Utility Week

Utility Week 27th September 2013

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Finance & Investment Market view Modest margins and fair prices Energy retailers need to seize control of the debate over fairness of energy prices – RMR could worsen outcomes for consumers, say Thomas Haller, Richard Greenwood and Christopher Peacock. Electricity and gas bills have risen steadily for UK households in recent years, driven by a combination of factors including successive governments' pursuit of green energy and elevated international commodity prices. As the prices paid by consumers have climbed, energy company profits have become a target for derision from the public and politicians alike, with the implication that the retail market is not operating competitively. Indeed, regulator Ofgem has been encouraged to "use its teeth" by MPs on the Energy and Climate Change Committee. This is arguably a partial and populist view of market dynamics and must be placed into a wider context, because the returns on retailing energy are relatively modest – often delivering low single digit margins. Though the enthusiasm for competition in energy markets is currently some way from the high watermark of the 1990s, the reality is that the public did benefit from falling bills immediately following market liberalisation as inefficiencies were driven out. The task now of explaining to those on low and fixed incomes why prices have gone up – and at a time when living standards have fallen in real terms – has had very few takers. Ofgem's recent Retail Market Review (RMR) contains proposals representing the latest effort to halt rising energy bills and to create a "simpler, clearer and fairer" energy retail market for consumers. Yet at the same time Alistair Buchanan, its former head, has warned of a pending capacity crunch as ageing power stations come offline. It is the evolution of the latter situation rather than the former that is more likely to affect the level of household bills in the future. Unless energy retailing remains a profitable venture, the necessary new generation capacity required is less likely to be built (at least by the private sector) and prices may rise higher still. In this environment it is imperative energy companies get on the front foot and communicate why profit is necessary and why prices are "fair". Since 2008, domestic energy bills have risen steadily. Graph 1, right, shows that the gas component of the Consumer Price Index (CPI) has risen by close to 80 per cent and the electricity component by nearly 50 per cent. By contrast, the overall cost of living measured by the CPI index has risen by 20 per cent. Alongside these increases in the domestic price of electricity and gas for consumers, there has also been growth in input costs for energy retailers (a proxy for which may be the UK NBPI (National Balancing Point Index), which has been resurgent from a trough in mid-2009. Costs have increased by around 70 per cent over the past four years to close to their January 2008 peak, as shown in graph 2. All six major suppliers have raised prices to consumers this year. This latest series of price rises provoked further unrest among consumer groups, which note that they have come during a period where utility companies have reported improved operating profits. The political response has been to subject the energy retail industry to greater scrutiny and to impose a supposedly more transparent tariff system aimed at ensuring improved outcomes for consumers. In a prior effort to boost transparency, Ofgem obliged the large suppliers to report their margins split between their generation and supply businesses. Retail margins for 2012 for those companies with year end 31 December 2012 are presented in table 1. These show that some suppliers have actu- Table 1: 2012 retail Ebitda margins of the big six, year ending 31 Dec 2012 Domestic electricityDomestic gas Centrica -1% 12% Eon 6% -1% EDF Energy -1% -3% Npower 7% 3% Scottish Power 22 | 27TH SEPTEMBER - 3rd OCTOBER 2013 | UTILITY WEEK 3% 7% ally lost money retailing to consumers as their costs have developed quicker than their ability to move prices. Few consumers ever consider the complexity of energy retail and the operational and commodity risk their suppliers bear. Utilities manage wholesale market volatility on customers' behalf to deliver relatively stable tariffs that typically move only several times a year. They also manage billing and customer service, while introducing new ways of interacting such as mobile and internet platforms. Furthermore, they have limited visibility of future revenues because customers can switch to another supplier. When all of this risk and outlay is considered, the returns look relatively modest. Similar businesses that manage wholesale and retail costs and prices and provide billing and customer service receive comparatively much less scrutiny. Granted, the use of fixed and mobile telephony is more discretionary than using electricity and gas, but in March 2013 BT's Retail arm recorded an earnings before interest, tax, depreciation and amortisation (Ebitda) margin of 23 per cent. Vodafone's UK Ebitda margin, reported in March 2013, was 24 per cent. The latest Ofgem proposals are set to introduce a number of measures to limit the latitude of energy retailers to offer different products. Under these proposals, suppliers will be required to provide consumers with personalised information relating to the cheapest tariff available. The proposal also includes a ban on complex multi-tiered tariffs, with Ofgem wanting to limit retailers to just four core tariffs per fuel type and per payment type. The regulator also proposes that energy retailers should provide customers with information relating to the cheapest rate applicable to them across the entire market, thereby effectively guiding customers to their competitor with the lowest price. It is hoped these proposals will mean more transparency in the market, increasing competition and improving outcomes for consumers, though in isolation they are unlikely to dramatically reduce prices for households. As shown above, it is not

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