Energy market failure

02 February 2022
It has been several years since I last wrote about the UK's energy crisis yet it feels like little has actually been done in the years since to try and sort it out, which was also the same observation I made back then. News of yet another UK energy provider going bust — this time affecting 1,700,000 customers — seemed to come and go since it was the 26th so far, and this is the expected outcome of a fundamentally flawed system. A system designed to keep costs down is now a major contribution to what could be the highest inflation in decades.

Asking for trouble

For much of the last decade lots of up-start companies have entered the energy market who took advantage of low spot-prices rather than utilising long-term hedges, which was good when whole-sale prices were low but as soon as the music stops they became royally screwed. I think there was supposed to be some form of financial buffering but this was both clearly inadequate from the outset, and likely as not this system was also gamed with some of the energy deals probably not being far off ponzi schemes. As it happens even well-run companies which stuck to their guns and maintained generous buffers are feeling the pressure. And for good measure there was also little in terms of buffering the actual gas itself, with the UK having reserves measured in days rather than months ever since the Rough storage facility was closed down. The idea was to rely on just-in-time delivery of gas at a time when there was a glut, but gluts have a tendency of not lasting and I do wonder whether the release of stored gas prior to the closure of Rough artificially suppressed wholesale prices. With coal gone and nuclear out of favour, there was an over-reliance on gas due to the lack of wind, and for many energy companies there was nothing to smooth out the more extreme spikes in the spot gas price. I had heard about some deliberate manipulation of Russian gas prices but to me the other major sources of gas don't seem any better.

Failure of price controls

I don't know the ins and outs of how the energy price cap system operates and why it was bought in, but it is clear that when there is a supposed ceiling of £1,277 but the actual cost is hitting £2,277 then there can be only one end result: Classical failure of price controls. The maximum selling price was far in excess of the market price so suppliers left the market, in this case by becoming insolvent. To make matters worse since the energy cap is based on average energy use there is the moral hazard that above-average households have no incentive to engage in any sort of energy-efficiency, and if anything are likely to become less efficient. One way or another people will have to pay a lot more for their energy, with the cap expected to increase 50–60%. There is pressure on the government to keep prices down but short of subsidising energy companites to the tune of £20billion or so there is little they can do. VAT on energy is already only 5% so zero-rating it won't make much difference, and scrapping £200 in supposed green levies will not mean much with bills busting £2,000. What is on the table is a loan system that just kicks the can down the road, as repayment will be via a surcharge on future energy bills.

Welcome back inflation

Ironically because of the way the cap is calculated using wholesale prices from the previous six months prior to February and is applied in April, the huge rise in the cap is going to coincide with the seasonal spring drop in wholesale prices which can be best described as salt in the wounds. This will cause overall inflation to reach 6.8% according to Goldman Sachs — my own prior prediction for 2022 was 8% — which is political suicide since it will also coincide with personal tax rate rises. It looks like the government has got itself in a position where the country is going to get crippled by inflation, but unlike the 1970s the causes are rather different.