Life beyond the Energy Storm: The need for fundamental market redesign.

I had a really thought provoking conversation yesterday about the current state of the energy market, and in the context of delivering net zero, where do we go from here.

Some key themes emerged in relation to where we are, and I’ve been reflecting on how they interlink and what they mean for ‘the big picture’:

1) From a consumer perspective, the worst is yet to come- domestic customers and businesses have not yet really felt the pain of sustained high wholesale costs.

2) Consumer trust in the industry, which has never been high, is now taking a nose dive- whether it be directed at suppliers, OFGEM or government. This decline in trust is in the context of multiple suppliers going bust in quick succession and before the pain of increased bills is felt. What motivation there was to switch supplier has largely disappeared. It will be even harder going forward, in this context, to sell the dream of changing behaviour and taking action to achieve net zero.

3) We are now operating with a nationalised tariff and are likely to for the foreseeable future. Suppliers remaining in the market will be clinging onto what wafer thin margins they can, and with reduced pressure on customer retention, this will mean that prices coalesce around the highest tariff permitted. The price cap, whatever it was designed for, will become de facto the national tariff.

4) Market design is not fit for purpose. Recent events have proven that suppliers can only survive in this market if they are heavily capitalised and operating at scale. The large suppliers who are managing to weather the storm, are doing so, not because they are better run or managed than many of the suppliers that have failed, but simply because they have deeper pockets. The fundamentals apply to big suppliers in the same way as small- and ultimately even for the surviving suppliers, without change, it is hard to see the motivation to play in the market as currently structured. A competitive market cannot be effective where costs cannot be recovered on a timely basis, only established large businesses can survive, and new entrants are pretty much doomed to failure.

5) Market design is asymmetric in the allocation of risk. Fundamentally, the ‘supplier hub’ model means that suppliers disproportionately bear risks which they cannot manage. The post event settled costs associated with CfD, ROCs, REGOs and FITs crystallise as a function of the pace of growth in the renewable generation market and are not directly influenced, nor can be managed, by suppliers. Balancing costs, in the new world of high volatility and weather associated fluctuations, are proving to be almost impossible to forecast, and therefore recover, accurately. The market, as designed, puts the price risk associated with all these costs onto the supplier. This design worked fine when the market was created with a small number of vertically integrated businesses- but is not fit for the world we are in now.

6) Regulatory reach, associated with the current market design is limited. There are increasing numbers of unregulated businesses interacting with energy consumers outside any scope of regulation. This number is only likely to grow as we transition to net zero.

So, if we are genuinely committed to delivering net zero, where do we go from here?

The first point where there was strong agreement is that tinkering around the edges is just not going to do it. It feels in many ways as if OFGEM is shutting the door after the horse has bolted, and what it needs to do when the dust settles, is take a step back and fundamentally review market design, how the market is regulated and who is regulated. We agreed that being bold in driving fundamental change is probably the hardest issue facing the Regulator, not least in the face of culture, government, market pressure and lobbying.

We also agreed that more than anything else, coalescing around the objective of building consumer trust was probably more important than anything else. Without rebuilding trust across every aspect of customer interactions, the market will be unlikely to deliver the fundamental transformation that it so desires and is required going forward. The significance of human sentiment and its influence on behaviour is habitually underplayed in the world of economic policy and regulation.

We need to think differently about consumers, what motivates them and how they behave. Parent/child instructions such as cuddling a pet and turning down the thermostat verge on the insulting. How do we engage with customers in different ways to drive behavioural change? How do we make the prospect of reducing demand exciting to the masses? Constraining regulation, high risk, low margin monolithic operations and weakened balance sheets are not a great place to start. This is where new entrants, new technologies and new approaches really can play a part, but only if the market structure enables rather than constrains them.

Fundamentally, the market is in the eye of a huge shock event- which plays through to market participants, consumer and investor sentiment and importantly the energy and motivation of those having to lead the way through. Whilst painful, it has the potential to be the catalyst for overdue market redesign which shakes up traditional thinking and puts us on track to deliver Net Zero- but only if the appetite for change is really there.