition, the primary effect of the price cap has been to massively reduce profits of suppliers while leaving competition intact. Suppliers have consequently invested in improved IT, and smaller suppliers have opted to not pay for hedging arrangements as a further cost-saving measure. This latter effect is why so many suppliers are now going to the wall, as they’re exposed to dramatically higher gas costs. While consumers will be insulated from these costs in the short term, as suppliers come to renew their hedging arrangements they will be charged significantly more, and you can expect to see all prices go up dramatically in the new year.

This will increase pressure on the Government to reform the sector further. The price cap will hold, but by itself doesn’t actually affect the fundamental costs of energy. The ‘thin’ model of suppliers was already under threat as part of the decarbonisation agenda, and in theory the current crisis should accelerate moves to drive costs out of the system wherever possible. Already, a range of commentators including Laura Sandys and Jeff Hardy have made proposals for reforms that both deliver decarbonisation and drive costs out of the system. They do so by exerting competitive pressure down the energy value chain, primarily through breaking up the existing tripartite structure and fashioning new roles in the system, such as wholesalers capable of providing more cost pressure on generators, aggregators who are both consumer-facing and play a stronger role in balancing the electricity system, or energy service providers who charge consumers a fixed cost for all their energy no matter how much they use – while taking over the operation of their heating system and upgrading the fabric of their homes.

Such reforms are complex and difficult to evaluate without spending significant amounts of Government resource, but offer the potential to drive costs out of the energy market. The Energy Retail Strategy only undertook to consider these towards the end of this decade; we expect that Government may wish to consider them earlier once the current crisis has passed. Without such reforms, we expect the Government to leave the price cap in place in perpetuity.