Written evidence submitted by E.ON (EPM0013)

BEIS Select Committee Inquiry:

‘Energy pricing and the future of the Energy Market’

Closing date for written evidence: 31 Jan 2022

E.ON submission

About E.ON

• E.ON is one of the largest energy companies in the world. Across Europe, we have over 54 million customers and operate c1.5 million km of energy networks. E.ON is the largest electricity supplier in the UK. We supply nearly one in five households and small businesses across Britain with 100% renewable electricity on all tariffs, as standard, at no extra cost. As npower Business Solutions, we are the largest electricity supplier serving the large industrial and commercial sector.
• E.ON has committed to the ‘Race to Zero’ with a science-based net zero by 2050 target; We have installed smart meters for more than 4m of our UK customers, and saved households across Britain more than £10 billion on their energy bills over the lifetime of the energy efficiency measures we have installed.
• E.ON no longer owns or operates conventional, large-scale fossil-fuelled power stations; we were a pioneer of major investment in renewable energy, particularly offshore wind in the UK, and have become so respected in providing and installing energy efficiency, smart meters and other building energy solutions for our domestic and business customers, we now do so commercially for other energy suppliers’ customers as well as our own.

Exec Summary

• The last ten years has seen a significant and catastrophic failure of energy policy and regulation in energy retail. More than 8 million households will have felt the impact of more than 50 energy supply companies leaving the market over the past five years. All customers will now face the costs of these failures. Over half of those failures have happened during the last few months as global gas prices have spiked, highlighting the fragility created by poor oversight of the market and an underappreciation of the vital role played by the energy retail sector.
• Over the last ten years, policy and regulation has sought to increase the number of energy suppliers in the market as rapidly as possible but failed to implement the prudential regulation needed to ensure all new suppliers operate responsibly. With no capital of their own and without the expertise needed to weather challenging times, many newer suppliers were encouraged to cut corners to undercut their rivals and grow by gambling with customers’ rather than investors’ money, knowing that if their gamble failed the rest of the market would be forced to pick up unpaid bills and debts via the Supplier of Last Resort process.
• Government and regulator must take swift and concerted action to fix the outstanding flaws in the retail market and improve market conditions to restore consumer trust and create a sustainable retail energy market that can unlock essential net zero investment. It must then swiftly turn attention from the retail market to the wholesale market where urgent reform is also needed:

1. Reform the Supplier of Last Resort (SoLR) process – Unlike regular company administration processes outside of the energy retail sector, investors of failed energy suppliers can expect a 100% return of any failed investment through the SoLR process with unpaid bills and other debts paid for by the rest of the market through mutualisation. There is a clear need to rebalance the cost of failure between customers and investors and enable better scrutiny of business plans by capital markets.
2. Implement prudential style regulation of energy retailers - via ring-fencing customer credit balances and introducing more frequent payment of industry costs (such as Renewables Obligation payments). The huge cost to customers of this unprecedented failure of policy and regulation has reached such levels (circa £5 Billion) due to the ability of energy suppliers to access and gamble millions of pounds of working capital from customers’ money rather than investor capital via customer credit balances and unpaid industry costs such as Renewables Obligation (RO) payments.
3. Remove market distortions – Government must deliver in 2022 the legislative powers needed to end small supplier exemptions (and other similar advantages previously given to new entrants to the supply market).
4. Reform the current retail market design – We agree that there may be a need for long term price protection. It is important that the design of such protection does not inhibit the necessary retail innovation required for the energy transition. Flaws in the existing price cap methodology must be understood and addressed to reduce risk alongside a recognition that there is no perfect answer. In particular, a future price cap should avoid mandating a hedging strategy for suppliers.
5. Introduce a subsidised social tariff – A comprehensive safety net for vulnerable customers should be put in place on an enduring basis. Not only should we continue with dedicated programmes that help upgrade the energy efficiency of homes, such as the Energy Company Obligation, but we should also provide an industry wide social tariff available automatically for eligible customers, which specifically recognises the additional challenges they face with engaging in the market. This should be deliberately set to be the cheapest tariff available, funded by everyone else in the market.
6. Reform the wholesale market – The generation mix looks set to change significantly over the next 10-15 years and by 2035, it will be dominated by renewables and nuclear.  We do not believe the current wholesale market framework is designed to cope with such a system and requires urgent reform to maximise the benefits to customers from the reducing costs of renewables as well as ensuring the cost signals are felt by those that need to respond in order to optimise a dynamic and flexible system.

E.ON Written Submission

We have split our full written submission under the various headings of the Inquiry Terms of Reference as follows:

“The regulatory requirements companies must meet in order to trade as a regulated entity in the retail energy market. “

“The mandate, role and performance of Ofgem in setting regulation and supervising regulated entities.“

“The performance of previous policies introduced to stimulate effective competition within the retail energy market, and an assessment of the impact on competition of proposed future regulatory frameworks.”

1. Energy policy over the last ten years has focused on promoting the entry of competitors into the retail sector, as distinct from promoting competitive market conditions. However, this ‘competition at all costs’ approach failed to implement the prudential regulation needed to ensure all new suppliers operated responsibly.
2. With no capital of their own and without the expertise needed to weather challenging times, many newer suppliers were given specific cost advantages and allowed to cut corners to undercut their rivals and grow by gambling with customers’ rather than investors’ money.  These suppliers knew that if their gamble failed, the remaining supply companies in the market would be forced to pick up the outstanding costs via the flawed Supplier of Last Resort (SoLR) process.  The SoLR regime encouraged little investor rigour of business plans in the knowledge that creditors would still be able to get back most (or even all) of their money in the event of a supplier going bust.
3. The policy and regulatory framework in place over the last ten years did not therefore create true competition in energy retail, only the illusion of competition as measured by the sheer number of supply companies, which peaked at over 70 in 2018. Far too many poorly capitalised and badly managed companies were allowed to enter the energy retail market and grow their customer base by offering unsustainably low prices despite timely warnings from those in industry[1] and customer champions[2] that the market was not working well.
4. More than 8 million households[3] will have felt the impact of the flaws in this policy and regulatory approach through the more than 50 energy supply company failures over the past five years. Over half of these failures happened in the last few months as global gas prices spiked, highlighting the financial fragility and lack of technical expertise created in Britain’s retail energy market. A report by NERA[4] estimates that 1 in 3 customer switches between suppliers in 2021 took place due to customers being rescued from failed suppliers under the SoLR process rather than being chosen by customers through traditional customer competition.
5. E.ON has consistently warned Government and Ofgem of the flaws in the current policy and regulatory framework for energy and supported plans for reform. For example,

5.1.   In 2018, we welcomed Ofgem’s intention to finally strengthen the rules used before granting a supply licence as part of their supply licence review but warned that the review had come too late and did not go far enough. In particular, the proposed reforms did nothing to solve the problem in the short term of financially weak suppliers operating in the market being allowed to act in a financially unsustainable way to the detriment of others[5].

5.2.   In 2019, due to our concern that customer money was being misused as working capital by some suppliers and the size of unpaid bills being built up by some suppliers was a significant risk to the market and our customers, we submitted letters to both BEIS and Ofgem[6] requesting that ”…A change in legislation to enforce more frequent payments for the Renewables Obligation (RO) and other schemes should now be seriously considered. We ask Ofgem to request this action of the new Government as a priority”.

6. Warnings about two of the key requirements of a more prudential style of regulation have therefore been considered by Government and regulator since at least 2018. However, Ofgem subsequently abandoned initial plans that suppliers must protect at least 50% of their customer credit balances and 50% of government scheme costs due to push back from other suppliers in the industry. In 2021, proposals to ensure credit balances were refunded annually and protected over a certain threshold were consulted on but, again, these proposals were received poorly by new energy suppliers and Ofgem again abandoned their implementation. Had these measures been implemented sooner, we may not have seen either the large number of consumers being directly impacted by failed suppliers or the high cost of mutualisation that all consumers are now facing as a result.
7. Citizens Advice’s recent report[7] was damning of regulation in the sector over recent years: “Ofgem allowed unfit and unsustainable energy companies to trade with little penalty. Despite knowing about widespread problems in the market, it failed to take meaningful action”.
8. The failure of suppliers, both old and new and small and large, as we now know, comes with a substantial cost to customers and taxpayers. The clean-up bill for this winter’s crisis in energy retail could easily exceed £5 billion[8] and add more than £100 to household energy bills at a time when global energy prices are already expected to push energy bills up by more than 50% and add 2% to inflation when the price cap is next recalculated by Ofgem of the next period commencing 1 April 2022. This huge cost of failure will either be borne by the customers of well managed companies or taxpayers, with investors of failed companies often bearing little or no consequence - particularly under the SoLR regime.
9. E.ON remain convinced that a market approach to retail energy supply is the best way to produce the innovation and investment needed to ensure customers can receive products and services they want at a price that is fair. A market approach is also the most effective way to create the most cost-efficient energy system, ultimately ensuring that costs are kept as low as possible for all customers as we invest for the future and complete the transition to a zero carbon electricity market by 2035 and a net zero economy by 2050.
10. In particular, E.ON believes that maintaining the UK’s commitment to reach net zero emissions by 2050 is the correct course of action and E.ON is committed to Science Based Targets under the ‘Race to Zero’ commitment. Energy retail companies like E.ON, with  sufficient scale and scope, will be vital in the next ten years to deliver the new products and services that households and businesses will need to effectively change their behaviour and radically lower their emissions.
11. Immediate and sustained action is required by Government and Ofgem to rectify the catastrophic failure of policy and regulation that led to the current crisis in energy retail and make the sector investible again. Ofgem should learn from recent supplier failures and ensure it proactively makes use of the tools and powers already available to it. Furthermore, new policy and new attitudes are required across Government, regulator and industry to swiftly deliver a new policy and regulatory framework that focusses on creating attractive market conditions that allow prudent, sustainable and innovative energy retailers to thrive and grow. Achieving net zero emissions for the entire UK economy must be at its heart.
12. Firstly, lessons must be learnt from the banking crisis. Prudential style regulation of commercial entities involved in the energy retail sector must be put in place urgently. Government and Regulator must move quickly to fix the most obvious flaws in the regulatory structure of the retail market, to prevent a recurrence of this crisis. E.ON fully supports proposals to:

12.1.1.        Reform the supplier failure process: there is a clear need to rebalance the cost of failure between customers and investors and enable better scrutiny of business plans by the capital markets;

12.1.2.        Deliver prudential style regulation of energy retailers: through stricter tests for new entrants, robust financial stress testing for all players and strengthening existing regulations including more rigorous assessments of increasing customer numbers and enhanced monitoring.

12.1.3.        Prohibit the misuse of customer money as working capital: via ring-fencing customer credit balances and introducing more frequent payment of industry costs (such as RO payments);

12.1.4.        Remove market distortions: deliver in 2022 the legislative powers needed to end small supplier exemptions (and other similar advantages previously given to new entrants to the supply market); and

12.1.5.        Address free riding risks: in order to ensure that there is no “free-riding” whilst market flaws are addressed, currently unused supply licences that free-riders may be able to take advantage of should be revoked.

13. Secondly, the supplier failure regime must be rapidly overhauled. Unlike typical administration processes for failed companies outside of the energy sector, the SoLR process effectively guarantees that 100% of any creditors’ investment is repaid by mutualising costs over the remaining market (i.e. the customers of more prudent supply companies). This has two key impacts on the effective running of the energy retail market.

13.1.1.        The cost of failure is mutualised, with remaining suppliers and their customer picking up those costs instead of investors as would be the case in other markets. This incentivises new entrants to gamble with customers’ money, knowing that if they fail, they will not pick up the cost of failure.

13.1.2.        Critically, this may mean investors may not properly scrutinise their investments in energy retail, as failure is less of an impact in energy retail than in other markets, meaning that new energy supply companies are not subject to the kind of capital market scrutiny of their management and business plans that should be expected in a well-run market.

14. Reform of the SoLR process should ensure that investors effectively scrutinise business plans and help provide confidence to the market over the enduring viability of organisations.  It will also reassure customers that future propositions in the market are financially viable and sustainable, helping to support healthy retail competition and attract investment and innovation. 
15. Thirdly, we should initiate longer-term reform of the retail market design. We agree that there may be a need for a form of enduring price protection for customers, but it is also important that the design of such protection does not inhibit the necessary retail innovation required for the energy transition to net zero.  Flaws in the existing price cap methodology must be understood alongside a recognition that there is no perfect answer when addressing them. We believe a future price cap should avoid forcing suppliers to offer an SVT-based default tariff and instead allow suppliers to make decisions about the types of default tariffs that best suit their customers. Similarly, the price cap must avoid mandating a particular hedging strategy, especially when there are appropriate stress tests in place. There are a number of price cap methodologies that could achieve this outcome, such as a relative cap that focusses on a supplier’s own tariffs. 
16. The dynamic nature of effective competition will ensure that new and existing customers are treated fairly under a relative cap without the need for Ofgem to have to second guess costs and risks which are difficult to forecast as has been shown to be the case ever since the price cap was introduced in 2019.  Nevertheless, we believe this should be supplemented by a subsidised social tariff, available across the market and available automatically for eligible customers, which would specifically recognise the additional challenges some vulnerable customers face with engaging in the market.  It should be deliberately set to be the cheapest tariff available, funded by everyone else in the market.   We should also continue with dedicated programmes that help upgrade the homes of vulnerable customers such as the Energy Company Obligation, reflecting the reality that they are likely to be adopting new low carbon technology at a much slower pace compared to the rest of the market without such intervention.  A social tariff and continued support for upgrading homes is consistent with the objective of delivering a fair and just energy transition to net zero. 

“The functioning and performance of the ‘energy price cap’ and an assessment of its use in the future.”

17. Recent wholesale market conditions have exposed two critical flaws in the design of the current absolute price cap implemented in the retail energy market:

Flaw 1: Market structure:

18. The current absolute cap methodology forces the same defined hedging strategy on all suppliers for their price cap (SVT) customers. However, competition in the market has evolved around shorter-term (usually one year) fixed contract products. It is impossible for any supplier to hedge for both a longer-term product and a shorter-term product for the same customer at the same time. The absolute price cap methodology constrains suppliers’ ability to hedge forward competitively.
19. The current price cap effectively forces a hedging methodology on suppliers for a significant proportion of their customer base by explicitly specifying a wholesale cost allowance. Any supplier that deviates from this strategy carries a significant risk during any market volatility.
20. This methodology means that, in a falling market, the price capped product has a higher cost than Fixed Term Contracts (FTCs). This is because the capped product is based on wholesale prices between 2 and 8 months ahead of the 6-month cap period, whilst FTCs are usually priced at the prevailing forward curve.
21. Since the introduction of the price cap in January 2019, until 2021, the wholesale market had been falling, so FTCs have been consistently cheaper than the cap over that time (please note the data for the SVT cap line in the below charts prior to Jan 2019 is based on the same methodology introduced by the cap):

Figure 1: Comparison of forward curve and default tariff

22. Given the predefined hedging assumption in the price cap methodology, this puts pressure on suppliers with a large share of their customers on capped SVT tariffs, as customers switch to cheaper FTCs.
23. As a result of this (noting that other factors also contributed), between January 2019 and December 2020 traditional suppliers with higher shares of customers on capped tariffs moved into loss making positions and one of them (npower) effectively became insolvent.

Large supplier residential EBIT (from Ofgem segmental accounts):

2019: £-0.4bn (loss)

2020: £-0.2bn (loss)

24. In 2021 the wholesale market has risen rapidly, reversing this picture, with longer hedged (default capped) products now cheaper than the forward curve or FTCs:

Figure 2: Comparison of forward curve and default tariff over the last year

25. This has created financial pressure for suppliers relying on FTCs as customers will renew onto the cheaper capped tariffs which are based on the now cheaper hedging strategy. As these suppliers are generally smaller and less able to withstand this pressure (and in many cases have limited or no risk management), we see peaks of SoLR events during or immediately after these periods (noting that before the price cap was introduced, the same impact could still manifest only based on a differential with longer hedged uncapped SVT products):

Figure 3: Relationship between wholesale prices and SoLR events

26. A retail market which features long and short-hedge products side-by side is not sustainable, particularly with the long-hedge product effectively being forced upon suppliers, with a mandated hedging strategy, via the price cap. Alongside a market that is based around short-hedged products for acquisition, this creates boom and bust as suppliers cannot hedge for rising and falling wholesale price scenarios for the same customer at the same time. Therefore, the market does not provide a stable structure for suppliers to effectively manage their risks, literally forcing both small and large suppliers out of business.

Flaw 2: Static methodology:

27. The absolute price cap is currently made up of 8 high level cost categories and almost 30 cost components that make up these categories. Many of these components have their own sub-components. These components are either fixed assumptions, based on an assessment of market conditions prevailing at the time the cap was first being developed (2017), or components that track a more dynamic view of costs and are updated in each cap price revision.
28. This bottom up ‘cost-plus absolute cap’ methodology, set in advance, can never keep pace with market conditions. Ofgem has to predict every cost component in advance and hard-code it into their calculations. It will never be dynamic enough to keep pace with reality which means either suppliers or customers, or both, lose.
29. In the limited time the cap has been in place we have already seen a number of areas where additional cost components have been added to account for changing market conditions (for example the Covid 19 adjustment, smart metering cost allowances, etc). Ofgem’s recent consultations on adjustments to the cap are proposing further changes and adjustments in recognition of changing market conditions.
30. In addition, there are costs that have changed significantly in the years since 2017, but which have not been adjusted and so have a material impact on suppliers’ profitability under the cap (for example RO mutualisation, or industry code costs that have significantly outpaced the CPI allowance in the cap).
31. The current price cap methodology locks Ofgem into an endless and thankless cycle of constant adjustment, of frequently being behind changes in the market and constantly having to balance errors that means either suppliers or customers, or both, lose. These become more complicated and onerous over time.
32. This is a fundamental flaw in the design of the current cap and needs to be addressed with a recognition that Ofgem cannot accurately predict and forecast every single cost component and prescribe them in a bottom-up absolute cap. The design of the cap needs to be realistic about this.

Action required to mitigate these issues and improve market conditions:

33. The requirement in the Tariff Cap Act for Ofgem to have regard to ensuring efficient suppliers are able to finance their activities, in conjunction with the two critical flaws with the design of the cap outlined above, mean there is an urgent need to change the current cap methodology.
34. We believe the current crisis offers an opportunity to create market conditions that are fundamentally better designed for customers and support more effective competition.
35. A default cap that doesn’t force a particular product structure would ensure that regulation is not artificially forcing a particular mixture of tariffs in the market that creates boom and bust when there is significant market volatility. We suspect this is likely to result in a market with both acquisition and default products based around fixed-term contracts (FTCs) rather than evergreen Standard Variable Tariffs (SVTs) but suppliers should be free to decide what’s best for their customers.
36. Suppliers may choose it is in their customers’ best interests to move to a default FTC where, rather than always defaulting to capped SVTs, customers who reach the end of a current FTC and do not actively choose a new tariff or switch (or otherwise join a supplier without a contract) could automatically roll onto a default FTC (for instance, a 1 year fixed deal), which could still be protected by a price cap.
37. This removal of an artificial ‘evergreen’ tariff structure could move the energy market closer to a market like insurance, which is based around an annual renewal, and so promote customer engagement, trust and fairness by creating an annual engagement window for every customer. Prior to the introduction of the cap a number of suppliers, including E.ON, started moving towards annual renewal products for some customers, so there is already a precedence for this in the energy market.
38. There must be a recognition of trade-offs in price cap design, there is no perfect answer, and all models of price cap design will have flaws. BEIS must work with Ofgem to understand those trade-offs. We highlighted above a fundamental structural flaw in the current retail market because of the current price cap’s structure which effectively mandates a hedging strategy that suppliers have to follow. This flaw is significant and creates the boom and bust we have seen in the retail market in recent years, which is not good for suppliers nor customers. To complement a less prescriptive tariff structure in the energy retail market and solve the other problems inherent in the design of the current absolute price cap, the future price cap must avoid dictating a supplier’s hedging strategy.
39. There are a number of ways to design a price cap to do this, we describe one possibility, a relative cap: Unlike the current absolute cap, a relative cap allows a supplier to have control of its own pricing with a constraint on its ability to acquire customers (essential in a competitive market) if it does not price its default tariffs competitively. A supplier can then keep pace with changes in the wider market as it adjusts its pricing dynamically.
40. A relative cap avoids the need for Ofgem to prescribe individual cost components, and in particular a specific prescribed hedging strategy, and the need for constant adjustment and consultation around what should or should not be covered.
41. Finally, a subsidised tariff that will consistently be the cheapest available in the market should be automatically made available to households on the lowest incomes in receipt of benefits. This would replace Warm Home Discount (WHD) and funded by a levy on other customers levelised across the industry in a similar way to the WHD today. This would address affordability concerns for the most vulnerable in society and play a significant part in ensuring a just transition to net zero emissions.

“…an assessment of the role of auto-switching.”

42. It is likely that the growth of unregulated auto-switching services exacerbated the current retail market crisis. The biggest auto-switching services were making switching decisions for 100,000s of customers. Citizen Advice research has shown[9] that these services are opaque for customers, with users not sure they’re getting the best deal available and unable to choose energy suppliers based on the quality of their customer service or other added services that customers may value.
43. The cost advantages given to new energy supply companies and the ability for new suppliers to cut corners and fund growth with customer’s money, allowed these suppliers to constantly undercut rivals, creating a race to the bottom in the energy retail market and presenting a skewed – and unsustainably low – perception of what were ‘fair’ prices for energy. Citizens Advice data shows that the average tariffs of suppliers that subsequently failed were significantly cheaper than that of suppliers remaining in the market.[10]
44. Auto-switching services assume that the only defining factor of importance to customers is the prices offered to customers at any one time. The current crisis has shown the critical mistake in that assumption. Not all energy retail companies are alike, and customers should be encouraged to value other factors alongside price just as in any other market.
45. Encouraging customers to switch from supplier to supplier on a frequent basis undermines incentives to invest in innovative business models that support net zero.  Here the payback on investment is likely to be over a much longer time horizon so why would an investor take a chance on investing in that business model. Auto-switching reinforces the status quo of only focusing on cost and ignores the other value components that are important for customers and the transition to net zero.  The retail model needs to reward loyalty and encourage a longer-term relationship with the customer.  This also could unlock new ways of managing wholesale price volatility in the future when a supplier has greater confidence over the tenure of a customer.
46. In delivering net zero emissions, energy retail companies have a crucial role to play, and further encouraging customers to value innovation and services beyond simply the cheapest commodity prices at any one time will be critical. We support Citizens Advice’s call[11] for Ofgem to address the risks posed by auto-switching companies, and government to regulate these services as soon as possible.

“The future of Bulb and the recovery of public funds and the cost to consumers of other energy supplier failures. “

47. E.ON notes that under the SOLR regime too much of the cost of supplier failure is borne by customers and too little by investors. NERA recently[12] neatly summed up the current situation: “The current arrangements around supplier exit privatise the benefits of success and socialise the costs of failure. It is therefore not a coincidence that suppliers have been failing and imposing costs on consumers.”
48. Rectifying the balance of these risks is vital to the proper running of this market. Without change to the supplier failure process, reforms to the normal running of the retail market will be undermined as investors do not need to properly scrutinise the business plans of suppliers in which they invest. There is a role for BEIS to drive this work across sectors to deliver the right outcomes, noting that much of the failure process is influenced by general insolvency law rather than specific energy regulation.
49. The role of the administrator in the SoLR process also needs reform. Administrators currently are only incentivised to obtain as much money as possible out of the process for their investors. There are no duties to customers or costs to the wider market. This needs to be addressed.  For example, administrators under the SoLR regime should have obligations to transfer final credit balance data to the supplier of last resort before they can access funds to pay creditors / investors. Unfortunately,  Ofgem has no authority over administrators but do over the SoLR regime via enforcement action and their supply licence. This imbalance is often exploited by administrators.
50. As an illustration of the difference in approach between SoLR and the Special Administration Regime (SAR) used with the largest failed supplier to date (Bulb), one of the creditors for Bulb has stated[13], “…the decision to put Bulb into the SAR means that the Investment Adviser is not currently able with confidence to ascribe any value to the assets of Bulb over which it has security and accordingly it is currently assuming that these will have no value at all after repayment of the Government’s capital. The Investment Adviser notes that, had a Supplier of Last Resort process been adopted, it would have expected full repayment of its loan in a relatively timely manner.”
51. The SoLR process must be reformed to at least a position similar to SAR. Under the current SoLR regime, customers are separated from the assets of the business and the costs of honouring credit balances and other costs must be borne by the new supplier, which are ultimately paid for by the entire market. In contrast, under SAR, the customers and assets remain with the firm, and its customers continue to have a claim on the assets of the business (e.g. credit balances and any in-the-money hedge contracts for wholesale costs). As a result, the SAR has the potential to reduce the costs socialised over the generality of customers and taxpayers.

“The role of retail market reform in the context of the UKs net zero transition and domestic energy security requirements. “

52. The new energy retail market should be focused on delivering zero carbon as the prime objective, as opposed to maximising the rate of customer switching or the number of competitors in the market. All reforms of the market should therefore be assessed against this criterion.
53. All levies and taxes on gas and electricity should also be assessed against this prime objective. Specifically, as there is already a carbon price applied to electricity but not to gas, at the appropriate time action should be taken so that the relative price of gas compared to electricity is increased by applying a carbon tax to gas (and oil) and permanently removing environmental levies from electricity costs and placing them instead into general taxation.
54. UK electricity demand is forecast by the Climate Change Committee to double over the next two decades and reach over 700TWh a year by 2050 under the Balanced Net Zero Pathway.  The UK Government has also set itself the ambition of having a zero-carbon electricity system by 2035.  This will be dominated by renewables and nuclear, an outcome which will inevitably have a profound effect on how the electricity market will need to operate in the future. 
55. Instead of continuing with a largely top-down energy system, where centralised generation is flexible and can respond to changes in demand from consumers, the energy transition necessitates moving to a system where demand will need to become increasingly flexible to match the production of energy.  Better economic signals will also need to be provided to low carbon generators so that they can receive both the benefits and costs of their actions on the wider system.  
56. The increased demand for electricity will be driven considerably by the uptake of electric vehicles and heat pumps.  However, if customers simply consume electricity whenever they want to heat their homes and power their vehicles, this will lead to much higher system costs, both in terms of the amount of generation capacity required to meet peak demand and the associated network reinforcement to transport the energy into homes and businesses. 
57. Delivering net zero in an affordable way will require customers to charge their vehicles and heat their homes in a smarter way which will help minimise additional expenditure which customers ultimately pay for in their energy bills.  The retail market has a pivotal role to play to help ensure customer behaviour delivers these favourable outcomes and encourages the adoption of new low carbon assets in the home and that customers are comfortable and confident that these outcomes don’t impact their quality of life.
58. Figure 4 illustrates both the challenge and opportunity from an Electric Vehicle (EV) perspective.  Today, there are very few incentives for an EV driver to charge their car at the time that best suits the Energy System Operator (ESO).  A typical driver who has off-street parking is most likely to charge the vehicle when they have finished work and have driven home.  This coincides with the peak 4pm to 7pm period when wholesale prices are normally at their highest.  Making it easy, through strong consumer incentives (including Time-of-Use tariffs), has the potential to flatten out this peak as illustrated below.  Whilst additional generation capacity will still be required by the system, it will be considerably less (and lower cost) under this smarter regime.

Figure 4: Changing demand profile for EV charging

59. Delivering a responsive demand-led system will require new innovative business models.  Some customers are likely to want to actively participate and respond to more granular Time-of-Use price signals, whereas other customers may be more willing to allow assets in their homes to be controlled by a third party in return for delivering agreed service outcomes.  Either way, this represents a change from the retail market approach which has been in place since market liberalisation where the focus has simply been on cost and selling kWhs of power and gas.
60. Making engagement easy and which avoids customers having to micromanage decisions over when to use assets or avoid consumption will be essential for many.  The retail market’s role will be to help turn this increasingly complex environment into simple compelling service propositions which customers are willing to buy.  This will require customers to have trust in retailers and a willingness to enter into potentially longer-term relationships that enable households (and businesses) to navigate with confidence their own personal pathway to net zero emissions.
61. The areas for reform highlighted above however were not adequately addressed by the recent Retail Market Strategy published by BEIS in 2021.  Instead, the strategy was largely built on the short to medium term goal of accelerating switching rates.  The events of recent months have undermined much of the rationale behind the type of interventions put forward to deliver this.  More importantly, the strategy did not adequately consider the questions that need to be answered in order for the retail market to play a central role in decarbonising buildings for millions of households and businesses over the next two decades. 
62. The time is right to reset the retail market framework so it is principally focussed on delivering the long-term goal of reaching a zero carbon electricity system by 2035 and net zero by 2050 whilst ensuring there are sufficient safeguards in place to protect vulnerable customers and ensure there is a fair and just transition.
63. Retail market reform built on a customer first approach within the energy eco system will not only help meet our net zero goals but also deliver security of supply at lowest cost.  To date, little consideration was given at the time around the role that customers could play in helping to keep the lights on and deliver security of supply as well as utilising the full potential of low carbon generation.  This needs to change so customers are encouraged to flex their demand to soak up local excess wind and solar generation or conversely reducing demand at times of low supply.
64. A key requirement will be to unlock the significant amount of flexibility that domestic and business customers will be able to offer under a reformed retail market.  This will be essential if the electricity system is to transition to zero carbon by 2035.  Key questions that will need to be considered include:

64.1.         How to exponentially grow flexibility markets to alleviate local network constraints especially if generation is not located in close proximity to consumer demand;

64.2.         Whether the current approach of having a single GB wholesale electricity price remains fit for purpose for delivering system security or is ripe for moving to more granular regional or local pricing signals; and

64.3.         The impacts that reforms have on different types of customers and the way in which vulnerable customers can be protected from such reforms which are designed to deliver a more efficient system.    

65. Market reform as we envisage will help to reduce the UK’s dependency on natural gas, thereby helping to insulate the economy from future global wholesale market shocks.  Relying more on home grown energy production is also good for the economy by reducing our balance of payments as a result of lower energy imports.  This needs to be complemented by a national energy efficiency programme so that we reduce energy waste and limit our future gas requirements to the absolute minimum.

Wholesale market reform

66. Alongside reform of the retail market, the wholesale market also requires reform. The last few years have seen the retail price cap as the centrepiece of energy policy. However, there has been insufficient focus on the impact of wholesale prices on customer bills and on ensuring that wholesale markets support the transition to net-zero (whilst delivering a secure supply).  Prior to this crisis, wholesale markets made up around 40% of the customer bill (which will be materially higher in April 2022), and so it is important to ensure that this is set up to deliver the most cost-effective outcomes today and in our transition to a zero-carbon electricity system in 2035. 
67. Today, the wholesale electricity market is based on prices set by the marginal plant on the system.  By 2035, the generation mix will be dominated by renewables and nuclear.  We do not believe the current wholesale market framework is designed to cope with such a system and requires urgent reform to maximise the benefits to customers from reducing costs of renewables, etc, and ensure cost signals are felt by those that need to respond in order to optimise a dynamic, flexible system for net zero.
68. While wholesale market reform is needed urgently to deliver net-zero, the lesson of the price cap is that a fundamental reform of this nature needs thinking through carefully. Therefore, E.ON believes this reform of the wholesale (and balancing market) needs proper consultation against a fixed timetable, with key decisions taken in the next couple of years and required legislation and implementation completed before the end of the next Parliament. 

Create a holistic approach to energy

69. Finally, there needs to be stronger and more effective leadership within Government to ensure developments in energy policy and regulation are delivered and implemented in a coordinated and holistic fashion. It must be made much clearer who exactly is responsible for each area of policy development in the energy system.
70. The changes required in the wholesale market as part of EMR 2.0, for example, need to be designed alongside the required changes in the retail sector, and those required in networks. Too often changes are drawn up in isolation with input only from those with expertise in the specific area in question with little regard for the design of the whole system. The design and implementation of the transition from today’s energy system to the ‘end game’ design for a net zero emissions system is also important, arguably more important, than the end game design itself.

“The comparison of UK wholesale prices and additional costs with the wholesale prices and additional costs across Europe.”

71. The price of energy depends on a range of factors including the national energy mix, network costs, social and environmental policy costs and energy taxes.  According to Eurostat, electricity prices in the first half of 2021 were highest in Germany (EUR 0.3193 per kWh), Denmark (EUR 0.2900 per kWh), Belgium (EUR 0.2702 per kWh) and Ireland (EUR 0.2555 per kWh).  The lowest electricity prices were in Hungary (EUR 0.1003 per kWh), Bulgaria (EUR 0.1024 per kWh) and Malta (EUR 0.1279 per kWh).  The price of electricity for household consumers in Germany was more than three times higher than the price in Hungary and 45.6 % higher than the EU average price.

Figure 5: EU Electricity costs H1 2021[14]

72. A closer look at Germany shows that policy costs represent a significant proportion of the energy bill.  However, in percentage terms a greater proportion of the bill in the UK is associated with policy costs compared to Germany even though customers pay 1.3p/kWh less for these programmes.

Table 1: Comparison of Germany and UK energy costs[15]

73. What this does highlight is the role that policy costs play towards the overall electricity bill, and the impact of funding these programmes via the bill will have on the over-arching electrification agenda.  In particular, analysis from Public First[16] and others has highlighted how this approach acts as a barrier to the deployment of heat pumps by artificially inflating the running costs of electric heating systems compared to gas and oil heating where there is little or no policy costs factored into the total bill.
74. In Germany, the Government has responded to the current energy crisis by cutting a surcharge levied on electricity consumer bills to support renewable energy by 42.7% to help households cope with soaring energy prices, effective from 1 January 2022[17].  The government will help fund the cut with 3.25 billion euros in revenue collected from carbon taxes.  This is an approach the UK Government should consider to help alleviate energy bills in the Spring, where forecasters are predicting the price cap will be increased by Ofgem by between £600 and £700.