Time to unwind Ofgem’s unhelpful interventions

Following a warning from Ofgem’s chief executive Jonathan Brearley that the regulator will clamp down on energy firms making excess profit, Utilita chief executive Bill Bullen outlines his frustrations with the impact the price cap is having on the market.

Jonathan Brearley has issued another ‘warning shot’ to the industry, claiming that Ofgem will clamp down on energy firms making excess profit.

Sadly, this is nothing more than just that – a warning shot. It will have zero impact on the companies making large profits because price capping has no impact on them.

The Ofgem price cap – which, as we have seen, is not very good at capping prices – is actually a profit cap on the retailing activity. But the big profits are being made in other areas of the value chain – production and distribution.

Whilst distribution is a regulated monopoly business subject to its own price capping regime, production for both gas and electricity, although licensed, is a largely unregulated business and not subject to a price cap.

Ofgem makes no attempt to cap the profits of producers, and this is where the big profits have arisen in the current crisis – a failed government intervention boosting them by a further £6 billion.

Whether producing gas or renewable electricity, with no significant change in costs but a huge rise in the wholesale market price, these businesses have become phenomenally profitable over the last two years. Even in the current market with retail prices “for the typical household” about £2,000 per year, compared with pre-crisis £1,000 per year, the vast majority of that extra £1,000 per household is going to either a producer of renewable electricity, or a producer of gas.

The super profits turning up at renewable generators aren’t just about free markets. They are also the result of a failing government intervention into the market, the Renewables Obligation. This provides about £6 billion of additional profits – above the super profits that high wholesale markets are delivering. Neither Ofgem nor the government has made any attempt to reduce that subsidy. Incidentally this is the same amount of money we’ve been arguing for as additional support for low-income homes for next winter (£600 for approximately 10 million households).

Ofgem’s attempt to control profits in the retail sector has actually cost consumers money during the current crisis – not just because of the costs now being carried by all consumers for the large number of failures and the unhedged positions of many suppliers that did not fail.

It should be immediately obvious that Ofgem cannot control the profit level of a retailing business to within 1.9%. The residual risk from the wholesale market prices, even after hedging, is greater than that, and the risk resulting from the weather is several times that level. Every degree difference from the seasonal norm results in a 5% change in gas demand alone, and since most days are either warmer or colder than the average it’s clear this is not a risk that can be managed that closely.

The consequence of this is that the hedging strategy of a supplier must follow the hedging strategy assumed in the price cap mechanism, which at the start of the crisis was six months and has now been reduced to three. Prior to price capping being introduced, we had a hedging horizon of up to two years at Utilita – a strategy that would have seen us comfortably through the worst of the crisis without having to pass on large price increases to our customers.

The longer-term impact of Ofgem’s retail profit capping mechanism is also going to result in adverse outcomes for consumers because it will starve investment and innovation in the retail sector and ultimately squeeze out specialist retailing operations. Consequently, it will limit competition to those vertically integrated large companies – the ones who are making super-profits upstream.

Nominally the equation that Ofgem uses to set the price cap does indeed contain an allowance for profit, and they have suggested increasing that amount from 1.9% to 2.4%. But it is a complex equation, and the reality is that errors elsewhere have resulted in retailers showing losses of 3% or more for retailing activity ever since price capping was introduced in 2019. Ofgem has been fully aware of this but has made the situation worse by adding to the cost of operating a retailing business since it introduced price capping.

Ofgem is not going to solve the problem of high residential energy costs by constantly attacking retail operations. Fundamentally it can only do that by addressing the well-documented failings that markets often have – poor information, lack of capital, and the difficulty to factor time into consumer decisions – which explain why all consumers would be better off investing in more efficient houses and appliances than buying too much energy. This means taking action on product and building standards.

In the shorter term the best it can do is to start unwinding the many unhelpful interventions that are preventing the market from working as well as it should.