You can’t have it both ways

Regulator, press and politicians are demanding that domestic energy prices follow close behind the wholesale curve, but is that really a good idea? Jillian Ambrose says, probably not.

No sooner had Ofgem finished its latest round of finger-wagging over stubbornly high energy tariffs than it emerged that bills are in fact falling. Just not for households.

Business customers have been seeing the benefit of this year’s steadily falling wholesale energy prices for months, locking in the lower value of gas and power for up to three years ahead, suppliers tell Utility Week.

So if energy companies can pass on falling wholesale costs to business customers, why are households still paying the same amount as they did over the past winter?

The answer goes some way to explaining not only why residential bills are slow to react to the weaker market conditions, but also why the current supply arrangements are not necessarily a bad thing for households.

Utilities face mounting political pressure to cut residential bills as wholesale price falls leave the market hovering around levels not seen since 2010. But analysts agree that any reduction in retail prices is only likely to take effect in autumn.

A Citigroup research note said the big six are unlikely to make changes to retail tariffs in the near-term because of weak financial results over the first quarter and because of forward hedging positions.

Utilities typically buy gas and power around two years ahead in order to hedge against market risk. And because 2013 saw prices sustained at strong levels after a long, cold winter, the recent price slump has not been fully passed through to the market position of utilities.

However, for business consumers, lower prices are already available.

“It is important to highlight that many business customers can and do benefit from falling energy prices already,” said business supplier SmartestEnergy in a statement. “At the time a customer transacts, Smartest­Energy will offer a price based on the wholesale market.”

And SmartestEnergy is not alone.

Energy procurement specialist Inenco has been encouraging clients to take advantage of lower market prices since April this year, origination manager Joe Conlan tells Utility Week. Business customers are typically offered either fixed-term or flexible contracts, both of which are based on the prevailing market price. The most recent high-profile fixed-price contract was signed in February between EDF Energy and South Staffordshire Water for five years at a cool £50 million, fixing most of the water company’s electricity costs until 2020.

By contrast, flexible contracts can be traded by a supplier on behalf of a client based on current prices for delivery up to three years ahead, or as close as the next day. This form of buying often carries a greater risk, but at current pricing levels offers buyers a bargain.

Conlan says flexible contracts are particularly in demand now because they allow suppliers to balance the higher costs locked in last year with cheaper prices today, bringing the overall cost down.

GDF Suez, another key energy supplier for business users, tells Utility Week that its flexible contract option also offers a “sell back facility” so customers can sell back energy they may have purchased at a higher rate once market prices start falling.

A savvy use of both fixed and flexible contract types can help business consumers offset market volatility, but companies are still exposed to strong fluctuations in price, which would not be acceptable to domestic consumers, Conlan explains.

For a business to be caught short when wholesale prices rise might mean a dent in profits, but for households a sudden increase could have far more devastating consequences. When it comes to residential bills the big six need to play it safe.

“If residential suppliers bought the way that business users do, they would see a more market-reflective rate but this would also mean more volatility,” Conlan says, pointing to last year’s dramatic price spike in late March as a key example.

“So residential consumers could have seen their bills triple in a month, which I don’t think would be acceptable,” he says. “If suppliers didn’t take the approach they do, it would be harder on households when the market moves higher.”

Rather than households facing soaring bills after last spring’s dizzying market surge, UK consumers were cushioned from the blow by the fact that much of last year’s energy was sourced the year before.

Bullish market prices did eventually filter through to retail tariffs, but the price rises came into effect six to nine months later, giving suppliers the opportunity to offset the gains by exercising other contract options.

The purchasing strategy of the big six helped households then, but has found little support as market conditions reverse.

The UK’s largest household supplier, British Gas, defended its unchanged tariff saying that wholesale market falls “do not feed through immediately to retail prices”, while Energy UK echoed this, saying “it can take time for bills to catch up”.

Ian Peters, managing director of residential energy at British Gas, adds: “We have other costs that are rising – regulated transport and distribution costs, environmental costs, metering costs.

“We are certainly not increasing profits on the back of lower wholesale gas prices – our trading statement last month downgraded profit expectations.”

It is not an easy, or popular, message for the big six to deliver: critics cannot have it both ways. If tariffs are made sensitive enough to respond to wholesale price falls, they will be sensitive to potentially debilitating rises too. By protecting residential consumers from a worst case scenario they also mute the ability to offer a best case.

Utilities such as SSE and EDF Energy have offered fixed-term deals extending years in advance, which not only protect consumers from rising market prices but could also prevent losses being passed through.

“When SSE announced its price freeze to 2016, it did say its ability to reduce prices if wholesale costs continued to fall would be limited due to forward hedging,” Citi analysts said. “But this is unlikely to reduce the pressure from politicians or the regulator.”