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Are energy companies charging too much?

by Professor Michael Waterson

EnergyIf next Tuesday Sainsbury’s announced its prices were all to rise by 5%, the following day Tesco raised its prices by 5.3% while on Thursday Asda said it was limiting price rises to ‘'only’ 4.8%, there would be a national outcry. Yet we seem to have become resigned to such shocks in energy markets. Perhaps that will change in light of the potential scandal involving alleged manipulation of gas prices – and ensuing calls for an open pool for sale and purchase of wholesale energy.

Most consumers buy both gas and electricity, but gas is also the most significant fuel in generating electricity in the UK, so even all-electric consumers are affected by gas prices. As it is, consumers face sometimes staggering rises in the prices of gas and electricity. These take significant fractions of their household budget and there seems to be little they can do to plan in advance.

Given that energy is such an important commodity, the price of which fluctuates considerably, the opaqueness of energy markets is a surprise to many people. As someone who has done research on the industry, I am often asked ‘Are the energy companies charging too much?’ This seems a simple question, so when I say, in effect, that it is difficult to answer, it feels a rather feeble response.

Yet it is not a simple question. Energy suppliers contract with consumers to meet their energy needs, which fluctuate over the day and over the seasons according to the weather and the nature of their activities. To meet consumers’ needs, energy suppliers have to arrange to buy electricity and gas, a proportion of it at short notice.

They do this by hedging, buying a portion of their requirements long in advance, a proportion nearer to the time and some very near in time to the point of consumption, so holding a portfolio of contracts. These hedging strategies are commercial secrets and sometimes a company will make a lucky guess or judgement, sometimes not.

Somewhat unusually, the prices at which the deals are made are also, by and large, secret in the UK. This does not mean they are unknowable; there is an active business generating what are called ‘price assessments’. So estimates of the cost changes facing energy suppliers can be made.

For example, OFGEM, the oil and gas industry regulator, does this using a portfolio fixed over time, buying price assessments from one of the leading companies. But it is in the somewhat opaque price assessments area that the alleged price manipulation appears to have taken place.

The extent to which wholesale prices in the energy market are opaque is somewhat unusual to the UK. Most countries have a more active ‘pool’ for wholesale electricity. Indeed, some are international, one of the best known being Nordpool, which is active across all the Scandinavian countries.

Having a well traded open market that reports prices and volumes traded freely makes comparisons over time much easier and makes manipulation more difficult. It also makes it easier for smaller companies to participate in the supply market.

Another unusual feature of the UK market is that what would seem like a straightforward activity, selling a rather homogeneous commodity to consumers, is largely the preserve of six highly integrated companies. Both major customers and smaller suppliers, many very experienced, have complained about the opacity of the market in parliamentary investigations.

The UK used to have an electricity pool. But back in 2001, the regulator decided to move to new electricity trading arrangements (NETA), which were extended to Scotland in 2005. One of the main reasons was the potential excess earnings for electricity generators that the pool was thought to create.

My own research strongly suggests that what in fact happened was that NETA did reduce the payments to generators, but increased them to suppliers (which are, by and large, the same companies), with essentially no net effect. So returning to a pool, for at least a proportion of power generated, would allow smaller companies easier access to the supply market. This seems like an overdue reform of the market.

Let’s return to the supermarket analogy. If Sainsbury’s, Tesco and Asda did as I imagined, the next day Morrisons, Aldi and Lidl would be extremely busy and consumers would rediscover their local co-op. If there was a genuine sudden increase in costs, then these chains’ prices would also have risen. Consumers would need, grudgingly, to accept the price rises. If costs had not risen, Morrisons and the others would gain substantial market share. Currently, in the energy market, this doesn’t happen.

Finally, in a physical market, conspiring to manipulate prices is a criminal offence, which is punishable by fines and potentially jail sentences for key executives. Indeed, the Office of Fair Trading regularly fines firms for agreeing among themselves to set prices or make arrangements with a similar effect. Not being a lawyer, I am unclear whether this manipulation is a criminal offence in financial rather than physical markets. In the light of the Libor-fixing scandal and this potential energy markets scandal, it seems clear that it should be.

Michael Waterson is a Professor of Economics at the University of Warwick and a Member of the UK Competition Commission. He writes here in a personal capacity.