Can the energy retail market be fixed?

UK Policy Net Zero

Can the energy retail market be fixed?

Commentary
Posted on: 24th May 2022
Tim Lord
Associate Senior Fellow | Net Zero

Energy hasn’t been far from the headlines in the last few months, and its profile has ramped up again recently with Ofgem’s announcements on changes to the retail market. But focus on the short-term risks ignoring a more fundamental question: can the energy retail market be fixed?

For most of the last decade, the guiding principles of energy retail policy and regulation have been pretty simple: we want energy suppliers to provide gas and electricity at the lowest possible cost to households.

To achieve that, the aim of government and regulatory policy was similarly straightforward. Maximise competition to improve efficiency and innovation by encouraging switching and incentivising market entry; and introduce a price cap to provide a ceiling on costs to consumers.

That strategy worked ok for the last few years. But the current crisis has exposed a fundamental problem.

Rising prices, failing suppliers

The key innovation produced by our retail market structure was in financial risk – most energy suppliers were incentivised to become what was once described as “a hedging strategy with a logo, a website and a call centre”. 

Some suppliers took lower risks, hedging their risk by entering into forward contracts at higher prices to reduce exposure to volatile spot market. Others took a chance on spot markets in the hope of being able to offer cheaper tariffs to consumers.

The unprecedented rise in spot market prices in the last 9 months – to 6x the government’s central estimate – exposed the flaw in these incentives.  The suppliers who weren’t hedged faced hugely increased costs; the price cap meant they couldn’t pass those costs on; and 23 companies serving over 4 million customers went bust as a result, with the cost of those failures falling to taxpayers.

Falling prices, failing suppliers?

The crisis has now entered a new phase. The market has, in effect, frozen. The gap between average SVTs and cheapest tariffs has disappeared, meaning the price cap is now the anchor at the bottom of the market, not the ceiling at the top.  And customer switching has stopped as a result, with an 83% fall in switching between February 2021 and February 2022.

 

Average SVT vs cheapest tariff (Feb 2019-22)

Customers switching energy suppliers (000s, Feb only)

The problem that Ofgem is now worrying about is what happens when the market gets moving again – and in particular if the fall in prices in spot markets persists.

In that scenario, companies unencumbered by forward contracts can offer cheaper deals, and have a pool of millions of households ready to switch the moment it makes financial sense.  That would give consumers a better short-term deal, but would leave well-hedged suppliers with contracts for lots of expensive gas, and no customers to use it. 

Ofgem’s response to that has been to introduce measures which discourage switching – in particular the Market Stabilisation Charge. This new charge means that, if you want to switch, your new supplier will have to pay a charge to your old supplier. That charge will be passed to households. In effect, those wanting to switch have to buy themselves out of the forward contract that their current supplier has entered into on their behalf.  The effect will be to make it much harder – and more expensive – to switch suppliers in pursuit of a cheaper deal.

The charge effectively stops companies passing on the reduction in cheaper spot markets to consumers in order to protect the long-term health of the market.  Ofgem have said as much, arguing that “we do not consider that we should prioritise the lowest possible prices for consumers…. Over the need to enable efficient suppliers to finance their businesses.”


This about-face has a rationale – namely, avoiding another round of supplier failures. But it exposes a much deeper problem. 

As we’ve seen in the last few months, if prices in spot markets rise, then the firms with riskier hedging strategies go bust – meaning government must intervene by in effect nationalising their businesses. 

But if prices in spot markets then fall, then companies with less risky hedging strategies could lose out unfairly – meaning the regulator intervenes to protect them at the expense of short-term savings to consumers. 

What next?

There are both short- and long-term implications of all this. Trying to tackle this problem with more and more layers of intervention seems doomed to failure – not least because of the political fallout that may lie ahead.  But if these measures are to have any chance, the government and Ofgem need to do a much better job at communicating what they are doing in the short-term and why - pro-actively making the argument for what they are proposing, and why it is in consumers’ interests.  Otherwise the toxic mix of high prices and a perception that suppliers are being protected at the expense of consumers risks making talk of civil unrest become a prediction, not a warning.

Beyond the immediate crisis, with this ‘market’ now a long way away from the vision of free-market competition and innovation, we urgently need a strategy for how it should operate in the long-term. Prioritising switching and price ahead of innovative service models has not worked, and is unlikely to work in a market buffeted by the disruptive forces of unstable global markets and the net zero transition. But if switching and purely price-based competition are no longer the goals of energy market policy, what is?

Government needs to answer that question by identifying what outcomes it wants the market to deliver. A market which differentiates not just on price but on the service levels offered, and which creates incentives for consumers to make the investments needed to decarbonise their homes. A market where suppliers are rewarded for providing a more intelligent demand function to complement intermittent renewable supply, and where we have reduced exposure to volatile commodities like gas. And a market where protection is targeted to those who most need it.

Some companies in the market are showing what might be possible – by seeking to differentiate not just on financial risk innovation but on tailored consumer offers, underpinned by innovative technology and data platforms. Only by leaning into this transition, and complementing short-term fixes with long-term reform, can we deliver an energy market that works.

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