Why are UK energy prices rising? - Economics Observatory

Gas and electricity are becoming more expensive, largely because of rising import costs. The recent increase in the price cap set by Ofgem, the UK’s energy market regulator, saw bills go up for millions of households across the country.

In April, gas and electricity bills rose sharply for most households in the UK. The main reason is that the cost of importing gas has gone up. But how are household energy bills determined – and why are we seeing such a large increase in them? This article sets out some of the key issues.

How are UK energy prices determined?

The price that we pay for electricity has to cover a range of costs. These include the costs of buying gas and electricity in wholesale markets, getting it to customers through pipes and wires, and a range of government policies that seek to help vulnerable consumers and to reduce carbon emissions.

Prices in the wholesale spot market are for next-day delivery and depend on what is happening now: as a result, they can be very volatile and affected by world events, such as the war in Ukraine. Companies can also buy in a forward market, whereby they are able to lock in prices for future delivery, months or even years ahead.

Most households are covered by price caps set by Ofgem, the industry’s regulator (explained in more detail below). But these caps rose sharply in April. For individual households, the size of their bills and the amount by which these rose depends on how much energy is consumed.

The increase in the price cap means that a household buying the ‘typical’ amount is seeing its bills rise by 54% from £1,277 a year to £1,971. Pre-payment bills are going up by £708, from £1,309 to £2,017 (Ofgem, 2022).

How does Ofgem’s price cap work?

The price cap for consumers on pre-payment meter energy tariffs was introduced in April 2017, followed by the cap on default energy tariffs (including standard variable tariffs) in January 2019. Collectively, these cover around 15 million energy consumers (Ofgem, 2020). The regulator announces the maximum amount that companies can charge in each six-month period, a couple of months before it starts.

While to date, these caps have limited costs for consumers, overall energy costs have gone up. When setting the price caps, the regulator has to predict energy suppliers’ costs, including those of buying energy over the last four months for delivery over the next 12 months.

These forward market prices essentially doubled between the summer months of 2021 used to set the price cap from October 2021 and the recent period used to set April’s new prices. The annual wholesale cost for an average household rose from £528 to £1,077.

Figure 1: Price cap components

Source: Ofgem, 2022

The cost of delivering energy has also gone up. Some gas is burned in compressors, electricity is lost as heat as it travels along the wires and there are balancing costs as power stations adjust output to keep the system stable. All these costs are linked to the price of gas.

In the autumn of 2021, many energy retailers were caught unprepared by these rising costs. Instead of buying energy in advance, they were relying on the short-term spot markets and had to pay much more than Ofgem assumed when it was setting the price cap.

More than 20 companies, with over four million customers, went bust as they did not have enough funds to cover the losses from selling energy for less than it had cost them to buy. (A company that had bought in advance from February to July 2021, the period used by Ofgem to set October’s price cap, would have been able to recover those costs.)

The failing companies included the crowd-funded People’s Energy with 350,000 customers, Pure Planet with 235,000 and Together Energy, part-owned by Warrington Council, with 176,000. Bulb, with 1.7 million customers, also needed a rescue but continued to trade under a special scheme.

The affected customers (including this author) were protected, usually when a stronger company took over their supplies. But someone has to pick up the cost of these loss-making contracts. This has been averaged over everyone covered by the price cap, and has added £68 to the April cap.

Why have wholesale prices risen?

The main driver for rising wholesale prices is the increasing cost of gas.

The UK has been a net importer of gas since 2004, and prices tend to be similar at each end of the pipelines between Bacton in Norfolk, Belgium and the Netherlands. Gas prices have been rising sharply since the middle of 2021, for several reasons.

Figure 2 shows that the European Union (EU) and Norway produced two-fifths of the gas they needed in 2019. They imported a similar amount from Russia and most of the rest came in the form of liquefied natural gas (LNG).

LNG is super-cooled and transported in large ships and as these ships can move around the world, prices in different importing regions tend to converge. Gas demand in Asia has grown faster than the supply of LNG, and lower European imports have helped to balance the market (Fulwood et al, 2022).

Figure 2: Gas supplies to the UK and EU

EU Gas Sources, 2020

UK Gas Sources, 2020

Source: BP World Energy Statistics and Digest of UK Energy Statistics

This was possible because EU gas storage was very full at the start of the winter of 2020-21, and so more gas than normal could be withdrawn over the colder months. It is normal to refill storage during the summer when gas demand is lower, but less gas than usual went into storage in the summer of 2021.

European demand was lower than in the same period in 2019 (2020 is not a good comparator year as the pandemic made energy demand very unusual), but so was local production, and by more, as Europe’s gas fields were gradually depleted.

Imports from Russia were also lower. The main supplier, Gazprom, was meeting its long-term contracts but usually sold large amounts in the short-term markets as well. By the autumn of 2021, it was becoming clear that European gas storage was much lower than normal levels for the time of year. Consequently, prices rose as companies tried to get hold of enough gas for the coming winter.

Were Gazprom’s reduced exports due to technical problems restricting its ability to supply? Was it ‘simple’ anti-competitive behaviour by a large firm attempting to push prices up, accepting fewer sales in the hope of much higher margins on the remainder? Or was it an attempt to pressure the German government into speeding up the final approvals for the Nordstream 2 gas pipeline, which runs directly from Russia to Germany?

The reasons are unclear. In any case, with less gas available, less could be put into storage, particularly by Gazprom (which owns several storage facilities within the EU).

Exports through Nordstream 2 would replace those that have gone through Ukraine, weakening that country, but the German government blocked its approval on 23 February, following Russia’s recognition of two breakaway provinces and subsequent invasion.

The other panel of Figure 2 shows that the UK produces just over the half of the gas we consume.

Imports from Norway represent a third of consumption, but the UK exports about a third of this amount (not necessarily the same molecules) to Ireland and the continent. About a fifth of our gas consumption arrives as LNG, including about 5% of consumption from Russia.

Those imports could very likely be replaced with cargoes from other countries, so the UK’s physical security of supply is hardly at risk, but we would have to pay whatever the market price turned out to be. Several EU countries are in a much more vulnerable position: they don’t have the import facilities to replace Russian supplies, and other gas exporters don’t have enough spare capacity in any case.

Figure 3: Gas spot prices

Source: Ofgem and Statistics Netherlands

The impact of this on prices can be seen in Figure 3, with a dramatic increase over the last few months.

There is a direct impact on gas bills, of course, and the rise also feeds into electricity prices because of the way that market works. The demand for electricity varies over the day, and between summer and winter. Generation has to match this demand from second to second, with a little help from electricity storage in batteries and pumped storage hydro stations.

In each half-hour, the owners of the most expensive stations needed to meet demand will want a price that is at least high enough to cover their costs of doing so. The owners of stations with lower operating costs won’t want to settle for much less.

Most markets are like this – sellers aim to receive the most that buyers are willing to pay, even if their costs are well below this level. The price in forward markets is based on what participants expect the spot prices to be at the time the power has to be delivered.

Figure 4: Day-ahead energy prices

Source: Ofgem

Figure 4 shows that the short-term (day-ahead) gas and electricity prices do tend to move closely together. The scales are chosen to align the cost of the amount of gas that a typical power station needs to burn to generate a unit of electricity with the price received for it.

The gap between the two lines represents the cost of carbon permits – which has been gradually rising over the period – and the generators’ margin to cover their other costs.

What about the generators that don’t burn gas?

In 2021, Great Britain got 37% of its electricity from gas-fired stations, and 42% from low-carbon hydro, solar, wind and nuclear stations. An additional 7% came from burning biomass (mostly wood pellets), just 2% from coal and the rest was imported.

Nuclear stations have low variable costs, but they sell at the normal market prices, giving their owner (EDF) a windfall when they are high. A previous owner, British Energy, nearly went bankrupt in 2003 when electricity wholesale prices were low.

The older wind farms also sell at market prices and receive a subsidy as retailers have to buy ‘renewable obligation certificates’ from them as well. Renewable generators are given these certificates in proportion to their output and sell them to retailers, which have to show that a proportion of the electricity they sell comes from renewable generators.

But the newest wind farms are supported through ‘contracts for differences’, which effectively set a fixed price. Low wholesale prices are topped up, but the generators give money back when market prices are high. In the last three months of 2021, this saved electricity consumers £133 million compared with the price of buying gas-fired power.

Would fracking have helped?

Energy markets in the United States have been dramatically changed by the rise of fracking – a process that involves drilling a well horizontally (so that it passes through a lot of gas- or oil-bearing rock) and injecting high-pressure water to fracture that rock so that the gas and oil can escape.

By 2015, US gas production was 50% higher than ten years earlier, while the price had fallen by two-thirds. It has risen with the energy crisis but is still less than a quarter of levels in the UK.

Cuadrilla tried to frack wells in Lancashire, but in 2019 the government banned further attempts because of (small) earthquakes. Could restarting the process have the dramatic effects seen in the United States?

Unfortunately, it would take a long time to expand production, if it proves feasible at all. The UK’s geology is different from that in the US shale areas, in ways that make it harder to extract the gas. And the impact of extra supplies on UK gas prices won’t be like that seen in the United States, because North America is an island – in gas terms – and the UK isn’t.

The United States didn’t have the facilities to export natural gas, so their prices had to fall until it was cheap enough to burn in power stations instead of coal. This would have been a good thing for the climate, except that the United States then exported the coal.

The UK, on the other hand, is well connected to the European market. We need gas to come in from the continent during winter, which means that our wholesale prices are normally very similar to those in Belgium and beyond.

To have a significant effect on prices across all of Europe would take much more gas than the UK is likely to be able to produce. The best thing we can do in the short term is to insulate our homes more effectively and to service our boilers to make them run as efficiently as possible.