ourEconomy: Analysis

Britain’s energy crisis has been decades in the making

Soaring gas prices have exposed longstanding vulnerabilities in Britain’s energy system. A radical overhaul is long overdue

Laurie Macfarlane
23 September 2021, 3.47pm
Andrew Paterson / Alamy Stock Photo

“There's absolutely no question of the lights going out,” the business secretary, Kwasi Kwarteng, told the House of Commons this week. “There'll be no three-day working weeks or a throwback to the 1970s.”

When senior ministers are forced to give such reassurances, it’s usually a sign that trouble is ahead. With Britain’s economy already battered from COVID-19 and Brexit, the last thing it needs is another crisis – let alone one relating to something as vital as energy. But that is exactly what the country is facing.

In recent weeks gas prices have soared, with wholesale prices rising to more than three times the level they were at the start of the year. Analysts have attributed skyrocketing prices to a ‘perfect storm’ of factors, including depleted European stocks after a prolonged winter; delayed maintenance by domestic gasfield operators; lower gas supplies from Russia; and strong demand for liquefied natural gas in Asia and Latin America. This turbulence in global gas markets has been compounded by a fire on a major subsea electricity cable between the UK and France, which has slashed energy imports from continental Europe, and some of the lowest wind speeds since the 1960s, which has dramatically cut output from the UK's 11,000 wind turbines.

As well as squeezing energy suppliers, surging gas prices are rippling through the economy – hitting everything from farming and food production to steel manufacturing and soft-drink carbonation.

But while market conditions have certainly created new challenges for Britain’s energy supply, not everything can be put down to bad luck. In reality, Britain’s energy crisis has been decades in the making.

Uniquely exposed

Following the privatisation of the gas and electricity sectors by the Thatcher-led government in the 1980s, the newly profit-hungry energy companies embarked on a ‘dash for gas’ – transitioning the British electricity generation away from coal towards modern gas-fired power plants, fuelled by newly discovered cheap gas supplies in the North Sea.

Over time, Britain became increasingly reliant on gas to power the country. Today, 86% of British homes use gas for heating, and more than a third of electricity supplies come from gas power plants.

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In the mid-2000s, however, domestic North Sea gas production began to fall sharply, while demand continued to rise. As a result, Britain became increasingly dependent on gas imports. In 2020, Britain imported around half its gas to meet demand – much of it via pipeline from Norway, the Netherlands and Belgium, with the rest imported by ship in the form of liquefied natural gas from Qatar, the US and Russia.

Given this reliance on imported gas, one might assume that Britain would have invested heavily in storage capacity to provide a buffer against market shocks. But the country’s largest storage site, the Rough facility off the Yorkshire coast, which previously accounted for 75% of all the nation’s gas storage, was closed in 2017 by its owner Centrica. Today less than 1% of Europe’s stored gas is held by the UK.

This lack of storage capacity left Britain’s gas supply at the mercy of volatile global markets, with few tools available to soften the impact of any future supply shock. This is the main reason why Britain has been among the hardest hit countries from surging gas prices: it is more reliant on gas for electricity generation than most other European countries, and its lack of storage capacity means it is particularly vulnerable to sudden price swings.

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In a desperate attempt to plug some of the power shortfall, in recent weeks the UK has temporarily fired up its coal power stations – the dirtiest of all fuels. But with coal capacity a fraction of what it once was, it can supply only around 2% of Britain’s energy needs. In the immediate term, there is little Britain can do to escape the clutches of soaring gas prices.

A fragmented sector

Britain’s vulnerabilities to global supply shocks have been compounded by a fragmented energy system, which has evolved in recent decades as governments and regulators have sought to inject more ‘competition’ and market incentives into the sector. But in practice, competition in the sector is either largely illusory, or built on increasingly fragile foundations.

Once energy is generated, it is transported around the country to homes and businesses via Britain’s transmission and distribution networks. Since privatisation, these networks have been owned and managed by a set of privately owned monopolies, including National Grid plc at the national level and a number of regional firms at the local level.

As natural monopolies with no competitors, the only safeguard to protect customers from exploitative practices is the industry regulator, Ofgem. In recent years, however, the regulator has been criticised for failing to keep network fees in check. A 2017 study from Citizens Advice estimated that customers were paying about £1bn per year more than what can be reasonably justified, enabling network operators to make significant excess profits.

Another study undertaken by the Energy and Climate Intelligence Unit estimated that around one-third of regional network operators’ revenue was being realised as profit, and at least half of this was being paid out to shareholders – leaving the system permanently. With network costs accounting for over a quarter of gas and electricity bills, these excess returns are a key reason why energy costs in Britain are higher than in many European countries.

Competition in the sector is either largely illusory, or built on increasingly fragile foundations

Once energy leaves the distribution networks, it is sold to households and businesses by energy retailers. These companies buy energy from the wholesale market and compete with each other to sell it to end customers, offering different tariffs and payment options. Their business model relies on their ability to sell energy to customers at a higher price than they purchase it for on wholesale markets. It is here where rising gas prices are creating significant problems.

For many years after privatisation, the retail market was dominated by the ‘Big Six’ energy suppliers: British Gas, EDF Energy, E.ON, npower, Scottish Power, and SSE. However, in response to growing criticism about market dominance and a lack of competition, in 2014 Ofgem reduced the barriers to entry for the energy supply market in order to make it easier to set up an energy company. While this allowed new players to enter the market (the number of household suppliers increased from just 12 in 2010 to around 70 in 2018) some embraced precarious business models that left them vulnerable to market shocks.

One of these came in 2019, when the government introduced the energy price cap, which empowered Ofgem to set a maximum price suppliers can charge customers on a standard tariff. While the cap protects consumers from sudden price surges, it also prevents suppliers from immediately passing on the increase in wholesale gas prices to customers. Following the introduction of the cap, a number of new entrants exited the market, citing the cap’s potential to squeeze profit margins.

But it has taken another shock, this time on the supply side, to reveal just how uneven the ‘competition’ between new entrants and the larger, incumbent companies really is. The Big Six – all of whom also generate energy on a large scale – are able to purchase their customers’ energy in advance in the futures market, locking in prices and hedging their exposure to market volatility in the process. However, smaller suppliers are typically unable to do this due to large trading fees, meaning they are forced to absorb higher costs straight away. Larger companies are also able to benefit from other economies of scale, such as a lower cost of capital and access to credit lines, meaning they are better able to ride out market volatility.

Without access to such privileges, rising gas prices have pushed many smaller retailers towards financial ruin. This week, two more firms, Avro Energy and Green, collapsed, meaning seven energy companies have now gone bust in the past six weeks – affecting 1.5 million customers. Analysts expect many more to follow suit in the weeks ahead.

With the sector on the brink of crisis, the government is now being forced to step in.

Privatised profits, socialised losses

With higher gas prices set to be sustained into the winter, the government faces a dilemma: should it try to prevent a bloodbath of energy companies by letting prices rise sharply, or should it protect customers from rising gas prices, and accept that this may kill off many of the recent entrants into the market?

The scope to pass rising wholesale costs onto households is already limited: millions of households in England, Wales and Scotland are already facing a 12% rise in their energy bills from October when a higher price cap comes into force. Five million of Britain’s poorest households will also soon have their incomes cut by £20 a week as the Universal Credit uplift expires on 30 September. With an estimated 3.2 million households already in fuel poverty in England alone, any further energy price rises could mean millions of households are forced to choose between heating and eating.

According to the Financial Times, the government’s preferred option is to let smaller retailers fail, and to persuade larger companies to take on the customers of their former rivals with the help of state-backed loans. A backup option is to create a ‘Northern Rock-style bad bank’ to house stranded customers, effectively creating a state-owned retailer.

Either way, the result is the same: the cost of the crisis would be partially socialised – a scenario that has become all too familiar when it comes to Britain’s privatised utilities. During the good times, executives and shareholders enjoy bumper pay packets and dividends, but during the bad times the taxpayer is expected to pick up the tab.

A future-proofed system

It’s clear that Britain’s energy system is broken, but what can be done to fix it? In Westminster, much of the policy debate focuses on making reforms to the energy retail market. For the free-market Right, the answer is to promote more genuine competition by levelling the playing field between new entrants and large incumbents. For the Left, the answer is often to create a publicly owned energy retailer to serve the public interest rather than private profit.

But while Ofgem can clearly do more to vet new suppliers and clamp down on exploitative pricing and tariff structures, for the most part, energy retailing is not where Britain’s problems lie. Instead, the root causes can be found elsewhere in the system: a reliance on imported fossil fuels for heating and electricity generation; a lack of energy storage capacity to provide a buffer against price volatility; a distribution and transmission system that is a playground for value extraction by private monopolies; and a regulatory framework that is failing to protect customers.

Addressing these issues can’t be achieved overnight. But if Britain is to future-proof its energy supply and meet its climate obligations, a radical overhaul is needed. What does this look like?

It means accelerating investment in renewable energy to wean the country off fossil fuels as rapidly as possible, and ensuring that the economic benefits of renewables are captured by local communities. It means investing heavily in storage technologies to ensure that clean energy can be stored, allowing prices and supply to be managed strategically. It means running Britain’s transmission and distribution networks as public utilities rather than private monopolies, easing pressures on customer bills. It means rolling out home insulation and other energy efficiency measures across the economy, lowering demand for energy while creating thousands of green jobs. And it means overhauling the regulatory framework to ensure that the entire system is working towards the common goals of decarbonisation, affordability and security of supply.

The gas crisis has exposed longstanding vulnerabilities in Britain’s energy system. While the lights that line the corridors of Westminster may not be going off anytime soon, it may be a different story for many families this winter.

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