The UK's energy market and its broader implications
The UK’s energy market and its broader implications
Thu 23 Sep 2021
Much of the recent news in the UK has been devoted to the spike in household energy costs and the potential collapse of the number of providers in that market from around 50 to 10 by the end of winter. In fact, since writing this first draft of this piece 2 providers have gone bust, leaving more than 800,000 customers without a provider. Of itself this is an interesting topic: it seems remarkable that rising wholesale gas prices can rupture the UK energy market and reduce the number of energy providers by 80%. For us the more relevant question relates to the wider economy and how energy costs can impact consumer demand and inflation, which contributes to our discussions when deciding asset allocation. This blog post aims to explore the former and explain the Mazars Investment Team thinking on the latter.
The factors leading to this situation are aptly described as a perfect storm, the first part of which relates to the rising cost of wholesale gas: Europe’s gas stocks were depleted after a long winter last year, Russia has been supplying the market with less gas, Asia has been taking up more of the gas available and supply from the North Sea is diminished while maintenance is performed that had been delayed due to the pandemic. These factors are not specific to the UK but led to an increase in gas prices which has affected all European countries.
In the UK rising gas prices have been felt particularly hard. The UK is more reliant on the spot market for gas supply than other gas-importing nations because it has significantly less gas storage capacity. Also, the UK’s renewable sources of energy have recently delivered less than would be expected normally due to lower levels of wind and nuclear energy production suffering outages. As a result, UK suppliers have bought more gas at the market rate than they have historically and more than other gas-importing countries have had to.
Regulatory interference over the last decade has also led the UK’s energy market to where it is now. The desire to reduce the hold of the so-called “Big 6” providers led to one of the world’s most fragmented markets which at one point consisted of as many as 70 energy providers. Within this crowded market firms competed aggressively on price and have not been able to achieve scale and the financial strength that accompanies scale. Therefore, not all gas supply was hedged because some companies simply could not afford the margin requirements to do so. A situation arose where customers who had previously purchased fixed rate energy contracts were being supplied with gas that was purchased at the market rate and some suppliers are incurring a loss equal to the difference between the lower price secured by customers and the current rising price of gas.
The final point is also regulatory in nature. The UK’s price cap that was introduced in 2019 to limit the profits made by energy providers is only reviewed twice per year, in October and April. As wholesale gas prices have risen in 2021 energy providers are still constrained by the price cap set last April which has squeezed the profits of an under-capitalised market.
This combination of factors is causing losses for energy providers and even triggering some to go out of business. The situation is causing much consternation among consumers as the UK government is being urged to step in to support the businesses in the sector and to protect consumer interests. For investors however the issue is larger and concerns the wider UK economy.
The first place that energy prices can impact the wider economy is consumer demand, particularly among low-income households. Larger energy bills reduce disposable income so money that could have gone into the economy is given up to higher commodity costs which is of no economic benefit. GDP data shows that the UK’s economy remained flat in July at 2% below its pre-pandemic level and August retail sales came in 0.9% lower than July, below the growth of +0.9% that was expected. For now, the impact on consumer spending across the economy is small but if gas prices were to continue to rise then this is something we will take into consideration.
The second issue is the effect of energy prices on inflation and the decisions of the Bank of England’s Monetary Policy Committee (MPC). Price changes in the UK as measured by CPI were 3.2% higher in August than 12 months earlier. When the energy regulator, Ofgem, raises the price cap on energy bills by 12% in October that is expected to add approximately 0.7% to CPI and were there to be a similar lifting of the price cap in April that would have a similar effect on CPI, pushing CPI well above 4%, all else being equal. However, 12 months after the rises their effect will drop out of the CPI reading meaning that unless energy costs go on to rise year after year CPI will fall back again. For now the MPC is likely to look beyond such temporary factors when it decides on the next move for monetary policy and will be inclined to leave interest rates unchanged but if we see sustained wage increases to match the cost of living then it will be forced to choose between choking off economic growth or allowing inflation to run well above the 2% level mandated for the Bank of England.
The drag of rising prices, including rising energy prices, and potential interest rate rises by the MPC on economic growth mean that investors need to consider whether the 7% economic growth forecast by the IMF for the UK in 2021 is achievable or overoptimistic. We are aware that domestically focused UK mid-cap companies have rallied 15% in 2021 and 40% over 12 months reflecting the economic rebound. An important question is whether there is too much optimism in the post-pandemic recovery given that the elevated pace of growth post pandemic must moderate at some point and should we therefore reduce our allocation to the UK. For now, we are satisfied with our overweight position in UK equities, happy that valuations are below developed market peers and that UK companies provide exposure to the cyclical rebound in the global economy post-pandemic.