Helping customers manage the risk of energy prices over the longer term
A proposal that would help UK domestic power and gas consumers manage their long-term exposure to price uncertainty.
Electricity and gas wholesale prices experience massive volatility in the UK. These prices are primarily driven by global gas markets, and are largely out of the control of energy retailers. Over long enough periods, supply and demand do drive prices to more normal levels. But this can take many years, and there is no guarantee of what the new normal prices will be.
These wholesale prices are a major part of the cost to supply customers, meaning that as wholesale prices rise, we expect retail prices to rise, although by a smaller percentage and with a lag. Likewise, as wholesale prices fall, we expect retail prices to fall.
At present in the UK, most domestic gas and power customers are either on a standard variable tariff, or are on a tariff that is fixed for 12–24 months. This means that if wholesale price rises are sustained, even fixed term customers will be hit as soon as they renew.
There is a cap on what can be charged for customers on standard variable tariffs, which is adjusted every six months based on wholesale prices, but this gives limited respite to customers when prices rise. And, the difficulties even this limited lag add to hedging have led to calls to update the price cap even more frequently.
This means that the current high wholesale prices are starting to lead to much higher domestic energy bills, in some cases to levels that are unaffordable. Desperate households are being forced to choose between heating in winter and food.
I also worry that people will incorrectly blame the high prices on efforts toward net zero, slowing down momentum. In fact, if we had more renewable energy we would be less exposed to global gas markets.
The problem with expecting retailers to offer longer term fixed prices
Some people would argue that the solution to this for retailers to offer longer term fixed contracts, say up to ten years. However, I’m not a fan of this approach, for a number of reasons.
- Customers may not have confidence that suppliers would still be around to deliver in ten years time.
- It gets quite difficult for suppliers to hedge that far out.
- If suppliers include exit fees in their tariffs, customers may not want to be locked in with one supplier for that long, perhaps fearing that it eliminates the incentive for the supplier to offer continued good service.
- Alternatively, if the supplier doesn’t charge any exit fee, they are effectively offering a ten year option on energy prices. This will have a cost.
- Those customers that are most vulnerable to price rises might not be able to enter into a long term contract, or might find themselves being locked into a bad deal.
An alternative proposal
I have therefore been thinking about how it might work for the government to take on the long term energy price risk.
Under this proposal, whenever the wholesale price for the coming year was higher than it had been forecast over the previous ten years, the government would pay the difference to each customer. Whenever the wholesale price for the coming year was lower than it had been forecast over the previous ten years, the government would add a surcharge.
To manage this risk, the government would ideally buy futures to cover the energy it expected households to use. It would buy 10 years of futures, on 10% of the volume, each year. This exercise would have the added benefit of supporting increased deployment of renewable capacity.
There are some details I haven’t worked out.
- Is 10 years the right duration?
- Should a customer be compensated for the volume they actually use, the volume they are expected to use, or a quantity that is fixed up front? The former has the advantage of simplicity, but reduces the customer’s incentive to respond when prices are high. If there was a way to agree a quantity up front that would be my preference. It might also make sense to just compensate up to a maximum annual quantity.
- Should customers be required to take part? For example, if a customer has solar panels, they are effectively hedging already, and might not want the government to hedge even more. If we are compensating based on expected use, then a customer with solar panels would use less so would automatically be opted out. But if a customer was just speculating that prices would come down, would the state still have a moral obligation to look after them if they got it wrong?
- What about the variation in when, in the year, the customer uses the energy? For example, a customer with solar panels may buy all their energy in winter. Will the standard compensation calculation be appropriate for them?
- Should the compensation be tied to some combination of baseload and peak futures contracts, or something more closely aligned with expected customer demand?
- Should the compensation calculation be at an annual level, or more granular? You could have the scheme pay more in winter when prices are higher, reducing the need for retails to overcharge in summer and undercharge in winter.
I realise that some people will dismiss this idea out of hand, believing that it shouldn’t be the government’s role, or that the government will mess it up. I’d argue that in many ways, the government already is responsible for ensuring that the most vulnerable are able to pay their bills, and by being explicit about it and preparing, they will be able to do it better.
It would be interesting to get thoughts on whether this proposal makes sense, or whether there are better ways of helping customers manage their long term price exposure.