2021 was a year of considerable volatility in the energy market. The full impact has yet to be felt as prices work through to retail bills, but the principal victims will be the consumers of natural gas—a group which includes most UK citizens. The volatility, however, was predictable and the problems it is creating were avoidable. The governance and regulation of the energy system has failed and, if left unchanged, will allow deeper problems to develop.
Global gas prices began to rise in the late spring of 2020, as China became the first major economy to emerge from Covid-induced recession.
Gas prices have historically been set through long-term contracts associated with dedicated supplies brought to market by pipeline. In recent years, a growing proportion has been traded in the form of liquified natural gas, with much of that also based on long-term contracts.
But an increasing proportion is traded on a spot market, with tankers moving from one part of the world to another in pursuit of the best immediate price. As demand outstretched immediate supply last year those spot prices rose. The end result: dramatic volatility, with prices at the end of 2021 three to four times higher than a year earlier.
For UK consumers, much of the pain of this is still to come. Long-term contracts adjust to market prices based on agreed formulas. The UK has a price cap, a Canute-style device which delays the imposition of the cost of supply onto consumer bills. The cap is next adjusted on 1st April and is likely to show a sharp and sudden increase year-on-year. To this will be added the cost of rescuing the 3.8m consumers from the numerous retailers who by the end of December had announced that they could not meet the terms of the deals they had signed. According to estimates from the campaign group National Energy Action, up to 1.5m additional households will face energy poverty as a result.
The shocking element of this story is that very little of the impact to be felt by some of the poorest people in society was inevitable. The UK is part of a global market, and imports around 60 per cent of its supplies. The global market is fluid, shaped by a mixture of global economic changes and raw politics. Nothing in these statements of fact is in any way secret and none of the consequences should have been unexpected. Indeed, the prospect of volatility should have been the starting point for public policy.
The lessons to be learnt are straightforward. First, working on climate change is crucial but policymakers should remember that whether they like it or not, the UK is not yet powered exclusively by offshore wind and solar photovoltaics. Renewables provide an important share of our energy needs but that share currently constitutes less than 10 per cent of final energy demand. The share of renewables will grow, but by the most optimistic estimates will be no more than 25 per cent before 2030.
Until then, and indeed for some time longer, we will still rely on oil and gas, which together provide over 75 per cent of current demand. With the North Sea declining as a source of production, more imports will be needed. Security of supply for natural gas can only be achieved through long-term contracts with trusted suppliers such as Norway, the US and Qatar. Reserve stocks should be a requirement—as they are in most of Europe—and the need for spot market trading should be minimised.
Securing reliable supplies is one part of the solution. For the next few months however, the challenge is how to deal with the impact of the recent price surge. Energy bills fall hardest on the poorest, who spend a greater proportion of their income on basic supplies. To make them the victims of the current mess should be unthinkable.
Three steps are necessary.
First, VAT should be taken off all energy bills, at least until prices stabilise. Second, the charges being added to cover the energy transition—subsidising offshore wind for instance, on contracts signed a decade ago—should be renegotiated or absorbed into general taxation. If these charges are not taken off bills, they risk becoming a source of resentment undermining support for the whole climate agenda.
Thirdly, the costs of rescuing consumers who signed up with now-failed suppliers should either be absorbed into a new, special purpose vehicle—a bad bank which takes on broken contracts—or spread over a period of several years.
None of these three steps would protect consumers from some increase in bills in April, but they would at least mitigate the worst of the impact. Additionally, for the very poorest there is a strong case for special support through the welfare system. As one of the richest countries in the world we should not be tolerating growing energy poverty.
As for the governance of the energy sector, Ofgem has failed as a regulator, neglecting its duty to protect consumers and its responsibility for managing the contract structure through which energy is supplied. Ofgem failed to notice—or even worse, chose not to be concerned—that dozens of retail suppliers were making contract promises which they could not meet if the market turned against them. Where were the standards of prudential oversight, of capital adequacy and risk management? Instead, Ofgem has set off on a mission to be not just the regulator of the whole transition to net zero but also a participant in the process, including bizarrely investing £300m to become the owner and operator of electric vehicle charging systems—a necessary service but one already being developed by numerous existing companies. At a time when the regulator’s core function is so important, this sort of mission creep is indefensible.
The current events will not be the last example of instability in the global energy market. As an importer of essential supplies, the UK cannot be immune to volatility. But we can and should learn how to be prepared and how to minimise the impact—especially on those hardest hit.
