Written evidence submitted by Centrica (EPM0024)
Business, Energy and Industrial Strategy Committee: Inquiry into Energy pricing and the future of the Energy Market
Centrica plc
January 2022
Executive Summary
Centrica welcomes the Committee’s decision to hold an inquiry into energy pricing and the future of the energy market. We believe it provides a real opportunity for timely and constructive dialogue across Government, Parliament, consumers, and energy suppliers to identify and resolve some of the critical challenges facing the energy market.
Recent events have clearly demonstrated the urgent need for changes in the UK’s energy supply market and its regulation. Since 2017, 50 suppliers have failed – including more than 28 suppliers in the last six months alone – in a crisis we estimate could end up costing consumers more than £3.5 billion. A new approach is required to ensure we develop a market that is resilient enough to protect current and future customers, while providing a solid basis on which suppliers can invest and innovate to deliver key policy objectives like net zero. We hope the comments and observations we make below help to prompt a dialogue that will lead to enduring solutions, so we do not see a recurrence of recent events.
In our submission, we have set out our responses to the issues highlighted in the terms of reference of the inquiry’s call to evidence.
Questions
• These regulatory gaps have meant that, until recently, it was possible in the UK to set-up as an energy supplier with limited capital, and should that business fail, walk away with the cost of failure (including customers’ credit balances lodged with that company) being met by consumers. This aspect of the market – where the cost of failure is mutualised - creates moral hazard, meaning that when a supplier fails, it is the solvent bystanders who make good the losses.
• As the current system allows for costs of failed suppliers to be spread across all consumers, it is vital that we introduce reforms that make the likelihood of these costs materialising remote.
• Since 2017, there have been 50 supplier exits and, in the second half of 2021 alone, customers of 28 suppliers have been assigned to Suppliers of Last Resort, while Bulb has entered Special Administration. We estimate the total cost to consumers of supplier failures over this period will be in excess of £3.5 billion. Approximately £340 million of this was customer’s credit balances. Failure to properly regulate the energy sector will simply see a repeat of this pattern in future price fluctuation situations.
• As we have set out in detail in response to question 2, we believe it is essential to protect consumers from the cost of future supplier failures by introducing prudential-style regulation in the energy retail market, similar to that brought in for the banking sector following the financial crisis.
Mandate and performance
• As the energy sector regulator, Ofgem is responsible for protecting consumers, implementing regulation and supervising the activities of energy suppliers. Government is responsible for setting the policy framework.
• The current situation has occurred, in a large part, as a result of an insufficiently robust regulatory framework, which has allowed a number of suppliers to operate unsustainable and reckless business models; these suppliers were unsurprisingly and quickly vulnerable to a large increase in wholesale energy prices.
• In our views, there was a lack of sufficient examination by Ofgem into the practices and management of suppliers, including the extent to which they were hedging and, therefore, their ability to meet their customer commitments. There were also insufficient sanctions in place to create a deterrent for non-compliance or incorrect use of customer funds. For example, smaller suppliers have not incurred fines for missing smart metering targets, yet recent failures have shown their smart meter penetration was far below others in the market, and customer credit balances lost to insolvent suppliers was approximately £340 million.
Proposed changes
• Recent years have been characterised by frequent policy interventions in the energy supply market. The focus of energy market policy has been to push suppliers and consumers to focus on price above all, and on levels of customer switching as the best measure of both competition and a well-functioning market. This has not taken into account the viability and health of the supplier and has arguably encouraged suppliers not to hedge their commitments to customers, which in a large part has led to the current situation.
• In the recent crisis we have seen that those suppliers that frequently set prices near the bottom of the market have been far more likely to fail than those that have not. The form of competition promoted by previous policy has been damaging to consumers when the costs of supplier failure borne by consumers are fully appreciated. Our objective should be to create a policy framework that promotes stable and sustainable competition for all energy consumers.
• The most recent Government intervention of this type was a proposal to introduce opt-in and opt-out collective switching, whereby energy customers would be automatically switched to energy companies offering the lowest prices. This policy incentivises more irresponsible commercial practices, including not hedging commitments to customers in the event they would be switched away, and would encourage entrants to offer unsustainably low prices to gain market share. This would in turn, lead to yet more suppler failures and additional costs to consumers. We are therefore pleased Government have decided to pause this piece of work. We believe that the Government should go further and remove the collective switching policy entirely; it is only ever going to undermine the interests of consumers by perpetuating the “switching and price above all else” market model that has already been shown as unsustainable.
• Previous policies have also made new energy suppliers exempt from paying policy obligations, such as Warm Home Discount (WHD) payments and the Energy Company Obligation (ECO), which has distorted competition.
• In addition, there has been no sanction for companies who failed to meet these obligations. This is despite the clear correlation between non-compliance and subsequent energy company failure. In this context, we believe changes to renewables obligations payments, which were first considered by Government in the summer of 2021 should be implemented without delay, requiring all suppliers to make payments at least quarterly and preferably monthly (removing the current cliff-edge created by annual payments). BEIS should require suppliers to keep up with Energy Company Obligation (ECO) delivery either by:
• The other significant intervention has been the energy price cap. Retail price regulation is playing an important role protecting consumers and should be retained to provide certainty to consumers at a time of volatility. However, the current price cap structure is clearly one which requires reform. The price cap is currently causing heavy losses for suppliers and price spikes for customers when a new level is set.
• Going forwards, the energy price cap will need to be redesigned to resolve these issues. Our views on possible short term and longer-term changes to the cap are set out below in our answer to question 4.
A future regulatory framework for energy
• It is clearer than ever that a structural shift in energy policy is required, through the introduction of a new stable and predictable policy framework. Only with this will be able to encourage the investment and innovation needed to meet net zero. It will only be achieved by joint working across industry, the regulator and policy makers.
• We suggest that the overarching policy objective for the retail market should be the protection of current and future consumers, which includes the reduction of greenhouse gas emissions. Underneath that overarching objective, we would suggest the following characteristics of the market that will best protect current and future consumers:
• Retail price regulation is playing an important role protecting consumers and should be retained to provide certainty to consumers at a time of volatility. However, the current price cap structure is clearly one which requires reform. The UK energy retail sector is collectively loss making and has been since the introduction of the price cap - for the past three years, sector margins have been negative on average. Average pre-tax domestic supply margins were -1.48% in 2019 and -1.02% in 2020. This was a warning sign of a market that was potentially unsustainable.
• There are two core issues with the price cap as it is currently structured. Firstly, the price cap acts as a backstop and protection for consumers - while we support this policy aim, when the policy is then to socialise the costs of failed suppliers across other customers, we need to do more to minimise the chance of failures occurring. This is why we advocate for the protection of customer credit balances and a prudential-style regulatory system. Secondly, the current design fails to provide appropriate incentives and certainty for suppliers to manage risk – by way of example suppliers are currently unsure how to hedge for customers on the cap when prices could fall dramatically and leave suppliers exposed to significant costs. An improved price cap design should look to avoid this issue, which in turn leads to sharp increases in prices for consumers, which reduces trust in the sector.
• We believe the energy price cap will need to be redesigned so that it is more capable of adapting to changing circumstances, promoting sustainable competition and the future investment necessary for the net zero transition. In the short term, it may be necessary to make amendments to the current price cap to try and remove the most immediate issues, which are resulting in heavy supplier losses and Ofgem are currently consulting on these options. Longer term, we believe a new model of price regulation should be designed to deliver a fairer market for consumers, which recognises the need for participants to recover efficiently incurred costs and make an appropriate return on capital invested. Without this we are concerned that we will not have a market that is fit for the future.
• While it is important that price cap reform better ensures that prices reflect underlying costs, this it is not a panacea on its own. When underlying costs are high – as they are now – those costs will ultimately be reflected in consumer prices, so affordability challenges remain and will need to be addressed through other well designed policies targeting help where it is most needed.
• As discussed above, the price cap as it is currently structured makes it difficult for suppliers to manage risk, particularly around hedging. As the cap is set for 8 months ahead of fixed term contracts that are bought in the spot market, there is misalignment between wholesale costs in the cap and between wholesale costs in the competitive fixed tariff market. The impact of this is that suppliers are exposed when wholesale prices rise, and when they fall, and these risks cannot both be managed at the same time.
• Ofgem is currently consulting on options to address this in the short term. One of these options, which we believe has significant potential, is a 12-month fixed term fixed price cap where each customer would pay no more than a set amount for a given consumption. There would be a cap on the pence per day standing charge, and a cap on the pence per kWh unit rate and there would be a new cap level for each customer after 12 months. The 12-month fixed term fixed price cap would enable suppliers to buy energy in advance and give them certainty over the volumes they need, whilst still providing consumers with certainty and peace of mind over their energy bills.
• Ofgem’s consultation considers what reforms can be made to the cap by 1 October 2022 and under current legislation. Any longer-term reform will need to consider a wide range of options and will also need to take into account the conditions for meeting net zero including time of use tariffs. Possible longer-term options which Government and Ofgem may consider include a relative price cap, a capped price for certain consumers i.e. those who are most vulnerable, and a fixed term cap as illustrated above. There are likely pros and cons with all these approaches which Government and Ofgem will need to consider these carefully.
• Whichever option is chosen, it must be well thought through and cognisant of all of the risks in the market to ensure that we never see the current situation repeated as it is costly and distressing to consumers.
Auto Switching
• In 2021 Government consulted on regulation in the Third Party Intermediary (TPI) market, such as Price Comparison Websites (PCWs).
• In our response to this consultation, we highlighted that whilst consumers have benefited from the huge growth in TPIs over the past decade, leading to many of them being more informed about price, it would seem sensible to review the interaction between markets in which prices are regulated to protect consumers and the unregulated intermediaries who extract material sums from these markets (and ultimately consumers) without recourse when the products they sell fail.
• We would support improved regulation of such TPIs in a similar manner to the regulation of financial intermediaries to align accountability with advice. Financial intermediaries promoting products and services from companies which are clearly very high risk without adequate warnings is hopefully a thing of the past – this should also be the case for other markets such as energy retail. Specifically, any regulatory changes should ensure that these third parties operate in a way that does not undermine market stability or promote flawed business models.
• We believe auto-switching services should be included in improved regulation of TPIs and we believe these services have accelerated the failure of some suppliers. Within the recent wave of supplier failures, four failed suppliers had 40% or more of their customers on such schemes. There are currently no requirements for market-driven collecting switching services to ensure that the chosen supplier is financially secure or able to provide adequate levels of customer service. Without these protections in place customers risk being moved to a supplier that will subsequently fail.
• Since 2017, there have been 50 supplier exits and in the second half of 2021 alone, customers of 25 suppliers have being assigned to Suppliers of Last Resort, while Bulb has entered Special Administration. We estimate the total cost of supplier failures over this period, to be borne by consumers, will be in excess of £3.5bn, which ultimately consumers will pay for.
• When Ofgem placed Bulb into a special administration regime in November 2021, it was the seventh largest energy supplier in the UK with over 1.5 million domestic customers. Whilst the Supplier of Last Resort regime has generally been appropriate for most of the recent supplier failures, it was decided by Ofgem that no one company could feasibly onboard 1.5 million new customers, due to the costs involved in administration and the costs of purchasing energy for the Bulb customers.
• Running energy companies in Special Administration is incredibly costly and requires HM Treasury and ultimately the taxpayer to step in and pay the full costs of running an energy supply company. This includes, but is not limited to, fulfilling wages and hedging and trading costs.
• To shield consumers from the significant costs of the Bulb special administration, we believe it would be most appropriate to recover the costs via general taxation over the long term. This method will ensure that those who are least well-off shoulder less of the burden of these costs and will help to mitigate what will already be an incredible difficult winter for some households.
• Given the costs of the Special Administration regime, we believe this emergency measure should only stay in place for as long as necessary.
• Our priority is to protect consumers and support them through this turbulent time. However, the market needs fundamental reforms to ensure this situation never arises again and that the retail energy market is sustainable, secure and is capable of delivering net zero.
Net zero
• Delivering net zero and reducing carbon emissions is an essential objective of competition in energy retail markets. In the context of net zero and energy retail, electricity supply is of special importance: not only must today’s electricity demand be decarbonised, huge amounts of additional demand from electrification of transport and heat must also be delivered from carbon-free sources.
• For the energy retail market to make a maximum contribution to net zero, consumers will need to use – and even supply - electricity in a way that minimises greenhouse gas emissions and minimises the need for grid reinforcement at the same time as adopting new low carbon fuels, such as hydrogen. Such changes would include: (a) shifting consumption – e.g. to periods of high wind; (b) reducing or eliminating consumption – e.g. energy efficiency; and (c) on-site/in-home production and use of storage – e.g. solar and batteries.
• We believe there are three key conditions that need to be met when balancing reform of the energy market with the need to meet net zero:
• Firstly, energy companies must be financially resilient. As we have outlined in question 3, the retail market needs a fundamental overhaul with the objective of delivering a prudential-style regulatory framework that promotes market stability.
• Secondly, we need to ensure key strategic enablers are in place, such as the roll-out of smart meters and half hourly electricity settlement and that suppliers are properly funded to meet these obligations through sufficient allowances in the price cap and that policy incentivises the take up of strategically important technology.
• Finally, as we continue the transition to net zero, we need to ensure the policies are in place to encourage consumers to move to low carbon energy sources and that producers and manufacturers are encouraged to develop low carbon technologies and drive down costs.
Security of supply
7. The comparison of UK wholesale prices and additional costs with the wholesale prices and additional costs across Europe.
• Over the last 12 months wholesale gas prices have increased by over 300%. A number of worldwide factors have contributed to the rise in energy costs, including the Covid pandemic, Europe’s cold winter, an unforeseen demand for liquefied natural gas from states such as Brazil and China, and the low renewable generation during the summer across Europe, which had to be replaced by power generated by CCGTs.
• As one of the Europe’s largest importers of gas, with over 85% of UK homes reliant on gas central heating and gas required to generate a third of our electricity, the UK has naturally been impacted. We currently produce around 50% of our gas domestically, we import 30% from Norway, and the remaining 20% from Qatar, USA, Russia, and Europe.
• Around 5% of the UK’s gas is imported from Russia, this compares to the EU which collectively imports over 20% of its gas supply from Russia. The current geo-political tensions between the EU and Russia impacting the Nord Stream 2 pipeline are well documented and create increased volatility in wholesale markets.
• Recent market developments are unlikely to be a temporary phenomenon. The world’s major economies are being driven to move away from hydrocarbon production abruptly and accordingly some of the constraints on natural gas supplies may increase in the near term; when combined with economies switching from coal and oil fired power generation to gas fired generation to substantially reduce carbon emissions on the journey to net zero it is not hard to see the reduction in supply and the increase in demand is likely to create future price volatility events, with adverse consequences for consumers.
• We fully support Government intervention. It is clear consumers need support in the short term to cope with the significant energy price increases. We believe it is necessary that these actions can happen quicky, are fairly easy to implement and unwind and do not risk creating longer term market instability or unintended consequences.
• We have proposed a combination of reducing VAT on energy bills, moving green and social levies to general taxation and increasing the scope and amount of the Warm Home discount – these interventions would provide vital support for consumers and fast, but without storing up potential problems further down the line.
January 2022