Our take: The energy crisis and what needs to change

The UK energy market is in a state of panic, as volatile wholesale prices and regulatory price caps make for an extremely difficult operating environment. At the time of writing this blog, 7 suppliers have ceased trading in the past 7 weeks with many more expected to follow suit over the coming months. Some are predicting that by Christmas there may be as few as 10 domestic suppliers in operation, down from a high of 70 in early 2018.

Despite the ongoing turbulence, commentators have noted that the energy market has been in consolidation since its March 2018 peak with high wholesale prices, regulatory price caps and weak business models all being cited as reasons for failure.

Others have suggested that although these factors are contributing to the instability, the market is in fact experiencing a correction after a period of rapid expansion.

This will be of little to no comfort to the suppliers who have ceased trading, the thousands of employees now out of work or whose jobs are at risk, and the millions of customers moving suppliers under Ofgem’s Supplier of Last Resort.

The next few months will be extremely challenging for the UK energy market, however, will this experience pave the way for a remodelled market that equally promotes and protects the interests of suppliers alongside those of customers? We take a deeper look at the factors contributing to the UK energy market’s current decline in hope of finding a more sustainable model for the future.

Limited gas supply and the move to renewables
We are currently seeing a significant increase in the wholesale price of energy due to shortages in the gas supply resulting from the UK’s reliance on offshore gas to compensate for limited onshore generation. When gas supplies reduce due to severe weather events or are artificially lowered by supply controls, prices will inevitably rise.

Some have suggested that a greater investment in UK renewables and nuclear power will decrease the reliance on offshore gas, reducing the impact of wholesale price escalations and moving the UK closer to its carbon reduction targets. However to reach the point where onshore renewable generation replaces offshore imports, significant investment is required. This will undoubtedly increase energy prices in the short-term prior to stabilising.

Assuming the appropriate price protections are in place for vulnerable consumers, we hope that policymakers, the regulator, generators and suppliers can find a workable solution to achieve this objective.

Wholesale prices and the need for hedging
The wholesale price of energy has risen steadily over the past 6 months and many suppliers have found themselves buying energy from the wholesale market at a higher price than they are able to sell it to their customers, resulting in significant losses.

Small suppliers either do not have sufficient capital to secure long-term hedges or choose not to hedge, profiting off falling wholesale prices, and as such find themselves exposed to expensive shorter term pricing when wholesale prices increase. A supplier can combat this by hedging over a longer period of time, however even those with robust hedging strategies can find themselves caught-out by extended periods of market volatility.

Larger suppliers, though not immune from the effects of rising wholesale prices, do have key advantages over smaller challengers. They have sufficient capital to hedge far enough in advance and many are generators of electricity allowing them to offset supply losses with generation revenues.

Although the recent wholesale price has reached record levels, severe fluctuations in the wholesale market are not unprecedented, meaning there is a reasonable expectation that these types of events will occur again. Sufficient capital and a robust hedging strategy should be obligatory for any new supplier entering the market. In reality there are very few barriers to entering the market allowing for suppliers to operate without sufficient capital exposing them to greater risk of failure.

Unsustainable pricing and the price cap
From 2012 to 2018 the energy market grew from 12 to 70 suppliers with many suppliers offering customers a cheap alternative to the “Big 6”. In most cases these new suppliers sought to differentiate on price alone, acquiring high volumes of customers through price comparison websites (PCW), relying on a “tease and squeeze” strategy of acquiring customers on cheap loss-making tariffs for the initial contract term then making a profit on those that default onto expensive standard variable tariffs (SVT). Small suppliers were not unique in this strategy and in 2019, in an attempt to protect disengaged customers, Ofgem introduced the default price cap – the maximum price to be charged for a SVT.

However many small suppliers have argued that insufficient thought was put into the price cap calculation methodology to ensure suppliers can run sustainable businesses. Citing the fact that the current cost of supplying energy far exceeds that of the price cap, leaving suppliers unable to absorb losses and forcing them to cease trading. Further to this, many industry experts claim that a price cap disincentivises switching, exacerbating the poor levels of customer engagement that have plagued the industry for over 20 years. Calls are now being made for the price cap to be removed, or if a price cap is necessary, moving to a relative price cap that tracks movements in wholesale prices. This will encourage competitive forces, increase engagement and allow smaller suppliers to price sustainably, weathering future market instability.

Others will argue that the price cap is an important mechanism to protect customers against predatory pricing strategies particularly for disengaged and vulnerable consumers. In addition to this they argue that barriers to entry are too low allowing small suppliers to enter the market without sufficient capital to hedge against fluctuations in the wholesale market.
With an efficient operating model, sufficient capital and robust hedging strategy, suppliers should be able to weather wholesale price fluctuations whilst adhering to the price cap.

Where the price cap was initially implemented to protect vulnerable customers from expensive SVTs, it has seemingly transformed into a mechanism for protecting customers against wholesale market volatility at the expense of smaller suppliers who entered the market appeasing the low level requirements set by Ofgem.

The future of energy supply
There are numerous elements to consider when determining what will make for a sustainable and successful retail energy market of the future – to boil it down to a handful would be an oversimplification of the problems at hand. We will however address the aforementioned problems (knowing this is not an exhaustive list) with possible solutions.

There is a clear need for sustainable pricing and future proofed business models that are sufficiently backed to withstand the fluctuations in wholesale prices. To this end, Ofgem must address the license approval process to ensure only sufficiently backed challengers working towards a collective goal of achieving net zero can enter the market. In the past 10 years, the market has benefited significantly from innovations developed by challenger suppliers. Any increased barriers to entry must not stifle innovation but rather help promote and encourage suppliers looking to differentiate beyond price.

This ties in with the need for greater investment in renewables, not only for security of supply or the need to hit carbon reduction targets, but for the greater good of the planet. Suppliers that are tackling this head on with investment in renewable generation and resources to decarbonise the home are contributing to the greater good while offering customers a differentiated proposition that goes beyond the price-led propositions of many of their competitors.

Finally, PCWs who position themselves as the consumer champions and control the narrative, have failed to adapt their business models to support suppliers with differentiated propositions. When promoting the value of switching, more needs to be done to promote the net zero goal and move away from the bargain basement “cheap is best” messaging that has dominated the industry for too long. There is an opportunity for innovative third parties to tackle the consumer engagement problem and promote a sustainable, value-led narrative that works for suppliers, customers and helps realise the UK’s net zero ambition.