The energy crisis has presented itself as one of only a few drags on the UK’s otherwise strong initial economic rebound from the COVID-19 pandemic. Given the fragile state of economic sentiment, and with inflation already reaching a near 30-year high of 5.5% during the 12 months through January 2022, easing the burden of rising energy costs on households has been a key focus for policy makers.
In response to soaring wholesale energy prices in recent months, energy regulator Ofgem has announced a 54% increase in the UK’s energy price cap. Despite dwarfing previous hikes in the price cap, this rise was somewhat inevitable given the current state of play in the UK energy market.
The rise in the price cap, which will come into force in April 2022, will provide welcome relief for suppliers, which have consistently called for government intervention amid surging costs. However, such is the extent of the rise in the price of natural gas, operators in the Electricity Supply industry will remain under significant financial strain until wholesale prices return to seasonal averages.
Supply security
The composition of the UK’s energy system leaves the market particularly susceptible to significant fluctuations in wholesale prices.
Since 2004, the UK has been a net importer of gas, with approximately 60% of its natural gas needs satisfied by imports.
In line with declining domestic production, the UK’s gas storage facilities have remained limited, with the closure of Centrica Storage’s Rough storage facility in 2017 contributing to a further 70% decline in storage capacity. As a result, the UK is more sensitive to volatile changes in the spot price of gas than other gas-importing nations, which tend to favour long-term contracts.
Soaring costs
After falling in line with low demand in 2020, natural gas prices started to increase at the beginning of 2021. Renewed growth in demand for natural gas during a particularly long winter period, in addition to geo-political tensions—which led to a fall in the delivery of gas into Europe from Russia— contributed to the depletion of Europe’s natural gas stocks.
Europe, and in turn the UK, was particularly affected by an accelerated rise in wholesale gas prices in the second half of 2021, as the widespread reopening of global economies led to excess demand for energy. Prices continued to rise in the latter part of 2021, peaking at over £4 per therm in the run up to Christmas. Prices have since dipped slightly but remain well-above seasonal averages.
According to data published by the Department for Business, Energy and Industrial Strategy, natural gas accounted for more than 40% of UK electricity generation in the first nine months of 2021.
This represented an increase on the previous year, as natural gas provided the most readily available back-up to intermittent renewable generation. As a result, wholesale electricity prices have followed a similar trend to gas prices in recent months, rendering the operations of energy suppliers unprofitable.
Out of energy
The energy crisis has so far led to the collapse 26 UK energy suppliers, representing more than half of suppliers active at the start of 2021. This has displaced more than two million energy customers, with larger suppliers forced to take on the burden of these unprofitable customer accounts in the short term.
This has fuelled widespread calls for financial support for suppliers prior to the price cap review, with suggestions including a cut in VAT on domestic energy and government-backed loans for energy suppliers. However, the government has held firm and refused any short-term measures.
The majority of collapses have been among smaller suppliers, with many of these firms failing to lock into forward-looking contracts, instead relying on spot prices. The failure of Ofgem to scrutinise the finances of these companies, many of which entered the market during an influx of suppliers encouraged by Ofgem to increase competition in the energy market over the past decade, has been criticised by many.
The largest supplier casualty of the energy crisis has been Bulb Energy. Following significant growth since its inception in 2013, Bulb controlled more than 5% of the domestic energy market, with 1.7 million customer accounts upon its collapse in November 2021. Bulb’s 1.7 million customer base was considered too large to enter Ofgem’s Supplier of Last Resort (SoLR) process, with the company becoming the first supplier to operate under a Special Administration Regime (SAR).
Continued challenges
The rise to the energy price cap should allow suppliers to claw back some of the losses incurred as a result of the recent surge in wholesale prices, particularly with global prices likely to drop-off in line with reduced demand in the spring.
Nevertheless, suppliers’ finances are expected to remain under significant strain in the short term, as wholesale prices remain elevated and previous spikes continue to filter through into forward-looking contracts, which typically reflect wholesale prices over the previous six months. As a result, further supplier collapses remain a likely prospect in the short term.
According to accountants Price Bailey, 12 of the remaining 22 energy suppliers outside of the largest six have negative assets on their balance sheets, with half of these identified as maximum risk due to poor credit scores.
Renewed support
In a report published in January 2022, Citizens Advice estimates that supplier failures since August 2021 will cost consumers £2.6 billion, approximately £94 per customer from 2022. This has already been reflected by a significant increase in network costs as part of the energy price cap, £68 of which was attributed to the recovery of SoLR levy. The report also highlighted regulatory failings by Ofgem, which allowed unsustainable energy companies to trade with little penalty.
Ofgem has admitted that it should have acted sooner to ensure the financial resilience of new entrants, and has proposed a number of reforms, including new financial stress tests for suppliers and increasing the frequency of price cap reviews to quarterly to better reflect current market prices.
The government has also introduced short-term measures to ease pressure on household finances following the price cap review. This includes a £200 reduction on domestic energy bills from October 2022, when the price cap is expected to record a further rise. The government has confirmed it will meet the cost of this reduction, with the discount to be recovered from consumers’ bills in five annual £40 instalments, starting from 2023 when it is anticipated that wholesale gas prices will have fallen.
Investing in storage
In addition to reform at the supplier level, significant investment throughout the energy supply chain is likely to be necessary to ensure improved security of supply and avoid a repeat of the current energy crisis.
Increasing the UK’s energy storage capacity is likely to constitute a key element of this. As the UK continues to increase its dependence on intermittent sources of renewable power in pursuit of decarbonisation targets, being able to draw on energy stored during periods of excess supply will be key to sustaining the replacement of fossil fuels in the UK’s energy mix, diminishing the effects of fluctuations in global commodity prices.
For more information on any of the UK’s 500+ industries, log on to alfabank-adres.ru, or follow Alfabank-Adres on LinkedIn and Alfabank-AdresUK on Twitter.
