The chickens are coming home to roost in Westminster. A surge in global gas prices is revealing the parlous state of the UK’s deregulated energy retail market. Independent suppliers are dropping like flies and the decade-long mantra of ‘competition is good for consumers’ is being thrown out of the window. Energy Flux examines the political and regulatory shortcomings that sowed the seeds of today’s epic market failure.

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The UK government spent the last decade encouraging nimble new entrants to compete with the UK’s ‘Big Six’ incumbent integrated energy retailers. These exciting digital natives, unencumbered by ageing power generation assets or armies of sales executives, were congratulated for spurring innovation, improving market efficiency and lowering prices.

Now, as the UK wholesale market explodes in the face of a global energy crunch, ministers are accusing those same heroes of liberalisation of being “badly run”. These tiddlers won’t be bailed out.

There are subtle echoes with the 2008 financial crisis. To prop up the failing market, the Department of Energy (BEIS) and the Treasury are considering throwing taxpayer-backed loans at those deemed too big to fail – i.e. the staid old Big Six utilities whose market stranglehold had for so long been the target of a concerted deregulation effort.

How did the UK, once held aloft internationally as a paragon of energy market liberalisation and utility deregulation, get itself into this mess? In a nutshell: by eschewing politically inconvenient questions about the true cost of decarbonisation and failing to adequately regulate free market competition.

Competition in the UK gas and electricity supply market swelled from the dominant ‘Big Six’ players in the late 2000s (British Gas, EDF, E.ON, npower, Scottish Power and SSE) to reach a zenith of more than 70 smaller companies by 2017. That figure was whittled down to around 50 by the time of the Sars-Cov-2 outbreak in late 2019.

With natural gas prices this month spiking to a series of all-time highs, consolidation is rapidly accelerating. Six UK energy retailers ceased trading this month and dozens more face insolvency, principally because the cost of supply has risen well above regulator Ofgem’s energy price cap. Reports suggest as few as 10 suppliers could be left by Christmas.

The current explosion in wholesale energy prices is undeniably the result of ballooning global gas prices, as detailed previously in Energy Flux. But the design of the UK’s liberalised market, and the political rationale for capping retail energy prices, predate today’s energy crunch and sowed the seeds of the market collapse.

At stake are two fundamental issues of principle: one of reconciling political expediency with market realities (and how short-term measures always cost more in the long term); and another of the tensions between market efficiency and resilience (and how shifting market conditions alter perceptions around which is preferable).

Truth, lies and politics

“I heard you say once that a lie is sweet in the beginning and bitter in the end, and truth is bitter in the beginning and sweet in the end.” – DJ Koze, from the track XTC

The UK’s political class seems to be of the view that telling an endless string of lies prolongs the sweetness and keeps the inevitable reckoning at bay. Or rather, keep the electorate in sweet denial until the next election (or referendum).

The idea of a price cap was espoused by the Labour Party’s Ed Miliband, who served as energy secretary during 2008-10. Miliband railed against what he characterised as an energy market led by a greedy corporate cabal that fixed prices to gouge captive consumers.

Despite the UK at the time enjoying some of the cheapest energy retail tariffs in Europe, that narrative struck a chord. Miliband kept pressing for a price cap while in opposition and was successful. Prime Minister Theresa May adopted it as a Conservative Party manifesto pledge in the run-up to the 2017 general election. Her minority government enshrined the Default Tariff Cap in legislation in 2018.

Co-opting a Labour Party policy with evident shortcomings was a convenient way for the Conservatives to shut down the pre-election debate about rising energy bills. Doing this was easier than confronting awkward questions about the cost to consumers of government schemes to reduce carbon emissions, tackle fuel poverty and modernise energy networks.

Schemes such as the Energy Company Obligation (ECO), Renewables Obligation (RO), feed-in tariffs (FiTs) and smart metering add 20-25% to the UK retail cost base of electricity, and 5-7% to the cost of natural gas. This leaves scant retail margins of 0-5%, which are now plunging deeply negative.

Every UK government since the first wave of energy market deregulation in the 1980s has embraced the mantra that unfettered competition among suppliers would lower retail prices. With some caveats, this is true and consumers have benefitted.

The trouble is, you can’t have it both ways. Either you subscribe to the view that markets set prices, or you set prices administratively by regulation. The mongrel halfway approach of a free market operating under a price cap was destined to fail as soon as market conditions deteriorated.

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Race to the bottom

Wafer-thin retail margins and limited recourse to pass rising costs through did not deter a wave of new entrants piling into the sector around 2015. They scrapped it out for market share by undercutting large incumbents and differentiating their offerings.

This strategy was largely a bet that a competitive edge could be gleaned from (i) being digital-first and agile, (ii) lowering overheads, (iii) having better customer service and (iv) buying wholesale power in spot or month-ahead markets.

This last point is critical: only the Big Six can fully hedge wholesale positions months or years into the future. They do this by leaning on their investment-grade credit ratings, integrated generation and trading operations and ability to stump up large sums as collateral.

Their integrated structure, with high-margin power generation and gas production arms, creates a “natural hedge” where “losses on the retail side as a result of higher prices are offset by increased profits from production and trading”, Reuters columnist John Kemp wrote this week (recommended reading).

Taking a prudent approach to risk management bestows resilience, which comes at a premium. The Big Six utilities spread their higher cost base across millions of consumers.

This means higher bills and therefore an opportunity for leaner, meaner retail competitors willing to ‘wing it’. Digital-savvy customers pounced on their cheaper tariffs, and the Big Six market share plunged from 99.5% in 2010 to 69% in Q2’21.

Some new entrants enjoyed meteoric growth, but have little to show for it. Bulb Energy, which is reportedly seeking emergency investment, grew very rapidly to 1.7 million customers despite racking up £187 million of losses in the two years prior to March 2020.

In a benign market with flat or falling wholesale prices and low interest rates, this approach passes as edgy and entrepreneurial: the business can always leverage the promise of future profits and refinance. The risk was always that a sudden price spike would leave non-integrated suppliers such as Bulb out of the money and unable to fulfil their gas or electricity supply commitments with their customers. This is exactly what is now happening.

Ironically, Bulb grew so quickly that it could be deemed too big to fail. With big suppliers baulking at the prospect of taking on its 1.7 million loss-making customers without government support, Bulb could be in line for a government bailout if it goes bust.

More political chicanery

The UK’s current energy secretary Kwasi Kwarteng is now scrambling for politically convenient answers to deep structural problems that his predecessors created. The price cap is not going anywhere because, Kwarteng insists, it protects millions of people from soaring bills.

Kwarteng knows that preventing suppliers from passing on rising wholesale costs to customers is a big part of the problem, but acknowledging that reality publicly is untenable. There is now an expectation that the price cap will shoot up by more than one-fifth next year. Kwarteng (or his successor) will claim the mechanism is still protecting some consumers.

This political chicanery stymies attacks from his opposite number Ed Miliband, the instigator of the price cap who is now shadow business secretary. Miliband this week praised the decision to keep the cap but warned any move to increase it would push millions more into fuel poverty. (Remember, this is the same man who in office declared that “there is no low-cost energy future”.)

But perhaps the most egregious politicking is Kwarteng’s attempt to heap the blame onto struggling smaller energy companies for their own misfortune, while talking sympathetically about supporting Big Six utilities that take on the insolvent suppliers’ loss-making customers.

At issue here is not the question of whether the government should save failing businesses, nor whether some suppliers acted irresponsibly (some did, others less so). It is that the regulator Ofgem’s laissez-faire approach allowed new entrants to take on disproportionate risks in an industry that is of strategic importance.

Moreover, if the government decides it is prepared to intervene and prop up the market, why wait until most of the smaller retailers have already gone bust? Robert Buckley of consultancy Cornwall Insight said in a blog post this week:

“Competition has been synonymous with consumer benefit for a decade or more of energy regulation and policy… Are we really to let over a decade of hailing competition as a desirable outcome be for nought? If so, many will have missed this rather critical change in energy policy objectives.”

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Technological fail

Adding insult to injury is the failure of the UK government and regulator to implement technological reforms to energy market infrastructure. Some of the small suppliers that are now going to the wall invested in business models geared towards delivering differentiated digital products and services predicated on timely execution of these reforms.

Ofgem consulted in 2015 on settlement of customer bills using half-hourly consumption data gathered via nationwide rollout of smart meters, with a view to this being available for the entire market on a voluntary basis by 2017. Today, half-hourly settlement and smart metering have been rolled up into a wider package of settlement reforms that won’t be fully completed until mid-2025 or later.

That package, known as the Market-wide Half-hourly Settlement (MHHS) programme, will enable consumers to be rewarded for ‘smart charging’ of electric vehicles or home battery storage systems during low demand periods when there is an excess of wind or solar power.

Several new entrants to the UK retail segment were banking on MHHS, or crucial parts of it, being up and running according to the original timetable. Tonik Energy was founded in 2016 to help reduce energy waste by selling consumers digital tech predicted on smart meters and half-hourly settlement. Tonik went into administration in October 2020.

Speaking to Energy Flux this week, Cornwall Insight’s Buckley explained that demand-side innovations such as these will be key tools in the push to decarbonise the UK economy, but there are tough decisions to be made around how to apportion costs and benefits.

The most politically challenging aspect is the creation of segmented market pricing, i.e. rewarding early adopters of technologies that not all consumers can afford to access, and spreading the cost of those rewards across all consumers. Buckley said:

“If you [the government] don’t want segmented prices because it is unfair, you should just say so. There’s been a fundamental unwillingness to explain to consumers the extra costs in their bills for decarbonisation. Until you front up to that, we are going to continue to come down these cul-de-sacs.

“Decarbonising the power market means we will see many times of plent[iful supply] and a few times of scarcity when we have to pay an awful lot for the marginal megawatts. The first of those cycles has come a bit quicker than many expected.”

If the UK allows most or all the smaller retail players that are driving digital innovation to fail, what message does that send to would-be investors keen to develop demand-side opportunities created by the energy transition?

Ultimately, as the UK economy electrifies, it is these innovations that will help ensure electricity market resilience by shifting loads out of periods of tightness and into more cost-effective windows of plentiful supply.

In times of stability, efficiency and innovation are rewarded while resilience via redundancy is penalised as a burden to competition (note here the closure in 2017 of the UK’s only seasonal gas storage facility in favour of global supplies of LNG). In times of crisis those priorities are reversed, and the market retrenches.

The UK needs to find a way of supporting electricity market innovation crucial to delivering its decarbonisation pledges without compromising on resilience, affordability and security of supply. It has taken a global energy crunch to reveal just how tricky that balancing act really is.

Seb Kennedy | Energy Flux | 23rd September 2021

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