What is to be done about UK energy bills?

17 May 2017

Portrait of Mr Stephen Heidari-Robinson

by Mr Stephen Heidari-Robinson

Stephen Heidari-Robinson is an Oxford Martin Visiting Fellow as part of the Oxford Martin Programme on Integrating Renewable Energy. Stephen has first-hand experience of setting national energy policy as the former UK Prime Minister David Cameron's ...

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Energy bills are, once again, a hot topic in a general election. The Conservative Party has promised a cap on energy bills. Theresa May is clearly trying to park her tanks on Labour’s lawn, but the Tories have also stated that their approach would be very different to Labour’s popular price freeze promise of 2015 since the Tory cap would go up and down based on market conditions. Meanwhile, Labour’s manifesto promises a Christmas tree of policy measures: their own “emergency cap”, which would keep average dual fuel bills below £1,000 until they figure out a fairer system for bill payers; nationalisation of National Grid, the Royal Mail, the railways and water companies to boot; a publicly-owned energy company in every region; and increased investment in insulating homes.

As shown above, average bills have indeed increased since about 2004, but, in the last two years, they have in fact fallen. Had Ed Miliband indeed intended a price freeze, rather than a cap in 2015 (the Tories insist he meant a freeze, he says he didn’t), the price would have remained higher than it should. It’s also interesting that public uproar at energy bills remains potent despite them falling in recent years. This is due to a combination of the energy companies’ own poor service and communications, and the tabloids continually hammering the Big Six, whatever they do. On the one hand, while Which? ranks energy suppliers by customer satisfaction, it does not feel it can recommend any of them because no energy company meets all its customer service criteria. The reaction of energy bosses to the Tory plans, which focused on how those plans would upset the market rather than on the implications for real people, showed just how little they get it. On the other hand, the same British Gas staff work on Sainsbury’s Energy as work on their own brand. Yet Sainsbury’s scores 4 out of 5 for customer service in the Which? survey, while British Gas scores 3 - illustrating the impact of pervasive bad stories about the Big Six.

Before examining whether the two main parties’ plans do anything to address this situation, it’s worth stepping back to look at what’s really driving cost in the energy retail market. Energy bills aren’t like dodgy financial products from loan sharks: they are made up of real things - the cost of fuel, plant, infrastructure and company workers - that you can’t simply decree away. The chart below, based on Ofgem data, shows the breakdown in costs across a dual fuel bill.

As you can see, over 80% of the cost is made up of three categories: wholesale, network and supplier company operating costs. Wholesale, which accounts for almost half the cost of a bill, comprises the cost of fuel and plant operations. In the UK, gas provides 90% of household heating. Gas plants are also the marginal supplier of power and hence the price setter (renewables, although currently costing more, get guaranteed prices). For a gas plant generating electricity, the split in costs is approximately two-fifths fuel to three-fifths operating expenses. For heating, where the gas is supplied directly into pipes after treatment, the fuel is, of course, the main wholesale cost. It is therefore very significant that, in the early 2000s, as North Sea production declined and the UK became a net importer of gas, UK gas prices started to go up. Today, imported liquefied natural gas (LNG) is the marginal supplier and price setter for UK gas, meaning that we now pay for the costs of liquefying, shipping and regasifying gas from other countries, in addition to production. Hence, UK prices are about two-and-a-half times higher than those in the US, which is self-sufficient in gas, and may indeed soon export LNG to the UK. The chart below shows the increase in the UK gas spot prices since the early 2000s, which matches the upward inflection in both gas and electricity bills (although, as other costs are involved in supplying energy to households, the rise is less pronounced). Furthermore, because we buy gas in dollars from abroad, the fact that the pound has devalued by about 15% since the Brexit result means that we will be paying significantly more for our energy in the future.

In addition, governments of all complexions have woefully underinvested in both plant and infrastructure, leading to a potential security of supply crunch in the winter of 2015/2016 which was only averted due to the warm winter and concerted government action. As a result, the UK has had to pay to keep old plant alive and to build new plant in the form of capacity payments which are also passed on to customers.

With regard to policy costs, the Climate Change Commission has calculated that green policies implemented since the 2008 Climate Change Act have added £104 to bills (largely to electricity) but this has been more than outweighed by £290 of savings from energy efficiency measures: i.e., the policy cost per unit of electricity has gone up but the demand for electricity has gone down more. It is also worthwhile remembering that the definition of “policy costs” is spectacularly unhelpful, as it includes some of the actual economic costs of plant and infrastructure that have already been committed (capacity payments, contracts for difference, smart meter installation) as well as discretionary taxes and levies such as the carbon floor price and Energy Company Obligation. So, judged as a whole, the decarbonisation agenda, including renewables and energy efficiency, is not the cause of increasing bills.

Finally, with regard to suppliers’ pre-tax profits, these comprise 4% of a dual fuel bill (or £45 of an average £1,125 total bill). The Labour Party’s proposal to cap average bills at £1,000 would mean that energy companies will make, on average, an £80 loss per customer. It would also be very hard to implement: how do you cap an average bill? This level of reduction in bills is impossible: the companies would go bust, and the government would need to step in to nationalise all of them to stop the lights going out. With regard to the increased spending on insulation: all three parties that have been in charge of the UK energy department have placed the cost of this on to consumer bills, so Labour’s promises here would cause upward cost pressures in the short term, unless they instead intended to fund the spend out of taxation.

Labour is also promising to nationalise National Grid, Royal Mail, the railways, and water companies (average annual water bills are £290 - much lower than energy bills). A number of estimates have been made on the cost of this (in the order of £60bn), but what people are missing is that the government may also need to pay the typical acquisition premium for utilities and will certainly need to take on board these companies’ debt (they are highly leveraged), as well as buy their equity. Taking these things into account, the full cost of the nationalisation programme would be £170bn-£220bn. So, that would mean an increase in taxation or government debt of this amount. None of this has been costed in Labour’s financial appendix to the manifesto, Funding Britain’s Future. These companies are owned by pension funds and foreign government wealth funds who would undoubtedly sue the UK government if they did not get the going rate. My own research shows that, in addition, energy companies going through an organisational change such as this typically experience a downturn of c.5–10% in their operating performance due to staff distraction, which would also imply a huge amount of disruption to service during the transition. Incidentally, the fact that National Grid’s share price has gone up, rather than down, since the Labour manifesto was leaked is a clear sign that the market is discounting a Labour victory. It is also not clear what the Labour Party would ask these nationalised companies to do differently and without doing something differently the costs would remain the same. For that, we need to await their plans for a fairer system for bill payers.

The Conservative plans, at least as reported in the press, also fall foul of simple mathematics. Ministers have promised that customers on standard variable tariffs - the most expensive, default tariffs - will be able to save £100 from their bills a year as a result of the announced cap. On one level, this sounds achievable, even unambitious: Ofgem reports that customers can save £130–240 per year switching from their standard tariff to the cheapest deal available in the market. But someone needs to pay for the wholesale, network, operations and other costs. Just under half of households are on standard variable tariffs: 13 million households. If all of them saved £100 a year that would completely eliminate the industry’s combined £1.3bn pre-tax profit. Again, if this were to happen, the companies would go bust and the government would have to step in to stop the lights going out. However, from speaking to people in a position to know, I understand that the Conservative cap is not intended to save money on current bills but to prevent future precipitate and unwarranted price hikes by setting a cap that sits just above current “reasonable prices” and is adjusted every 6 months by Ofgem based on market conditions. Had this already been in place, it would have acted as a break on the recent company price hikes that Ofgem has called “difficult to justify”. This sounds more workable, but it would do little to reduce the structural costs of the industry.

The significant savings on household bills that the Conservatives, Labour and, most of all, customers would like to see are achievable, however, if we put much greater emphasis on energy efficiency and company operating efficiencies. Energy efficiency delivers the holy trinity: lower bills, reduced carbon emissions, and more security of supply. Human habits are very difficult to change, so technology offers a surer fire means of controlling energy demand. It also costs less than physical insulation - although, of course, you can have both. For example, British Gas states that its smart thermostat, Hive, can save consumers up to £150 per year on gas bills. Google’s thermostat product, Nest, sets the savings at 8–17%, which would be £40–90 off an average gas bill, and more for higher users. Supporting the development of this market would be a good way to go. A more active regulatory approach which forces greater transparency and year-on-year improvements in the cost of companies’ operations (i.e. the costs they can control) would also help reduce bills. Whilst companies are making progress on this (e.g. British Gas cut 6,000 jobs to reduce costs), if you speak to most people in the industry, they would admit that inefficiency remains. Here, we can learn from the water industry, which does provide this kind of regulatory transparency and pressure on companies’ operating costs.

But, much more than average savings, the real issue is social inequality in energy bills. The 2016 Competition and Markets Authority investigation into energy prices revealed that the poorest 10% of the population spends almost 10% of total household expenditure on electricity and gas, while the richest 10% spends about 3%. A 2011 report from the Institute of Fiscal Studies and University College London suggested that the variability of spend in the poorest 10% of households is also very high and, for some, energy bills can constitute up to a third of their household spending. Many of the poorest households find it difficult to switch away from the most costly tariffs because they lack the capabilities or are hampered by historic debt issues. By contrast, many of the wealthiest are probably not switching because the cost is simply not large enough compared to other household expenditure to warrant their attention. Even the Business Secretary, Greg Clark, said that he hadn’t switched because it was too much of a hassle. Between them, the government and companies know who the poorest are because they help them through the Warm Home Discount scheme. Whilst the Tory cap on standard variable tariffs or the Labour commitment to keep average bills low would benefit most of the population a little (including some who don’t need the help), a more focused cap for the energy poor (such as those in receipt of the Warm Home Discount - about 8% of households) would deliver more impact for those that need it most. It’s unfortunate that this very achievable act of social justice has been lost in the political hue and cry against energy companies.

This opinion piece reflects the views of the author, and does not necessarily reflect the position of the Oxford Martin School or the University of Oxford. Any errors or omissions are those of the author.