Is the UK Power Industry Having its Cake and Eating It Too? A Special Report

Utilities need to make money in order to run effectively but should there be an earnings limit?
Published: Wed 27 Nov 2013
In order to boost investment in an ailing infrastructure, create a more reliable service for consumers, and provide competitive rates for the consumer, the UK introduced market liberalization in the late 1980s. Mostly, the process appears to have been successful. The process has contributed towards the transformation of the sector, its employment, industrial relations, pricing and impact on the environment. Between 1990 and 2005 the industry delivered major price cuts to consumers; according to a report by Pique [Liberalisation, privatisation and regulation in the UK electricity sector]. Consumers even have the freedom to switch suppliers in search of better rates and service.
A very different world
Recently, tariff increases have become more frequent, leaving consumers outraged. Analysts are predicting that there will be more increases. Research shows that it is one of the largest regular bills that a UK household has to pay. It is interesting to note, however, that the country’s average domestic electricity price, including taxes, ranks fourth lowest amongst 15 EU countries, and the fourth highest among the G7 group of nations.
But, why so many increases? Mostly, it is because we find ourselves in a new world with new pressures. Energy suppliers blame “green fees” for the increases. Approximately 11% of the electricity bill goes towards government schemes aimed at saving energy, reducing carbon emissions and tackling climate change. The UK government has already told energy companies that, by 2020, they can add a total of £7.6bn to household bills in order to pay for all the new power plants, wind farms, and other “clean” energy projects. Figures already indicate that energy companies charge about £20 extra per year to help pay for clean energy projects. This will eventually rise to £95 by 2020.
Another reason for the hikes is grid upgrading. The UK (and most countries in the developed world) requires an urgent upgrade to its transmission grids. Utilities are building transmission lines, installing new equipment and fixing power plants after years of under-investment. This is not only to accommodate renewable power generation but also to facilitate increased distributed generation and energy storage. These are key elements of any nation's energy security strategy. It is naive to think otherwise.
Another British Pound squeezer is natural gas imports which are on the increase. This has a major effect on the consumer’s pocket. Today, the UK imports more than half of the country’s gas. Over 20% is piped from Norway, 10% from the Netherlands, and a further 20% arrives as liquefied natural gas (LNG) from Qatar. The UK’s growing exposure to tightening LNG markets in recent years has been a key driver of rising natural gas prices. In the last month the UK’s “Big 6″ utilities have raised natural gas prices (and electricity prices) by 8-11%. These prices had already doubled in the last decade.
It’s a market, not a charity
Ofgem’s latest figures show that the majority of the consumer’s money goes towards the purchasing of gas and electricity on the wholesale market or direct from the electricity generator or gas supplier. The cost of running a retail business accounts for 58% to 67% of a utility bill. In addition to this, distribution costs account for 16%, transmission networks, 2% to 4%, and VAT, 5%. Metering costs and gas storage also need to be accounted for.
Wholesale gas and electricity is made of contracts. Each company buys energy at different prices depending on the delivery date. The purchases are done at intervals in order to avoid the risk of volatility, for instance, during unrest in oil-producing regions. That helps protect customers when fuel prices spike, but it prevents customers from enjoying the benefits of a price drop. A bit of a catch-22 situation really.
Excessive profits
Energy retailers are very clearly commercial entities, not charities, which are entitled to make a profit. But, some say that the major energy suppliers’ profits are “excessive.”
Ofgem has collected data on utilities’ profit margins for the last three years and statistics show that from mid September, the average profit margin on a £1,315 bill is £65. This was £30 higher than September 2011 and September 2012. Ofgem warns that this is merely a snapshot as the figure has been volatile. In some months, the profit margin escalated to over £100, whereas in others the margin has been negative. Apparently seasonal factors are mostly to blame for this fluctuation.
Price control
There are 14 million distribution networks and because they are regional monopolies, customers must rely on regulation from Ofgem to get reasonable tariffs. Although Ofgem can’t control the rates, they can regulate them.
Five out of the six electricity distributors’ business plans have been rejected (2015 to 2023) as they do not demonstrate sufficient value for the customer. Ofgem says they must do more to cut prices for consumers.
"We are pleased that nearly all companies have pledged to cut bills, but we feel that most companies can go further in cutting their costs and expect to see further improvements when they re-submit their plans in March," said Hannah Nixon, Senior Partner for Distribution at Ofgem.
Energy regulator Ofgem, which Labour plans to replace after 2015, has suggested legislation would need to be passed to change pricing arrangements. Six companies own 96% of the UK’s retail business. This will need to change to allow for more competition and hopefully better rates.
Although customers are encouraged to switch utilities in order to find better rates, these are usually short term gains and they find that the rates do escalate eventually and another switch is too time-consuming. Perhaps with an increase in suppliers and improved contracts, utilities will be forced to bring their prices down.
Energy security needs long-term solutions
If consumers are demanding cheap prices right now, they must realize that they will forfeit energy security in the long term. You can’t have both. Customers need to know that eventually prices will come down. They must be updated on progress so that they will support various infrastructure projects where extra funds are required. They are no longer just consumers-they have also become investors.
If energy security is to be achieved, a long-term vision must be employed. For instance, the politically and environmentally sensitive shale gas extraction will deliver a brief respite but figures show that a 10% recovery of shale gas will supply the UK with only four years of energy. What happens when we close in on 40 years’ worth of supply? If this option is followed through, a long-term vision must be adopted. For instance, the money made off this could go towards a more sustainable solution such as renewable energy, energy storage and a fit for purpose smart grid. Natural gas imports are also costing a fortune and less reliance on these will save the consumer money in the long run.
Possible Solutions to bring prices down
It was hoped that the extraction of shale oil and gas, through hydraulic fracturing, would bring household energy prices down. The US has recently experienced a natural gas boom and prices have come down in some States. Unfortunately, this appears unlikely for the UK since the costs of production are expected to be much higher than in the US and the political pandering to NIMBY elements is likely to continue with a general election looming.
Renewable energy may be the answer. It’s cheap (once the infrastructure is in place) and sustainable. However, Germany’s Energiewende, the major transformation towards renewable energy production, has left Germany with a hefty price tag for consumers. Germany's electricity costs are among the highest in Europe and could soon be among the highest in the world.
Another possible solution is to make the distribution and transmission infrastructure run without profit and allowing this entity to integrate storage solutions across the spectrum. That is, the infrastructure should not be market-driven but should instead be financed by a leavy. A good example of this is Road Tax. The upgrade plan should be in the region of 20 years and consumers should be kept up to date with its progress.
Is tariff-freezing the answer? We don’t believe so. UK politician Ed Miliband, who says that energy firms are overcharging consumers, is calling for a 20 month tariff freeze. This will be a short-term solution only. It may help consumers avoid further tariff increases for a limited period but, from a long-term perspective, it will probably have a negative effect on the power industry and its consumers.
Utilities will ensure that revenue lost over this period will be accounted for. And, even if it isn’t much in reality, they will use it as an excuse to ramp up power prices in the future. Price fixing has the potential to increase the risk of outages, jeopardize jobs, and chase investors in low carbon power generation.
Privatization works
Privatization is a long-term solution in itself. The main argument for privatisation is that private companies have a profit incentive to slash costs and run efficiently. Government-run industries do not usually share in any profits. Private firms are more interested in making profit and tend to cut costs and aim for efficiency, keeping stakeholders happy.
It is often said that governments generally make poor economic managers as political pressures tend to distort sound economic and business sense. Also, governments generally focus on the next election. It is for this reason that they may not want to invest in infrastructure improvements which will benefit the firm in the long term. They are more concerned about projects that will benefit an election campaign.
Engerati Analysis
There is no doubt that privatization of the electricity industry is the way forward. However, there is no place for politics. But, since electricity is needed by a country to thrive, a regulator, such as Ofgem, must be in place in order to ensure that consumers receive  fair prices and macro long term planning is in place. The progress of energy efficiency, infrastructure and renewables programs- all requiring additional funding, should be communicated to the consumer. There appears to be a lack of transparency and consumers are being left in the cold by utilities with the general media not helping the cause. Consumers need to know that their pennies are being wisely spent. They also need to know what the long-term benefits are and when prices will come down again as a result of these programs.
Utilities must also recognize the fact that consumers are no longer simply consumers. They have become investors in their own right, as well as prosumers. With technology improving every day (and dropping in price), utilities need to establish trust with consumers or they will lose them. [Read:Utilities Still Have a Place in e-Street]