Are we being too critical of energy suppliers for raising prices?

Every year, as we head into the winter months, energy companies feel the full force of consumer and political opprobrium when they raise energy prices above the rate of inflation.

A lot of the time they deserve the criticism, and occasionally the criticism serves as a convenient distraction for politicians in order to divert from their own failings to meet the future energy needs of the UK.

It is certainly true that energy prices tend to change a lot quicker when prices rise rather than when prices fall, but that is as true for petrol prices as it is for gas and electricity prices. In the last twelve months utility companies have raised prices, cut them and then raised them again, while UK natural gas prices have risen from lows of 53p in July to be trading just shy of 70p in mid-October.
As well as criticism for raising prices last week, domestic energy companies also came under scrutiny with allegations into price fixing on the wholesale gas market. Coming, as it did, the week after Barclays Bank was fined by the SEC for alleged manipulation in the US electricity market between 2006 and 2008, the revelations are a hot issue for regulators and politicians, especially in the wake of the recent manipulation of LIBOR.

While the prospect of an enquiry into energy price fixing might seem appealing to a lot of people, proving that price fixing happens won't be as easy as it was for LIBOR. Unlike LIBOR, energy prices are an actively traded market with supply and demand dictating price movements, while companies also look to hedge against rising and falling prices, which means that we are unlikely to find conclusive proof of price fixing in the absence of a 'smoking gun'.

The real issue

Since August natural gas prices have been trending higher, though they remain below their 2011 highs. However, the real issue isn't one of price fixing but one of where the UK's future energy needs will come from in the next 10 years.

We are set to lose about 20% of our power generation capacity by the end of the decade, as old coal fired power stations close down, due to European Union CO2 emission regulatory rules, and tighter green regulation.

Without the investment in new power stations there is a risk that power companies will look elsewhere if they find that their profit margins start to shrink beyond what is viable to satisfy their shareholders.

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If that were to happen, rising fuel bills would be the least of the UK's problems if the lights start to go out due to a political failure to plan for the future energy needs for a growing population.
The main power companies at the centre of this storm include E.On, Centrica, Scottish and Southern Energy, EDF Energy, two of which are not UK owned. Only last week German energy giant E.On issued a profits warning as it struggled to turn profits at its gas fuelled power stations.

On the other hand UK owned Centrica announced it was on track to make a £1.4bn profit for the year, while another UK based company Scottish and Southern Energy also announced a 38% rise in profits.

Both these companies have been criticised for announcing big profits at the same time as hiking energy prices.

While the timing is unfortunate, the fact remains that if the UK is to keep the lights on in the forthcoming years these profits will need to be reinvested in new power stations, mainly nuclear, as well as other new technologies for not only renewables, but fracking as well. If these new technologies like fracking get regulatory approval and pay dividends like they have in the US, then that could well see natural gas prices fall in the longer term as supply becomes more plentiful.

Investing for the future

Politicians will certainly have to tread a careful line with respect to power companies given that it is also government policies that are helping push bills higher, and giving these companies pause for thought with respect to future investment plans in the UK. Companies should not have to apologise for making profits, especially when they are being asked to make big commitments to future power generation projects.

For this reason alone, irrespective of the furore surrounding price rigging allegations and political blowback for rising prices, politicians would be ill advised to do anything more than rebuke the power companies publicly, lest they walk away from investing in future UK nuclear energy projects as RWE and E.On did earlier this year, while reports that Centrica could well do the same were circulating in the weekend papers only recently.
The reality is the UK government needs the energy companies to safeguard the UK's future energy needs. Over regulating them in order to score political points in the short term could well blow up in everybody's face in years to come. That is certainly the concern with respect to the recent announcement to force energy companies to offer customers the lowest prices.

This move could actually force bills higher and lower competition as energy companies find their room to compete on price restricted by a tighter tariff structure, and could well see companies increase the rates of their lowest tariffs.
There is certainly an argument for simpler billing but that sort of oversight should be left to the regulator, and not subject to the whims of populist politics.

Share price performance in both Centrica and Scottish and Southern Energy has been positive through 2012, but certainly not spectacular given some of the outperformance of other markets, but what they lack in price outperformance they make up for in dividend yield with both returning a yield in around 5%, which when interest rates are near zero, isn't too shabby, however the unknown going forward remains political interference impacting profit margins.

Michael Hewson is senior market analyst at CMC Markets UK

This article was written for our sister website Money Observer