The Price Cap is not responsible for the demise of energy companies

Bulb is the most recent casualty of global energy prices, and its demise is sad. I feel for the people - employees and customers (or members, as Bulb called them) - who invested a lot of emotion in the promise of cheaper, greener energy with simple pricing. I’m delighted that the Special Administration regime will enable most of the employees to retain their jobs, and customers get an even smoother transition than the usual “Supplier Of Last Resort” process.

The failure of so many energy companies is not driven by the price cap. Primarily - companies have failed because they were not well enough “hedged”. Hedging is the practice of a company buying its energy in advance - thus being certain of the prices it will pay.

For example, I read that Bulb were “hedged to the end of 2021” so they had locked in prices up to this period. But the energy price cap runs until March 2022. If reports are correct, it means that Bulb would have to buy its energy from January 2022 to March 2022 at prevailing wholesale prices - several times higher than they were a year ago, whilst the price cap limited what they could charge customers.

So - is this the fault of the price cap? Of course not. The price cap methodology and timing are known to all energy companies. Most prudent companies are believed to match their “hedging” to the price cap periods. So if the price cap fixes what we can charge customers in a given time period, we fix our costs for that period too.

Whilst energy wholesale prices are volatile, most of the time the movement is “a few percent here, a few percent there”, so many companies have taken a gamble. By being partially hedged (say, three months) they could capitalise on times when the wholesale market fell by offering low prices and scoop up new customers. You see, you don’t need to be miles cheaper than rivals to scoop up large customer numbers. Energy switching sites are “sorted by price” - so if you’re 1p cheaper than a rival you’ll come ahead of them - and people are hugely influenced by ranking rather than the absolute prices. That is - the difference in price between position one and two in the rankings could be just 1p (0.001% of a typical annual bill) but position one will get perhaps twice as many customers as position 2 - ie. a 0.001% difference in cost leads to a 200% difference in the number of customers acquired.

The gamble companies took is that if wholesale prices rose they could increase prices and absorb the change. With a typical challenger being able to break even at perhaps £100 below the price cap, they’d see that they could afford a fairly big increase in wholesale even if they weren’t fully hedged. When energy prices were £1000 / year, wholesale costs made up perhaps £450, so a company could absorb something like a 20% or 25% increase in wholesale costs. More if they were willing to make a loss for a period. And they know that whilst a small price advantage compared to rivals will bring them lots of new customers, they don’t lose the same number when they’re more expensive.

But just like the martingale method in a casino is bound to fail eventually, so this strategy will come undone when wholesale costs rise sharply, as they have done this year

When wholesale prices rose by £1000 per customer, unhedged companies were on borrowed time. You simply can’t find £1000 (or thereabouts) when you earn perhaps £50 profit per customer in a good year.

This situation was exacerbated for Bulb in particular because they ran a single variable tariff. Most large companies have some customers on a variable tariff (usually protected by the price cap) and others who’ve bought energy on 12-month fixed prices. The companies will hedge those customers for 12 months, further reducing their exposure to the risk of rapid increase in wholesale prices.

It’s worth noting that hedging is fraught with complexity, which is why so many of the companies didn’t do it, at least not as extensively as others. Hedging requires serious amounts of capital, and sophisticated risk management (see footnote).

Regardless of the price cap, it’s disastrous for an economy to have large companies managing billions of pounds of business, essentially guaranteed by energy billpayers, if those companies are not sufficiently capitalised or sophisticated to manage this sort of risk. As the government and regulator dwell on changes to the market - there are therefore three areas they need to focus on: how well companies are capitalised, how well they manage risk and how effectively they are hedged.

There’s a good argument that there’s regulatory failing here. Regulators are hard-pressed, monitoring and measuring many things which are in the grand scheme unimportant, but in so doing can be distracted from the big picture. Existing regulation already allows energy retailer financial resilience and risk management to be better monitored and enforced.

We should free regulators of many day-to-day burdens on minor details, and instead ensure the system-critical work - eg. stress tests - are applied with appropriate frequency and thoroughness. The regulator should not be there to chase an ever-growing list of minor issues but instead to ensure we don’t end up with system-scale issues whose costs outweigh all the rest by orders of magnitude.

Our regulatory and political leaders may find it interesting to read about subtractive thinking:

And all is good with the price cap?

No - it’s a clunky mechanism, looking back over too long a period when setting prices, and not reviewed often enough.

Octopus always pushed for a “relative price cap” - that is, one which ties the default price for an energy company (its SVT) to the price it charges new customers. This would have provided real flexibility at a time like this, whilst limiting the ability of a company to tease new customers and squeeze loyal ones. There was never a good reason to reject this - it harnesses competition to drive down prices whilst reflecting the real market behaviour.

If we’re to stick with the current absolute price cap, we need to make it more agile - perhaps reducing its period from six months to three, and shortening the period over which it observes historical prices to make it better reflect the current market. But we should be very suspicious of the calls from some companies to “increase the headroom” (code for “allow higher margins” or “allow us to remain bloated or inefficient”).

The price cap has reduced prices by billions - forcing energy companies to cut margins, treat customers more fairly and undergo efficiency and technology programmes which have demonstrated just how bloated they’d become in the old oligopoly. We shouldn’t return to that world…

Footnote: Complexity of hedging:


First - you can’t simply hedge a price. You need to hedge a volume at that price. So you essentially estimate how much energy you think your customers are going to use, and lock in the price for that amount.

If your customers use more than expected, you need to buy the difference, and if they use less, you need to sell it. And you do so at the prices which prevail at the time of usage. In electricity this is done every half hour - on gas, it’s done daily. So if you hedge a year in advance, you are including a guess of how many customers you’ll have and how much they’ll each use, which is very weather-dependent. And also massively affected by things like changing work-patterns with the pandemic.

You can see the issue - if you grow rapidly, or if there is more consumption than expected - you need to find the cash to pay for the extra unhedged energy. And if you see customer numbers fall or lower consumption - you can find you’re selling a lot of energy, often at a loss.

And many hedging contracts include “mark to market”. This means that if the energy price falls below what you’d hedged at, the traders who sold you the hedge will demand cash to cover the difference. Eg. If you’d bought £500m of energy, and the market price falls 10%, the trading house will ask for £50m - often within 24 hours…

Others will demand big deposits - or cash in advance - to cover the value of the hedges, taking us back to the need for retailers to be well capitalised.

Published on 23rd November 2021 by:

image of Greg Jackson

Greg Jackson

Founder

Hey I'm Constantine, welcome to Octopus Energy!

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