By Chris Edwards
In the last three months of last year, the major energy companies announced big price increases of between 8% and 11%. The reaction of former Prime Minister, John Major to these rises was to call for a windfall tax to be levied on the energy companies. The reaction of Ed Miliband was to say that if Labour came to power, it would impose a 20-month freeze on energy prices and reform the energy market.*
These reactions put David Cameron and the Coalition government on the defensive and their response was to roll-back some of the green levies imposed on the energy companies. As a result, and with some delay, the energy companies have announced cut backs on the price rises. However these are small and the net effect is that prices in 2014 will still be 5% higher than in 2013.
The implication of the calls from Major and Miliband is that energy companies’ profits are excessive. This suspicion was reinforced in a letter recently written to Ofgem by Ed Davey, the Coalition’s Secretary of State for Energy and Climate Change. In the letter, Ed Davey said that profit margins made by the ‘big six’ energy firms on supplying gas were higher than previously thought.
A defence of the energy price rises then came from Angela Knight, the Chief Executive of Energy UK, the trade association of the energy companies. Her claim as quoted in Management Today of October 28, 2013 was:
“The profits here are four or five pence in the pound. That isn’t particularly big, and at the same time everybody is looking at an extremely large investment as well”
The arguments of both Angela Knight (the profit margins of the energy companies are small) and Ed Davey (the profit margins are large) are highly misleading precisely because they are focusing on profit margins on sales rather than profit rates on capital. For example the profit margin of energy retail suppliers in 2012 was less than 5% whereas the profit margin on generation was a little under 20%. Which of these should we focus on? The answer is neither. Instead the focus should be on the rate of profit on capital since it is this which attracts or repels investment in a particular industry. It is this which indicates the return to the shareholders and it is this which provides some reflection of competition.
Although Ofgem is the regulatory body for the gas and electricity markets in the UK, it has not yet investigated whether the energy companies’ profits on capital are excessive. Partly because of this, it has been labelled a ‘toothless tiger’. In mid-January, I decided to try to do at least part of Ofgem’s job by measuring the return on capital employed of the company with the biggest share of the UK market. That company is Centrica and the division of Centrica dominant with a 23% share of the UK heating and lighting market in 2012 is British Gas.
My analysis shows why profit margins on sales are misleading. In 2012, the profit margin on sales by British Gas was 8%, but its sales were more than 11 times as great as its capital employed. This means that its return on capital employed (before tax) was over 90%. This return on capital is excessive. How excessive is clear when we compare the 90% with the average return on capital of 11% made by UK companies as a whole.
One implication of this is that Major’s windfall tax could be £900 million (just on British Gas alone) or 6.6% of its sales and yet British Gas’s return on capital would still be well above the average for UK companies. A second implication is that even with Miliband’s price freeze in force for 20 months, at the end of that period and even if the costs to the energy companies rose at the average rate of inflation (about 3 per cent a year), the energy companies’ return on capital would still exceed the return of UK companies in general.
A third implication is that if the energy companies were nationalised and if prices to households were reduced by 6.6%, the new state companies would make a return of more than twice the public sector’s cost of capital. A cut in prices of 6.6% amounts to a cut of £81 in the average household energy bill, about double the price reduction resulting from the Coalition’s rolling back of the green levies.
My analysis shows why it is pointless to focus on the profit margins on sales. Instead the focus should be on the return on capital employed of the energy companies. I have focused on British Gas which has almost a quarter of the household heating and lighting market. The other five of the ‘big six’ energy companies cover all but a few per cent of the rest.
What the regulator Ofgem needs to do now is to look in detail at the profit rate on capital of the other five major companies and at the transfer pricing practices, if any, used by these companies. And the time is ripe for a radical overhaul of the energy market.
Chris Edwards is an External Research Associate, University of East Anglia, Norwich
*Labour’s reforms are set out in Powering Britain: One Nation Labour’s Plans to reset the energy market, 2013.
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