Recession and the future of electricity utilities

The country has now entered a severe recession and considering the widespread impact already caused by Covid-19 and the resulting lockdown, this period of economic downturn is set to shake the energy sector further. So, how can the government keep policy for the industry on track, and maintain pace of transformation, while tackling the deepest financial crisis on record?

The effects of the pandemic have been far-reaching, with the power industry losing out on £1.1 billion between March and August as reduced electricity demand and wholesale prices cut revenues for suppliers, generators and network companies.

The retail supply sector – which was already in some turmoil as a result of a combination of price caps and volatile wholesale energy prices – has been struggling to react to the change in consumption patterns. Over the recent lockdown, demand dropped in some areas by as much as one fifth. Most significantly, suppliers serving industrial and commercial customers have been exposed to the downturn in consumption due to shops, schools, offices and factories being closed.

With corporate customer insolvencies set to continue, there is no sign of this pressure easing in the coming months. Domestic suppliers are showing signs of concern around the long-term financial impact of the recession. The end of furlough, rising unemployment figures, and the subsequent financial impact on consumers will mean that many are simply unable to pay.

Whilst suppliers may have benefitted from the fall in wholesale electricity prices over lockdown, those holding excess volumes of electricity purchased forward in the wholesale market are now having to be sold back to the market at lower prices. Energy retail has always been a low margin business and the smaller suppliers, in particular, have limited capacity to absorb cost shocks.

Last year, Ofgem introduced new tests for energy suppliers entering the market, including demonstration of adequate funding; while this may build resilience for the future, it is obviously too late for the current crisis. For now, energy suppliers should be preparing to take a financial hit, as it will be increasingly difficult to pass these costs back to customers. The harsh reality is that suppliers will be required to swallow some of these costs. In such a volatile environment, the retail sector can therefore expect to see increased insolvencies and M&A activity.

While attention has recently been focussed primarily on the immediate economic crisis, conversations around green energy have, once again, been brought to the fore. The pace of transformation in the sector has been increasing rapidly, following the government’s introduction of a legally binding net zero target for UK greenhouse gas emissions by 2050. So, while delays to policy announcements and the Energy White Paper have been disappointing, they are not a significant barrier to achieving the long-term aim of net zero emissions by the middle of the century.

In the deepest recession on record, it is crucial that government spending continues to support the green economy, introducing or increasing subsidies for energy efficiency and renewable energy. The focus on electricity decarbonisation has seen coal use drop to its lowest in 100 years and record levels of wind and solar generation. A similar approach is needed to find the sweet spot for heat decarbonisation, including the possible combination of electrification with hydrogen. However, there is a question mark against how viable it is for the energy sector to maintain investment through the recession – ultimately, in the absence of subsidy, investors will be reluctant to invest, at least until wholesale prices recover substantially.

In the drive towards net zero, energy networks are undergoing a major transition. For electricity networks, the challenges of decentralisation and digitisation are compounded by the requirement to support increased demand resulting from decarbonisation of the heat and transport sectors.

In particular, electricity distribution networks will require substantial investment to accommodate increasing levels of electric vehicle charging. Investment in regulated electricity networks will be driven primarily by the price controls. It is therefore vital that the new RIIO-ED2 price controls provide the certainty that the network companies will require in order to commit to these substantial levels of investment.

The UK recession is set to shake the energy sector and may put the brakes on investment just at the time when it is needed the most. It is more important than ever for the government to be proactive and maintain the pace of change. At least until the effects of recession have worked through the economy, an extra boost from the government by way of subsidy will be essential to ensuring that the energy sector stays ahead of the game. By the time it hosts the next round of global climate change talks in Glasgow next year, the UK government should have laid out a clear sense of direction.