by Dr. Mark Powell, Head of Utilities, AT Kearney
The UK has experienced some of the lowest cost energy in Europe over the past twenty years or so. Part of the reason for this has been the success of privatization and liberalisation which has driven significant efficiencies in the sector in comparison to the era of state ownership. This reality has largely been ignored in more recent times as we have increasingly felt the pain of rising costs. This has placed energy affordability as the centre of the Energy debate. Everyone us now ganging up to blame everyone else for these rises. Labour blame the energy companies despite the fact that there is increasing evidence that energy policy and the drive to hit aggressive carbon and renewables targets is also a key reason for costs rising. Whatever view you hold, one thing is clear, energy affordability is now front and centre as a key issue and is not going to go away and will become a key factor in the future direction the industry takes.
The problem with the debate is that terms like “affordability” and “fuel poverty” are being thrown about without a proper consideration of the facts and figures which surround them. We thought it was about time we had a proper look at the issue in order to shed some light on this important debate.
From 1978 to 2012, domestic energy prices in the UK have grown by an average of 5% per year for electricity and 6% per year for gas. These hardly seem excessive although have outstripped the retail price index. Furthermore, when you compare them to the average gas and electricity prices for Europe as a whole they have been between 20 and 40% lower than the average. This leads to the first reality of affordability in the UK – we actually pay less for our energy than our European neighbours, the problem is that we consumer more on average than they do so our total bills are, on average, increasingly higher. The problem, it would seem, is not so much prices as consumption. We have some of the least efficient housing stock in Europe and, one supposes that our weather does not exactly help either.
We next have to also consider the real income affects as well. Since the financial crisis households have experienced a decline in real incomes. This has led to an increase in the proportion of household income spent on energy. This has risen from an average of 2.8% in 2005/06 to 4.2% in 2011/12. This however hides the more important fact which is that this has affected the lower third of households by a much greater degree with the proportion of their income spent on energy rising from 6.4% to 8.8% in comparison with the top third only experiencing a 1% increase from 1.5% to 2.5%. The reduction in real incomes has not been experienced evenly across groups such that affordability is much worse at the bottom and this is partly due to real income affects.
It is however the case that energy prices have outstripped most other general costs faced by households. From 2001 to 2012 the CAGR for RPI was 3.1% while retail gas prices went up by 9.5% and retail electricity by 6.5%. Interestingly however, despite the ongoing debate about the link between wholesale gas and retail gas and power prices, on average for this period wholesale gas prices increased by 7.2% and so are not that out of step with retail prices across time as many would like to believe. This does support the view that retail prices do largely follow wholesale movements and challenge the automatic assertion that the power companies do not align retail and wholesale prices over time.
Let’s move away from prices for a moment, as I said earlier, prices are one thing, but affordability is also about consumption. What becomes clear is that affordability would actually be significantly worse had we not experienced a noticeable decline in average electricity and gas consumption which has declined by 2% per year from 2004 to 2014. If this trend continues then average consumption in 2024 would be 27% less per household. This starts to demonstrate that consumption reduction will have a greater impact than prices movements over time.
What do we think the picture will be like over the next ten years? Our analysis shows that when price and consumption patterns are taken into account, an average household duel fuel bill will increase from £1,324 in 2013 to £2,012 by 2024. This is an increase of £680 per household and a rise of 51% over the next ten years. At an average CAGR of 3.9% this is almost certain to outstrip RPI and lead to affordability becoming worse.
Modelled average residential dual fuel bill – A.T. Kearney base case, 2010-2024 (£/year, Nominal £)
The question is while gas prices have clearly had a large effect on costs in the past few years, what will be driving these increases in the next ten years? If you break down the bill, what becomes clear is that the single biggest factor driving these costs will be energy policy both at a UK and European level. EU policy costs will drive a CAGR in bills of 7.9% and UK only policy a staggering 16.2%. This is against wholesale costs which will remain largely static. If you include all elements of the bill including retail costs and profits and network costs, only 18% of the bill is actually within the control of the individual energy companies.
The projections on bills have assumed that we continue to enjoy the effect of ongoing consumption reductions. What happens if you are unable to enjoy these reductions? Many household suffer from much poorer housing standards and have less access to new efficient appliances which are driving these reductions. Our analysis shows that while a dual fuel bill for most would increase by in real terms by 0.6% per year, it would go up by a 6.7% from 2013 to 2024 for those unable to take advantage of ongoing efficiency measures. When you look at all of this across all households, our analysis suggests that without energy efficiency by 2020 up to 80% of All UK households would be spending more than 5% of their household income on gas and electricity.
So where does all of this leave us – there are a few conclusions to draw:
Energy costs are going to continue going up and become less and less affordable with duel fuel bills 52% higher in 2024 than they are today.
The key driver for cost rises over this period is policy costs, at both UK and European level. Without these costs bills would actually be 2% lower in 2024 than they are now.
There is little that the energy companies can do to change this as only 18% of costs are in their control and very little of the 18% is actually profit.
The real issue for affordability is not prices, it’s the increasing impact of relative efficiency those who are unable to take full advantage of efficiency reductions will see their bills raise massively and the poorest in society will experience a regressive effect as they pay increasingly higher proportions of their income on energy than anyone else.
What this analysis highlights is that we should not be talking generically about “affordability” without understanding the drivers and the facts and economics that underpin what is actually happening. The UK has had lower than average prices and higher than average consumption profiles than the rest of Europe. Affordability is much more about consumption management and the costs of greening our system with more expensive renewables than it is about wholesale gas prices and retail profits.
The time has come to have a proper debate on the best way to handle the issue of energy affordability, not to get into tit-for-tat debates about who is to blame. Affordability is much more complicated than that but it is clear that this issue is not going away anytime soon. Maybe when it comes to Energy Policy in the UK we need a new debate and a plan B.