If you’ve ever changed energy supplier, you’ll know that it’s surprisingly easy to do. You enter some details online, and the following month your bill has a different logo at the top. Nobody turns up and rewires anything: somebody updates something in a database, and whazam, you’ve changed energy supplier.
This is because everybody is plugged into the same grid – the National Grid in the UK – so your electricity supplier isn’t literally the person who supplies you with energy. They don’t own the wires. They rarely generate the electricity. They don’t operate the substations and transformers. So what the heck do they do? 1
Your supplier takes all the price risk and gives you a fixed price
As a consumer, you probably pay a fixed price for your electricity – say 12p/kWh. But this masks the fact that the actual – or wholesale – price of electricity varies hugely throughout the year. Last year, the price of electricity peaked at £1.75/kWh on the 15th September. However, the average price for year was £0.11/kWh, a difference of 1590%.
The vital service your energy supplier provides is one that you probably aren’t even aware of – they absorb all this variability, and give you a fixed price 2. This is very helpful, because electricity markets, as recent experience has shown, are really volatile.
Of course, this is also where suppliers make their money. If they’re clever, they buy the energy for less than they sell it to you, and they pocket the difference. Of course, if they’re not clever – or simply unlucky – they end up having to buy it for far more than you’ve agreed to pay them, and then they go bust.
Where do suppliers get their electricity from?
Electricity is really hard to store.
Your energy supplier needs to ensure that for every 30 minutes in the year, they’ve bought enough energy to cover their customers’ usage. They can’t just buy a bit extra when the price is low and then use it later: it’s so expensive to store that you have to buy precisely the right amount in the 30 minute segment you’re going to use it in.
Ideally, you sort this out well in advance of the actual 30 minute period in question. Most energy trading goes on behind closed doors, in the form of long term contracts between energy producers and suppliers. This provides some stability for both the buyer and the seller, neither of whom can be sure what’s going to happen to the price of energy.
However, if you’re feeling really lucky – or you think that prices are going to drop precipitously- you might just wait and buy all the energy you need just before you need it. You can buy power the day before (the day ahead market) or even on the day (intraday, or spot prices). In the UK, there are two such exchanges – Epexspot and Nordpool.
The risk, of course, is that if the price shoots up, you’re left facing astronomical bills, and you can’t pass them onto the consumer because that’s the whole ball game: you’ve guessed how much it will cost to supply them energy, and locked them in at that price.
In essence, this is the gamble that Bulb and other suppliers got wrong: they hadn’t hedged effectively against massive increases in electricity prices. Although people are now grumbling about Bulb being propped up by the UK government, the alternative scenario was on display last year in Texas, where suppliers merrily passed on price volatility to consumers and left some people with $15’000 electricity bills; scarcely more palatable. 3
The price cap
Life is slightly harder than I make out for suppliers, because they don’t have complete liberty in how they charge consumers. The Ofgem price cap limits the amount consumers can be charged on a default tariff. This was introduced largely because lots of people don’t pay very much attention to the details of their energy supply, so it’s easy for suppliers to exploit them if there aren’t some guiderails in place.
Ofgem announced yesterday that the price cap is set to increase in April 2022, from 21p/kWh to somewhere around 29p/kWh. Incorporating a similar increase for gas, this equates to a £693 increase to total bills.
This increase was not a surprise. The cap is calculated using the average price of electricity and gas over the past 6 months. We’ve seen industry-wide increases in the cost of energy, largely due to the gas squeeze (much of the UK’s electricity generation is still supplied by gas). This is bad news for consumers. It’s actually even worse than it seems, because many more people are now on these default tariffs than this time last year; these are the tariffs to which customers were migrated if their original supplier failed.
It’s not clear to me how important the price cap was to the failure of companies like Bulb. Sure, they could have charged a higher fixed price if the cap didn’t exist, but they were known for charging very low prices anyway, often undercutting the competition. It seems like competitive forces alone might have driven them to fly too close to the sun irrespective of government intervention. Here’s a great post from Octopus Energy’s founder Greg Jackson explaining why hedging strategy, and not price cap, was the issue for Bulb.
Is there any alternative to a fixed price?
Because electricity is hard to store, we need to balance supply and demand instantaneously. Since supply is increasingly dictated by uncontrollable forces such as the sun and wind, it would be great to be able to move around demand instead: have people use more energy when the grid is green and plentiful. This idea is known as demand side response.
By flattening the price of electricity throughout the year, suppliers effectively blunt any financial incentive for consumers to shift demand to match generation. Why would I go to the trouble of running my washing machine at night if I’m paying a fixed price of 35p/kWh?
The solution: start passing on price variability to the consumer! Flexible tariffs such as Octopus Agile pass on wholesale prices (up to a point – it’s still capped), so that you pay less for electricity when markets are cheap, such as during the night. These have found particular favour amongst electric car owners, because they offer very cheap charging overnight, and sometimes even negative pricing – you’re paid to take energy off the grid.
This sounds like a great deal for energy suppliers, because they don’t take all that price risk! If all of Bulb’s customers were on this kind of tariff, they probably wouldn’t have gone bust: they could have passed on a large part of the unexpected surge prices to consumers 4.
Except, of course, that most energy companies couldn’t offer this tariff because they don’t even know how much energy you’re using or when you’re using it! Most households still rely upon analogue meters (56% as of March 2021), which simply tot up the kWh without recording when they’re used. Moreover, your supplier doesn’t have direct access to the meter – Google knows more about your plans for the weekend than your supplier does about your electricity usage.
This also leads to surprising amount of confusion about questions that you’d think would be easy to answer, like “how many people have solar panels in the UK”? The whole system involves a lot more gaffer tape and guessing than you’d expect. As the grid becomes more volatile and distributed (i.e. more people are contributing small amounts of energy, and we have fewer massive power stations), more precise information about generation and demand will become essential. Wisely, the government is now mandating that all suppliers switch over their customers to smart meters by 2025.
What if suppliers don’t buy enough electricity to cover their customers’s usage?
If a particular supplier misjudges the amount of electricity their customers will use, the net result is that there won’t be enough electricity in the system to fulfill everybody’s needs. This is a very bad thing and there are a variety of mechanisms in place, organized by the National Grid, to remedy these situations.
The most important of these is called the Balancing Mechanism. This is a fast moving market where generators and suppliers of electricity offer to increase (or decrease) generation (or consumption) in order to balance the grid. This is administered by a company called Elexon. In our example, Elexon would buy the extra energy needed to top up the grid to account for a supplier’s failure to estimate their customers’ usage.
Of course, Elexon doesn’t foot the bill for this – they pass on the price they paid (called the System Price) to everybody in the system who got their predictions wrong. Suppliers who used more than they bought get charged. Generators who didn’t generate enough also get charged.
Conversely, anybody who bought or generated too much electricity can get paid as part of this transaction, because their overcalculations were used to cancel our others’ undercalculations. Again, in about 5% of 30 minute periods in April and May 2020 this logic all flipped – there was much more energy generated than we needed, and so people who consumed more than they’d predicted actually made money.
A final piece of the puzzle: how does anybody know how much energy a supplier actually consumed at which times, given that >50% of households lack smart metres? Sure, at the end of the year we can compare metre readings, but that doesn’t help identify the 30 minute periods where my supplier bought too much or too little electricity, or what price they should be paying for those imbalances. In fact, there’s a fairly complex and arcane system of guessing what usage might have been, by assigning households to different categories based on their load profiles and then using readings from smart metres from each of those categories to approximate the rest. After 14 months (!) there’s a sinister sounding Final Reconciliation in which customer’s actual metre readings are squared with the approximate ones.
If you enjoyed this, you might like:
- ☀️ Should we be building West facing solar panels?
- 🤑 How Hayek would solve climate change,
- 👩🏻💻 Why more data scientists should work on climate
Thanks to Hamish Lazell and Peter Dudfield, actual experts, who provided lots of feedback and conceptual clarifications.
- I have never worked for a supplier – this is my attempt to answer this question, but it’s imperfect and cobbled together from an outsider’s perspective. I would love to hear how it’s wrong if you could spare the time for feedback
- They also make sure that everybody in the supply chain gets paid – the energy producer, the transmission and distribution networks, and a variety of taxes and levies. Thanks Hamish for this detail
- A more nuanced analysis: Bulb had hedged, but not far enough into the future. The FT reports that they had a 6 month hedge in place, but that this proved insufficient.
- Agile prices are still capped at 35p/kWh, to prevent Texas-style whopper bills