Headlines are scary: the price of natural gas in the UK quadruple in 2021, Russians accused of manipulating natural gas supply, rising gas prices are forcing the closure of fertilizer factories, resulting in a shortage of carbon dioxide necessary to stun animals before slaughter, which could lead to a shortage of meat. On top of that, fire closes main power transmission line to mainland, and the government is wondering what to do. But there is another story, financial, that we want to focus on. UK energy providers, companies that buy electricity and natural gas from the wholesale market and then retail it to consumers, are in dire straits, and most are set to shut down by the end of the year. The government is trying to figure out how to transfer its customers to the surviving businesses. The potential losses are not yet quantified, but they will be significant.
Here is how this market works. Suppliers acquire energy from wholesale markets, where prices change daily. They sell this energy (at a low margin) to customers through fixed price contracts capped by the government. You’ve probably spotted the problem with this business model. Unless these suppliers carefully hedge their purchases or have strong balance sheets, a sharp increase in wholesale prices could wipe out their profits or put them out of business altogether. Apparently, the losing suppliers did not meet either of the two safety conditions.
Now free market advocates might say, âSo they ran the business recklessly and went bankrupt. it is the market. Why should we care? What happens, however, to those millions of customers who have signed contracts with these publicly licensed and supposedly regulated suppliers, innocently assuming that if the government has approved the supplier, it has to be solid? The government has said it will not bail out failed suppliers. But the surviving vendors won’t want those customers with these contracts to lose money unless they are compensated. Someone will have to pay.
This brings us to a peculiarity of the procurement activity. All suppliers buy the same product in the same markets. It’s hard to believe that any of them could consistently buy the product at a lower price than other vendors. All suppliers must price their contracts to cover product purchase, administrative costs, marketing costs, hedging costs and a profit. Both small and new suppliers must offer a price advantage to attract customers from large suppliers. They can’t reduce the wholesale price they pay for the product, so they have to cut something else. Did they cut costs by not spending enough on coverage?
Financially prudent suppliers should put in place hedges to protect against price volatility in wholesale markets. But hedging costs money, and maybe they didn’t think it was worth hedging against highly unlikely events. Either way, gas prices had been stable for so long. Is it possible that consumers who paid low energy bills to suppliers who did not properly cover themselves were bailed out by consumers who paid more to suppliers who covered properly and had to charge more for reach this goal ?
The UK government, affirming its references to the free market, has pledged not to bail out collapsing energy providers. But business bailouts or subsidies aside, the government must find a way to move âstrandedâ energy customers to surviving entities. Surviving energy retailers are now increasingly reluctant to accept large numbers of new customers, fearing potential losses due to extreme price volatility. If the government does not step in in one way or another to provide blanket insurance or some type of financial support to the remaining energy retailers, UK energy consumers as a whole could have to pay a surcharge loss sharing.
If energy supply were not such a vital part of modern life, one could excuse this kind of blackout as being due to a unique set of unfortunate circumstances: manipulation of the Russian market, weak wind and fire that shut down a main electrical transmission line. In a way, it sounds like contemporary disaster reporting as a one-off episode that now seems to recur with some regularity. Planning for extreme or unlikely events is part of risk management, which, like coverage insurance, can be considered a business expense. Are energy retailers skimping on their risk management? Presumably. Is their business model to file for bankruptcy at the first sign of real financial distress? These entities are inherently fragile. While we expect a lot of hyperventilation from regulators, their past infatuation with so-called free markets makes them incapable, complicit, or both. The result is that consumers or the government will have to foot the bill for these spikes in energy prices.
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The impending financial collapse of the UK energy supply industry raises another question. Why do we have energy suppliers? What useful service do they provide? Theoretically, the raison d’Ãªtre of the energy supply business is to create competition at the retail level, which should lower prices for consumers. But there is a design flaw here. All the supposedly competing energy suppliers buy the same product in the same wholesale markets. As we have noted, even the smartest retailer is unlikely to be able to maintain a significant relative price advantage for long. In addition to the now highly volatile cost of purchased energy, retailers also have to spend significantly more on hedging expenses, cost of capital, and massive marketing and administration expenses. None of these costs were incurred separately when consumers simply purchased energy directly from the regional utility.
We have always believed that energy suppliers have a function and that is to provide hedging mechanisms for producers or producers. The aim is to ensure that consumer prices remain relatively stable in a context of fluctuating wholesale prices. When wholesale prices increase, the wholesale power producer makes a higher profit and the supplier a lower profit because he sells at a fixed price while the variable wholesale cost has increased. Tying the wholesale energy supplier directly to its customer base accomplishes the same thing as financial hedging, but at much lower costs. But conceptually, it reintegrates a business the UK “deregulators” hoped to separate. The only region in the United States that looks like this is Texas with its proliferation of electricity retailers.
Does retail energy supply add value to consumers by creating competition? Or, have the ideologically motivated free traders dating back to the Thatcher administration gone a little too far, destabilizing their energy pricing mechanisms and imposing another layer of unnecessary costs? We believe correcting these fundamental design flaws deserves as much attention as crafting a consumer bailout. At least the choices consumers made made sense back then, picking energy plans that fit their budget, buying a product whose availability and price they believed was overseen by the government.
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But separating the retail function from the wholesale function in energy supply never made economic sense and was a recipe for financial disaster. As stand-alone entities, producers or retailers had no way of having the financial resilience necessary to withstand the high price volatility in wholesale energy markets. They would be continually at the mercy of the markets and would often find themselves in the financially disadvantageous position of buying high and selling low.
Many Thatcher-era deregulation efforts were based on three basic tenets: ideological conflict with British unions (especially coal miners), aversion to government ownership, and a neoliberal belief in the effectiveness of government. competition. Neither coal nor coal miners play a significant role in the UK anymore. None of the political parties advocate government ownership anymore. And competitive policies in energy markets were superseded a long time ago because they worked badly. And yet, the political structures associated with this policy persist. We believe it is time to reverse deregulation efforts that could make systems less stable and possibly more expensive. The bottom line here is that monopolistic provision of public services or government ownership can both be terrible systems, but the created “deregulators” may not be much better.
By Leonard S. Hyman and William I. Tilles for Oil chauffage
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