The headlines are terrifying: Natural gas prices in the UK will quadruple in 2021, Russians accused of manipulating natural gas supplies, Gas price increases force the closure of fertilizer plants, This leads to a lack of carbon dioxide, which is needed to stun the animals before slaughter, which could lead to a shortage of meat. Furthermore, Fire closes the main power line to the continentand the government is undecided what to do. But there is another story, a financial one, that we want to focus on.
UK utilities, who buy electricity and natural gas on the wholesale market and then sell them to consumers, are in desperate trouble and the majority of them are likely to give up by the end of the year. The government is trying to figure out how to pass its customers on to the surviving firms. Potential losses are not yet quantified, but they will be large.
This is how this market works. Suppliers get their energy from wholesale markets where prices change daily. They sell this energy (with a small margin) to customers through fixed price contracts that are capped by the government. You have probably recognized the problem with this business model. If these suppliers do not carefully hedge their purchases or have strong balance sheets, a sharp rise in wholesale prices could wipe out their profits or put them out of business. Apparently, the losing suppliers did not meet either of the two security criteria.
Now, free market proponents could say, âSo what? You have run the business carelessly and you are going bankrupt. this is the market. Why should we care? âBut what happens to those millions of customers who have signed contracts with these publicly licensed and supposedly regulated providers on the innocent assumption that if the government approves the provider, it must be solid? The government said it will not bail out the failing suppliers. But the surviving suppliers will not want these customers with these money loss contracts unless they are compensated. Someone will have to pay.
This brings us to a peculiarity of the supplier business. All vendors buy the same product in the same markets. It’s hard to believe that either of them could permanently buy the product cheaper than the other vendors. All suppliers must price their contracts to cover the purchase of the product, administration costs, marketing costs, hedging costs and a profit. Small and new providers must offer a price advantage in order to win customers from the large providers. They can’t reduce the price they pay for the product in the wholesale market, so they have to cut something else. Did you cut costs by not spending enough on insurance?
Financially prudent providers should use hedging to protect themselves from price volatility in the wholesale markets. But hedging costs money, and maybe they thought it wasn’t worth protecting against highly unlikely events. In any case, gas prices have been stable for so long. Is it possible that consumers who paid low energy bills to suppliers who did not properly cover will be saved by consumers who paid more to suppliers who did proper cover and had to charge more for it?
The UK government reiterates its market economy credentials and has pledged not to bail out collapsing utilities. But aside from business bailouts or subsidies, the government needs to figure out how to convert âstrandedâ energy customers into surviving businesses. Out of fear of possible losses due to extreme price fluctuations, the surviving energy traders are accepting more and more new customers. Unless the government intervenes somehow to provide protection insurance or some form of financial backstop to the remaining energy retailers, UK energy consumers may have to pay an overall loss sharing tax.
If energy were not such an important part of modern life, a unique set of unfortunate circumstances could excuse this type of breakdown: Russian market manipulation, low wind conditions, and a fire that shut down a main power line. In a way, this is similar to contemporary disaster reporting as a one-off episode that now seems to repeat itself with some regularity. Planning extreme or unlikely events is part of risk management, which, like insurance, can be viewed as a business expense. Did energy traders do business in risk management? It seems so. Is your 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 previous infatuation with the so-called free markets makes them incapable, complicit, or both. The result is that either the consumer or the government bears the responsibility for these energy price spikes.
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The impending financial collapse of the UK utility business raises another question. Why do we have energy suppliers? What useful services do they offer? In theory, the rationale for the utility business is to create competition at the retail level that should lower prices for consumers. But there is a design flaw here. All supposedly competing energy suppliers buy the identical product on the same wholesale markets. As mentioned earlier, even the smartest retailer is unlikely to be able to claim a significant relative price advantage for long. In addition to the now strongly fluctuating costs of the purchased energy, traders also have to spend significantly more on hedging expenses, capital costs and considerable marketing and administrative costs. None of these costs were incurred separately if the consumers simply obtained electricity directly from the regional energy supplier.
We always had the feeling that energy suppliers have a function, namely to provide safeguards for producers or producers. The aim is to ensure that consumer prices remain relatively stable against the backdrop of fluctuating wholesale prices. When wholesale prices increase, the wholesale energy producer makes a higher profit and the supplier makes a lower profit because he sells at a fixed price while the variable wholesale cost has increased. The direct link between the energy wholesaler and its customer base has the same effect as financial security, but at significantly lower costs. But conceptually this is the reintegration of a company that the British âderegulatorsâ hoped to separate. The only area in the US that is similar to this is Texas, with its proliferation of electricity retailers.
Does retail energy supply add value to consumers by creating competition? Or did the ideologically motivated free marketers from the time of the Thatcher administration go a step too far by destabilizing their energy price mechanisms and imposing another layer of unnecessary costs? We believe fixing these fundamental design flaws deserves as much attention as a consumer rescue package. At the very least, it made sense at the time for consumers to choose energy plans that fit their budget and purchase a product that they believed would be monitored by the government for availability and price.
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The separation of retail from wholesale in the energy supply, however, never made economic sense and was a recipe for financial catastrophe. As separate entities, neither the producers nor the retailers had the financial resilience to withstand the high price volatility in the wholesale energy markets. They would be constantly at the mercy of the markets and often find themselves in the financially unfavorable position of buying at high prices and selling at low prices.
Much deregulation efforts from the Thatcher era were based on three fundamental principles: ideological conflict with British unions (especially coal miners), aversion to state property, and a neoliberal belief in the effectiveness of competition. Neither coal nor miners play a significant role in Great Britain. None of the political parties advocate more state ownership. And the competitive policy on the energy markets has long since been superseded because it worked badly. And yet the political structures associated with this policy persist. We believe it is time to reverse the deregulation efforts that have made systems less stable and potentially more expensive. The bottom line here is that monopoly provision of utility services or government ownership can both be terrible systems, but the “deregulators” created may not be much better.
By Leonard S. Hyman and William I. Tilles for Oil Genealogie
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