Energy Prices, Profits and Poverty - Energy and Climate Change Contents

3  Profits

Energy company profits

43. Mr Lloyd of Which? suggested that the six largest vertically integrated energy companies (big six) had been making regular and substantial profit announcements whilst at the same time raising energy prices:

    I think there is a justified lack of trust. [...] I think there are a number of causes. One is a lack of transparency about how the price and, in particular, the price increases that people have been paying have been arrived at, with very regular, very substantial profit announcements by particularly the vertically integrated suppliers [...]. That fuels the perception among consumers that there is something going on in the industry.[93]

Ms Gallacher, Director of Energy of Consumer Focus supported this view, suggesting that from 2008 to 2011 there had been a 36% increase in (pre-tax) profits across the big six.[94] In its written evidence Consumer Focus reported the big six's profits increased from £6.67 billion to £9.09 billion.[95] Table 4, however, doesn't appear to support this. It is also worth noting that the figures referred to by Consumer Focus are absolute profits rather than profit margins. Absolute profits will inevitably rise if energy company activity and investment rise.

44. Table 4 shows the reported turnover for the six largest energy companies. whether profits are 'excessive' is a matter of opinion. we accept that energy companies need to be profitable and profits will increase if the investment in infrastructure that the UK needs comes forward. Nevertheless, there remains a perception that profits are excessive. In this chapter we focus on how transparency can be increased in order to facilitate a better understanding of energy company profits.

45. Calculating energy company profits is, however, complicated. Despite very large turnover, and in some cases large pre-tax profits, the big six made significantly different levels of profit and loss in different parts of their business (see table 4). Furthermore, understanding how much profit an energy company was making requires an understanding of company structure (including whether they are based offshore), how they operate in the wholesale market and whether it is easy to trade in the wholesale markets (i.e. are they sufficiently "liquid", and how they use their trading arm - if they have one).

Table 4: Turnover and profit for the big six (£ million)

Turnover Pre-tax profit Profit margin
Company2007-11 average 20112007-11 average 20112007-11 average 2011
EDF Energy Holdings Limited 2,4577,371 386627 15.7%8.5%
EDF Energy PLC n/a3,849 n/a41 n/a1.1%
EDF Energy Customers PLC 5,3014,951 -127-211 -2.4%-4.3%
British Energy Direct Limited 1,009676 1522 1.5%3.2%
SSE PLC24,458 31,7241,031 2694.2% 0.8%
SSE Energy Supply Limited 22,81232,008 375-7 1.6%0.0%
British Gas
Centrica PLC 20,97922,824 1,5271,268 7.3%5.6%
British GAS Trading Limited 12,31612,786 7131,898 5.8%14.8%
Scottish Power
Scottish Power UK Holdings Limited 6,2617,450 690327 11.0%4.4%
Scottish Power UK PLC 5,0986,441 625295 12.3%4.6%
Scottishpower Energy Retail Limited 3,1923,378 76-14 2.4%-0.4%
E.On UK PLC 9,0719,240 621-199 6.8%-2.2%
E.On Energy Solutions Limited 6,5297,028 24157 0.4%2.2%
RWE Npower PLC 785687 96-38 12.2%-5.5%
Npower Limited 3,2243,293 -1255 -0.4%1.7%
Npower Northern Limited 1,4491,686 -102-117 -7.1%-7.0%
Npower GAS Limited 606386 -36-11 -5.9%-2.9%
Npower Direct Limited 412355 4655 11.2%15.4%
Npower Yorkshire Limited 309236 -57-27 -18.4%-11.5%

Note: The subsidiaries listed include energy supply among their activities, some but not all include other activities both inside and outside the energy sector. The table showed relevant subsidiaries for each of the big six. This excluded some of the much smaller subsidiaries. The range of operations of each company varies considerably. There is no direct read across from one company to another from such figures.

Source: FAME database


46. SSE and British Gas are owned by UK companies. E.ON and RWE are owned by German companies, EDF Energy is owned by a French company, and Scottish Power a Spanish company. Some companies have upstream oil and gas exploration and production arms while others have gas storage arms. Common to all the big six is an (upstream) generation arm, a (downstream) supply/retail arm and a trading arm which provide trading services for both the generation and supply arms (see table 5). In oral evidence, each of the big six outlined the different parts of their business:

·  Mr Cocker of E.ON said it had a, "retail business, which supplies electricity and gas to residential customers and business customers. We have a generation business, which generates electricity. We have a renewable business. We also have an upstream gas business and a gas storage business."[96]

·  Mr Poole, Director of Business-to-Consumers of EDF energy said it had an, "upstream business, which is largely generating energy, on one hand and we have a downstream supply business supplying electricity and gas to our residential and business customers."[97]

·  Mr Phillips-Davies of SSE said it had three business streams. "We have a network stream that is completely regulated and separated. We also have a wholesale or generation stream, and then we have a retail stream that deals with customers."[98]

·   Mr Peters, Managing Director, Energy of British Gas said, "We have a very clear separation between downstream supply and our upstream business. We do also have a smaller storage business that is held out to one side through undertakings we made to Ofgem relating to the Rough transaction. Our trading operations are a route to market for both downstream and upstream and are embedded in our upstream business."[99]

·  Mr Clitheroe of Scottish Power said it had three businesses. "The generation business, the energy management business and the retail business. The energy management business manages the buying and selling of energy on behalf of the generation and retail business."[100]

·  Mr Massara of RWE said, "as of 1 January [...] the generation business is now a European generation business and therefore that is a separate P&L (profit and loss) completely. The trading division will have their P&L and, effectively, the downstream supply business will have theirs."[101]

47. The big six argued that their businesses were simple, but the structures and relationships between the component elements are varied and complex. Some of the big six had a parent company which owned, or partly owned, multiple companies in different countries around the world. When these companies reported their overall profits they included all these multiple different companies. This complexity made it difficult to determine where profits and losses were being made within the company and how they might relate to recent energy price rises (see paragraph 4). Indeed, SSE explicitly pointed out that:

    With energy retail just one part of SSE's business, and given the many factors that determine energy prices, attempting to draw correlations between energy prices rises and company-wide profits is misleading.[102]

Mr Lloyd of Which? said:

    [...] consumer perception is one of distrust in the energy market. A part of that is the lack of transparency about what is driving retail prices, but then if you look at the results that companies are reporting, they are reporting much healthier margins on the generation businesses than the retail businesses. That is part of why there is a perception, on the part of consumers, that there is something perhaps untoward going on between the different arms of vertically integrated companies.[103]

Energy Action Scotland stated its belief that, 'in order to obtain a true competitive market for all suppliers big and small there must be a more transparent wholesale market with strong regulation from Ofgem.'[104]

Table 5: Different arms which make up each of the six largest vertically integrated energy companies
Company Exploration/production Generation Trading Retail Net-work Gas storage Renewables
E.ON* xx xx x x
EDF xx x xx
SSEx xx xx xx
Centrica/British Gas

*E.ON operates each of the businesses listed (Exploration and Production, Generation, Trading, Retail, Gas Storage and Renewables) as an independent standalone business within the overall E.ON group, which must optimise its own position separately, and not on a vertically integrated basis.

Source: Q 115, Q 224

Increasing transparency of energy company profits


48. In an effort to increase transparency of the big six's profits, Ofgem has, since 2009, required them to publish Consolidated Segmental Statements (the statements) annually. The statements are intended to provide greater transparency about the profitability of the different parts of vertically integrated companies. Ofgem highlighted that as a result, for the first time, data was available on the companies' revenues, costs and profits, disaggregated for their generation and supply arms.[105] The Secretary of State said, "[the statements are] a unique regime, to my understanding, and therefore I think it is something that should be celebrated and supported."[106]

49. Ofgem has summarised the average profit margin of all big six energy companies (see table 6 below) over the last three years using the statements from them.[107] Its figures are aggregated across the big six and show that the supply margin fell to 3.1% in 2011 after increasing from 1.8% in 2009 to 3.8% in 2010, and that the generation margin rose from 21.9% in 2010 to 24.4% in 2011. Ofgem reported how in its 2008 Energy Supply Probe it found that suppliers' margin targets were between 4 and 10%. We would expect generation margins to be larger because it requires larger capital investment and carries greater financial risk. The Probe also explained more about the structure of energy supply businesses, which have low levels of invested capital and a high level of pass-through costs. Both these factors, Ofgem reported, would suggest significantly lower levels of profitability on the supply side than the capital intensive generation parts of these companies.[108]

Table 6: Average profit margin by segment

Profit margins  2011 aggregate margin2010 aggregate margin 2009 aggregate margin
 All segments 7.6%7.2% 5.8%
 Generation  24.4%21.9% 22.5%
 Supply  3.1%3.8% 1.8%
 Electricity - Domestic 1.5%0.3% 2.1%
 Electricity - non-Domestic 3.3%4.7% 4.0%
 Gas - Domestic 4.3%5.7% -0.4%
 Gas - non-domestic  6.5%6.2% -0.5%


Source: OFGEM: Consolidated Segmental Statements

50. Most of the big six believed that the statements helped to improve transparency. E.ON described them as a, 'valuable tool'.[109] EDF Energy similarly suggested that they, 'provide robust information'.[110] Scottish Power proposed that media and political commentary should focus more on the statements and that they should be made more visible to consumers.[111] Ms Gallacher of Consumer Focus said they had stimulated discussion around energy company profits which she thought was positive:

    [...] it does generate quite a lot of debate now. Maybe if we had not had them, the level of consumer interest in energy prices might not be as great as it is, so I think they have definitely prompted a degree of debate. [...] If that is something that brings focus on this market and encourages Ofgem, Government, consumer bodies, and industry to try to sort it out, rebuild consumer trust and try to give greater confidence on price fairness and transparency, then that is a good thing.[112]

51. There were, however, limitations to the effectiveness of the statements in increasing the transparency and comparability of the big six's profits. Ofgem put this down to how companies operate and structure themselves:

    This is mainly because of the various differences among the companies in how they operate and structure their businesses and therefore how they report their results. In particular, differences in the way the trading arm remunerates the generation and supply arms will create differences in how the information contained in the Statements is calculated.[113]

Mr Lloyd of Which? also thought that the Statements had failed to demonstrate that consumers were paying a fair price:

    What it [CSS] has not done, if I may, is [...] translate what we think is an accurate picture of what is going on in the market to consumers. [...] if part of what is intended through the publication of segmented accounts is to give customers some assurance that the businesses are operating competitively and the retail end in their interest, as well as to show shareholders what is going on, then they are failing in that objective. There is not sufficient data there for us to be able to say with confidence that consumers are in a competitive market that is giving them keen prices.[114]

52. Ofgem emphasised that, since introduction of the statements, it had worked to improve their transparency and cross-comparability. In 2011, it commissioned a detailed review of the statements by the accountancy firm BDO. The review concluded that the methods the big six used to complete the statements were 'broadly fair and appropriate'. However, it also identified a number of inconsistencies in the business models used, limiting cross-comparability. BDO made a number of recommendations to improve the statements. Ofgem consulted on a range of proposals based on the recommendations and enacted them in 2012 (see table 7). They did not take forward any of the proposals in their original form. Ms Gallacher of Consumer Focus said she did not understand why Ofgem did not implement all BDO's recommendations:

    I do not understand [...] why Ofgem did not choose to implement all the recommendations from BDO. It would be quite helpful to understand whether it was cost drivers or technical or physical ability to do that but you would really have to question why you would pursue this if it is not really helping the situation.[115]

53. Mr MacGregor, Head of Advisory Services of BDO told us that if its recommendations had been implemented it would have led, over a period of time, to more transparency over the performance of the big six.[116] When asked why they didn't take the recommendations forward Mr Wright, Senior Partner of Ofgem said Ofgem had taken forward five modified recommendations and rejected three:

    [...] because they did not meet our criterion of meeting our cost benefit analysis, so we did not think that the cost associated with the usefulness of the information released would be in the interests of consumers.[117]

54. In written evidence Ofgem did, however, state that there is, 'still more that the companies can do to make the statements clearer to consumers in a way that substantially increases their understanding and trust'. Ofgem asserted that companies, 'have a key role in delivering this and we would hope to see them taking this responsibility seriously'.[118]

Table 7: Ofgem revised proposals following BDO's report
Recommendation January 2012May 2012
1. Require the companies to publish their Statements to the same year-end We do not intend to take forward this recommendation As in January
2. An independent auditor to provide an opinion on the Statements We propose obtaining an independent opinion, at least for the first year, but not necessarily from an auditor As in January
3. Instruct reconciliation of the Statements to an audited IFRS income statement We propose to take forward this recommendation We propose to take forward a variation of this recommendation and require companies to reconcile to the UK result in their published Group Accounts
4. Require the reporting of trading function results, including disclosure of the risk each trading function assumes We do not propose to take forward this recommendation, although we do propose companies produce a checklist to identify where functions are undertaken As in January
5. Perform further work to assess current transfer pricing policy We do not intend to take forward this recommendation As in January
6. Introduce uniform reporting treatments for generation fuel costs and free EU ETS allowances We propose to take forward this recommendation We propose to take forward a variation of this recommendation and allow companies that operate toll processing arrangements to provide the fuel costs as a supplementary note to the main results template
7. Guidance on scope and definition of exceptional items We propose to take forward this recommendation As a result of our amended proposal on recommendation 3, recommendations 7 and 8 are no longer required in their original form.
8. Specify consistent profit base for reconciliation We propose to take forward this recommendation

Source: Ofgem, Improving the Reporting Transparency of Large Energy Suppliers consultation, 1 May 2012


55. Trading provides a route to market for energy companies.[119] The trading arms of the largest vertically integrated energy companies provide a service buying and selling energy on behalf of the generation and supply arms.[120] There are two key markets which energy companies use: the day ahead market (usually done through an exchange) and the forward market (usually done through a trading platform using bilateral over-the-counter (OTC) transactions). The big six described how they buy and sell (or "churn") energy products from these markets several times before delivery.[121] The big six emphasised that they traded as part of a risk management strategy to manage (or hedge) any peaks in market prices (see paragraph 11). Mr MacGregor of BDO agreed with this assertion:

    What we are talking about is the companies themselves trying to work out what the future is going to look like as far as demand is concerned and then coming up with pricing modelling to manage that risk over the period of time. That is what they are doing as far as the trading is concerned. They are basically trying to work out what future demand is and keep their costs of purchase to a minimum, because of course the closer you get to needing power, if you do not have a contract which will give you that power, the more money it will cost you.[122]

Mr MacGregor went on to say that, 'there is nothing suspicious about trading and hedging itself. It is a perfectly rational business activity, especially for these businesses.'[123]

56. Trades in both gas and electricity were overwhelmingly transacted in OTC trades with comparatively only a very small amount traded through exchanges (see table 8). EDF Energy said that since the advent of the New Electricity Trading Arrangements in March 2001,[124] the OTC electricity market has been the main route to the wholesale market for energy companies who wish to forward hedge their electricity market risks.[125] This market is also the most liquid for both gas and electricity which means that prices are more competitive which is important for companies looking for the most economic route to market.[126] In addition, British Gas and Scottish Power reported that trading forward contracts on exchanges could be more costly than the OTC market.[127]

57. Which? was concerned that the wholesale market was dominated by OTC trades. They argued that these trades were not transparent because they were not disclosed and were, therefore, vulnerable to manipulation. They also argued that it raised questions about whether contracts linked to OTC indexes were value for money.[128] Richard Lloyd of Which? described BDO's conclusions and its implications;

    it was impossible to see whether the transfer pricing had been done in the best interests of consumers. It was impossible to determine the prices offered to the supply businesses within the vertically integrated companies. I think much more transparency about transfer pricing and the methodologies that are being used is a start, but in the end, without more structural changes the segmented accounts, to be honest, at times just raise more questions than they answer.[129]

58. All of the big six stated, however, that there was either no or minimal price difference between the OTC and exchange market.[130] In particular, British Gas and RWE suggested that any price difference which did emerge was quickly reduced by arbitrage.[131] RWE stated that, 'traders buy the cheaper product (wherever it is traded) and sell the more expensive product (on the other platform) to ensure that prices return to an equivalent basis.'[132] In written evidence, the big six also consistently specified that price bids were available to everyone on the trading platform and that is it is not the case that preference for OTC trades were necessarily secretive thereby advantaging the company.[133]

Table 8: Percentage of volume of gas and electricity traded in either over the counter trades or through an exchange

Electricity Gas
CompanyOTC Exchange OTC ExchangePeriod
EDF71% 21%95% 5%2012
E.ON80% 20%70% 30%N/A
SSE100% (forward) 0% (forward)99% 1%Current
RWE96% 4%99% 1%2011
Centrica (British gas) 96%4% 77%23% First four months of 2013
Scottish Power85% 15%90% 11%2012

Source: Ev 9, Ev 18, Ev 35, Ev 94, Ev 110, Ev 119

59. The original consolidated segmental statements did not require the big six to explicitly disclose their trading activities. Ms Gallacher of Consumer Focus told the Committee that not including trading in the statements was a fundamental omission.[134] MacGregor of BDO said that trading was an important part of their overall business model.[135] Mr Wright of Ofgem said that:

    [...] because we do not necessarily have the full picture of all the relationships between the license businesses and the trading businesses, we accept that there is a possibility there are some missing pieces of information.[136]

60. In the interests of promoting increased transparency, BDO recommended that trading function results be reported, including disclosure of the risk each trading function assumes. Instead Ofgem proposed that the statements include a checklist table where trading activity can be allocated to segments. Mr Wright said he thought that, "the independent checklist adds value."[137] Mr MacGregor, however, asserted that the checklist was not at all satisfactory:

    My recommendation was including the trading in the segmental accounts, not a checklist. The checklist is possibly open to interpretation. I don't know the value of it. Including the trading gives you a much better idea of the total picture of the financial performance of the companies, if that is what you are trying to get to. The review was—my instruction was—to look at improving the way these CSSs are prepared. Quite frankly, I would much prefer to see numbers, rather than a checklist with some ticks on it.[138]

61. Mr Wright emphasised that this there might be difficulties in obtaining full information because the regulator did not necessarily have the power to make companies disclose profits they were making overseas.[139] Mr MacGregor, however, said that he thought the big six would have detailed trading information.[140] He doubted that the cost of producing trading information is significant.[141] He agreed that the perceived reluctance of energy companies to include their trading information in the statements reinforces the suspicion that is an activity which can be used to confuse and obscure.[142] He underlined his opinion that trading could be used to move profits from one part of the business to another:

    Yes, in trading and the transfer pricing aspects of trading, as between generation and supply, of course there is an opportunity for profits to be moved around, within certain parameters. There is no doubt about it.[143]

He concluded that including trading activities in the Statements would give a much better idea of the total financial performance of the companies.[144]

62. We understand that there may be difficulties in getting large vertically integrated energy companies to report their trading activities especially if they are foreign owned or based overseas. However, we believe that the increase in transparency and associated consumer trust clearly justifies including trading activities in the statements. We recommend that Ofgem require the big six to include trading activities in the statements. There is an opportunity for energy companies to make reputational gains by setting an example of best practice. In the context of low consumer confidence, we hope that energy companies will see the benefits of increased transparency.


63. Unlike the statutory accounts, there is no requirement for the segmental accounts to be certified as true and fair by an independent auditor. Auditors are subject to a regulation and supervision regime governed by the Financial Reporting Council. Audits must follow International Standards on Auditing, whereas accountants' reports can follow any format agreed in terms of reference. Auditors are also subject to ethical standards that are designed to limit conflicts of interest and maximise quality assurance. Non-audit engagements are not subject to these limitations. BDO recommended that an independent auditor provide an opinion on the statements. Ofgem, however, instead proposed obtaining an independent opinion, at least for the first year, but not necessarily from an auditor.

64. Mr Wright of Ofgem said he thought that an audit, "would be quite an extensive and intrusive thing to do to companies that are already audited."[145] Mr MacGragor of BDO said he thought a review did not provide the same level of assurance:

    An audit will look at the information in the CSSs and how that relates back to the underlying financial information. It will give some level of assurance—that is the point of audit—that that segmental information has been correctly prepared and stated. The review does not do anything like that. As I understand it, it is a desktop review with no enquiries made of the companies or their auditors. [...]. It does not give an assurance.[146]

65. We believe that obtaining an independent opinion as opposed to requiring an audit of the statements is unsatisfactory because it does not provide a sufficient level of assurance to bolster trust in energy companies. The potential cost and inconvenience to the large vertically integrated businesses would be eclipsed by the gains in confidence an audit would bring. We recommend that Ofgem require the statements to be audited.

Publishing statements to the same year end

66. The financial reporting period is not mandated. All of the big six have a 31 December year end, except for SSE, which has a 31 March year end. This reduces comparability because the cost of generation fuels varies with time and because the later year end for SSE means that Ofgem takes much longer to produce its analysis of the statements for the big six. BDO recommended that companies be required to publish their statements to the same year end. Mr Macgregor of BDO suggested that he didn't think it would cost very much considering the size of the big six.[147] Mr Wright, however, disagreed suggesting it was of limited value because the numbers were still comparable: the difference over the three months would not be huge. He suggested that significant costs would be incurred by SSE. He suggested, "all of that needs to be borne in mind against the limited improvement in transparency that would provide. I do not think there is a great deal been lost by SSE having a different year-end when you look at the statements that have been published so far."[148]

67. We note that Scottish Power recently changed its financial reporting period to align with the majority of companies.[149] We believe that the costs and inconvenience to SSE to change its year end would be outweighed by the gains in comparability across the different statements. We recommend that Ofgem require SSE to change its financial reporting period to align with the other large vertically integrated energy companies.

Uniform treatments for EU Energy Trading System (EU ETS) allowances[150]

68. Trading activities related to environmental measures, such as sale of Renewable Obligation Certificates or Carbon Trading may not be adequately disclosed in the statements. Similarly, supplier spending in support of other schemes (e.g. domestic energy saving) may not be included in the statements. Carbon permits in the EU Emissions Trading Scheme have an intrinsic value that varies, depending on market conditions. BDO recommended that Ofgem introduce uniform reporting treatments for generation fuel costs and free EU ETS allowances. Mr Macgregor said this should be done in the interests of improving comparability of the Statements:

    They just treat things differently. One of my recommendations—again, I take you to my overall contextual point at the beginning—was that if you are going to do things and look at comparability, you need the information compared on a consistent basis. The carbon credits and things like that are just one of a number of areas where I was recommending that you need to start from the same base point. You need to have a consistent approach to exceptional items, for example. You need to reconcile back to the same starting points—EBIT or EBITDA.[151] Otherwise, as I said before, you end up with six statements that mean something on their own but do not really mean anything as a group.[152]

Treatment of exceptional items

69. Areas of accounting estimate, such as depreciation and impairment on asset values, can distort the presentation of figures. Significant one-off items, such as provisions for restructuring, or profits or losses on the disposal of an asset, can distort the financial statements and reduce year-on-year comparability. BDO recommended that Ofgem introduce guidance on scope and definition of exceptional items. Mr Macgregor credited Ofgem with pursuing this. He suggested that one-off items were to be expected. He highlighted however, that, "you do need the ability to strip [exceptional items] out of the ongoing activities so you can understanding what the underlying financial performance has been."[153]

70. We reject Ofgem's assertion that most of BDOs recommendations would put unnecessary burdens on the big six. The impact of BDO's recommendations should be considered as a package We believe that taken as a whole, the benefits of BDOs recommendations - in terms of improvements to transparency and comparability of the statements and associated improvements in consumer trust - significantly outweigh any burdens on the six largest vertically integrated energy companies. We acknowledge that there will be additional costs involved with implementation of BDO's recommendations, but we believe that the benefits in terms of increased transparency and competition, and the potential downward pressure on prices that may result, justifies the expense.

71. We recommend that Ofgem should require the six largest vertically integrated companies to implement BDO' recommendations 1 (publishing statements to the same year-end), 2 (independent auditor opinion on statements), and 4(reporting of trading function results). We also encourage Ofgem to consider requiring implementation of BDO's recommendations in full and to publish, in its response to this report, its analysis of the cost to energy companies of full implementation. We also recommend that Ofgem undertake further work to assess current transfer pricing policies.


72. The SMI is Ofgem's key indicator to improve transparency in the retail market. Its role is to help interested parties gain a greater understanding of the relationship between retail prices and supplier costs. It is a rolling average net profit margin which an energy supply company could expect to make on supplying a typical customer on a standard tariff for both gas and electricity. Ofgem also produce a snapshot estimate of the net margin on supplying a typical, standard tariff dual fuel customer for the next 12 months (see table 9). In order to calculate this average net profit margin Ofgem uses:

·  Data: including an average of the estimated net margin data for the previous six months, the current month, and the next six months.

·  A methodology: based on a number of assumptions such as the typical household energy consumption. It also uses its own hedging strategy (similar to actual energy companies) to estimate supplier wholesale costs.

Table 9: Changes in retail bills, costs and total indicative net margin for the next 12 months - June 2013
Dual FuelYear
Jun-09 Jun-10Jun-11 Jun-12Jun-13
Customer bill£1,150 £1,105£1,170 £1,310£1,420
Wholesale costs£655 £485£570 £635£640
VAT and other costs £400£435 £480£525 £560
Gross margin£95 £185£125 £150£220
Operating costs£130 £130£130 £130£130
Total indicative net margin for the next 12 months -£30£55 -£10£20 £90
Rolling net margin -£5£55 £45£45 £100

Source: Ofgem, Electricity and Gas Market Indicators,

73. SMIs have in the past caused heated public debate between Ofgem and the energy companies.[154] Consumer Focus describe the SMI as 'very useful' with 'significant use as a diagnostic tool in order to understand what's driving bills'.[155] Mr Wright of Ofgem highlighted the benefits of SMI:

    The supply market indicator, once again, is an initiative from us to improve transparency in this market. Had we not taken this initiative there would be no ongoing view of the forward looking profitability of these companies. It enables consumers, politicians and the media to have a dialogue about whether or not price increases were justified, whether price increases are in the offing. It is used by other agencies, for example, the Bank of England, to look at inflation forecasts. So it is a useful addition to the transparency in the market. You cannot expect us, in the position we are in, to be able to make accurate forecasts of the company's profitability looking 12 months ahead.[156]

74. Several organisations argued that methodological deficiencies reduced the accuracy of SMIs. In oral evidence, some energy companies suggested that energy consumption figures under the SMI were overstated, leading to exaggerated profit margins. SSE stated that Ofgem's methodology "appears to have a consistent bias towards overstating profit margins". Alistair Phillips-Davies of SSE explained:

    Unfortunately there are errors in those figures. They consistently overstate the consumption that people make. It is the most fundamental part of the errors they make. We could give you a list of the errors they make, but they fundamentally and consistently overstate the levels of consumption that people make and therefore that causes a fundamental overstatement of the profitability of those businesses.[157]

Mr Wright said he accepted the accusation on consumption. He agreed that consumption levels had changed. Ofgem had initiated a review both for use in the supply market indicator and the average consumption levels that Ofgem would use in the media when quoting the size of a typical bill. They will update the assumptions following this review.[158]

75. But Mr Wright also defended the methodology overall:

    [...] because we want to make what we are doing transparent, we have a published methodology which we allow other people to replicate. We rely on public domain information and as a result, there are some simplifying assumptions in that. I think that makes it practical to update the supply market indicator regularly. As a result of that, we look at the profitability of a typical customer, with typical consumption, on standard dual fuel tariffs. Now, that is not the same as giving a forecast of the profitability of the companies. The companies point out the differences; typical consumption is not necessarily the same as average consumption. They have discounted tariffs that we don't take into account. We use a simplified hedging strategy, an 18-month hedging strategy because we do not know the companies' hedging strategies. They do not disclose it and we have no way of knowing. So inevitably there are going to be differences, but does that mean this is not useful? I don't think it does. I think this is a useful indicator that provides a useful indication.[159]

76. Some organisations have identified disparities between the SMI and the CSS which call into question their accuracy. Consumer Focus explains:

    It should also be noted that it is hard to reconcile the statements with Ofgem's separate monitoring of supply market indicators. For example, the statements suggest that in 2010 three of the big 6 made profits on their electricity supply business while three made losses, with an aggregate margin of the six businesses of 0.3 per cent - roughly breakeven. However, its supply market indicators reports suggest that electricity supply was consistently profitable throughout 2010 at about a £30 margin on an approximately £500 average annual bill, inferring a supply margin around 6 per cent. Although the supply market indicators are based on a 'typical' standard tariff bill at average consumption levels rather than all bills, the majority of consumers remain on standard tariffs. To get from a ~6 per cent margin across the majority of consumers to a 0.3 per cent margin across all consumers might imply predatory pricing; that market leading deals are being sold at a very heavy loss. Alternately, it might imply that either the statements and/or the supply market indicators provide a false perspective of supplier profitability.[160]

77. We believe that the Supply Market Indicator is a useful tool, for assessing the supply margin of the big six's retail business. The disagreements between Ofgem and the energy companies over the figures, played out in the media, are deeply unhelpful and only work to erode public trust in the companies and confidence in the regulator. Companies should engage constructively in improving the SMI. We recognise the methodological concerns and recommend that Ofgem actively review the methodology and improve it so that the SMI more accurately reflects the actual activities of energy companies.


78. The EU regulation No 1227/2011 on wholesale energy market integrity and transparency (REMIT) came into force in December 2011. It is aimed at preventing market abuse including market manipulation and insider trading in wholesale energy markets. It will do this by introducing explicit prohibitions of market manipulation and insider trading. It requires public disclosure of insider information by market participants and introduced an obligation to report suspicious transactions. Importantly it provides Ofgem with enforcement and investigatory powers. Consumer Focus hoped that the regulations would provide Ofgem with greater powers to disclose energy companies' actual traded cost of energy and therefore allow it to verify suppliers' wholesale costs.[161] With regards to REMIT the Secretary of State said that he was implementing REMIT and that he wanted to be one of the first EU countries to transpose it.[162]

79. We recommend that the Government ensure Ofgem takes full advantage of these new REMIT powers.

Improving wholesale market competitiveness

80. In addition to improved transparency and communication, measures to encourage more competitive markets were proposed as one of the best ways to ensure customers were paying a fair price. This was especially true for the electricity wholesale market. Which? described the important role wholesale markets play in encouraging investment and influencing future energy prices. They suggested that the Government and regulator should consider what action was needed to ensure that price information was robust and that the markets were competitive.[163] Mr Cocker of E.ON also emphasised that liquidity in the market was important for his company's business model and to engender confidence in market:

    [...] it is absolutely vital for us that we have a deep and liquid market in order to enable that business model to work. So we had a clear self-interest in supporting liquidity. In addition to that, I personally believe that it is very important to have liquidity in order to engender confidence in the market and competition.[164]

81. Consumer Focus said that there were significant problems with liquidity in the wholesale electricity market. They suggested that, 'while spot and prompt markets are relatively heavily traded, the forward market is thinly traded and largely illiquid.' Liquidity was an essential prerequisite for a healthy market and to keep costs down, they argued.[165] This was confirmed by Ofgem. As part of their proactive monitoring of the wholesale electricity market they identified, 'poor and stagnating liquidity as a barrier to compensation, preventing entry and growth of new players and imposing costs on consumers.[166] Consumer Focus described how, 'for all stakeholders, liquid heavily traded markets would provide clear signals of the 'real' price of energy - and could therefore help gauge whether end user prices are fair.'[167]

82. Since its 2008 Energy Supply Probe, when it first identified liquidity as a problem, Ofgem has used a combination of carrot and stick techniques to improve liquidity. Mr Wright of Ofgem said that, 'it is far better that the industry steps up and solves this problem itself rather than responding reluctantly to rules we put in place.'[168] Its Liquidity Project which sits alongside Ofgem's retail market review (see paragraph 21) is, 'central to [its] efforts to ensure that consumers get the best possible deals from competitive energy markets.'[169] The Liquidity Project challenged the industry to deliver three key objectives:

·  Availability of products which support hedging;

·  Robust reference prices along the curve; and

·  An effective near-term market.

83. Mr Wright of Ofgem described the improvements Ofgem has made to market liquidity:

    There have been significant increases in the volumes traded on the day-ahead market, for example. The day-ahead auction is now well established and the short-term market is a critical part of the market. It is not only useful in its own right but potentially encourages other people to come into the market to trade on longer-term products as well. On top of that the companies now treat small suppliers far better than they used to. We used to have a litany of complaints about the credit terms, the clip sizes and a whole bunch of barriers about why small suppliers were not able to get hold of the electricity and gas they needed from the Big Six.[170]

84. SSE in particular had supported smaller suppliers. Mr Phillips-Davies of SSE explained that they had made available to smaller suppliers' 'free credit' so they could trade in the market.[171] When asked why it did this, Mr Phillips-Davies said it was responding to criticism that the big six were not helping smaller suppliers and that, '[it was] very happy to see a deep, liquid and competitive market, and we would support actions that delivered that.'[172]

85. Ofgem reported that even though there had been improvements, overall its objectives remained unmet.[173] Mr Wright said that it could no longer wait for the industry to solve the issue by itself and would plug the remaining gaps that exist.[174] In written evidence Ofgem said it had a, 'firm preference for intervention to improve liquidity.'[175] This included proposals it had recently announced designed to give independent energy suppliers a more level playing field to compete against larger companies. Ofgem also hoped that it will increase competition between these larger companies. Ofgem said that under the proposals:

    The big six suppliers will have to post the prices at which they buy and sell wholesale electricity on power trading platforms up to two years in advance. They will be obliged to trade at these prices, which means independent suppliers and generators will have far more opportunities to buy and sell the power they need to compete effectively. Posting prices in this way will make wholesale prices clearer for all firms in the market. The new licence conditions will be backed by Ofgem's powers to fine companies if they are in breach.[176]

The Secretary of State said that he had made it clear that he wanted to see much greater liquidity in the forward markets because it was good for competition and transparency:

    Just in case anyone was in any doubt, we obtained in the Energy Bill reserve powers so that if Ofgem proposals do not work, we would still have the powers to come and revisit the wholesale markets to get liquidity. I do not think we could have been clearer supporting the independent energy regulator and giving a clear steer that we want to see more competition in the wholesale markets.[177]

Consumer Focus outlined their view that, 'Ofgem has made little progress despite five years of trying." They encouraged the Government to set a firm deadline to use the powers in the Energy Bill. They believed that imposition of a deadline would focus Ofgem and the industry on the need for progress (see paragraph 23).[178]

86. Some organisations advocated more fundamental reform of the wholesale market. The IPPR suggested that a way to reform the wholesale market, improving transparency and liquidity, would be to consider 'whether all wholesale trading activity should go through some kind of pooling system, similar to the Nordpool system in Europe.'[179] Which? suggested that ideas for improving wholesale market liquidity included a self supply restriction and the legal separation of the supply and generation divisions of the big six.[180] E.ON suggested that, 'clear and consistent prohibition of cross-subsidy between the generation and supply activities that are within the same group', together with 'some form of self supply restriction' would help create clarity in energy company profits.[181] Mr Wright of Ofgem however suggested that implementing a self-supply restriction or a mandated auction presented challenges including for example how it was enforced. Instead he highlighted, 'the important thing is that people who want to trade are able to trade at fair prices.' Ofgems proposals outlined above represent, according to Mr Wright, Ofgem's view on what was the best and most appropriate solution to this issue.[182]

87. Improving wholesale market competitiveness will be vital in ensuring customers are paying a fair price for their energy. We are astonished at how long it has taken Ofgem to act since it first identified this as an issue in 2008. The relatively light touch approach favoured by Ofgem has failed to deliver the changes required to improve competition. We recommend that urgent intervention is required to resolve this problem. Ofgem needs to implement its proposals to improve liquidity as soon as possible taking a more assertive approach than it has in the past.

93   Q 44 Back

94   Q 56 Back

95   Ev 54 Back

96   Q 115 [Mr Cocker] Back

97   Q 115 [Mr Poole] Back

98   Q 115 [Mr Phillips-Davies] Back

99   Q 224 [Mr Peters] Back

100   Q 224 [Mr Clitheroe] Back

101   Q 224 [Mr Massara] Back

102   Ev 4 Back

103   Q 52 [Mr Lloyd] Back

104   Ev w17 Back

105   Ev 123 Back

106   Q 448 Back

107   Ofgem uses EBIT (Earnings before Interest and Tax deductions) as our measure of profit. In the 2009 and 2010 summarydocuments it used EBITDA for the supply margins, where EBITDA adds back depreciation and amortisation to the profit figure. It has now chosen to present all the results on a consistent EBIT basis. Back

108   Ev 123 Back

109   Ev 30 Back

110   Ev 101 Back

111   Ev 113 Back

112   Q 76 [Ms Gallacher] Back

113   Ev 123 Back

114   Q 75 [Mr Lloyd] Back

115   Q 75 [Ms Gallacher] Back

116   Q 345 Back

117   Q 376 Back

118   Ev 123 Back

119   Q 224 [Mr Peters] Back

120   Q 118 Back

121   Q 133 [Mr Cocker] Back

122   Q 361 Back

123   Q 366 Back

124   New Electricity Trading Arrangements (NETA) is the name of the system under which electricity is traded in the United Kingdom's electricity market. NETA came into force on 27 March 2001. As of April 2005, NETA changed its name to the British Electricity Trading Transmission Arrangements (BETTA), and expanding to become the single Great Britain electricity market of England, Wales and Scotland Back

125   Ev 110 Back

126   Ev 9, Ev 18, Ev 35, Ev 94, Ev 110, Ev 119 Back

127   Ev 94, Ev 119 Back

128   Ev 26 Back

129   Q 74 [Mr Lloyd] Back

130   Ev 9, Ev 18, Ev 35, Ev 94, Ev 110, Ev 119 Back

131   Ev 18, Ev 94  Back

132   Ev 18 Back

133   Ev 35, Ev 18, Ev 94, Ev 110, Ev 119 Back

134   Q 74 [Ms Gallacher] Back

135   Q 349 Back

136   Q 377 Back

137   Q 380 Back

138   Q 356 Back

139   Q 377 Back

140   Q 357 Back

141   Q 357 Back

142   Q 358 Back

143   Q 359 Back

144   Q 356 Back

145   Q 380 Back

146   Q 353 Back

147   Q 352 Back

148   Q 381 Back

149   Q352 Back

150   EU emissions trading system (EU ETS): a 'cap and trade' policy tool for reducing industrial greenhouse gas emissions cost-effectively. It is the first and largest international system for trading greenhouse gas emission allowances. The EU ETS covers more than 11,000 power stations and industrial plants in 31 countries, as well as airlines Back

151   Earnings before interest and taxes (EBIT) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Back

152   Q 370 Back

153   Q 372 Back

154   Ev 1 Back

155   Ev 54 Back

156   Q 382 Back

157   Q 209 Back

158   Q 232 Back

159   Q 382 Back

160   Ev 54 Back

161   Ev 54 Back

162   Q 428 Back

163   Ev 26 Back

164   Q 141 [Mr Cocker] Back

165   Ev 54 Back

166   Ev 123 Back

167   Ev 54 Back

168   Q 390 Back

169   Ev 123 Back

170   Q 390 Back

171   Q 126 Back

172   Q 141 Back

173   Ev 123 Back

174   Q 390 Back

175   Ev 123 Back

176   Ofgem, Opening up electricity market to effective competition, 12 June 2013  Back

177   Q 437 Back

178   Ev 54 Back

179   Ev w11, Ev w46 Back

180   Ev 26 Back

181   Ev 30 Back

182   Q 389 Back

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© Parliamentary copyright 2013
Prepared 29 July 2013