Price cap profit increase will only stem retail losses

The price cap profit margin is only “theoretical” and must be increased by much more than Ofgem is proposing to stop energy retailers losing money, the boss of Utilita has warned.

The company’s chief executive Bill Bullen said if nothing changes more suppliers will leave the market as Shell confirmed it is doing on Tuesday (6 June).

Alongside the announcement of a large cut to the price cap from July, Ofgem recently proposed to recalculate the EBIT (earnings before interest and tax) allowance and introduce a fixed element to cover capital requirements for fixed assets and the ring-fencing of Renewables Obligation payments.

The EBIT allowance is applied to the sum of most other allowances, including those for wholesale, network, policy and operating costs, meaning it broadly scales with overall price cap level. It is currently set at 1.9%.

Under the proposed arrangements, which would come into effect in October, the EBIT allowance would have both fixed and variable components. The latter would be applied to relevant allowances at a rate of 1.41%.

Ofgem gave an indicative profit margin per customer of £47, equating to 2.4% of the forecast price level during the period. It estimated that the changes would raise customer bills by £227 million over the 12 months following their introduction.

However, speaking to Utility Week, Bullen disputed Ofgem’s suggestion that the energy retailers will return to profitability this year, saying the proposed changes will instead only help them cut their losses.

“Ofgem have this quite complex model of where they think prices ought to be,” he explained.  “There’s a wholesale bit. There’s an operating cost bit. There’s a profit margin. It’s all theoretical.

“The reality is that when you add up all those bits, supply businesses are loss-making.”

Labour shadow chancellor Rachel Reeves recently accused energy companies of making “war profits” from Russia’s invasion of Ukraine after they reported increased earnings in their financial results for 2022. For example, British Gas-owner Centrica saw adjusted operating profits across the group more than triple year-on-year from £948 million to £3.3 billion.

But Bullen said the segmental statements produced for Ofgem by British Gas, Scottish Power and EDF show their retail arms are on average losing money “and not a little bit.” He said the increased profit margin proposed by Ofgem is “a complete load of nonsense.”

Consolidated segmental statements for domestic electricity and gas supply (2022)

A theoretical model

“Everybody needs to understand this is a theoretical model Ofgem has got and the number isn’t big enough,” he added. “I don’t care what you call it… there has to be an increase in the price cap and a bigger increase than the one they’ve proposed.”

He said what Ofgem is attempting to do with the price cap is “actually impossible” in the current situation: “Ofgem are talking about wanting to manage costs and revenues for supply businesses to within 1.9%. It will be 2.4%. That’s incredibly close.”

“You’re trying to manage something down to such as a small margin when the underlying uncertainties are just too big,” he remarked.

Bullen said the inaccuracy of the price cap model is the result of an accumulation of issues, but the main problem is wholesale markets, which are “pinging around all over the place.”

Despite their efforts to match the wholesale index as closely as possible, Bullen said energy retailers are never going to be spot on.

They don’t know exactly how many customers they are going to have and they don’t know how much energy they are each going to consume: “You don’t even know what the weather’s going to be like. A one degree shift in temperature can add 5% to your gas demand, or take away 5% on a daily basis during the winter period.”

“All kinds of things happen,” he added. “And all you can buy in advance, of course, is a flat monthly product as well. You don’t get any of the sort of daily shaping. The markets aren’t open today.”

He said the problem is being exacerbated by the ban on forced prepayment meter installations, which means energy retailers are “racking up bad debt like crazy”. Energy UK recently estimated that the ban on forced PPMs was adding £30 million a month to the sector’s bad debt levels.

The politics of profits

Utility Week asked how politicians and regulatory bodies could find a palatable solution to the issue given that many retailers’ parent companies’ are earning billions of pounds, and suppliers, some of which are standalone firms, are often conflated with more profitable parts of the industry.

Bullen experienced this first hand in December when he appeared on Good Morning Britain and was accused of profiteering from the energy crisis by host Susanna Reid. He disputed her characterisation of Utilita’s financial situation, saying the company had lost £100 million over the previous three years and expected to lose £1 million per day that month.

“There probably isn’t a politically palatable answer here,” Bullen told Utility Week. “That’s the reality of it. Because what has happened over a long period of time is the politicians have talked up a situation that is fundamentally untrue. Somebody’s just got to call their bluff.”

He continued: “All I’m saying as somebody who’s trying to run a commercial business is this price capping regime doesn’t work. You cannot have a situation where the government is forcing people to make a loss. It just doesn’t make sense. At some point, that’s going to stop. And it’s not my problem to deal with the politics of it.”

At the moment, Bullen said Ofgem’s various parts seem to be pulling in different directions: “You’ve got one team in Ofgem that’s looking at a price cap, which basically means we don’t have enough money to run a business. There’s another team in Ofgem that’s looking at introducing new obligations of various sorts. Adding to that, you’ve got another group at Ofgem that are looking at financial resilience.

“And then you’ve got another group in Ofgem in the enforcement team that come along and say: ‘Well, you’re not financially resilient. You’re not meeting your obligations. We’re going to fine you some money and make the situation even worse.  You couldn’t make it up.”

A spokesperson for Ofgem said the regulator “closely analyses allowances for suppliers to ensure they can recover costs, while protecting customers from excessive costs.”

“A number of adjustments were made to these allowances in response to unforeseen situations throughout the gas crisis,” the spokesperson said. “We will continue to hold suppliers to account if they breach the level of the price cap or fail to uphold high customer service standards.”

Pulling out of the market

Bullen said if nothing changes “we’re in for a bad time because things are going to get worse.”

He said the problem is demonstrated by Shell’s decision to sell its retail energy business in the UK. In January, the oil supermajor announced it was reviewing the future of its energy retail arms in the UK, the Netherlands and Germany, and on Tuesday (6 June), the company revealed that the sale processes are already underway.

“I don’t know that we will necessarily see another big spate of failures, but I think what we will see is companies deciding to pull out the market, one way or another, as Shell has done,” said Bullen.

He said the only way Utilita will be able to continue managing its way through the crisis is ensuring that they “beat the wholesale market”.

Bullen said the company has also worked to be cost-efficient as possible but “one of the flipsides of that is of course you customer service suffers.”

“We’ve now got a situation where Ofgem is basically moaning at suppliers for not maintaining customer service standards,” he lamented.

“We’re not proud of having call wait times of an hour or whatever they might be, but at the same time, we have to survive and if we need to shave an extra 1% of our costs in order to be profitable or to breakeven, then obviously that’s what we do as a business.”

He said the deregulation of the sector was meant to “atomize the market so that companies become more efficient specialists in different areas. I think the fact that we’re performing where we are relative to the big guys is an indication that actually that economic strategy is the right one to take.”

“Unfortunately, because price capping impacts just on the retail operations, it does make it particularly difficult for companies that are just retailers.”

But Bullen said even the vertically integrated companies that are able to cover their retail losses with profits from other parts of the group will eventually start to ask: “Why are we sacrificing a big chunk of the profit we could be making by running a loss-making supply business?”

Attracting investment

Dhara Vyas, chief executive of Energy UK, said customers are still suffering from high energy prices and the cost-of-living crisis more generally. She said it is important customers have some form of price protection and this protection is “future proof”.

Vyas said the companies still operating in the retail markets have “done very well to weather the last 18 to 24 months” but “I don’t think we are necessarily out of the woods.”

“Whilst profits have been made in parts of the market, that’s certainly not been the case in the energy retail market and of course that leads to confusion,” she added.

Vyas said energy retailers need to be able to earn enough more to justify the large investments that will be required in coming years: “The reality is if we want a retail market that can help support people to get their homes, businesses, buildings ready for net zero, we need an energy retail market that can unlock that unlock that value; a market that can innovate, whether it’s services, products, tariffs.

“Most suppliers don’t make money where they feel they can genuinely invest significantly in that sort of innovation and unlock the value in the system that’s going to get us to those net zero targets.

“Right now, I don’t think the market’s well positioned to do that.”