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
|
Company | 2007-11 average
| 2011 | 2007-11 average
| 2011 | 2007-11 average
| 2011 |
EDF |
| | |
| | |
EDF Energy Holdings Limited
| 2,457 | 7,371
| 386 | 627
| 15.7% | 8.5%
|
EDF Energy PLC
| n/a | 3,849
| n/a | 41
| n/a | 1.1%
|
EDF Energy Customers PLC
| 5,301 | 4,951
| -127 | -211
| -2.4% | -4.3%
|
British Energy Direct Limited
| 1,009 | 676
| 15 | 22
| 1.5% | 3.2%
|
SSE |
| | |
| | |
SSE PLC | 24,458
| 31,724 | 1,031
| 269 | 4.2%
| 0.8% |
SSE Energy Supply Limited
| 22,812 | 32,008
| 375 | -7
| 1.6% | 0.0%
|
British Gas
| | |
| | | |
Centrica PLC |
20,979 | 22,824
| 1,527 | 1,268
| 7.3% | 5.6%
|
British GAS Trading Limited
| 12,316 | 12,786
| 713 | 1,898
| 5.8% | 14.8%
|
Scottish Power
| | |
| | | |
Scottish Power UK Holdings Limited
| 6,261 | 7,450
| 690 | 327
| 11.0% | 4.4%
|
Scottish Power UK PLC
| 5,098 | 6,441
| 625 | 295
| 12.3% | 4.6%
|
Scottishpower Energy Retail Limited
| 3,192 | 3,378
| 76 | -14
| 2.4% | -0.4%
|
E.On |
| | |
| | |
E.On UK PLC |
9,071 | 9,240
| 621 | -199
| 6.8% | -2.2%
|
E.On Energy Solutions Limited
| 6,529 | 7,028
| 24 | 157
| 0.4% | 2.2%
|
Npower
| | |
| | | |
RWE Npower PLC
| 785 | 687
| 96 | -38
| 12.2% | -5.5%
|
Npower Limited
| 3,224 | 3,293
| -12 | 55
| -0.4% | 1.7%
|
Npower Northern Limited
| 1,449 | 1,686
| -102 | -117
| -7.1% | -7.0%
|
Npower GAS Limited
| 606 | 386
| -36 | -11
| -5.9% | -2.9%
|
Npower Direct Limited
| 412 | 355
| 46 | 55
| 11.2% | 15.4%
|
Npower Yorkshire Limited
| 309 | 236
| -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
COMPANY STRUCTURE
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* |
x | x
| x | x
| | x
| x |
EDF |
| x | x
| x |
| x | x
|
SSE | x
| x | x
| x | x
| x | x
|
Centrica/British Gas
| x
| x
| x
| x
| | x
| x
|
ScottishPower
| | x
| x
| x
| x
| x
| x
|
RWE |
| x
| x
| x
| | | x
|
*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
CONSOLIDATED SEGMENTAL STATEMENTS
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 margin | 2010 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 2012 | May 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
Trading
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 | | |
Company | OTC
| Exchange | OTC
| Exchange | Period
|
EDF | 71%
| 21% | 95%
| 5% | 2012
|
E.ON | 80%
| 20% | 70%
| 30% | N/A
|
SSE | 100% (forward)
| 0% (forward) | 99%
| 1% | Current
|
RWE | 96%
| 4% | 99%
| 1% | 2011
|
Centrica (British gas) |
96% | 4%
| 77% | 23%
| First four months of 2013
|
Scottish Power | 85%
| 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
wasmy instruction wasto 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.
Auditing
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 assurancethat is the point of auditthat 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 recommendationsagain,
I take you to my overall contextual point at the beginningwas
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
pointsEBIT 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.
SUPPLY MARKET INDICATORS
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 Fuel | Year
|
| Jun-09
| Jun-10 | Jun-11
| Jun-12 | Jun-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,
www.ofgem.gov.uk
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.
REMIT
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
|