As we move through the Covid crisis, the energy market has rightly been focused on the here and now, with the need to keep the lights on, support home owners and businesses, and keep employees safe, all front of mind.
Most of the market commentary aroudn Covid has been focused on low demand, low wholesale prices and the challenges of balancing the system to keep the lights on. OFGEM have been uncharacteristically agile in enabling changes to be made quickly and this week announced some welcome solace to cash strapped suppliers by permitting payment arrangements to be put in place with the DNOs for delayed payment of distribution charges.
Looking further forward beyond the immediate, there are two things happening now which will have an enduring impact of the market. They are as a direct consequence of the Covid crisis and are a function of market design, but will ultimately flow through to consumers as additional costs in bills. The issues are already providing serious headaches for suppliers, whether operating in domestic or business markets.
Firstly, it is important to remember that even before Covid less than 40% of bills related to the wholesale cost of energy. The greatest part of the bill is represented by network costs and environmental costs which together account for around 45% of the bill. These buckets of cost represent multiple different elements associated with developing and maintaining the national distribution and transmission networks, and funding the various schemes developed to incentivise investment in new renewables. What is common to all the cost elements, is the market principle of spreading the total cost across total demand (or consumption) on a per unit basis.
This principle has worked well for years and is fine in a ‘business as usual’ world. However, in a world where total demand has suddenly shrunk by 15-20% the cost per unit consumed will noticeably increase.
This charging issue is compounded by the fact that for several elements of the bill the total cost that needs to be recovered has increased. Most visibly the costs of balancing supply and demand across the national system have materially increased. As industrial demand has dramatically fallen we have had a coincidental period of high winds and solar output. National Grid ESO, have had to pull out all the stops to ensure that the system is kept in balance during lockdown and use all the tools available to them. These tools are primarily represented by a plethora of commercial contracts with parties who can provide fast response in turning up or turning down locational demand. Based on the updated forecast, these necessary actions cost an additional £500m to the end of May 2020, raising total annual forecast costs from £1.5bn to £2bn. The May bank holiday (subsequent to this forecast) is reported in itself to have cost a further £51m in balancing actions- and with ongoing lockdown and good weather, these costs are likely to continue to grow through the summer.
The good weather will also impact total costs associated with the various incentive schemes whereby generators get paid a set amount for every unit of power generated, ultimately funded via energy bills. High levels of solar and wind generation will ultimately flow through to a higher total cost associated with schemes attracting ROCs, FITs, capacity market payments and CfDs. These increased costs will again be spread over lower total consumer demand on a per unit basis which will ultimately flow through to customer bills.
Suppliers have always had the challenge of forecasting all these costs ahead of setting prices in order to ensure that sufficient revenues are recovered from customers to pay for the cost outturns. The sudden diversion from ‘normal’ will have made accurate forecasting all the harder.
In the opposite direction, wholesale costs have been at historic lows, with a surplus of gas, good weather and low demand all driving prices down- which should provide some relief to the growing non commodity costs that will dominate forward bills. Overall, however, the challenge of setting tariffs and prices has suddenly become a lot harder- and all in the context of ongoing price caps. Suppliers, both large and small, have little room for manoeuvre if they get their forecasts wrong.
We are already seeing a more sympathetic approach from OFGEM, who are clearly concerned about the sustainability of competition in these exceptional market conditions. We’ve also seen SSE raising a proposed code modification to spread increased balancing costs over a longer period to lessen the pain. And now public confirmation that Bristol Energy is up for sale. The signs are all there.
There are no simple answers to the challenge that the pandemic has raised. But with continued low demand, we should not expect to see bills heading down despite low wholesale prices. And for suppliers who were already struggling with profitability and cashflow, their ability to accurately forecast, and adapt their products accordingly, will potentially be the difference between survival or failure.
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