The headlines are scary: natural gas price in the UK quadruples in 2021, Russians accused of manipulating natural gas supply, gas price hikes force closure of fertilizer plants, leading to a shortage of carbon dioxide needed to stun animals before slaughter, which could lead to a meat shortage. On top of that, fire closes the main electric transmission line to the Continent, and the government is in a dither about what to do. But there is another story, a financial one, that we want to focus on. The UK’s energy suppliers, the firms that buy power and natural gas in the wholesale market and then sell it retail to consumers, are in desperate trouble, and the bulk of them are likely to fold by year-end. The government is trying to figure out how to transfer their customers to the surviving firms. Potential losses have not yet been quantified, but they will be big.
Here is how this market works. The suppliers acquire the energy in wholesale markets, where prices change daily. They sell this energy (at a small margin) to customers via fixed-price contracts capped by the government. You probably spotted the problem with that business model. Unless those suppliers carefully hedge their purchases, or have strong balance sheets, a sharp wholesale price increase could wipe out their profits or put them out of business, altogether. Apparently, the losing suppliers met neither of the two qualifications for safety.
Now, free-market advocates might say, “So what, they ran the business imprudently and they go bankrupt. that’s the market. Why should we care?” What happens, though, to those millions of customers who signed contracts with those publicly licensed and supposedly regulated suppliers, innocently assuming that if the government approved of the supplier, it must be solid? The government said it would not bail out the failing suppliers. But the surviving suppliers will not want those customers with those money losing contracts unless they are compensated. Somebody will have to pay.
This brings us to a peculiarity of the supply business. All the suppliers buy the same product in the same markets. It is difficult to believe that any of them could consistently buy the product for less than the other suppliers. All suppliers must price their contracts to cover the purchase of the product, administrative costs, marketing costs, hedging costs, and a profit. Small and new suppliers need to offer a price advantage to get customers from the big suppliers. They can’t reduce the price they pay in the wholesale market for the product, so they have to cut something else. Did they cut costs by not spending enough on hedging?
Financially prudent suppliers should execute hedges to protect themselves from price volatility in the wholesale markets. But hedging costs money, and maybe they thought it is not worth hedging against highly unlikely events. Anyway, gas prices had been stable for so long. Is it possible that consumers who paid low energy bills to suppliers that did not hedge properly will be bailed out by consumers who paid more to suppliers that did hedge properly and had to charge more to achieve that end?
The UK government, asserting its free-market credentials, has pledged not to bail out collapsing energy suppliers. But corporate rescue or subsidies aside, the government does have to figure out how to move “stranded” energy customers to surviving entities. Surviving energy retailers are now increasingly reluctant to take on large numbers of new customers fearing potential losses from extreme price volatility. If the government does not somehow step in to provide hedging insurance or some type of financial backstop for remaining energy retailers, UK energy consumers as a whole may have to pay a share-the-loss surtax.
If energy supplies were not such a vital component of modern life one might excuse this sort of breakdown as being due to a unique set of unfortunate circumstances: Russian market manipulation, slack wind conditions, and a fire that closed down a main electric transmission line. In a way, this resembles contemporary disaster reporting as a once-in-a-fill-in-the-blank episode which now seems to recur with some regularity. Planning for extreme or unlikely events is part of risk management, which like hedging insurance, can be viewed as a business expense. Were energy retailers skimping on their risk management? It seems so. Is their business model to file for bankruptcy at the first sign of genuine financial distress.? These entities are fragile by design. While we expect a lot of hyperventilating by regulators, their previous infatuation with so-called free markets renders them incapable, complicit, or both. The result is that either consumers or the government will be left footing the bill for these energy price spikes.
The imminent financial collapse of the UK energy supply business brings up another question. Why do we have energy suppliers? What useful service do they provide? Theoretically, the rationale for the energy supply business is to create competition on the retail level, which should reduce prices to consumers. But there is a design flaw here. All of the supposedly competing energy suppliers purchase the identical product in the same wholesale markets. As we noted, it is improbable that even the most astute retailer can maintain a significant relative price advantage for long. On top of the now highly volatile cost of purchased energy, retailers also need to spend considerably more for hedging expenses, cost of capital, and considerable marketing and administration expenses. None of those costs were incurred separately when consumers simply purchased energy directly from the regional utility.
We have always felt that energy suppliers had one function and that was to provide hedging mechanisms for producers or generators. The goal is to ensure that consumer prices remain relatively stable against a backdrop of fluctuating wholesale prices. When wholesale prices rise, the wholesale energy producer makes a bigger profit and the supplier a lower profit because it sells at a fixed price while the variable wholesale cost has risen. Linking the wholesale energy supplier directly with its customer base accomplishes the same thing as financial hedging but at far lower costs. But conceptually this is reintegrating a business that the UK’s “deregulators” hoped to split apart. The only area in the US that resembles 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 dating back to the Thatcher administration go one step too far, destabilizing their energy pricing mechanisms and imposing another layer of unnecessary costs? We believe fixing these fundamental design flaws deserves as much attention as fashioning a bailout for consumers. At least the consumers’ choices made sense at the time, pick energy plans that fit their budget, buying a product whose availability and price they thought was supervised by the government.
But divorcing the retail from the wholesale function in energy supply never made any economic sense and was a recipe for financial disaster. As standalone entities, there was no way either the producers or retailers could have the financial resilience to withstand severe price volatility in wholesale energy markets. They would continually be at the mercy of the markets and often find themselves in the financially disadvantageous situation of buying high and selling low.
Many Thatcher era deregulatory efforts were rooted in three basic tenets: ideological conflict with British labor unions (especially coal miners), dislike of government ownership, and a neo-liberal belief in the efficacy of competition. Neither coal nor coal miners play a meaningful role in the UK anymore. None of the political parties advocate government ownership anymore. And the competitive policies in the energy markets were replaced long ago because they worked poorly. And yet the political structures associated with this policy persist. We think it’s time to reverse deregulatory efforts that may make systems less stable and possible more expensive. The bottom line here is that monopoly provision of utility services or government ownership may both be terrible systems but the “deregulators” created may not be much better.
By Leonard S. Hyman and William I. Tilles for Oilprice.com
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