The rotten UK energy market is expensive and difficult to fix

Just as the global financial crisis exposed shocking complacency in UK banks’ business models and financial regulation, the surge in wholesale gas prices has demonstrated rot at the core of the UK energy sector.

With minimal domestic gas storage facilities and a retail energy market far too closely entwined with spot wholesale gas prices, the industry, regulator Ofgem and ministers deserve to feel the full force of consumer anger.

Decisions are due soon. All potential solutions are difficult and expensive.

The acute problem is that the energy price cap, governing most retail energy bills, is likely to rise by over 50 per cent in April on current estimates, raising the cost of gas and electricity for a UK household with typical energy consumption from £1,277 to around £2,000 per year. It’s enough, according to Goldman Sachs, to push the UK inflation rate from 5.1 per cent in November to 6.8 per cent in April, the highest in 30 years.

The extra £723 represents roughly 3 per cent of disposable income after housing costs for a household at the middle of the income distribution, a hit to living standards equivalent of a sizeable recession. Tax revenues will also be hit because households will have to pay more for energy, which attracts only a 5 per cent value added tax rate, rather than on other goods and services with an average VAT rate at least twice the level. The industry absurdly claims there will be an exchequer windfall.

If Rishi Sunak wanted to mitigate the increase by socialising the total cost, taxpayers would face a bill of £20bn a year to lower bills by £723 for the 28.5m domestic households connected to the electricity grid. That is far more than the annual £12bn plan announced last September to repair the NHS and fix social care. It is not going to happen.

The only questions are who pays and when. On the first, the government might decide that those with the highest energy bills relative to income should get greater protection. Boris Johnson hinted at this on Tuesday, highlighting the Warm Homes Discount scheme, which currently offers an energy price rebate of £140 for those in danger of falling into poverty. The prime minister did not mention, however, that this scheme is financed by imposing higher energy bills on those not eligible for assistance. A big expansion would require energy prices to rise even further.

Another idea is to hope that wholesale gas prices fall and bill increases can be spread over time: pain postponed rather than pain avoided. But deferring the moment of truth is highly risky because the chronic problem in UK retail energy markets is that bills are likely to remain high for some time after a failure of regulation to foster competition in the public interest.

Before the energy price cap, companies used every tactic to reel people in with teaser rates and then exploit their inertia, generating high margins. After the price cap was introduced to solve that problem, companies tied themselves to the spot market to offer the cheapest deals. They knew that if things went well, they would make good money and if prices rose, they would go bust with the rest of the sector — or the government would pick up the tab. Heads, we win; tails, you lose.

Ofgem’s failure to address this lack of resilience in the industry it regulates is identical to financial services regulatory failure before 2008-09. That it has happened so soon after the financial crisis should be a national scandal. Had ministers acted on the market reviews they commissioned, such as Sir Dieter Helm’s 2017 cost of energy review, many of these problems could have been avoided. But his report, like so many others, was shelved.

The UK energy crisis of 2022 is a problem without a silver bullet solution. Households will feel financial pain for years. The industry and regulator will need another shake up. It is quite some mess.


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