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The Mystery of Energy Prices

 4 min read / 

Over the past year, wholesale gas and electricity prices have fallen 23% and 12% respectively while domestic energy prices have risen by 4% over the same period. The lack of correlation has not gone unnoticed, with several newspapers and organisations criticising the Big 6 energy firms for not passing on savings to customers. Political parties have even gone as far as to pledge to freeze prices and split up energy firms in order to increase competition in the market. But are they correct in saying that energy firms are engaging in ‘unfair’ practices or are there legitimate reasons behind the rising energy prices?

Members of the Big 6 (British Gas, E.ON, EDF, Npower, Scottish Power, and SSE) have all defended their price rises by stating that they are as a result of external cost pressures and their need to hedge risk. At the end of 2013 directors of energy firms broke down their price rises in front of a parliamentary enquiry. Despite prices falling after they set their tariffs, the energy companies had been forced to pay higher wholesale costs due to the fact they had secured the majority of their supply up to 2 years earlier using energy futures. The energy futures that have been redeemed over the past 18 months might have been bought during a period of particular volatility in the energy markets, causing the risk premium on these futures to rise. Energy firms also have to reduce their exposure to any sharp cost increases in the coming year so they tend to be quite pessimistic in their predictions for wholesale price rises. In 2013 they passed on their average estimate of 3.5% to consumers.

Government policy has also been blamed for the unusually high energy costs. UK electricity and gas distributors are subject to the “Energy Companies Obligation” which requires them to help their customers reduce their energy consumption through the subsidisation of measures such as home insulation. The government also requires these firms to “improve the ability of low income and vulnerable households to heat their homes”. The combining and restructuring of the Carbon Emissions Reduction Target and the Community Energy Saving Programmes at the beginning of 2013 may have led to a short term spike in policy costs for energy firms but it will be interesting to see how much of an effect these have had on The Big 6’s costs more recently.

On the other side of the argument there have been accusations of tacit collusion between energy firms. Due to the nature of the beast, it is very hard to prove that energy firms are avoiding reducing their prices, but the regulatory body Ofgem stated that there was enough evidence supporting this view to recommend an investigation into the topic. One of the major causes of distrust is the tendency for retail prices to rise in line with wholesale price increases but not fall as greatly when wholesale prices fall. From the graph above it’s easy to see that prices rose very sharply in January 2008 but retail prices remained high even after wholesale prices fell in 2009. However it could just be that the price is following a long run trend rather than being the result of unfair practices.

Currently, one can only speculate as to how the next government may deal with rising energy costs with each major political party taking opposing views upon the issue. The Labour Party desires to take a very direct approach, freezing energy prices for 20 months, believing that putting pressure on the energy distributors is the best way to ensure future cost reductions. A potential price freeze is certainly popular among voters but has proven controversial within the industry. Many firms have highlighted the risk of gas and electricity shortages that may arise if investment is stymied by these measures. This is especially relevant now given that last week the National Grid warned of a record 8-year low in spare capacity.

The Conservative Party has been quieter about their policies in recent months, avoiding any discussion of the Big 6 at their political conference. Of the plans they have announced, the largest seems to be a reduction in green levies and a broad focus on ‘reforming’ the industry as a whole in order to increase competition. The Liberal Democrats have followed a similar line, pledging to increase the number of smaller distributors who can help compete The Big 6’s profit margins down, but still defend the benefits of green energy levies.

In any case there are likely to be some significant changes to the energy industry over the coming year. It will be interesting to see what effect, if any; the policies enacted by future governments have on the structure of the industry and the prices they charge.

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