gas pipe laying

What drives wholesale energy prices?

Chris Roper, Pricing

1st December 2016

Of all the elements of your energy bill, the wholesale cost is a big chunk – typically around 43% for a dual fuel customer (Ofgem 2016). 

And like any product that's bought and sold, the price varies.

To understand what drives these variations, it's helpful to know a bit about how the energy market works. You can think of it as having three main parties:

1. Suppliers – who buy energy on behalf of customers. 

2. Generators – who sell the energy, so power stations, oil rigs, solar farms, and so on. Your own home might also be a generator if you have a Feed-in Tariff.

3. Support – the various organisations that regulate the buying and selling, provide platforms for trade, and build and maintain energy infrastructure. Bodies like National Grid and Ofgem.

Confusing things a little is that some suppliers are also generators. We have our solar farms, EDF has its nuclear plants, and British Gas's parent Centrica owns gas-fired power stations. In fact, the Big Six supply three quarters of the UK's energy capacity, but to maintain competition they can't sell to themselves. They buy what they need from the market, like everyone else.

Why do wholesale prices go up? 

Wholesale price rises are usually the result of a problem with one of the three elements above. Supply and demand rules also apply – the more people buy, the more expensive it gets; the less, the cheaper. 

Small price changes occur all the time, which is why energy is bought in advance. These changes depend on demand, how much is being generated at the time, where it's coming from, how it's being generated, the season, fuel prices (coal, gas, and oil), and so on.

As a nation, we buy energy abroad as well as generating our own, so these rules apply on a global scale. The North Sea supplies just 50% of our gas, leaving us exposed to European gas pricing. Europe gets most of its gas from Russia, or in liquified form from the Middle East. Stresses on any part of the global chain, be it civil unrest, war, natural disasters, accidents (like Piper Alpha or Chernobyl), or political/societal changes, will affect the price you pay for energy.

Let's take a look at three events that led to wholesale price rises.

1. The Fukushima Daiichi nuclear disaster

Following a devastating tsunami on 11th March 2011, the Fukushima I Nuclear Plant went into nuclear meltdown. It was the largest nuclear meltdown since Chernobyl, and the radiation leakage is likely to cause hundreds of cancer deaths in the future. Unsurprisingly, nuclear power's popularity among the Japanese plummeted, with many prefectures refusing to allow their plants to operate.

Japan decided that while they reviewed their nuclear arrangements, they'd turn to gas-fired and coal-fired power stations for all their electricity. They bought all the gas they could get their hands on, and were willing to pay a lot of money to get it. This pushed the price of gas up for everyone else, including the UK.

2. The Russia-Ukraine dispute

Russia and Ukraine have clashed over gas several times in the past, and most recently over Russia's annexation of Crimea. Ukraine, and the rest of Europe, are reliant on Russia for a significant portion of their gas. When these political punch-ups escalate, usually when one side withholds gas or payment, Russia threatens to cut supply to its main pipeline to Ukraine. This same pipe takes Russian gas to the rest of Europe, so has a knock-on effect for us in the UK.

Russia supplied almost a third of EU gas in 2015, and this is set to increase due to falling oil and gas prices (which have reduced domestic generation). They plan to build another pipeline that bypasses Ukraine called Nord Stream 2 (the original being Nord Stream 1), with expected pipe-laying to begin in 2018.

While this second network will add some security to EU (and UK) gas supplies, the cost of building such a pipe might bleed into the purchase price. And it doesn't mean that political tensions won't occur along the new route.

3. French nuclear plant safety concerns

France gets most of its electricity through nuclear power: 76.3% in 2015.  Recently, the government majority-owned nuclear plant builder, Areva, reported problems with the materials used in its nuclear plants. Naturally, the energy market began to tremble – if France had to take some, most, or all of its nuclear plants offline to address the safety concerns, where would three quarters of its energy come from?

So far the wholesale price has gone up significantly as a result of this news, so you could argue the changes are driven as much by sentiment as actual events. But without a crystal ball, there's no telling how long the higher prices will remain. They could just as easily fall again if France rectifies the problem without shutting down any of their reactors.

Energy pricing is a bit like an auction – the price is set by the last executed trade. This means that when a nation is willing to pay much higher prices for a specific type of generation, say in the case of Japan's focus on gas, it pushes the price up for everyone else. 

When do wholesale changes affect customer bills?

Believe it or not, energy suppliers don't like putting up their prices. It attracts a lot of negative publicity and can push customers away. But wholesale energy prices are another cost to the business, so when it goes up, the customer price has to rise too, otherwise they could end up offering "loss-leading" products, which is illegal under UK law.

So, to compensate for possible price increases, suppliers buy energy in advance. This is called "hedging" – buying energy today for consumption later. With fixed customers hedging is easy. The supplier decides how much energy they need for their customers, and buy it when they come on supply. 

If there's a radical change in prices during the fixed term period, the supplier must honour the fixed price, but for new customers, they might substitute that particular fixed deal with a new one if the prices stay high. This works the same in reverse, suppliers might release a cheaper fixed deal if the prices drop. (It's worth noting that "tease and squeeze" pricing differences are much bigger than any changes in wholesale prices.)

Variable tariffs, on the other hand, are a little more complex. Smaller suppliers tend to hedge over a period of months, and if prices increase they might need to pass that on to customers when the next round of buying takes place. The Big Six have a much longer hedge – in some cases buying over two years in advance. While this helps avoid negative media attention should wholesale go up, it limits their ability to lower prices if wholesale goes down. 

In either scenario, it's a complex challenge to buy the right amount of energy – at the right time – to keep customers' bills as stable and affordable as possible.

We can't predict the fluctuations of the future, but we can promise that the price you pay for energy is a fair reflection of its cost to us. We'll cut our prices when we can, and only ever increase if we really have to.

http://www.telegraph.co.uk/business/2016/06/16/europes-reliance-on-russian-gas-to-hit-record-highs-this-year-sa/

http://oilprice.com/Latest-Energy-News/World-News/Russia-Almost-Doubles-Gas-Exports-to-the-UK.html

Various Wikipedia articles

http://www.telegraph.co.uk/news/2016/05/03/frances-nuclear-giant-areva-admits-to-400-irregularities-in-nucl/

Hey! Just so you know, your device is fully charged and you're still charging it. Removing the charger will avoid degrading your battery 😊

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