Energy Price Caps: How certain is your strategy in this volatile market?

OFGEM first launched a ‘price cap’, or standard variable tariff (SVT), in the domestic market on 01 Jan 2019. The cap price setting algorithm is complex but driven by the average wholesale price in a preceding 6-month period. The intention of the cap was to protect ‘passive’ households, that did not actively seek the best energy deal, from being overcharged by their supplier. It was anticipated that cheaper fixed-price contracts would be taken by the majority of households, with the SVT acting as a reasonably priced backstop for the minority that couldn’t, or wouldn’t seek the cheapest competitive price.

The SVT was never intended to be a mechanism to protect against rising prices. However, in a rising wholesale market, average prices in a preceding period will be lower than the current. For this reason, the SVT has, for the last year, been cheaper than any competitive fixed-price deal; OFGEM figures suggest that 22 million (78%) households are now on the SVT.

This surge in the number of households choosing the SVT caught energy suppliers by surprise, each additional unexpected (and therefore unhedged) SVT customer causing a loss of £1000 or more; playing a major role in the 29 supplier insolvencies over the last year.

Whilst OFGEM has never explicitly acknowledged the part SVT played in these failures, their decision to shorten the length of each price cap period from 6 months to 3, appears to be a tacit acknowledgement of this fact.

Previous price spikes affecting energy markets have been relatively short-lived, with a rebalancing of supply and demand fundamentals soon returning prices to more ‘normal’ levels. It became increasingly obvious this summer that this time was different, with geopolitical tensions causing high gas and electricity prices to persist.

Even with the lagging effect of the cap, the forecast increase in energy bills for the 22m households on SVT was eyewatering. The SVT increase to £3500 on October 22 (compared to <£1000 before the crisis) was widely reported in the media, and less attention was given to the further increase to £5000 or more by April 23.

Businesses were feeling similar energy bill pressure.  Earlier in the crisis, many businesses were protected from the increases, either through long-term fixed contracts or through hedges purchased within flexible procurement frameworks. However, as high prices persisted, many of those contracts and hedges expired, increasingly exposing businesses to higher prices. Typically businesses used to paying <20p/kWh were seeing renewal offers in the range of 80-100p/kWh. Some businesses, especially those in sectors perceived by suppliers as being risky, were unable to secure renewal pricing, exposing them to out-of-contract pricing as high as £1.40/kWh.

There was a clear need for Government to act, a £5K annual bill would eliminate discretionary income for over 50% of the population. The combination of this reduction in spending power, combined with increased business costs would have caused significant economic disruption.

However, the extent and duration of the support offered raised eyebrows.

The Energy Price Guarantee (EPG) was intended to cap average household bills at £2500 for 2 years, with the Government paying the difference if wholesale costs remained higher.

The Energy Bill Relief Scheme (EBRS) for businesses was more complex, recognising the more complex contract arrangements and costs incurred by businesses. However, for the majority of businesses, the EBRS provided a similar level of support to the EPG, capping wholesale costs at £211/MWh, equivalent to a delivered price of around 35p/kWh.  The EBRS was initially only confirmed for 6 months, but with the potential to continue if prices remained high.

At the time of the announcement, the cost of a 2-year EPG was estimated at £120-150bn. The cost of the EBRS, just for this winter was estimated at a further £70bn.  For context funding, this policy through borrowing would add almost 10% to the national debt.

The actual cost of the scheme was uncertain, and directly related to future wholesale costs; a £100/MWh increase in wholesale prices would add £80bn per year to the cost of maintaining EBRS/EPG. This policy was a massive and arguably unaffordable punt on wholesale prices rising no further.  John Maynard Keynes’s famous quote: ‘The market can remain irrational longer than you can remain solvent’ comes to mind.

Also notable, was that no new money was announced for energy efficiency measures, with EPG/EBSS dwarfing the total £16bn that has been allocated to reducing energy consumption. Additionally, by reducing energy costs, the motivation to invest in energy efficiency, or other demand reduction measures has been reduced; flying in the face of the other often quoted truism, that the best solution to high prices, is high prices.

The financial markets responded to this policy with great concern, with FX rates falling and Gilts rising equally sharply; causing Kwasi Kwateng to lose his job.  His replacement, Jeremy Hunt, has satisfied market concerns by limiting EPG to 6 months. Whilst further support next summer has been hinted at, the scope of this will likely be limited to only the most vulnerable households and businesses.

So what’s our advice to you?

1. Plan the remainder of your winter ‘22 hedging strategy with the confidence that the EBSS is highly likely to remain. Some more aggressive hedging strategies might include exposure to spot markets, day-ahead prices have traded below the £211 EBSS support level so far in October on mild weather and comfortable supplies. This is, however, a high-risk strategy, with the possibility of colder weather tightening fundamentals at some stage.

2. Assume that there will be no further EBSS support from April 23 onwards, plan hedging strategies accordingly. Closely monitor the level of EU gas in store, in the second half of this winter, and the price risk associated with next summer’s injection season.

3. Review all Energy Efficiency and Onsite generation CAPEX opportunities, to reduce exposure to high and volatile wholesale prices. Base payback/ROI calculations on up-capped forward prices.

4. B2C organisations must plan for an increase in the EPG cap to £3000 next spring, as announced in the Autumn statement.  Whilst the revised EPG still represents a sizable discount to the April SVT (likely to be in the range £3500-4000) the increase from £2500 to £3000 means a significant tightening of discretionary income.

5. Consider refocusing energy-intensive supply chains away from Europe/Asia towards the US, where input gas prices are significantly lower and relatively stable.

If you would like any further advice on Energy, please contact our Head of Energy Rob Morgan (Rob.Morgan@4cassociates.com) or Managing Partner 4C Services & Thought Leadership Allison Ford-Langstaff (Allison.ford-langstaff@4cassociates.com). We’re always happy to chat.

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