Energy networks owe consumers £7.5 billion. Now they need to give it back

In July, we published an investigation into the profits being made by Britain’s energy networks, the companies that own and maintain our national energy infrastructure.

It turns out the networks are making massive excess profits, far above what’s required to keep the lights on. This adds up to £7.5 billion over the current eight year price settlement and it’s nothing less than a windfall, reflecting an accidental generosity in the rules that determine the prices these firms can charge.

We’ve now met with all 11 networks to share our findings and to ask them to give this excess profit back to consumers. Unsurprisingly, they don’t agree with every point of our analysis — -and they didn’t sign cheques right away. But most recognise that an average 10% return, for low-risk businesses, is not sustainable, legitimate or acceptable. Nor is such unfairness in the long-term interests of their shareholders.

Now, they’re starting to act.

On Wednesday, Scottish and Southern Electricity Networks (SSEN) did the right thing, returning £65.1m of excess profit to customers. There’s also a case for saying National Grid, in more complex ways, have begun to return some of their share too.

Aside from anything else, this shows why a strong consumer voice matters. On its own, SSEN’s payback is over 15 times the annual budget for our work representing energy consumers, of which this research was only a fraction.

Still, 1 out of 11, or even 2, is not enough. Other networks must follow suit.

To see why that’s the only acceptable outcome, you have to appreciate just how unearned, and unnecessary, this windfall was. And to do that you have to understand something about price settlements themselves.

Because it doesn’t make sense to have more than one set of gas pipes and electricity wires, energy networks are run as regulated monopolies. This means one company runs each part of the network, so there are no competitors to drive down the price. And that means the prices energy networks charge are set by the regulator Ofgem, rather than the market, to stop these monopolies from exploiting their position.

You can imagine how complex these agreements become. Price settlements are fiendishly technical debates in which there’s no right answer, and so they play out as a negotiation. The regulator does its level best, under fierce heat from a well-funded industry, to balance the interests of consumers against those of industry, weighing up the relative need for profit to incentivise investment, versus the need to keep bills down for consumers.

If you want to read about the specifics of these agreements, I’d recommend this blog from my colleague Morgan Wild. The headline is that the recent energy price settlement hit consumers in three main ways:

• Energy networks argued that their businesses were about as risky as the average business, and therefore that their cost of equity would be moderately high over the price settlement period. It turns out they’re not and it’s not. They are low risk businesses with a low cost of equity. This mistake led to the networks earning £3bn of excess profit.
• The regulator assumed (not unreasonably) that returns on government bonds (a key factor in the cost of equity) would recover, to be moderately high over the full period. In fact, they’ve stayed unprecedentedly low. And, while Ofgem tried to match debt costs to real market conditions, the index they used was too broad. This cost consumers £3.4bn.
• Energy networks secured over-generous rewards for making their businesses more efficient. This results in an additional £1.1bn profit over and above what was intended.

That adds up to £7.5bn more than anticipated. And remember that’s just the excess; our best guess is that investors and creditors will make somewhere around £25bn in total over the current settlement (although that figure is surprisingly hard to estimate).

There are three things worth saying about these outcomes.

One, the sums involved are enormous. Keep £7.5 billion in your head in the run up to this year’s Budget. It will be more than the cost of almost all the changes to tax or welfare that feature in public debate.

Two, these mistakes are highly regressive. Because energy consumption is very flat by income, higher bills hit poorer people hardest as a proportion of their income. (Cutting energy bills, by contrast, is therefore highly progressive; it’s much better targeted at low income household than, for example, any tax cut.)

Three, the problem here is not so much that the numbers turned out to be wrong. Any process that involves forecasting the future will be wrong, not least if you run that process in the deep economic uncertainty of 2012 to 2013.

The problem is that the errors were so large and that they went (as they always do) so systematically in favour of industry over consumers. That’s an outcome both sides of the political aisle should care about: free marketeers who want competitive and efficient markets and big statists who oppose the idea of profits in an essential service like energy.

So the remaining networks must now write those cheques. But wider lessons must also be learned.

First, the next price settlement must be far tougher than the last one, as the regulator Ofgem has indicated it will be. And similar lessons must be learned for price settlements in other markets: look across water, telecoms, and transport, and there’s a clear pattern of errors always favouring high profits over low bills. Tackling this rent-seeking behaviour is vital to consumers and the wider economy.

Second, these processes must be made more transparent.

In most other areas of policy, £7.5 billion couldn’t go so unnoticed. Imagine a stealth tax or a hit to benefits of that size. The annual theatre of Budget day, or party conferences, would roll around, and the spotlights would come on. An industry of think tanks, from the IFS to the Resolution Foundation, would then pore over the detail, and op-ed pages would come alive.

In regulatory policy, there is no theatre — and there are good reasons for that. Economic regulation, and particularly price settlements, requires long-termism, not buffeted by daily political debate.

But long-termism shouldn’t need to mean a lack of transparency. It took us months to get to the bottom of these figures and translate them to the consumers who foot the bill. In future, these outcomes must be made clearer for outsiders to see.

Third, the process must be fairer too. In energy, for example, industry currently has the power to ask the regulator to reopen the price settlement if they’re in financial difficulty as a result of low returns. But if consumers are in financial difficulty, struggling while industry makes hugely excessive returns, pushing bills up, they can’t do the same. A sensible mechanism should let consumers trigger a review when returns far exceed expectations.

Of course, these changes won’t make the negotiation perfectly balanced; as a consumer advocate, we’ll always be the non-league club, facing the top flight resources of industry. But at least we won’t be playing uphill.

For today, though, what matters is that consumers get their money back. Other energy networks must follow SSEN’s lead. And, if they don’t, the regulator should step in to force their hand.