In the UK energy sector, the past decade has been characterised by seemingly positive developments. The use of renewables has surged, accounting for a larger share of electricity generation than fossil fuels in 2020.
At the energy retail level, industry regulator Ofgem has pursued efforts to increase competition, spurring an influx of new gas and electricity suppliers. However, this transformation has contributed to a crisis within the sector during the current year, one that is expected to have significant repercussions throughout the economy.
Operators throughout the energy supply chain are currently contending with soaring fossil fuel prices.
Wholesale gas prices have recorded a significant increase, reaching record highs in recent weeks.
This has contributed to a significant rise in wholesale prices throughout the energy supply chain, culminating in increased costs for end users and considerable losses for energy suppliers.
Suffering suppliers
At the start of October 2021, day-ahead gas prices reached more than £3 per therm in the UK, representing a more than six-fold increase compared with the same period last year. This current spike in prices stems mainly from an imbalance between supply and demand for gas, spurred in part by the reopening of global economies following the COVID-19 pandemic. However, longer-term factors, including the rapid rate of decarbonisation and lack of energy storage capacity, have left the UK’s energy sector particularly vulnerable to price volatility.
The UK’s reliance on natural gas for heating and electricity generation has caused a similar spike in wholesale energy prices in the current year.
The tendency of suppliers to rely on spot markets, rather than locking into longer-term contracts, has left them particularly exposed to these soaring costs.
Ofgem’s energy price cap limits the ability of suppliers to recover these costs from consumers, and despite enacting a 12.2% increase in October 2021, the Financial Times reports that there is currently a shortfall of approximately £700 per year between how much suppliers can charge and the cost of buying energy from the wholesale market.
This unprofitable operating environment has stretched the finances of suppliers, confirming long-standing concerns regarding the ability of small and medium-size suppliers to withstand commodity price shocks. Following an influx of smaller suppliers in the first half of the past five-year period, the trend of enterprise growth reversed in 2018-19, as the lower tariffs offered by some smaller suppliers proved unsustainable. Despite tougher entry requirements implemented by Ofgem in June 2019, the financial strength of smaller suppliers remained in question, with a number of firms falling victim to increased customer default rates during the COVID-19 pandemic.
The current surge in wholesale energy prices has significantly increased the rate of decline in enterprises, with nine suppliers collapsing in September 2021 alone, displacing more than 1.7 million domestic customers. To stem the outflow, industry leaders have called for government support, while appeals for an upward adjustment to the price cap prior to its next review have so far been ignored.
Despite adding further fuel to current inflationary pressures, Ofgem has suggested that it expects a significant increase in the price cap from April 2022. However, with gas prices expected to remain elevated, further supplier exits seem inevitable in the short term.
Supply chain effects
Although the energy price cap has so far protected consumers from the worst effects of the price hikes, businesses do not benefit from this safeguard. Energy-intensive industries, such as steel and cement producers, are most exposed to fluctuations in the cost of energy, with some large firms purchasing energy directly from the wholesale market.
The spike in energy prices is expected to constrain profit margins for firms within heavy industry in the current year.
While some firms, including steelmakers, fertiliser producers and glass manufacturers, have already been forced to curtail output during times of the day when energy prices peak. Despite maintaining expected levels of output, British Steel has stated that energy price hikes have made production unprofitable at certain times of the day.
While heavy industry is expected to encounter the most severe squeeze on profitability in the short term, the effects of reduced production at major industrial plants are expected to have wide-reaching effects throughout downstream sectors. For example, potential reductions in the production of building materials such as cement, glass and steel, could exacerbate existing shortages within the construction sector.
Reduced fertiliser production as a result of the gas price crisis has also had a significant indirect effect on downstream supply chains. The main effect has been on food and beverage supply, with a shortage of carbon dioxide (CO2), a by-product of the fertiliser industry, causing significant disruption for meat processors and fizzy drink producers.
In order to limit supply chain disruption ahead of the busy festive season, the UK government was forced to provide subsidies to CF Industries, the UK’s largest supplier of CO2, to cover increased production costs at its Billingham plant for a three-week period. The company has since agreed to continue supplies until early 2022, facilitated by a new pricing structure agreed with its clients following the easing of competition law.
Conclusion
The energy sector is poised for a challenging winter, with wholesale gas prices expected to remain elevated and little scope for suppliers to increase tariffs until April 2022.
Additionally, the effects of the gas price crisis are expected to continue to filter through to the wider economy as price increases are passed down already fragile supply chains. This presents a threat to the recovery of key industrial sectors, as well as increasing the likelihood of further gaps on shelves in supermarkets.
With the cost of energy for domestic customers likely to escalate further at the start of 2022-23, the trajectory of wholesale gas prices is expected to be a key driver of the UK’s economic recovery in the medium term.
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