As Elizabeth noted in Fuelling the Political Playing Field, there has been much debate recently about energy prices in the UK. Four of the ‘Big Six’ energy companies have now announced price rises. They average 9.1% – way above the rate of consumer price inflation and even further above the average rate of wage increases. What is more, they are considerably above the rate of increase in wholesale energy prices, which, according to Ofgem, have risen by just 1.7% in the past year.
The bosses of the energy companies have appeared before the House of Commons Energy and Climate Change Select Committee to answer for their large price increases. The energy companies claim that the increases are necessary to cover not only rising wholesale prices, but also green levies by the government and ‘network charges’ for investments in infrastructure. However, it is hard to see how, even taking into account all three of these possible sources of cost increases, the scale of price increases can be justified.
Another possible explanation for the price hikes is that they are partly the result of a system of transfer pricing (see). The energy industry is vertically integrated. Energy companies are not only retailers to customers, but also generators of electricity and wholesale shippers of gas. It is possible that, by the producing/shipping arms of these companies charging higher prices to their retailing arms, the retailers’ costs do indeed go up more than the wholesale market cost. The result, however, is higher profits for the producing arms of these businesses. In other words, a higher transfer price allows profits to be diverted from each company’s retailing arm to its producing arm.
This is an argument for making the wholesale market more competitive and for stopping the by-passing of this market by producing arms of companies selling directly to their retailing arms. What the companies are being accused of is an abuse of market power and possibly of colluding with each other, at least tacitly, to support the continuation of such a practice.
So is the answer a price freeze, as proposed by the Labour Party? Is it an investigation of the energy market by the Competition Commission? Or is it, at least as a first step, much more openness by the energy companies and transparency about their pricing practices? Or is it to encourage consumers to switch between energy companies, including the smaller ones, which at present account for less than 5% of energy supply? The videos, podcasts and articles consider these issues.
Webcasts and Podcasts
Energy bosses blame high bills on wholesale prices Channel 4 News, Gary Gibbon (29/10/13)
Why are energy bosses being questioned? BBC News, Stephanie McGovern (29/10/13)
Key questions Big Six energy companies must answer The Telegraph, Ann Robinson (29/10/13)
Energy bosses offer excuses for prices rises The Telegraph (29/10/13)
Energy bosses face MPs over price rises BBC News, John Moylan (29/10/13)
Energy boss ‘can’t explain’ competitors’ price hikes The Telegraph (29/10/13)
Ovo boss: Competition Commission would take too long BBC News (30/10/13)
Dale Vince: Energy market is ‘dysfunctional’ BBC Today Programme (30/10/13)
Tony Cocker: Public mistrust energy industry BBC Today Programme (30/10/13)
Ed Davey: Energy deals not just for ‘internet savvy’ BBC Today Programme (31/10/13)
Energy giants ‘charge as much as they can get away with’ The Telegraph, Peter Dominiczak (29/10/13)
UK energy markets need perestroika Financial Times (27/10/13)
Britain’s energy utilities must embrace glasnost Reuters, John Kemp (29/10/13)
Small energy firms ‘escape levies’ BBC News (30/10/13)
Is the energy market structurally flawed? BBC news, Robert Peston (30/10/13)
The energy market needs a Competition Commission investigation Fingleton Associates, John Fingleton (12/10/13)
Energy firms raised prices despite drop in wholesale costs The Guardian, Rowena Mason (29/10/13)
Only full-scale reform of our energy market will prevent endless price rises The Observer, Phillip Lee (26/10/13)
Energy Giants Blame Rising Bills On Green ‘Stealth Taxes’ Huffington Post, Asa Bennett (29/10/13)
Big Six energy firms ‘like cartel’ Belfast Telegraph (30/10/13)
Energy boss says he hasn’t done sums on green levies The Telegraph, Georgia Graham (30/10/13)
Graphic: How your energy bills have soared in ten years The Telegraph, Matthew Holehouse (30/10/13)
British energy suppliers’ explanations for price hikes just don’t add up The Guardian, Larry Elliott (31/10/13)
The 18th energy market investigation since 2001: Will this one be different? The Carbon Brief, Ros Donald (31/10/13)
Energy: Is there enough competition in the market? BBC News, Hugh Pym (26/11/13)
Information and Reports
Wholesale [electricity] market Ofgem
Wholesale [gas] market Ofgem
Response on wholesale energy costs Ofgem Press Release (29/10/13)
Response to Government’s Annual Energy Statement Ofgem Press Release (31/10/13)
Real Energy Market Reform The Labour Party
- Why may the costs of energy paid by the energy retailers to energy producers/shippers have risen more than the wholesale price?
- Explain what is meant by transfer pricing. How could transfer pricing be used to divert profits between the different divisions of a business?
- How can transfer pricing be designed by multinational companies to help them minimise their tax bills?
- Why is policing transfer pricing arrangements notoriously difficult?
- What evidence is there to show that switching between retailers by customers can help to drive retail energy prices down?
- How did the old electricity pool system differ from the current wholesale system?
- Should electricity companies be forced to pool the electricity they generate and not sell it to themselves through bilateral deals?
- Comment on the following: “The current electricity trading arrangements ‘create the very special incentive for the oligopolists. …The best of all possible worlds is where nobody invests. As supply and demand close up, the price spikes upwards, and supernormal profits result.'”
The energy sector has a history of criticism with regards to prices and practices. In the past, Ofgem have tried to make the sector more competitive, by ensuring that price comparisons are easier. At the beginning of this year, many of the big six providers announced price cuts, but within the next few weeks, we will see the reverse occurring, as energy prices begin to rise.
British Gas has announced price rises of 6% from 16th November that will affect over 8 million customers by adding approximately £80 per year to the annual dual fuel bill. Npower will also put its prices up 10 days later (8.8% for gas and 9.1% for electricity), creating higher bills for 3 million people.
In January of this year, when we saw energy prices fall, it was not solely due to Ofgem’s findings. We had a relatively mild winter, which reduced the demand for energy and this fed into lower prices. As the winter now approaches once more, demand for energy will begin to increase, feeding into prices that are now higher.
Furthermore, the energy companies have said that a range of external factors are also adding to their costs and putting increasing pressure on them to increase their charges. Npower’s Chief Commercial Officer said:
“There is never a good time to increase energy bills, particularly when so many people are working hard to make ends meet…But the costs of new statutory schemes, increases in distribution charges and the price of gas for the coming winter are all being driven up by external factors, for example government policy”
Significant investment is needed in the energy sector. Energy companies are required to set aside money for maintaining and improving the national grid and investing in renewable energy, such as wind and solar power. In order for the energy companies to fund these investments, more money must be raised and the logical method is to put up prices. However, critics are simply blaming ‘these very big lazy companies’ who are passing ‘above-inflation price rises’ onto already squeezed households.
Part of this is undoubtedly to do with the market structure of this sector. A typical oligopoly creates a market which, under certain circumstances, can be highly competitive, but because of barriers to entry that prevent new firms from entering the market may charge higher prices and be inefficient. Indeed, Ofgem has plans to reduce the power of the main energy providers by forcing them to auction off some of the electricity they generate. The aim of this is to free up the market and make it more competitive.
While only three providers have announced price rises, it is inevitable that the other three will follow. The relative increases will create incentives for consumers to switch providers, but crucial to this is an ability to understand the different tariffs on offer and lack of clarity on this has been a big criticism previously levelled at the energy sector. Indeed, half of UK customers have never switched energy providers. Perhaps this is the time to think about it, firstly as a means of saving money and secondly as a means of putting the energy companies in competition with each other. The following articles consider this market.
Energy price rises: how to switch, save and safeguard your supply The Guardian, Mark King (12/10/12)
Npower and British Gas raise energy prices (including video) BBC News (12/10/12)
Energy price rises? We’re like turkeys voting for Christmas The Telegraph, Rosie Murray-West (12/10/12)
British Gas and Npower to raise prices fuelling fears of a ‘long, cold winter’ for more households Independent
, Graeme Evans (12/10/12)Wholesale prices rise as energy costs jump Wall Street Journal, Sarah Portlock and Jeffrey Sparshott (12/10/12)
British Gas raises gas and electricity prices by 6pc The Telegraph (12/10/12)
Osborne warns energy firms over price hikes Reuters (12/10/12)
Energy price hikes to take effect from next week Independent, Simon Read(13/10/12)
- What are the main reasons influencing the recent price rises? In each case, explain whether it is a demand- or supply-side factor.
- Using your answer from question 1, illustrate the effect of it on a demand and supply diagram.
- Which features of an oligopolistic market are relevant to the energy sector. How can we use them to explain these higher prices.
- How has government policy affected the energy sector and energy prices?
- Why are customers reluctant to change energy providers? Does this further the energy company’s ability to raise prices?
- Are there any government policies that could be implemented to reduce the power of the energy companies?
EU environmental legislation is beginning to cause problems in the UK. As it prohibits coal-fired power plants from generating power, they will be forced to close. This means that the UK will be forced to rely more on imported energy, which could lead to price rises, as energy shortages emerge.
Ofgem, the energy regulator has said that the risk of a gas shortage is likely to be at its highest in about 3 years time, as the amount of spare capacity is expected to fall from its current 14% to just 4%. Energy shortages have been a concern for some time, but the report from Ofgem indicates that the predicted time frame for these energy shortages will now be sooner than expected. Ofgem has said that the probability of a black-out has increased from 1 in 3,300 years now to 1 in 12 years by 2015.
The government, however, has said that its Energy Bill soon to be published will set out plans that will secure power supply for the UK. Part of this will be through investment, leading to new methods of generating energy. The Chief Executive of Ofgem, Alistair Buchanan said:
‘The unprecedented challenges in facing Britain’s energy industry … to attract the investment to deliver secure, sustainable and affordable energy supplies for consumers, still remain.’
One particular area that will see growth is wind-farms: a controversial method of power supply, due to the eye-sore they present (to some eyes, at least) and the noise pollution they generate. But with spare capacity predicted to fall to 4%, they will be a much needed investment.
Perhaps of more concern for the everyday household will be the impact on energy prices. As we know, when anything is scarce, the price begins to rise. As energy shortages become more of a concern, the market mechanism will begin to push up prices. With other bills already at record highs and incomes remaining low, the average household is likely to feel the squeeze. The following articles and the Ofgem report considers this issue.
Electricity Capacity Assessment Ofgem Report to Government, Ofgem (5/12/12)
Power shortage risks by 2015, Ofgem warns BBC News (5/10/12)
Britain faces risk of blackout The Telegraph (5/10/12)
Ofgem estimates tightening margins for electricity generation Reuters (5/10/12)
Electricity shortages are ‘risk’ by 2015 Sky News (5/10/12)
Future energy bills could give customers a nasty shock ITV News, Chris Choi (5/10/12)
- What is the role of Ofgem in the UK?
- Explain the way in which prices adjust as resources become more or less scarce. Use a demand and supply diagram to illustrate your answer.
- To what extent do you think the UK should be forced to close down its coal-fired plants, as a part of EU environmental legislation?
- Are there any market failures associated with the use of wind farms? Where possible, use a diagram to illustrate your answer.
- Explain why an energy shortage will lead to an increase in imports and how this in turn will affect energy prices.
- What are the government’s plans to secure energy provision in the UK? Do you think they are likely to be effective?
EDF, one of the big six energy retailers in the UK, has agreed to pay out a record £4.5m. £1m of this will go to funding an energy advice centre; the rest will go to providing £50 each to 70,000 ‘vulnerable customers’ who struggle to pay their bills and who receive the government’s warm home discount.
The agreement was made with Ofgem after an investigation into mis-selling, both on the doorstep and over the phone. Customers were persuaded to switch energy suppliers with the promise of savings on their bills. As the FT articles states:
Ofgem found that EDF’s sales force did not always provide complete information to customers on some contract terms, or on the way in which their monthly direct debits had been calculated. In some cases, telesales agents claimed savings without knowing whether they were accurate for the specific customer on the call, the regulator said.
Ofgem did not accuse the company of directly sanctioning such practices, but rather of weak monitoring and control of its sales force’s actions.
The £4.5m payment is in lieu of a fine. Consumer groups have welcomed this, preferring the company to pay compensation to a fine, which would have simply increased Treasury funding.
It is the first settlement in a broader investigation into mis-selling, involving four of the six major suppliers.
EDF to pay out £4.5m in mis-selling case Financial Times, Guy Chazan and Hannah Kuchler (9/3/12)
EDF agrees to pay £4.5m misleading sales ‘fine’ Guardian, Lisa Bachelor (9/3/12)
Is it a fine? Is it a penalty? No, it’s EDF’s mystery Ofgem payment Management Today, Rebecca Burn-Callander (9/3/12)
‘Misleading claims’ cost EDF a £4.5m payout from watchdog , Independent, Tom Bawden (10/3/12)
EDF Energy agrees to pay a £4.5m ‘fine’ BBC News (9/3/12)
EDF Energy agrees to pay a £4.5m ‘fine’ BBC News, John Moylan (9/3/12)
More energy payouts could follow EDF’s £4.5m The Telegraph, Kara Gammell (9/3/12)
EDF energy agrees to invest £4.5 million to help vulnerable customers following Ofgem investigation Ofgem
- What types of market failure are present in the energy supply industry?
- What are the arguments for and against fines being paid directly to victims of crime rather than to the government?
- In what ways could the energy industry be made more competitive?
- Why do the utilities, such as gas, electricity and water, require their own regulator rather than simply being subject to competition law?
In an earlier blog Energy profits margins up by over 700% we analysed the increasing pressure on many households as they saw their energy bills increase in price year on year. This helped the big six energy companies achieve a 700% rise in their profits.
However, it also sparked interest by the regulator Ofgem, which was looking to ensure that consumers found it easier to make price comparisons and create a more competitive market. One issue that Ofgem were looking into was how to make the energy sector more open to competition, given that the big six companies own the power stations and hence this acts as a barrier to the entry of new firms.
The latest announcements from some of the big energy companies will therefore come as a pleasant turn of events for Ofgem. On Wednesday January 11th 2012, EDF announced that it would be cutting its energy prices by 5% from 7th February in response to a fall in wholesale costs. Only a day later, Npower announced its plans to cut its tariffs by 5% from 1st February. British Gas cut its prices by 5% with immediate effect and SSE will reduce its gas prices by 4.5% from March 26th.
Is this a sign that the market is becoming more competitive thanks to Ofgem or is there another explanation? For the past 2 winters, temperatures have been consistently below freezing and hence demand for gas/electricity was at an all time high, speaking concerns of gas shortages. However, with the mild winter we are currently experiencing (I hope I haven’t jinxed it!) demand for heating etc has been significantly lower, which has reduced wholesale costs and the big six companies have begun to pass these savings on to their customers. Yet, despite this seemingly good news, are they being as ‘kind’ as we think? Most of the companies are cutting their prices by about 5%, yet wholesale prices fell by significantly more than that. Furthermore, over the past few years, customers have seen their tariffs increase significantly – by a lot more than 5%. To some extent, this confirms the criticism levelled at the energy sector – when costs rise, they are quick to pass on the full costs to their customers. But, when costs fall, they are slow to pass on only a fraction of their cost savings. The following articles consider this issue.
Npower will cut gas prices by 5% BBC News (13/1/12)
EDF cuts gas price by 5% Reuters, Karolin Schaps and Henning Gloystein (11/1/12)
British Gas readies push to promote price cut MarketingWeek, Lara O’Reilly (13/1/12)
British Gas cuts prices by 5% Independent (13/1/12)
Energy suppliers do battle in the war of modest price cuts The Telegraph, Emily Godsen (13/1/12)
British Gas and SSE follow EDF Energy price cut Financial Times, Guy Chazan and Sylvia Pfeifer (11/1/12)
British Gas cuts electricity prices, but keeps gas on hold Guardian, Hillary Osborne (12/1/12)
British gas and SSE announce price cuts (including video) BBC News (12/1/12)
More power firms cut energy tariffs The Press Association (12/1/12)
- In which market structure would you place the energy sector? Explain your answer.
- What is the role of Ofgem? What powers does it (and the other regulators have)?
- Using a demand and supply diagram to help you, explain why wholesale costs have fallen.
- Why have the energy companies only passed on about 5% of cost savings to their customers, despite falls in wholesale costs of significantly more than that?
- Do you think price wars are likely to break out in this sector? Are they in the interests of consumers?
- Why did energy prices increase so quickly last year and the year before? Use a diagram to help you.