The true price of winter warmth

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By Professor Andy Mullineux
Lloyds Banking Group Centre for Responsible Business, Emeritus Professor of Financial Economics

Making suppliers offer pay-as-you-use, one month in arrears, direct debit contracts would in turn encourage more parsimonious energy usage. Both could make heating our homes this Christmas a little less stressful and easier to manage financially.

With UK temperatures plunging at the same time as energy prices have sky-rocketed, one of people’s biggest concerns heading into Christmas is the cost of their heating bills. Energy suppliers have been hiking up monthly direct debits since the summer in anticipation of a winter squeeze. But many customers who have reduced their consumption are unhappy at being unable to just pay for what they use, building up excess balances that aren’t automatically refunded. While those on pay-as-you-go meters, who are likely to be the most vulnerable in society, are still paying more per unit of energy than anyone else.

On 25 November, Ofgem, the energy market regulator, published proposals that aim to better protect consumers of gas and electricity by strengthening the sector. The shortcomings of the previous regime resulted in around 30 failures of mainly small suppliers and one large one, Bulb. The latter was bailed out at the expense of taxpayers to the tune of £6.5bn, while customers paid the £2.7bn cost of transferring accounts from smaller suppliers that failed to stronger suppliers through £94 added to each household bill this year. The failures resulted from a policy that encouraged entry by new suppliers with, as it turned out, inadequate capital backing to compete with the big six suppliers dominating the market.

But the most contentious part of Ofgem’s new proposals is the decision not to ‘ringfence’ customers’ positive balances. This has drawn criticism from Centrica (which owns British Gas), as well as Octopus, which is likely to become a much bigger supplier by buying Bulb from the Treasury. The concern is that these balances, on which no interest is paid, can be used to fund day-to-day business, especially by the suppliers who remain precarious.

Even though the balances were protected in the previous bailouts, they may not be so in future. Ofgem promises to take action against suppliers it detects making reckless use of customer balances and has proposed introducing capital adequacy requirements to assure enough capital is held to prevent future failures. This may encourage smaller and weaker suppliers to exit the market. Ofgem’s previous ‘light touch’ regulation is thus to be tightened, but has enough been done? And if not, what more could be done?

To the extent that customers and taxpayers continue to bear the cost of bailouts, there remains a ‘moral hazard problem’ that risky energy firms can reap substantial profits and yet be bailed out when things go wrong to the benefit of their shareholders. Further, there is a perverse incentive to overestimate customer usage so that direct debit payments and the resulting credit balances are higher than they should be and the energy companies then need to borrow less and pay less interest to their creditors.

Customers paying for their energy using pay-in-advance meters can choose how much they buy, though many cannot afford to buy more than the bare minimum and essentially ‘pay as they use’. And all pay more per unit than those willing and able, by virtue of their credit standing, to pay monthly by direct debit. There is thus a ‘poverty premium’.

Before ‘smart meters’ were introduced, someone had to visit the household to physically read the meters of customers paying by direct debit – and this is still the case for those without them. Suppliers then charged according to quarterly usage, so that households paid for, and were potentially fully aware of, how much energy they used in the previous quarter. A disadvantage was that bills were higher in the winter months, particularly around the Christmas period; although in the summer households could live relatively cheaply, and perhaps afford a holiday. The installation of smart meters meant that people no longer needed to contact suppliers to supply readings if they had missed the ‘gas man’s’ visit.

However, contracts to buy energy more cheaply at fixed prices for an agreed period were progressively introduced by new entrants to attract customers, and by the larger incumbents to retain them. These introduced regular monthly payments based on estimated annual usage, so that positive balances accumulate over the summer, to be drawn down as usage increases in the winter, thus ‘smoothing’ payments over the year.

This is attractive to many, but it relies on suppliers accurately gauging each household’s annual usage for which past usage data is required that will not be available for new customers. So excess balances can often build in error, even where a supplier is not willfully overestimating necessary payments. Further, households that are currently economising on usage can also build up excess balances. It commonly requires a phone call to request reimbursement of excess balances, even though suppliers should be required to refund customers automatically. Many suppliers refuse to let customers opt to make direct debit payments of the amount actually used a month in arrears, based on smart meter readings, and also require a credit balance of at least a month’s usage to be held.

Direct debit customers should be permitted to enter into pay-as-you-use contracts, which, if more widely available, would enhance transparency relating to usage and encourage energy saving. Further, suppliers should be required to pay market-related interest on credit balances to customers to discourage their ‘overestimation’ of the required monthly payments and to compensate customers who could earn interest from deposits in savings accounts.

It might be argued by the energy companies that they could not offer such attractive fixed-price deals if they could not require regular monthly payments. But smart meter readings of usage have to be recorded to produce monthly statements, and consumers are forgoing interest to the supplier’s benefit. More fairly priced contracts, requiring payment of interest on positive balances, would encourage reimbursement of excess balances and make the market more transparent and competitive. Making suppliers offer pay-as-you-use, one month in arrears, direct debit contracts would in turn encourage more parsimonious energy usage. Both could make heating our homes this Christmas a little less stressful and easier to manage financially.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the University of Birmingham.

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