Energy and Climate Change CommitteeWritten evidence submitted by the Institute for Public Policy Research (IPPR)

Executive Summary

Wholesale energy costs are the largest costs that suppliers incur, and constitute around 46% of consumers’ energy prices. However, because private, bilateral contracts between generators and suppliers are the dominant form of trading in the wholesale market the exact amount suppliers pay is unknown. Improved transparency on wholesale costs is required for a clearer understanding of how they impact on energy prices.

In the past the amount suppliers spend on delivering their energy efficiency obligations, and therefore the impact they have on energy prices, has also been unclear. IPPR research suggests that these costs to suppliers have been over-estimated in the past, by as much as 40% (Platt et al. 2012). As a result other supplier costs that contribute to energy prices, including the suppliers’ profit margins, may have been underestimated.

The introduction of the Energy Company Obligation (ECO) presents an opportunity to gain an accurate understanding of energy efficiency policy costs and how they impact on energy prices. IPPR research suggests the ECO may cost more to deliver than the government expects (Platt et al. 2012).

Suppliers’ operational costs are another key component effecting energy prices. IPPR research has identified that Ofgem’s estimates of these costs show no sign of the suppliers’ achieving efficiency savings since 2008 (Platt 2012). This is evidence that competition is not working effectively in the supply market.

To ensure consumers pay a fair price for their energy, the government should focus on improving competition in the supply market. The government has adopted IPPR’s recommendation to restrict the number of tariffs suppliers can offer. We believe this will make switching options simpler for consumers to navigate, therefore improving switching rates and competition, and we welcome its introduction. The government should now assess the benefits from forcing all wholesale trading to occur through some kind of pooling system. By improving wholesale market liquidity this could significantly improve the prospects for independent operators in the supply and generation markets, while also improving transparency on wholesale energy costs.

In addition to improving competition in the energy market, the government must do more to tackle fuel poverty. The number of fuel poor households in England alone is currently 2.7 million (according the definition of fuel poverty proposed in the Hills Review (2011)). The ECO is the main policy for tackling fuel poverty but will only scratch the surface of the problem, improving the energy efficiency of just 125,000 to 250,000 fuel poor homes across the whole of the UK by 2023.

Spending on ECO could go further in tackling fuel poverty if the government resourced local authorities to help initiatives, conducted a review of challenges the suppliers faced in delivering their obligations under previous policies, and piloted a new area-based approach to delivering energy efficiency improvements that focuses on low income and low efficiency areas.

Ultimately, however, the government must commit more resources to tackling fuel poverty. When deciding what resources to commit it should factor into its decisions the large simulative effect that energy efficiency spending can have on jobs and growth.

Detailed Submission Response

Prices

What factors determine energy prices? What contribution do these factors currently make towards a typical household energy bill and how might this change over time?

1. The overall price a company’s consumer base pays for its energy is determined by the total of that supplier’s costs and targeted profit margins. The different prices individual consumers pay, however, are determined by that supplier’s pricing strategies.

Wholesale energy costs

2. Wholesale energy costs are the largest costs that suppliers incur. According to estimates published by Ofgem they may have accounted for around 46% of the average annual consumer energy bill in 201112 (Platt 2012).

3. The amount suppliers actually pay for wholesale energy is, however, unclear. This is because private, bilateral contracts between generators and suppliers are the dominant form of trading in the market. The ability of the “Big Six” energy companies (British Gas, EDF, E.ON, Npower, Scottish Power and SSE), which dominate both the generation and supply markets, to “self-supply” (ie transfer energy between their generation and supply arms) is a particular cause of low transparency on wholesale costs.

4. More generally, it is clear that the cost of wholesale energy, in particular the cost of gas, has risen significantly in recent years. The Committee on Climate Change (2011) has estimated that increases in the wholesale cost of gas were the main driver behind energy bill rises from 2004 and 2010, adding around £290 to the average annual bill1. This compares with £75 added by low carbon policies over the same period.

5. Predicting how wholesale energy costs will change in coming years is an exercise fraught with uncertainty. Nonetheless, we have no reason to question the Department for Energy and Climate Change’s (2012) view that gas prices are likely to rise in the medium term.

Policy and regulatory costs

6. Suppliers incur costs as a result of government policies and regulatory requirements. For the purposes of this submission, we focus solely on the cost of energy efficiency policies.

7. Previous energy efficiency policies, the Carbon Emissions Reduction Target (CERT) and the Community Energy Savings Programme (CESP), which ended at the end of 2012, obliged the Big Six to deliver a specific amount of energy efficiency improvements to properties in the residential sector. While the government monitored the suppliers’ progress towards achieving their targets it did not monitor how much they were spending on implementation. As a result the amount the suppliers spent on the policies is unknown.

8. In assessing the costs that make up energy bills the cost of CERT and CESP have often been assumed to be in line with government estimates (see for example CCC 2012 and DECC 2010). However, in IPPR’s recent report Energy efficiency: who pay and who benefits? (Platt et al. 2012) we showed how, in 2008, suppliers may have spent 40% (around £14) less than the government assumed on CERT. We identified that the cost of the policy overall may have been below government estimates.

9. If, as our research suggests, the cost of CERT was over-estimated, other elements of energy bills, including the suppliers’ profit margins, may have been under-estimated.

10. Some suppliers claimed that the cost of CERT rose sharply during 2012. The Super Priority Group (SPG) sub-target within the policy was identified as a particular cause for these increases. Our report shows that despite increases in 2012, the cost of CERT and the SPG target have stayed in line with government estimates. These increases were unlikely to have had a major impact on energy bills. Even if the cost of the SPG target rose by 85% in 2012, as one energy company has claimed (Beech 2012), this will have added just 0.5% to energy bills. This compares to recent tariff increases by the energy companies of 6 to 11%.

11. CERT has now been replaced by a new energy efficiency policy, the Energy Company Obligation (ECO). The government’s “central” cost estimate for the policy is that it will add around £1.3 billion a year to energy bills but we have identified a number of reasons why the cost could be higher (Platt et al 2012). First, high levels of subsidy may be required to encourage uptake of solid wall insulation. Second, the solid wall insulation supply chain is not well developed, which may create bottle necks. Third, the Affordable Warmth sub-target within ECO may be very challenging for suppliers to fulfil. Fourth, potential cost reductions resulting from strong local authority engagement are unlikely to arise because local authorities’ budgets and resources are severely stretched.

Operational costs and profit margins

12. As with other cost elements, the suppliers’ operational costs are very uncertain and therefore hard to predict. Ofgem publishes estimates of the suppliers’ operational costs in their Supply Market Indicator series. In 201112 Ofgem estimated them to make up around 10.4% of the average bill (or £130 of a £1,255 bill) (Platt 2012).

13. In IPPR’s report The True Cost of Energy (Platt 2012) we show that Ofgem’s estimates have increased in real terms over time, by £9 per customer per year from 2007 to 2011. If Ofgem’s estimates are accurate it implies that the suppliers have not delivered efficiency savings in their operational costs that should be expected if competition was working effectively in the market. Alternatively, if Ofgem’s estimates are wrong and have not captured efficiency savings that the suppliers have achieved, other elements of energy bills in the Supply Market Indicators, including the suppliers’ profit margins, may have been under-estimated.

14. In our report, drawing on available public evidence, we also show that the difference between the most and least efficient supplier, in terms of operational costs per account, increased from a 90% differential in 2007 to a 113% differential in 2010. Theory suggests that in a competitive market the operational efficiency of the suppliers should be converging over time. We take this as further evidence that competition is not fully effective in the market.

15. Limitations with the current reporting requirements on suppliers mean their profit margins are unclear. Examples of profit margins for nationalised energy companies and businesses from other industries suggest that a profit margin of 3% or slightly more is reasonable for an energy supplier operating in a fully competitive environment (Platt 2012).

16. By over-estimating the cost of environmental policies and operational costs our research suggests that Ofgem’s Supply Market Indicators may have under-estimated the suppliers’ profit margins on the average bill by between 0.5 and 1.5% (Platt 2012).

To what extent (if at all) should the Government or the regulator intervene in the market to affect the prices consumers (or certain groups of consumers) pay for their energy? Should any changes be made to the Government’s current approach?

17. We believe there is insufficient evidence of market failure to support price setting by government or the regulator. We believe the government’s ambitions for an affordable, secure and decarbonised energy system are best achieved through a competitive market environment, that is attractive to private investors and in which innovation has the opportunity to flourish. We believe price setting would have negative implications for competition.

18. Nonetheless, as research by Ofgem (2011) and IPPR (detailed above) has shown, competition is not fully functioning in the supply market and measures must be introduced to improve competition. We welcome Ofgem’s adoption of IPPR’s proposal (Platt 2012) to limit the number of tariffs that suppliers are able to offer. We believe this will lead to greater levels of switching by consumers and therefore result in a greater level of competition.

19. Further measures are needed to improve competition. In True Cost of Energy we identified how some “Big Six” suppliers overcharge their “sticky” customer base (ie customers who they inherited from their time as monopoly suppliers and have never switched provider) in order to offer deep discounts to more active customers. Smaller and newer suppliers, who have not inherited sticky customers in the same way, find it hard to compete against these discounts. This has a negative impact on competition. In the past Ofgem has taken the view that these deep discounts are a healthy part of competition, which we believe is the wrong approach. All tariffs, including discounted tariffs, should be reflective of the suppliers’ costs. Indeed, allowing this practice to continue, while good value for the small number of consumers’ who take advantage, is bad for those who are over-charged and is ultimately uncompetitive.

20. Another potential barrier to effective competition is that the energy efficiency obligations kick in for a supplier when they exceed 250,000 customer accounts. Several small suppliers are now reaching this threshold. The government must ensure these costs do not represent a cliff edge for small suppliers as this will be detrimental to their ability to grow and compete with the Big Six.

21. Finally more action is needed to reform the wholesale market. Low levels of liquidity in the wholesale market have been identified by Government as the primary barrier to greater independent activity in the supply and generation market (HMT and DECC 2010). Ofgem is assessing options for improving liquidity and we believe this should include consideration of whether all wholesale trading activity should go through some kind of pooling system, similar to the Nordpool system in Europe. As well as improving wholesale market liquidity this would also improve transparency of wholesale prices.

How effective is Ofgem in ensuring consumers get a fair deal? Are there any areas for improvement?

22. The energy system is complex and stakeholders often hold very different views on how the market should be regulated. As a result Ofgem has a challenging role. Nonetheless, one example of Ofgem’s approach to enforcement gives cause for concern.

23. In March 2011 Ofgem launched a formal investigation into the pricing practices of Scottish Power, who appeared to be offering non-cost reflective tariffs in contravention of their licensing requirements. Now, almost two years later, there has still been no update on this issue. This is simply too long a period to constitute effective enforcement. It may be the case that the licensing requirement is simply too difficult to enforce effectively, in which case Ofgem should state this publicly and seek other ways to ensure the suppliers offer fair prices. As it stands the example of Scottish Power sends a signal to the other suppliers that they may be able to breach the requirements without fear of recrimination.

Profits

Many consumers believe that energy company profits are the reason energy bills have been going up in recent years. Is this perception fair?

24. The main cause of recent energy bill rises has been the increasing wholesale cost of gas. Increases in the costs of regulation and policy have also played a role, albeit far smaller. Low levels of transparency around the suppliers’ businesses make it hard to tell if their profits have altered substantially in recent years.

Why is there so much uncertainty about the level of profits the large, vertically integrated energy companies are making? What could be done to improve clarity?

25. Low levels of transparency on suppliers’ wholesale costs and the costs of energy efficiency policies prevent an accurate understanding of their profitability.

26. Improving wholesale market liquidity, potentially by introducing a “pool” system for trades (see above) would significantly improve transparency on wholesale costs.

27. To improve the transparency of energy efficiency policy costs, Government should require the suppliers to submit detailed information on the costs of delivering their ECO obligations, which should be independently verified, for example by Ofgem. The average cost of carbon for each sub-target within ECO, aggregated across the suppliers, should then be published alongside data on the suppliers’ performance against these sub-targets. These could then be used within Ofgem’s electricity and gas supply market indicators.

How useful are Ofgem’s electricity and gas supply market indicators in monitoring the level of profits made by energy companies? Could they be improved?

28. The indicators should be adjusted to include actual and not predicted costs of the energy efficiency obligations.

Fuel Poverty

Is the Government on track to meet its target of eliminating fuel poverty by 2016 and will reduced Government spending in this area affect their ability to achieve this target?

29. Improving the energy efficiency of fuel poor households is the most cost effective, and only long-term, solution to tackling fuel poverty. From now until 2016, the primary government policy for addressing fuel poverty through energy efficiency improvements is the ECO which looks set to fall woefully short of addressing the government’s legally binding target to eliminate fuel poverty by 2016.

30. According to the indicator for fuel poverty proposed in the Hills Review there are currently 2.7 million households who are fuel poor in England alone2. The government’s own estimates show that the policy will improve just 125,000 to 250,000 homes by 2023 (Platt et al 2012). It will therefore only scratch the surface of the UK’s fuel poverty problem by 2016. In IPPR’s recent report Energy Efficiency: who pays and who benefits? we estimated that £17.5 billion of investment is needed to improve all fuel poor homes (ibid.), which, at the current level of expenditure, would not be achieved until 2045.

31. In our report we recommend a number of policy improvements that government could implement to enable the ECO funding to go further in tackling fuel poverty. These include supporting local authority engagement in delivering energy efficiency by investing around £40 million in staff and resources, conducting a review of the challenges that suppliers have faced fulfilling their obligations under CERT, and piloting a new area-based approach to delivering energy efficiency improvements that focuses on low income and low efficiency areas (the “LILEA” approach).

32. The LILEA approach is substantively different to, and could be significantly more effective than, the existing area-based element of ECO, the Carbon Saving Communities Obligation (CSCO). CSCO directs support towards households in low-income areas, specifically those in the bottom 10–15% of the income distribution. Targeting of resources under this method will be very inefficient with recent research suggesting just 26.9% of the recipients will be fuel poor. Under the LILEA approach resources would be provided to all households in an area that is low income and known to contain inefficient houses. Designed in this way LILEA could be significantly more efficient than CSCO, with fuel poverty statistics suggesting areas where 50% of people are fuel poor could be targeted. It would also be less administratively onerous and so reduce costs. We believe this approach should be piloted and that local authorities are well placed to identify appropriate areas to target.

33. Ultimately, even with the changes to policy we have proposed, an increase to the financing available for energy efficiency improvements is necessary if fuel poverty is to be eliminated. Fortunately, spending on energy efficiency is likely to act as a significant stimulus of economic output. Modelling by Cambridge Econometrics and Verco (2012) found that improving energy efficiency in fuel-poor households “generates greater macroeconomic benefits—more jobs and greater growth—than the same injection of spending through other government spending programmes or cuts in VAT or fuel duty”.

34. Some groups are calling for revenues from the EU ETS and carbon price floor to be spent on energy efficiency to tackle fuel poverty. Because these instruments increase energy bills and therefore increase fuel poverty there is logic to their argument. However, since the Treasury has already banked this revenue, other sources of financing must be considered. One promising route is for the Green Investment Bank, or a British Investment Bank, to be properly capitalised and allowed to borrow, with funds made available for energy efficiency measures. If this was to occur ample financing would be available for energy efficiency without recourse to fiscal easing.

Has the Hills Review resulted in any changes to fuel poverty policy? How could its findings be used to improve the efficacy of fuel poverty policy?

35. The current indicator for fuel poverty captures large numbers of people, including some wealthy households. This can distort debates about where resources should be targeted and therefore we support the government’s proposal to redefine the way that fuel poverty is measured. The Hills Review provides substantial insights on the best way to achieve this which the government should take into consideration.

To what extent are current fuel poverty policies reaching the right people? Are there any particular groups that are currently not getting the necessary support? And will this change under the move to ECO?

36. The targeting of support for fuel poor households that will be provided under ECO is very poor. Recent research suggests that just 37.2% of the recipients of support under the Affordable Warmth sub-target of ECO and 26.9% of the recipients of support under the Carbon Saving Communities Obligation sub-target will be fuel poor. As a result precious resources are being wasted. There is substantial evidence that if policies are designed to take account of property-based characteristics their targeting efficiency will significantly improve. As described above we believe an approach that focuses on low income areas with low efficiency households holds promise.

37. Targeting of support for fuel poor homes through the Warm Home Discount has had similarly bad results to that achieved by ECO, with 27% of recipients being fuel poor. The Warm Home Discount should be means tested and the resources that are saved allocated to other areas of government spending.

References

Beech (2012) “Suppliers ready to publish CERT costs but not alone”, Utility Week website, 26 September 2012. http://www.utilityweek.co.uk/news/news_story.asp?id= 197471&title=Suppliers+ready+to+publish+Cert+costs+-+but+not+alone

Cambridge Econometrics and Verco (2012) Jobs, growth and warmer homes: Evaluating the Economic Stimulus of Investing in Energy Efficiency Measures in Fuel Poor Homes. Cambridge: Cambridge Econometrics.

Committee on Climate Change (2011) Household energy bills. London: IPPR.

Committee on Climate Change (2012) Energy prices and bills: impacts of meeting carbon budgets. London: CCC.

Department of Energy and Climate Change (2012) Fossil Fuel Price Projections. London: DECC.

Hills (2011) Getting the measure of fuel poverty: Final report of the fuel poverty review. London School of Economics and Political Science: London.

HM Treasury and Department of Energy and Climate Change (2010) Energy market assessment. London: HMT

Platt (2012) True Cost of Energy. London: IPPR.

Platt, Rosenow and Flanagan (2012) Energy Efficiency: who pays, who benefits? London: IPPR.

February 2013