Why capping energy prices will not increase energy security or affordability

A position paper on the latest UK energy package, written by our energy economist Dominic Whittome and energy market advisor Clive Moffatt, which was discussed in the media and in Westminster, on what can be done to improve energy security and lower energy prices for the supplier and consumer.

Rising energy bills are a problem for some but not a crisis for everyone

Market intervention should not be used as a tool of welfare policy especially in the UK energy market, where there is a high dependency on gas imports for heat and power and the Government has no control over the global gas market and UK retail prices.

All that freezing or capping wholesale and/or retail prices will do is support shippers (e.g. US and Qatari exporters of LNG) and suppliers (e.g. the “Big Six”) both of which have already benefitted significantly from the current energy crisis as it is. Meanwhile consumers and industry will be left with having to finance a massive increase in Government borrowing (estimated at £150bn) via higher taxation in future years.

The disadvantages of blanket subsidies

Blanket subsidies, of the sort now proposed, benefit all consumers and not those who need it most. They reduce the market impact that higher prices will have in reducing demand. They postpone any normal market correction that might otherwise happen in the level of wholesale and retail prices and given the current state of the global gas market, they increase the risk of gas and power shortages.

The stark reality is that you cannot control retail prices when you have no influence on global wholesale prices

So, if the Government wants to reduce energy bills, it has the choice of either helping consumers and businesses directly, with grants and tax rebates to mitigate the temporary impact of rising global gas prices, or using public borrowing to subsidise gas shippers, traders and suppliers to artificially depress energy bills.

The time has come for the Ofgem retail price cap to be abolished

All that the cap has done, since Theresa May introduced it in 2019, is force smaller suppliers to go bust and make it easier for better resourced suppliers to expand their market share at the expense of consumers – the rescue of Bulb for example will cost consumers £3bn at least.

Ofgem is now more concerned about supporting suppliers than consumers and is desperate to avoid the embarrassment of more failures. So, the current retail price cap which Ofgem presents as a proxy for average annual household bills was to be adjusted upwards more frequently than before (up to £3,549 from 1 October) with a further increase currently predicted on 1 January 2023. But now the Government has said it will freeze annual retail bills at c £2,500 from October by funding the extent to which what suppliers have to pay for gas in the wholesale market and the new maximum cap.

In effect, consumers are paying to help suppliers finance the difference between the cost of the gas they buy and what they charge consumers even though several of them have reported bumper profits in the last 18 months.

It is important to note that this cap does not take account of any reduction in consumption

Consumers can and should be encouraged to respond to higher prices but so far Government and suppliers have been reluctant to work together to promote a major energy saving campaign for this coming winter, which could not only reduce bills but also reduce risk of energy shortages e.g. when gas demand (on a cold winter’s day, when the wind is not blowing) exceeds the available supply of LNG.

In truth, most households with some helpful advice from suppliers and Government could reduce their consumption by at least 10% which would reduce energy bills to around 7% of average household expenditure – an historic high but significantly below the 10% fuel poverty threshold.

Further market intervention

In addition to freezing retail bills, the new Government is also considering an even more drastic form of market intervention to help – namely capping (via subsidies) the UK wholesale price of gas that suppliers and generators pay, so that they can reduce the price they charge for heat and power. Depending on the likely future rise in global prices and level of price volatility, this could prove to be very expensive in terms of additional Government borrowing.

Also, as capping retail prices does, it would benefit all consumers and industry i.e. give money to those who don’t need it and it would provide no incentive for consumers to reduce demand, which in turn could mean that the wholesale price in the UK remains higher than it would be had the market just been allowed to work.

Furthermore, with the UK’s heavy dependency on gas for heat and power and high level of dependency on gas imports, particularly LNG in winter, any tinkering with wholesale gas prices would increase the risk of energy rationing because the UK would not be able to compete in the global market to secure supplies when they are most needed during the forthcoming winter months.

In short, market intervention to cap either wholesale or retail prices should not be used as a tool for welfare policy. Wholesale or retail prices should not be fixed and the current Ofgem cap should be abolished.

What should be done in its place?

Underpinning UK energy security requires measures to ensure the reliable supply of affordable energy

The UK is not immune to energy rationing and much more needs to be done to put in place measures which will increase the flexibility of gas supplies. In other words, 1) the reopening of the rough gas storage facility and funding to enable major industrial users to voluntarily curtail demand at a time of system-stress and 2) in the longer term we need to reduce our dependency on gas imports via fracking and more North Sea production.

We do not know what will happen to future global gas prices and supplies

It could be that we have a mild winter and there are plentiful supplies of LNG available and of course, any sign of a ceasefire in the Ukraine could trigger a reversal in the direction of wholesale gas prices in Europe, but right now it would be wrong to assume that this rise in energy costs will persist or that it is a crisis for all and commit massive public borrowing to help everyone in the same way.

The danger now

Panic meddling now by the Government could preclude a downward price, a correction in the wholesale gas market, one prompted by fears of global recession and normal market profit taking. Currently, the break-even supply cost of North Sea gas and most imported LNG is less than half the current future traded price. Some adjustment can be expected next year if not before.

The danger now is that this adjustment will not take place because the Government is about to intervene on such a scale that will prevent the market from working. Market traders will benefit but at a huge cost to UK consumers and industry in terms of continued high level of energy costs plus the future burden of higher taxation to fund the subsidies. Experimental intervention in the market on the scale now being initiated is not justified.

Dominic Whittome

Dominic is a highly experienced energy economist. He was formerly Gas Field Negotiator within Mobil Oil Corporation Europe and Head of Gas Trading within EDF, and Gas Competition Advisor to a former Chair of the Parliamentary Energy Select Committee. He worked with Moffatt Associates on the first-ever comprehensive study of wholesale market liquidity and competition in EU gas and electricity markets as part of the impact assessment of the EU’s Third Energy Directive in 2005. Mr Whittome advises Prospect Law clients on company strategy, energy contracts & trading and related expert witness matters.

About Clive Moffatt

Clive has been at forefront of major energy market and policy developments in the last 30 years including advising the Electricity Pool (early 1990s) on wholesale market reform and launch of retail supply competition ; the design of the EU’s 3rd Energy Directive (2005); the creation of the UK Capacity Mechanism (2012) and the launch (2017) of the cross-industry UK Energy Security Group to advise Government and Ofgem on measures needed to underpin the physical security and affordability of gas and electricity.

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