Attacks on the Big Six over gas prices miss a key point

Gas prices: are we being scammed? Calum Moy, CC BY-SA

Following intense pressure from consumer groups, politicians and the media, the UK’s Big Six power companies have all announced price reductions on some of their gas tariffs.

Cuts ranged from Npower’s 5.1% to EDF’s 1.3%, while independent suppliers such as Ovo and Good Energy followed suit with their own reductions (10.4% and 3.2% respectively). Apart from E.ON, whose cut came into effect last month, the rest of those from the Big Six are still to come, starting with EDF on February 11 and ending with SSE on April 30.

Much has been made of the apparent disconnect between these reductions and the much larger falls in wholesale gas prices over the past year or so (this is the first time the Big Six have reduced tariffs since the wholesale rates began to fall). With comparisons made to the sharp fall in petrol as a result of the sliding crude oil price, people have questioned whether utilities are fully passing on the fall in wholesale gas costs – not least consumer group Which?, which has claimed that customers are being overcharged by £145 a year.

Why prices are falling

So what has been happening? Prices at the UK’s wholesale gas market have largely dropped on a combination of oversupply and weakening demand. Temperatures in the 2013-14 winter in the UK and Europe were above average, which reduced domestic heating demand. Moving into the summer 2014 period, this led to storage inventories being higher than in previous years. Where normally the gas companies would replenish their inventories over the summer period, they needed less in 2014 so demand for wholesale gas was lower than usual.

The changing gas price

Prices in pence per therm. Energy Brokers

And, so far, the 2014-15 winter has been relatively mild (albeit temperatures in January were at least seasonally typical). This has again lowered domestic heating demand and is likely to lead to another abundance of gas being left over in storage entering the summer season. Gas supplies have also been high due to increased arrivals of LNG cargoes late in 2014, caused by softer gas demand and an abundance of supplies in the Asia-Pacific and Latin American regions.

A more long-term drag on gas demand has been the growth in green energy, since gas-fired electric power has, to some extent, been substituted by renewable electricity – particularly from wind turbines. It is now the case in the UK that gas has predominantly become the power-generation source to which electricity providers turn during periods when the wind is not blowing.

Coal is not substituted in the same way because Europe has been flooded with cheap coal since the mid-2000s, mainly from the US where it was unwanted because power generation companies could produce electricity more cheaply using shale gas. (This means, rather ironically, that increased renewable-energy generation displaces gas-fired generation from the grid, rather than the more polluting coal.)

Household gas and electricity demand has also been reduced because of increased energy efficiency in homes due to better insulation and more energy-efficient appliances. The falling oil price has had an effect on wholesale prices as well, since many utilities buy gas on long-term contracts with a built-in price mechanism that is linked to the price of oil.

On top of all this oversupply and weak demand, the fact that the euro was weakening against the pound during 2014 lowered costs for contracts further ahead as it reduced the cost of future gas imports from Europe.

In short, we shouldn’t expect wholesale gas prices to start rising soon, even if the factors related to the two mild winters are only temporary and will not keep dragging down demand forever.

The hard numbers

The net result has been that wholesale gas prices in January were around 27% lower than this time in 2014 and 40% lower than last summer. The contract for delivery of gas in winter 2015-16 is around 30% lower than a year ago.

Looked at over a shorter time period, prices are still falling. Last week Ofgem published its rolling monthly forward-looking statement on cost trends and bills for customers. Because of the recent tariff changes, an average dual fuel bill was expected to fall to £1,305 for the year from a forecast of £1,326 in November.

Wholesale costs were expected to be £574 for the year, 44% of the total. Due to the continued fall in wholesale prices, this was £13 lower than the previous estimate made in November (which was also 44% of the total). It is not easy to make direct comparisons with much further back, but the proportion of bills comprised of wholesale costs is certainly falling, from 59% in 2009, 53% in 2010, 51% in 2011 and 50% in 2012.

It is also worth pointing out that the tariff reductions are occurring as winter ends, meaning that consumers typically use less gas. This is likely to mean that the power retailers will be less financially exposed to their cuts.

Old gas

But there is an important argument in mitigation of the Big Six that is often overlooked, however: much of the gas that is being delivered to customers now was purchased on wholesale markets much earlier in 2014 – or indeed in previous years, since gas is sometimes traded as much as three or four years ahead. When these purchases took place, prices were higher. This means that the gas being supplied to customers now was not bought at the current wholesale prices being quoted.

So the test of how much the utilities are really passing on falling wholesale costs will be further ahead into 2015 and next year when they begin to take greater delivery of gas that has been purchased at the current lower prices. Until then, despite all the noise in the press, the jury will have to remain out.