OPINION: The energy price cap makes for an unpredictable wholesale energy market

David Gilchrist of lawyers DWF argues that small suppliers and new technologies will suffer under plans for a price cap

A 2015 investigation by the Competition and Markets Authority accused the UK’s energy suppliers of overcharging their customers to the tune of £1.4 billion a year. The government has responded with draft legislation imposing a price cap on suppliers’ standard variable and default rate tariffs (SVTs), the latest in a long line of attempts to protect customers in the energy sector.

However, there is a significant risk that the price cap will cause more harm than good. The government is failing to recognise that market competition and a fair deal for consumers are not necessarily compatible objectives – and it will likely be consumers that lose out.

While there is uncertainty around the form the price cap will take, it seems probable that Ofgem will propose a cap based on its view of the wholesale market and other costs suppliers face – replicating the arrangements it has in place for companies with pre-payment meter customers. So, what does the future hold for suppliers and customers in the energy market?

A changing market

The wholesale energy market is key to determining the end price paid by customers.  With a staggering 60% of customers currently on SVTs – almost all of whom are completely disengaged with the market – there will be little incentive for suppliers to reduce prices below the price cap.  Once Ofgem sets the maximum price, the objective of suppliers to provide electricity at as low a price as possible will, for SVTs, no longer be the main factor in pricing and product strategy.

The end of the hedge

While there are many possible consequences of this intervention, the most likely is increased price volatility.  The price cap will become a key determinant of suppliers’ hedging strategies: with no certainty as to how or when the cap will be reviewed, suppliers will be reluctant to enter into long-term forward purchases for fear of a downwards adjustment in the cap. Such an adjustment would mean a supplier could risk being forced to supply energy at a price below which it has contracted to forward purchase.  Such a scenario is clearly unsustainable.

A shift to the short term

The inevitable result? Less incentives for suppliers to enter into longer-term hedging and forward purchases of energy.  This, in turn, will have a negative impact on liquidity in the wholesale market, as suppliers move to shorter-term forward purchases.  The shift in demand from long to short term purchases will create more volatile pricing in the short term and less liquid long-term markets.  Assuming that the price cap is set by reference to this new world of energy pricing, we can expect SVT pricing to become far more volatile – with customers’ bills reflecting these erratic changes.

Unintended consequences

There are two unforeseen victims of the increased volatility in the wholesale markets: the small supplier and new energy technologies. Small, challenger suppliers, unable to sustain the short-term spikes in prices, will struggle to trade, and some will likely collapse.  Meanwhile, investment in new and innovative generation technologies – historically secured by longer term forward purchase contracts – will likely see a drastic reduction.

So, while the price cap might deliver on the objective of decreasing the gap between the most expensive and cheapest electricity tariffs, there’s a big question mark as to whether this reduction is in fact in the long-term interest of consumers.

First  published in the March 2018 issue of New Power Report