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Raise income tax to tackle escalating energy prices

10% price rises are becoming the new normal. Rui Vieira/PA

Energy prices seem seldom out of the news. Politicians show their frustration with the energy market in proposing various solutions.

This week Tory grandee and former prime minister John Major has called for a tax on energy companies. Last month at the Labour Party conference Ed Milliband proposed a 20 month price freeze. And last year, David Cameron had his own stab at “solving” the energy market, proposing that each company should be restricted to a single tariff in order to facilitate choosing between competing firms.

It is easy to sympathise with these attempts to tackle an issue of considerable and understandable concern to voters. But they rely on limited understanding of the domestic energy market. Consumers are not switching their supplier much, partly because it is boring and (to some extent) difficult; they would prefer “the market” to solve the problem by assuring them they are not being ripped off with expensive tariffs.

But the market is not very competitive, and proposals to limit companies’ range of action are likely to have the incidental impact of rendering it even less so. It’s not the only market in which consumers get poor deals - the savings industry is another. But consumers spend a significant proportion of their budget on energy, and price hikes of up to 10% have become almost routine, blowing a hole in many consumers’ budgets. This is not a market where prices can be frozen for long without real consequences.

Have costs increased?

Companies, predictably, say that costs have increased, or are due to increase. Actually, it’s remarkably difficult either to demonstrate or disprove this claim, so far as input costs are concerned, for two reasons. One is that the companies buy a portfolio of future contracts in order to ensure that the wholesale supplies they will have are enough to meet future demand. So the only way to keep a rough track on this is to assume a particular portfolio structure over time and plot the difference between this and retail prices, as Ofgem does.

But there is a second feature. The wholesale market is by no means transparent because all six major electricity suppliers are also major generators, selling to themselves. So to keep track it’s necessary to examine profitability across both stages. This lack of transparency is what creates significant difficulties for potential new players on the supply side, in principle a rather competitive business. So it’s difficult to assess whether the companies are “too” profitable overall.

Follow the money

What we can say, roughly, is where the money has gone, after the event. One thing the big six have been obliged to do by Ofgem for the past couple of years is publish accounts with some separation of costs. The most interesting of these (because the most potentially opaque) are the accounts for domestic electricity retailing; those for 2012 are the most recent available.

They show that all the companies spent roughly half the revenue they got from domestic electricity consumers on their fuel costs. They then spend around 20% on distribution and transmission costs - these are regulated elements of cost. The bit that is least clear is their “supply costs” - the costs of running their retail operations - because these contain a variety of items including marketing costs and a profit margin. In total, though, these are perhaps 10% of the revenues.

The companies also claim they need to invest in new generation facilities, so need some headroom in prices. There is some truth in this, because our old and dirty power stations are coming towards a forced end to their life. There is truth also in their claim that increasing amounts are being added to the bill by imposed environmental measures, themselves proposed by the government. These include the money they are forced to spend to try to make our homes better insulated, plus the money they in effect pay out to subsidise solar and wind generation. Emissions and environmental costs added 11% to the typical bill in 2012, and the bad news for consumers is that this element is set to rise over time.

A breakdown of a typical household energy bill. Ofgem: Household energy bills explained/Factsheet 98/Feb 2013

Supply gap

So one government aim, concerned as we must be with the potential impact of global warming and the influence of fossil fuels, is pushing policies that raise energy prices to consumers. But voters have a short-term interest in seeing low prices, and an increasing proportion find themselves in fuel poverty. It really is an intractable issue, made worse by the increasingly wide gap between rich and poor in this country. It is not going to improve.

Governments have dithered about how to meet the inevitable supply gap created by decommissioning old coal and nuclear power stations, and in this sense the recent agreement over the Hinkley Point C nuclear power station is welcome news. But the power it will supply is going to be very expensive; around double current wholesale prices.

With this deal, plus governmental subsidies for wind and solar power, we are moving away from a market for wholesale power towards a managed system. It is also an inherently less reliable system - wind and solar power is not flexible - so needs backup from gas power stations and other more rapid response facilities, which requires investment. So long-term power needs will be assured only at high prices.

An unpopular solution

Moves to open up the wholesale market, although not headline grabbing, are the best way to inject more competition into the retail market. But because the retail profit margins are modest, there is limited headroom for lower prices from this source; a 5% fall would be at the optimistic end of the spectrum, and of course the other pressures discussed above are all in the other direction, and are larger. So increased competition at the retail level is unlikely to increase downward pressure on wholesale prices much.

In sum, my view is that the energy market is an area which exposes the increased income inequality that Britain has experienced for some years now. There are very many people in the UK who find it difficult or impossible even now to afford their energy bills and unfortunately I think this will only increase, given the price pressures.

Therefore, in my opinion, an even more difficult political decision needs to be made - deliberately reduce inequality and even out the income distribution by raising income tax and increasing transfers to the poor, in order to make the higher energy costs more affordable for all. Subsidies for energy would be a short-term fix, not a long-term solution.

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