As the dark nights draw in, fundamental change is needed to avoid an energy crisis

The crisis on petrol forecourts has diverted some attention from the crisis in the energy retail market. The Supplier of Last Resort arrangements have – so far - helped get the sector through some of its immediate short-term problems.

This is clearly important for those consumers impacted by firms going bust. But it is unlikely to be enough. The energy sector is not in a ‘steady state.’ It is going through fundamental transformation, both in the UK and globally. Some factors, including international gas wholesale prices, are largely beyond our immediate control. Others, including who pays for what and how we distribute costs and risks fairly within the UK, are down to us.

The challenges faced are multiple and inter-dependent. They are both longer-term and immediate.

In the UK, one consideration fast rising up the decarbonisation policy agenda is how best to shift the current significant burden of environmental and social policy costs from household electricity bills. Eventually this could be handled through a transfer to a mix of taxation and/ or gas bills. The aim is to start to provide more effective price signals – albeit in a phased way - to shift home energy usage away from gas boilers to electric heat pumps.

But the immediate crunch is the very significant number of households facing big hikes in the cost of living. Whilst it may make sense to load costs away from electricity and onto gas in the medium term, when faced by the reality of cold homes and people struggling between heating and eating, the need to proactively address the wider social impacts and ‘soften the pain’ must be urgently grasped.

The energy price cap, which today will see many bills increasing by 12%, is currently due to be reviewed again in April 2022. The bets are on that it will then go up again by at least several hundred pounds. On top of an end to the universal credit uplift, the increase in national insurance contributions, and wider inflationary pressures (green and otherwise), this is likely to lead to a rapid growth and deepening in financial hardship. The new Household Support Grant, just announced, whilst welcome, is unlikely to be enough to tackle the scale of the problem.

In this context, making the case for hard pressed families to pay even more on their gas bills to cover green costs will become more challenging. And this is even before those who are struggling to keep afloat are required to find the up-front money needed to install heat pumps or make their own switches to electric vehicles.

BEIS should shortly announce its long awaited call for evidence on affordability and fairness in the energy market. This will need to consider how to balance these competing goals of net zero and the affordability of one of our most essential services – whilst keeping the lights switched on.

As the safety net of the Supplier of Last Resort arrangements creak and groan, it is vital that all sides - government, regulators, and energy companies – use any breathing space that has been created by these arrangements to look at these different problems in the round and fundamentally review our energy retail markets, and associated regulatory and social protections, at a strategic level.

For an essential service such as energy, ongoing scenario planning, stress testing assumptions and being honest about what can break the system should be simple and ongoing good practice. We need to do all this but more. We need to not just get through the crisis but use it as a catalyst to create a fundamentally different market and regulatory framework that can deliver a cleaner, greener, and fairer energy system.

Below, we identify six questions that we consider a review of energy markets and associated regulatory and social protections needs to consider. These questions are inter-linked. At their heart lies the need to recognise that to decarbonise and provide resilient services in a fair way a substantial proportion of the population will need at least some form of access to favourable finance / lending and / or social protection. We need to face up to this and tackle it now. Bold leaders will recognise that this is an issue that won’t go away. Market solutions will take us so far but on their own won’t solve the problem. There is an opportunity to create something better than what we have now.

1. How do we protect all the customers of failed companies – especially those already struggling?
This issue has understandably perhaps received the most attention to date. Although the Supplier of Last Resort arrangements have so far prevented interruptions to consumer supplies, these arrangements need to work for everyone, particularly those who may already have payment difficulties (for example, those who are on debt repayment plans or are in receipt of the Warm Homes Discount) or those who may no longer be able to budget given the price hikes experienced as they are move across to a new supplier (Citizens Advice have calculated that these will be on average £30 a month).

2. How do we ensure that only healthy companies that are ‘fit to play’ are licensed to operate?
Ofgem sets the bar for which companies can enter the energy market, and, following longstanding concerns, introduced tighter rules in 2019. These need to be reviewed once again in the light of the current crisis to ensure they give sufficient protection to enable the company to address underlying social, environmental, and economic risks and to withstand a range of shocks. This is likely to include, but not be limited to, company credit insurance / hedging arrangements for wholesale gas prices.

Going forward, Ofgem will need to carefully consider what assurance and disclosure it needs that a company has a sufficient grasp of its risk universe to know whether they can keep their promises. Some have pointed to the move to prudential regulation in the financial services sector post 2008 as a way forward. Whilst the risks in energy may in some ways be less systemic, understanding how the people, culture and governance of a business shapes their approach to risk – and ultimately whether they have a holistic view of their risks, understand how these can become material to the business and are able to mitigate these - will be important.

Our research has shown that a focus on a company’s purpose, getting a diverse mix of people around the board table to avoid group think and meaningful stakeholder engagement can be vital to build intelligence and pick up on the early warning signs of problems. These are core to what it means to have a ‘Sustainable Licence to Operate’ for an essential service such as energy.

3. How do we define and track what a healthy energy market looks like?
For too long, we have judged the success of the energy market by short-term metrics such as switching rates and the number of suppliers, rather than the extent to which it is delivering on fundamental and enduring societal goals. We all know that competition is not an end in itself. We can use this shock to refocus the system on the key desirable outcomes for the sector, for both today and tomorrow.

The long anticipated BEIS Energy Strategy and Policy Statement for Ofgem provides a clear opportunity to do this. The Statement will need to consider how Ofgem should approach trade-offs between different goals, such as security of supply/resilience, decarbonisation, and affordability, particularly when these will lead to significant distributional impacts. These are political questions and politicians need to lead.

To get assurance that the market as a whole is healthy, will require a review of the social, environmental, and economic metrics that all market participants across the value chain are required to disclose and report on. Crucially, due consideration is also needed of how policy makers and regulators actually analyse and use this information to track leading indicators, identify emerging trends, and carry out scenario analysis and stress tests of the market in the round.

4. How do we protect citizens going forward?
Even if the above points are addressed, there are still some fundamental ‘fairness’ questions left around who is best placed to take risks in the energy market, who should pay for failure, how social and environmental policy costs are shared and what priorities for action should be. Our traditional policy and regulatory arrangements, by focusing on energy supply and the interests of individual consumers rather than outcomes, communities, and citizens, have historically either assumed customers will bear the risks and costs or ducked these issues.

This crisis has brought to the fore the urgent need to reframe and refocus policy and regulation so that it takes a wider and longer-term perspective. Crucially, this needs to give more focus to solutions that deliver co-benefits.

Tackling the energy efficiency of cold and leaky homes - which will cut carbon, reduce fuel poverty, and provide good jobs - has to be top of the list. In this sense, Insulate Britain have got it right. We just need the political will to address this. To decarbonise at the scale and pace needed, this needs to be accompanied by suitable loans and grant-aid for people on low-incomes to be able to buy heat pumps, electric vehicles, and the kit to access new energy services.

Government will need to carefully consider who then pays; whether the above are best delivered via environmental and social policy costs going on gas bills and then groups of consumers getting loans/grants to insulate their homes and make them future fit, or whether these distributional issues are more effectively tackled through progressive taxation.

All this has implications for retail market models. There is a strong case for supporting radical thinking such as that set out by Laura Sandys and Jeff Hardy - to separate out markets for basic essential energy services which are covered by a universal services obligation, and markets for enhanced premium energy services which can provide the flexibility the energy system needs and where competition can drive prices down and stimulate innovation. Any change needs to work in practice. An essential energy allowance charged at a lower unit rate, as Sustainability First Associate Maxine Frerk proposed in our 2019 What is Fair? Paper, may be easier to implement.

In our response to the forthcoming BEIS call for evidence on affordability and fairness in the market, we will explore the breakdown of policy costs, including legacy costs, and propose different cost recovery mechanisms for each bucket of costs.

5. Do we have the right arrangements for enduring energy security of supply and resilience?
The current complex and historic web of duties and responsibilities on energy security – across the full energy supply chain (retail included) - needs a full ‘drains-up’ review. The new Future Systems Operator presents an opportunity here. It is expected to have responsibility for electricity system operation, possibly greater responsibility for the capacity markets and market design, plus new long-term strategic responsibilities for integrating electricity and gas network planning and network competition arrangements (plus, potentially, hydrogen network plans). In the face of dramatically increased electricity dependence - including end-user connectivity and the extended transition period away from fossil fuels - for power, industrial-use and heat – the review needs to consider the fitness of current duties and responsibilities for energy security of supply and resilience and how the market deals with common risks, such as what is an appropriate level for UK gas storage, to see us safely and securely through the scale of the net-zero transition.

6. Are failing energy companies worthy of state support?
If one of the larger energy players folds, a very real prospect if latest reports are true, the Supplier of Last Resort arrangements are unlikely to be sufficient and we may instead be looking at the Special Administration Regime – the true test of ‘too big to fail’. And even if we get through the immediate crisis, it is a long time until next April when the price cap is currently scheduled to be raised again. Much could happen in the intervening six months.

Failing companies are part and parcel of most competitive markets. If no failure is allowed, there’s a risk of sclerosis and reduced incentives for innovation. In many ways energy is different as we rely on it 24/7 and 365. Even more so in a cold dark winter. But that doesn’t mean companies should be supported at any price.

If state backed loans are needed, it will be crucial that these are not a blank cheque. There should be clear and transparent conditions attached – in terms of the social and environmental outcomes this support should be used to deliver. In such an eventuality, Government could use the crisis and its intervention to drive purposeful business and to support its wider social and environmental goals. Robust governance in the public interest will be essential.

Once again, the above six questions are inter-linked. As we move into winter, the cost-of-living crisis plays out, and Ministers war game different market scenarios, having a government backed company in the sector might begin to have its attractions. Could a ‘bad bank equivalent’ for the energy sector also be used as a vehicle to deliver the universal service obligation and/or provide services for those who will need protection as we go through the transition?

In the 1980s The Smiths famously sang ‘The dark nights are drawing in, and your humour is as black as them.’ It doesn’t have to be this way. Things are tough. Things are complex. But we now have an opportunity to use the current energy crisis to reshape the energy market and how it is regulated in a way that many people have been calling for – for a long time. Let’s seize the moment.