The UK businesses are in the midst of a car crash with expensive new power supply contracts coming into force, leading to power being unaffordable for smaller companies. This scenario is also expected to hit the struggling retail and hospitality sectors the hardest. The government support has dwindled, and smaller companies that renegotiated their contracts at the market’s peak last year are now stuck with unaffordable bills.
The Situation
Commercial and industrial sectors consume around two-thirds of the UK’s approximately 300 TWh of electricity demand. Smaller companies generally have fixed-price contracts that reflect the expectations for future energy costs and grid-related levies. Last year, around 13% of these companies, or 90,000 in number, renegotiated their contracts when the market was at its peak. This has led to these companies being stuck with unaffordable bills.
For instance, a worst-case example is a company that renegotiated an electricity contract from April 2023 to March 2024 at the market’s peak in August last year. They would have expected forward electricity prices above £600/MWh according to Cornwall Insights, a consultancy. In this scenario, a small business consuming 20MWh of electricity per year would be hit with a bill of £14,000. In 2019, this would have been more like £2,600. Meanwhile, under the new government discount programs, support has been drastically reduced.
The Problems
High energy costs will make it uneconomical for some companies to operate. This year, energy debt defaults are expected to go up to a record, which is a worrying sign for the UK economy. Additionally, contracts at high fixed prices feel unfair, given how quickly energy costs have subsequently fallen.
However, companies like EDF, Eon, and Drax cannot merely undo a contract and sign another. They are typically hedging fixed-price contracts, buying power on the forward market at a high price and securing a margin. Centrica’s EBIT in non-domestic electricity supply in 2022 was just 1.7% of revenue, and non-domestic supply has been earning below utilities’ cost of capital.
Renegotiation and Alternative Solutions
Renegotiation is necessary, and the FSB has proposed a “blend and extend” program. This idea suggests that companies extend contracts from 12 months to 24 months and pay an average fee, with British Gas and EDF offering a version of this alternative. It would help to average down to a considerable extent, and the forward price curves for the year from April 2024 are currently around £110/MWh. Based on these calculations, the average wholesale cost for a two-year contract would drop from around £600/MWh to £360/MWh.
However, providers would charge for postponing some revenue and assume longer-term credit risk for customers. While these solutions may ease the pain, the burden on smaller businesses in the UK remains significant, and more government support may be requested before this crisis passes. Ideas range from direct subsidies to credit risk insurance, allowing providers to offer longer-term contracts at cheaper rates.
The Solutions
The UK should think about reducing wholesale energy costs as a priority. A review of how the electricity market operates was welcomed last year and would be a good start. Additionally, reducing energy consumption should also be part of the answer. The current sky-high prices undoubtedly encourage users to think about reduced energy consumption and adopt new processes to achieve this.
One other solution would be for the UK to encourage the adoption of renewable energy. While the transition is expensive, companies can save money in the long run as renewable energy technologies reduce operational costs and lead to a more sustainable future.
The Summary
Smaller UK companies that renegotiated their energy contracts at the market’s peak last year are now stuck with unaffordable bills, which makes power unaffordable for some and is likely to hit the struggling retail and hospitality sectors the hardest.
The government’s support has dwindled, leading to energy debt defaults in 2021, which is a worrying sign for the UK economy.
Renegotiating energy contracts is necessary, but providers face multiple constraints to accomplishing it.
The UK should focus on reducing wholesale energy costs, reducing energy consumption, and encouraging the adoption of renewable energy as potential solutions to the crisis.
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UK businesses are in the middle of a slow motion car crash. Expensive new power supply contracts are coming into force, just as government support has dwindled. This makes power unaffordable for some smaller companies and is likely to hit the struggling retail and hospitality sectors the hardest.
Of course, all of this was terribly predictable. The commercial and industrial sectors collectively consume around two-thirds of the UK’s approximately 300 TWh of electricity demand. Smaller companies generally have fixed-price contracts, many of which renew in October or April. These reflect expectations for future energy costs when the contract is renegotiated, as well as a plethora of policy and grid-related levies.
Several smaller businesses: The Federation of Small Businesses estimates 13 percent of them, or 90,000 companies — renegotiated their contracts when the market was at its peak last year. Now they are stuck with unaffordable bills.
As a worst-case example, a company renegotiating an electricity contract from April 2023 to March 2024 at the market peak in August of last year would have been looking forward electricity prices above £600/MWh, according to Cornwall Insights, a consultancy. Adding grid and other charges would bring the bill to almost £700/MWh.
In this scenario, a small business consuming 20MWh of electricity per year would be hit with a bill of £14,000. In 2019, it would have been more like £2,600.
At the same time, under the new government discount program, support has been drastically reduced.
Companies are, unsurprisingly, very unhappy. High energy costs will make it uneconomical for some to operate. In fact, energy debt defaults this year are supposedly on the way to a record. That is a worrying sign for the UK economy. Ofgem, the regulator, has launched an investigation into misbehavior in non-domestic power supply.
Contracts at high fixed prices also feel unfair, given how quickly energy costs have subsequently fallen. By March, expectations for future electricity prices had fallen nearly 70 percent.
That helps explain call vendors to lend a helping hand. However, companies like EDF, Eon and Drax cannot easily undo one contract and sign another. They typically hedge fixed-price contracts, buying power, in this case at a high price, on the forward market and securing a margin.
Historically these have been very thin. Centrica’s EBIT in non-domestic electricity supply in 2022 was 1.7% of revenue. “Non-domestic supply has been very difficult for utilities,” said Mark Freshney of Credit Suisse, “who have been earning returns below their cost of capital.”
There are signs that energy companies may be tired of this suboptimal state of affairs. Eon is reportedly looking to sell the trading arm of its Npower subsidiary. Centrica and Scottish Power have been reducing their presence in the market. Leaning on providers to go to more trouble could encourage more of this kind of action.
There should be some room for mutually beneficial renegotiation. The FSB has proposed a “blend and extend” program. The basic idea is that companies extend contracts from 12 months to, say, 24 months and pay an average fee. British Gas and EDF are offering a version of this.
Averaging down would help, up to a point. The forward price curves for the year from April 2024 are currently around £110/MWh. Based on this calculation, the average wholesale cost for a two-year contract would drop from about £600/MWh to £360/MWh. However, providers would likely charge for postponing some revenue and assuming longer-term credit risk for customers.
But while mixing and spreading would ease the pain, the burden on smaller businesses remains significant. More government support is likely to be requested before this crisis passes. Ideas range from direct subsidies to credit risk insurance, which would allow providers to offer longer-term contracts at cheaper prices.
In the meantime, the UK would do well to think about how to solve this problem structurally. Reducing wholesale energy costs must be a priority. A review of how the electricity market operates, lscored last year is a welcome step. Reducing energy consumption should also be part of the answer. The current sky-high prices certainly encourage users to think about that.
https://www.ft.com/content/231fd967-f3b2-4bc9-b856-4670fa6a4380
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