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24 August 2022

What energy message should be whispered to the new UK PM?

By Harry Morgan

A new UK Prime Minister will inherit a bundle of problems, from national strikes, to pay demands and spiralling inflation – but all of them are caused by the increasing price of natural gas.

Sadly these problems come as a cost-of-living crisis voters across the UK and are diametrically opposed to the financial state of the energy sector.

Along with supply-side dynamics from Covid-19 disruption and OPEC+’s inability to meet production quotas, energy companies are profiteering off the shocks caused by Russia’s invasion of Ukraine. Throughout the past quarter Brent crude oil futures traded at an average of around $114 per barrel – up from $69 per barrel in Q2 2022 – boosted by a slow return of output from OPEC+, as well as labor shortages in many producing markets.

Having trimmed down the oil major’s break-even price for oil and gas production during the heights of Covid-19, when oil prices at times dipped into the negative, the margin between the reduced cost of production and the soaring market prices for crude oil has pushed beyond 60% in some places.

In total, the five largest oil companies have yielded nearly $100 billion in profits so far this year – more than three-times more than in 2021.

Meanwhile, Ofgem, the country’s energy regulator, has announced a sharp increase in the UK’s energy price cap, from £1,971 to £3,600 per year. Many are expecting this to rise to £4,200 in January, with yet another raise next April.

With energy sitting as the bedrock of any modern economy, it is vital that this price cap returns to its position as a backstop, rather than a primary feature of the market’s pricing. (It was initially introduced in 2019 to prevent suppliers overcharging loyal, but disengaged customer, to subsidize those prepared to switch suppliers.)

So far, the Conservative government – albeit reluctantly – has implemented a 25% windfall tax that will apply to the profits of oil and gas producers in the British North Sea. It expects to raise £5 billion through this, which it will use to offset bills for consumers across the country.

This one-off tax does not go far enough. The £400 energy rebate being offered to households, which it has funded, will not make energy bills of over £4,000 much more affordable. The additional £650 for those receiving means-tested benefits barely scratches the surface of the problem. When implemented, the windfall tax is also full of loopholes that will allow energy companies to continue with business as usual. Even with the tax, the UK will still have one of the world’s lowest government tax takes from offshore oil and gas, sitting 6% lower than the global average. These companies will also now benefit from a new ‘investment’ allowance that will offset the cost of new oil and gas projects by 91%.

With the tax coming into force this quarter, it also misses the key period where energy companies were able to dish out profits to shareholders rather than reducing customer bills. In total, 60% of the profits across the big 5 have been received by shareholders.

The same is true for the country’s energy retailers, which have been able to give out £43 billion in dividends and shareholders between 2010 and 2020.

Politicians across the spectrum have been pitching their plans to address this crisis, placing pressure on the two candidates to take over as Prime Minister in September: Liz Truss and Rishi Sunak. Neither has yet provided a strategy that is any better than laughable.

Sunak has so far promised to eliminate the 5% VAT on energy bills and offer £10 billion additional support for vulnerable households. Truss has been less willing to offer “handouts,” and is likely to stick with a strategy of cutting taxes and removing green levies from energy bills.

Keir Starmer, leader of the country’s main opposition party, Labour, announced his policy to freeze bills last week, at the lower level of £1,971 per year. That plan is estimated to cost £29 billion, with £8 billion of the funding coming from backdating the existing windfall tax to January, rather than from May 26 as planned.

Preferring to prioritize the needs of those with the lowest income, Labour would also reverse the £400 rebate for all households, saving £14 billion. The party believes that capping bills will limit inflation to a peak of 9%, saving the government a further £7 billion in the costs of servicing index-linked debt.

There are some problems here too. The sustainability of this solution relies on the assumption that by April 2023, natural gas prices will be falling, which Rethink Energy thinks is unlikely. If prices stay high, the cost of Labour’s proposals could be as high as £73 billion and then there would be no end in sight to further spending.

Those in the energy industry have been suggesting that the government use tax revenues to remove some charges on bills that are not related to the wholesale cost of gas. This could reduce bills by up to £420 per year but would leave bills heavily exposed to the cost of natural gas, which is likely to remain high for years to come.

The most radical plan comes from the country’s Green Party, which is calling for a permanent nationalization of the UK’s big five supply firms – British Gas, E.On, EDF, Scottish Power and OVO, which supply 70% of UK homes.

Initially proposed by the TUC last month, this sweeping overhaul of the country’s energy system would come at a cost of just £2.8 billion to purchase all of the companies’ shares in one go.

This sits pretty much equal to the £2.7 billion that the government has already used to bailout the 28 companies that struggled to turn a profit under Ofgem’s previous price cap. By the time the country has finished bailing out Bulb Energy, associated costs to UK households could have risen to more than £4 billion, saddling every home with an additional £150 on its bills next year. Ministers have also had to allocate £12 billion to directly cut the cost of household bills.

The reason that this bailout was required is because these companies had prioritized short-term profits over long-term stability – another key argument for bringing the country’s energy sector under national control.

Ending shareholder dividends and share buybacks would make more funding available for cutting consumer bills in the immediate term, “enabling pricing structures with much lower costs for basic energy needs,” according to the TUC. Beyond this, activities may be sped up that are not explicitly associated with revenue generation. Energy efficiency improvements and insulation in UK homes could be accelerated drastically, while carbon emissions could be reduced more quickly if governments can directly align climate ambition with energy supply.

In France, where national energy provider EDF is 84% owned by the state, household bills have risen by just 4% this year – in stark contrast to the 200% rise expected in the UK by January. As the main shareholder, the French government was able to instruct the company to reduce profits for the good of the consumer.

This amounts to directly interfering with the price of wholesale auctions – a remedy we have suggested in the past – whereby the energy firms give back the excess profits that they have made because natural gas has set the price of electricity for the past 6 months. In France this was led by the government controlled nuclear industry, in the UK it would have to be somewhat different, but a kind of contract for difference whereby only the increases in raw gas costs were allowed in electricity price increases, and where they did not exist they would be repaid. It is an idea very similar to the subsidies made in Contracts for Difference.

Of course, the situation in France is somewhat difference, with a reduced dependency on natural gas due to its large nuclear fleet. Only around 2% of the average household’s electricity bill ends up in the profit pool of the retailers. But while immediate savings may be limited, the long-term benefits associated with efficiency measures could be vital. When privatized, energy companies are incentivized to sell more energy to make profits for shareholders – not to invest to cut energy use. Governments, in contrast, are motivated by political pressure rather than solely economic and business factors.

The UK’s energy market was fragmented through the mass privatizations of Margret Thatcher’s governments in the 1980s. One idea that has been suggested is to nationalize the National Grid, and have it procure the least amount of gas it can, by changing its regulations.

Labour included a huge plan to renationalize the country’s energy sector – spanning producers, retailers, and distribution – in its manifesto during the 2019 general election. Such broad nationalization was set to cost up to £200 billion, funded through a controversial raise in corporation tax. And it was largely why Labour lost the election. Rather than focusing on nationalization now, Labour is more focused on the “national emergency where people are struggling to pay their bills” stating that “the right choice is for every single penny to go to reducing those bills.”

Targeting retailers for nationalization, however, will be easier to swallow for British voters that the sweeping reforms in 2019. In fact, 62% of Conservative voters, along with 75% of Labour voters, now agree that energy should be run in public sector.

Such a plan might allow flexibility and agility in the government’s energy strategy even when it is run by “wholly unsuitable politicians,” like the candidates for the Prime Minister’s role.

Key criticisms of renationalization often focus on the cost, efficiency, and sluggish innovation of the public sector. However, in terms of innovation, the large incumbent energy retailers have been sluggish to adopt decentralized energy assets and VPPs.

Smaller companies, like Octopus Energy, EV Energy, Tesla, and spinouts like OVO’s Kaluza, need to remain under private operation, while distribution and the grid might perhaps do better out of being nationalized.

Only a few more weeks left until we find out which approach the UK takes, but to conservative candidates drastic measures like nationalization are unlikely to appeal.