So how does Energy supply work?

The basic business model of an Energy Supplier is to sell gas and electricity to end user customers. In order to sell the gas and electricity, it must first buy the gas and electricity from the respective wholesale market, and then transport it to the end customer’s property to fulfil its supply obligations to the customer. The customer consumes the energy and is billed by the energy supplier for the energy that they’ve used.

Every day, all Energy Suppliers need to buy the precise volume of energy from the wholesale markets that the customer consumes daily. This becomes extremely challenging by virtue of a fundamental disconnect between how an energy supplier buys gas and electricity in the wholesale market and how it sells gas and electricity to its end customers. This daily challenge is something called Balancing.

When an Energy Supplier takes on a new domestic customer, it fixes the unit price for consumption as per the rates within the tariff purchased. This unit price applies to each unit of energy consumed by the customer, irrespective of when it is consumed and how much is consumed, with no limitations in place. As we know, the customer’s energy consumption can change from day to day and it is only known after the event, once the meter has recorded how much was used. Unfortunately, the wholesale markets work very differently.

The physical gas and electricity markets are forward markets, and they operate on a fixed price, fixed volume basis. The contracts that are available to purchase gas and electricity specify (i) the unit price, (ii) the volume of energy to be delivered on each day of the delivery period and (iii) the delivery period – the period of time over which the energy is to be delivered, with the same volume delivered each day of the period.

At present, the contracts that are available for purchase are defined by their delivery period, such as:

Prior to taking on a new customer, the Energy Supplier will ask the customer for an estimate of its likely annual consumption (referred to as Annual Quantity, or “AQ”), however, this is only an estimate. Some energy suppliers will purchase this AQ volume, using a combination of the available contracts in the wholesale market. In doing so, they know upfront the cost of the energy that they’ve procured to service their customer, on the assumption that actual consumption=estimated consumption. These energy suppliers are “hedged”, as they have tried to proactively and completely match their supply with their demand, in terms of volume and time.

Other suppliers at the time of taking on the customer may choose to do nothing, expecting to be able to progressively purchase their energy supply requirements using the Within Day, Day Ahead and other short-term contracts. These energy suppliers are “unhedged”, as they do not know upfront the price for the gas and electricity that they will supply to their customer over the term of their supply contract. The wholesale market price for gas and electricity can fluctuate from day to day, up or down, based upon a variety of factors that influence the market (e.g. weather, infrastructure availability, activity in connected markets, etc.) and each Energy Supplier will have its own policies on how it manages this balancing.

Finally, the energy supplier must balance the exact volume of supply with their demand on a daily basis. Each of these wholesale contracts can be bought and sold by an energy supplier to meet this requirement, with tolerances that allow for slight mismatches. This process of matching supply (purchases) with demand (consumption) is called balancing.

A hedged energy supplier may need to buy or sell small volumes of gas and electricity in the wholesale market in the event that there is a difference between actual consumption and the original estimate that formed the basis of the hedging. An unhedged energy supplier is likely to need to purchase greater volumes than a hedged supplier and is therefore more exposed if there is a movement in the price of the underly commodity in the wholesale market.

Why has the price of Gas risen so much?

The simple reason behind the unprecedented increase in the wholesale cost of gas, is that demand is increasing as the economy rebounds from the global pandemic, while supply has been reduced.

A cold winter in 2020 meant European stocks were unusually low, while gas supplies coming from Russia have also been lower than expected. Adding to the cold winter felt over in Asia, meant the competition to import liquefied natural gas (LNG) is higher than ever.

The increased demand has seen wholesale gas prices rise by as much as 400% across the UK, Europe and Asia. Where prices last Winter have risen from circa £0.40/therm to over £2.00/therm at the moment (Therm=A unit of heat, equal to ~ 2.83m^3 or 29.3 kWh).

So where does the price cap come in?

The energy price cap sets a maximum unit price that an energy supplier can charge its end customer on defaults tariffs, to prevent energy companies from immediately passing on higher costs to their customers.

The industry regulator, Ofgem, sets the price cap based on a estimate of how much it costs an energy supplier to provide gas and electricity to a customer. The price cap is reset each 1 April and 1 October for a period of 6 months, and at the time of being reset is calculated based on observed wholesale prices in the previous 12 months.

When combining wholesale costs with a price cap that was set back in April 2021 (which was based on observed wholesale prices from April 2020 through to March 2021) suppliers are being asked to fund the difference between the record costs of wholesale energy and what they are allowed to sell it for to consumers. This simple equation of Costs > Revenue is enough to put any unhedged energy supplier out of business. Unfortunately, what we are observing in the market at present is that energy suppliers who had not already either majority or completely hedged for the period of Winter 21/22 are now ceasing to trade.