The real reason energy bills only ever go up

Britain's energy market isn't working.

Last week we had the usual round of utility bashing by the press as British Gas announced that customer bills would go up in November by 6%. Most of its competitors have followed, or will follow, suit.

Competition was supposed to lead to more choice and better prices for customers. We certainly have more choice. Where once we bought our energy from the local electricity board and British Gas, there are now six big energy firms and a handful of small suppliers.

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But has competition made us better off? When you're paying your energy bill, it certainly doesn't feel like it. But that's not all the fault of the big bad utility companies. Britain's energy problems have far deeper causes than just profiteering' by energy firms.

Here's why.

Are utility companies really ripping us off?

One key reason why competition hasn't dragged down prices for British energy consumers is that no single company seems to be able to buy cheaper electricity and gas to supply to us consistently. EDF's nuclear power stations can produce cheap electricity for now, but whether it can buy gas cheaper than any of its rivals is doubtful.

This is why talk of switching suppliers to save lots of money is largely nonsense. Yes, maybe if you are on the most expensive tariff and you haven't bothered looking for cheaper deals in the past, you can save money. If that's you, it's worth your while going on to a comparison site and seeing if you could save by switching.

On the other hand, if you buy gas and electricity from the same supplier, pay by monthly direct debit and submit your meter readings online, there's not a lot of difference between the big suppliers. Take a look at the table below.

Source: Ofgem

This chart comes from Ofgem, the energy industry regulator. It keeps a monthly watch on how much money it thinks the energy suppliers are currently making. Based on an average household dual fuel bill of £1,310, they are making an average of £45 per customer in profit - a margin of 3.4%. This is hardly evidence of profiteering. After the latest increases, profits are expected to go up to £65 - but it's hard to say that we are being fleeced.

So why do our bills keep going up, if it's not down to suppliers running a cartel? To answer that question, you have to look into how Britain's energy market actually works.

How short termism creates flawed energy policies

The bad news for all of us is that unless something radical changes, our energy bills look set to keep rising in the years ahead. This is regardless of what conditions are imposed on utility companies by headline-seeking governments.

One reason for this is the rising wholesale cost of gas. Our supplies of cheap North Sea gas are running out. We now import half of our gas needs. By 2020, this will rise to around 80%. And growing demand for gas is driving up prices - British Gas says it's paying around 13% more for wholesale gas compared with last year.

Now you'll probably have heard all about the shale gas bonanza' in the US. The trouble is, gas is not yet a global market. It's not easy to transport around the world. So while gas is dirt cheap in the States, that has so far had little impact on the price we pay over here. This is changing, as my colleague James McKeigue discussed in this week's MoneyWeek magazine cover story. But it's unlikely to solve our problems in the near term.

The fact is that most of the problems with our energy market lie closer to home. Probably the biggest sources of our difficulties are short-termism, and underinvestment in power stations and infrastructure.

For example, we have far less gas storage space in the UK than Germany or France. If we could store more gas, we could buy it in summer when it's usually cheaper, and buy less in winter.

As for power stations, Ofgem thinks that the amount of spare capacity in the system could fall from 14% today to around 4% in 2015. So not only are we paying more for power, there's also a risk that the lights might go out more often.

Meanwhile, many coal-fired UK power stations decided not to spend lots of money making their electricity cleaner to meet EU rules. As a result, they can only run for a restricted number of hours until 2015. Unfortunately, those hours are being used up more quickly than expected, because it's quite profitable to make electricity from coal right now (because coal is relatively cheap). This means most will close by 2015, which will reduce the supply of electricity, driving up the price further.

Where we are investing, we are building the wrong type of power generation. We've been flinging up wind farms in the hope of getting 15% of our electricity from renewable sources by 2020. But wind power is both expensive and unreliable. An offshore wind farm might generate power 40% of the time. Modern nuclear and gas stations can run 80-90% of the time.

If you take into account the cost of back-up power to support wind farms, they cost more to build than nuclear or gas plants. And this will be reflected in our bills. Consultants Mott-McDonald estimate that an offshore wind farm will need power prices of £180 per megawatt hour (MWh) in 2017 to cover its costs and provide a return to investors. A gas station would need £100 and nuclear £70. Current peak time electricity prices are around £61 per MWh so you can see which way prices for consumers are going.

So why not build more gas or nuclear? The trouble is, power prices are not high enough to incentivise utility companies to build new gas and nuclear power stations. Nuclear could give us a long-term, secure supply of electricity but the government will not explicitly guarantee the prices that give the companies a satisfactory return on investment. However, it is happy to do this for wind farms.

Instead, the government is trying to raise prices by the back door by introducing a minimum price for power generators to emit carbon dioxide from April 2013. It hopes this will make it more expensive for coal and gas stations to produce electricity, pushing up the price. Whether prices rise enough to encourage new power stations to be built remains to be seen though.

But the bottom line though is that you and I are going to have to pay for this new investment via much higher bills.

So while I won't discourage you from switching providers (particularly if you've never done it before), it's not going to make a life-changing difference to the amount of money you pay. The only sure way to cut your energy costs is to use less. This means making your home more energy efficient. The Energy Saving Trust website has some useful tips on how to do this.

Of course, the other way to offset your rising energy costs is to invest in the energy sector, and make some money from the companies that are trying to solve some of these problems. As I mentioned earlier, we've looked at the best bets in shale gas in the latest issue of MoneyWeek. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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