Power giants under fire

Energy firms face a consumer revolt and a £9bn tax bill. Danny Fortson reports

For Britain's energy suppliers, this could yet prove to be their winter of discontent. As they "regrettably" push through major price hikes to send the average annual dual-fuel bill back up above £1,000, Ofgem, the Government's energy regulator, has resurrected the idea of a multi-billion-pound windfall tax on the industry. Awash in profits, gas and electricity suppliers are also being forced to fend off allegations that they collude on pricing, and are combating charges that they contribute "meagre" amounts to their oft-trumpeted efforts to give discounts to the country's poor.

The public vitriol directed against the companies that keep the lights on and houses warm has reached boiling point. But do they deserve to be so vilified? Are our rising gas and electricity bills really a case of greedy power company executives rubbing their hands with glee at their billions in profits, extracted at the expense of their lowly customers?

There is no simple answer. It is true that the wholesale prices of gas and coal, the fuels used to fire three-quarters of the plants that produce the nation's energy, have both more than doubled in the past year. The price of carbon has also increased several-fold and other initiatives to reduce emissions have added significantly to bills. These were among the main reasons trooped out by nPower and EDF Energy for becoming the first two companies to raise their rates this month. The rest—Centrica, Scottish & Southern, ScottishPower, E.On—are expected to follow their lead very soon.

Yet the price rises are hardly a case of magnanimous corporations begrudgingly pushing through rises as a last resort—the UK's big six power companies are doing very well indeed.

Through the first nine months of 2007, mild weather meant that demand for gas in the winter and electricity in the summer was much lower than traditional levels. Air conditioners lay dormant, radiators were switched off. Yet British Gas, the owner of Centrica, Britain's biggest power supplier, managed to nearly double its profits through the first half of the year, from £692m to £1.2bn, despite a drop in turnover.

It is not alone. Indeed, for the sprawling foreign giants operating here, such as Germany's E.On and RWE, the owner of nPower, their British businesses are their star performers.

E.On said that despite a 10bn kilowatt/hour drop in UK power consumption through the first nine months of the year, its profits here increased by a very healthy 38 per cent over the same period a year before to €989m (£761m). nPower, meanwhile, generated a 35 per cent jump in profits for parent RWE to €635m through September this year, because of "tariff increases" and the addition of new customers. This is despite a raft of price decreases – which came, it must be said, after even bigger increases the year before – over the past year across the industry as the wholesale gas price plummeted.

So how is it that they can reduce prices but drastically increase profits? Allan Asher, head of the watchdog energywatch, said the vertical integration of power companies, in which groups produce much of the electricity and gas that they then supply to retail customers, is to blame. Before liberalisation, generators and suppliers were separate, and there were more of them. But a rash of mergers and acquisitions since then has left the country with six suppliers, down from 20 a decade ago, who, to varying degrees, have secured their own generation assets as well.

The effect is that they have essentially bought themselves a hedge against one market going sideways. If the wholesale electricity business slumps, for example, a supplier can compensate by increasing customer bills, or make up lost earnings from retail tariff cuts by increasing its generating activity.

The effect is clear. According to energywatch, the average dual fuel price in 2003 was £572. Today it is £937, an increase of just over 60 per cent. Yet rather than having to swallow hard as well, power companies have in fact done the opposite – according to the annual accounts of the big six suppliers, the industry as a whole has actually increased operating profits every year during that period amid stagnant demand.

It is understandable then that Ofgem's pronouncement this week that "Britain's competitive energy market is working" inspired guffaws of disbelief from some quarters. The regulator pointed out a range of factors to explain why prices are rising. Principle among them is the price of gas, which has been driven upward by the UK's exposure to the uncompetitive European market. Suppliers from the Continent buy UK gas that is cheaper than Europe's oil-indexed gas while hording their own supplies, thus simultaneously crimping supply and bidding up prices. In some cases, they buy gas in the UK, store it away, and then resell it here at a higher price later.

Ofgem also said the costs of meeting the Government's ambitious emission reduction targets were responsible. According to the regulator, costs from carbon credits that power companies are forced to buy to meet their pollution caps translates to a £31 per year addition to the average bill. A government initiative to force suppliers to install more efficient appliances in customers' homes and foment greater efficiency adds another £38, while requirements for more renewable power sources tacks on another £20. Increases in transport tariffs to pay for system upgrades will add another £3 to customer bills.

However, the headline grabber was unleashed by the Ofgem boss, Alistair Buchanan, when he said that because carbon emission permits are given away free, and that the cost of those permits is already factored into our higher energy prices, it equates to a whopping £9bn windfall for electricity producers between now and 2012, when the current phase of the Emissions Trading Scheme (ETS) ends. He suggested that the Treasury should claw some of that back through a windfall tax on the energy industry.

The Association of Electricity Producers, the industry lobby group, not surprisingly, cried foul. From the first of the year, the second phase of the EU's ETS came into effect, putting into place emissions targets that are below what the UK now produces. In other words, power generators may be given some permits for free, but they will be forced to buy others on the market – currently trading at about €23 (£17.70) per tonne – to get back under their allowed emission caps.

They also argue that of the 7 per cent of carbon permits that the Government has decided to auction, an inordinate proportion are devoted to the power generators. So in reality, they must buy about 30 per cent of their required permits, all the while reducing their emissions – which is a different picture than the totally free pass described by Mr Osborne.

It is clear that if climate change objectives are to be met, energy prices will only go in one direction. The question is how much of the pain should be borne by customers, and how much by industry. Mr Asher said much of the fault lies at Mr Osborne's door as head of a supine regulator that should force energy suppliers to disclose the reasons, broken down factor by factor, for their price increases, beyond vague references to market forces.

Few think a windfall tax will actually happen, but as the rest of the Big Six pass the pain to customers, they will find themselves in the spotlight, even if it costs more to shine it.