Facing its demons: inside the UK’s broken energy market

Andrew Tunnicliffe 3 July 2019 (Last Updated June 28th, 2019 15:47)

With a number of sensational business collapses in recent months, the UK energy sector is enduring a difficult time. Andrew Tunnicliffe speaks with Warwick Business School Global Energy Research Network’s David Elmes about the challenge smaller companies face and how regulators are moving to stabilise the sector.

Facing its demons: inside the UK’s broken energy market
Battersea Power Station, which was decommissioned in 1983. Credit: Alberto Pascual

It’s an issue that has been challenging household budgets and occupying much of the political narrative (before Brexit at least) for years; energy prices. Throughout this decade, and much of the last, the UK’s political parties have made claims and counter claims, floated policies, amended policies, and even ditched their own policies. The result of which is a situation where it is very difficult for companies to exist profitably, leading to knock on affects for consumers.

Making politics out of power

Since the UK Secretary of State for Energy, Ed Miliband, declared the end of low cost energy was upon us in 2009, politicians from all parties have been contesting that idea – even Miliband himself during his time as Leader of the Opposition a few years later. His change in position serves to highlight how politicised the issue has become.

“We’ve seen increasing political and consumer concerns about cost,” says Professor David Elmes. He says both of the major parties have been searching for policies that will address those concerns in the hope of attracting the attention of the electorate.

Elmes heads the Warwick Business School Global Energy Research Network, with a particular interest in how the structure of the global energy industry is changing, after working for more than 20 years in business management and energy.

“At some point that sort of out bidding each other to be tough on power companies has led to a situation where it has become very difficult for retail energy companies to exist profitably,” he argues. The figures support him, in around 16 months, the number of energy companies to collapse hit double figures; 11 to be precise as of the end of April 2019.

There are two noteworthy contributing factors to the collapse of these businesses, and the reshaping of the UK’s energy market according to Elmes. The first, he says, is the push to offer consumers lower prices, supported by political decisions such as a price cap. However, price caps are something even the industry regulator had concerns over. “Ofgem was not supportive of it but once it was done they had to toe the line.”

The second factor is the energy transition that Britain, and many other developed economies, are going through right now.

Volatile markets and energy caps don’t mix well

Restricting the amount energy companies can charge their customers is risky and could have negative consequences. Elmes argues it leads to clustering – a situation where a number of energy suppliers are offering similar tariffs at the upper end of the cap – and means suppliers do not have the flexibility to react to a fluctuating, sometimes even volatile, wholesale market.

“Energy costs do rise and fall. They depend on global markets, particularly things like gas,” says Elmes. “There are times when prices go up or down, which really aren’t in the control of the energy retail companies. Setting a price cap means that the Government has the responsibility to change the price cap to reflect what is happening in global markets.”

He questions, however, whether they could do it fast enough to reflect that change and protect companies from the financial hit.

The push for more sustainable, renewable energy sources is, whilst noble, not cheap. It requires investment and innovation, often through new companies utilising the latest technologies.

“We wanted to encourage the development of renewables, we wanted to move away from using coal and so on. So the energy system stopped being just about trying to use competition to get prices down. It started trying to encourage companies to invest in doing new and different things to change the way we use energy, as well as providing it at a competitive prices,” Elmes says.

Unfortunately, some of those new entrants were not structured to deal with the vagaries of wholesale markets.

Historically dominated by the Big Six energy suppliers, by the beginning of 2019 the number of energy suppliers in the UK had risen to more than 70. It led to accusations by analysts and senior industry figures that obtaining permission to operate in the sector was too easy. “It’s easier to become an energy supplier than it probably is to set up a bank account,” Centrica’s Chief Executive, Iain Conn, told the Financial Times.

He bemoaned the lack of financial clout many new companies had, something Elmes agrees with: “You need a certain amount of financial headway to weather the ups and downs that will naturally happen in a market that depends on global commodity prices. There is also some structural side of it, obligations companies have to pay at certain times.”

Those payments are Renewable Obligations, established by the Government in 2002 and administered by Ofgem. They require suppliers to source a proportion of the energy they sell from renewables, which increases annually. If a supplier fails to meet their obligations they face financial penalties.

Energy companies challenged by competition

According to Ofgem figures, in the year till 1 September 2018, 34 suppliers – almost half of those operating – failed to meet Renewable Obligations’ requirements. The figure amounted to tens of millions of pounds. “By November some of those companies had paid but some still hadn’t,” says Elmes. “Ofgem had to basically charge everybody else nearly £59m through the mechanism they have. If some don’t pay, then everyone else has to pay a bit more.” A short while later some of the debtors went bust, with Ofgem announcing investigations into their failure to pay.

“So we’ve seen companies come into the retail market, they offer a compelling proposition, possibly a really low price. They can make money for a while but then wholesale market prices change and they can’t always pass those on to they have taken on fixed contracts.”

Following the growing criticism of the ease with which companies can start out, and the collapse of these businesses, Ofgem announced it was to tighten entry requirements. The move includes requiring applicants to prove they have the financial capacity and pass a fit and proper test. “Applying new requirements on suppliers entering and operating in the market will aid us to weed out those that are underprepared, under-resourced and unfit,” said Mary Starks, Ofgem’s executive director of consumers and markets.

Elmes welcomes the news, particularly the additional scrutiny those new entrants will face. “The accusation was that people saw energy companies as a relatively easy thing to get into and make money. As I said, in the long-term there are also more difficult times.”

UK energy is in transition: but do customers feel the change?

The UK energy market is going through a period of transition. From being a sector dominated by a handful of suppliers, to one populated by numerous, often innovative, businesses, what the UK has today is a totally reformed industry from that at the beginning of the millennium. Renewables too are amplifying that evolution. However, some things remain unchanged; particularly the accusation power companies are cashing in on their customers.

It’s an allegation Elmes has no sympathy with: “Ofgem produces results each year that say how prices have tracked the wholesale price. Companies have to report their profitability, none are making excessive profits compared to what Ofgem is prepared to accept.” He adds a market review by the Competition and Market Authority supports that, actually concluding there are good deals out there if consumers shopped around. “But it still doesn’t stop politicians seeing it as a good topic to win votes on, by putting in extra requirements and controls like price caps and so on,” Elmes adds.

While the negative consequences of an opened-up energy market are clear, the positives should not be forgotten. Competition has benefited consumers, and not just in price. Customer satisfaction is on the rise and the push to be more competitive has forced suppliers to ask, what more can we do? That can only be good for a healthy market in the long term.

Image in text: Professor David Elmes. Credit: Warwick Business School Global Energy Research Network