Energy bills are predicted to rise again as the cost of living crisis continues to affect people across the UK.
The increase has been blamed on a number of factors, and campaigners have asked for government action to halt spiralling gas and electricity bills.
But how did we get here? How are the prices we pay for energy decided? And what can governments do to help? FFS explains the current situation.
How much have bills increased?
The average energy bill for a typical household could reach £5,038 per year in 2023, according to estimates from energy analysts, Auxilione.
Estimating average household bills can be difficult due to varying levels of energy consumption and different types of energy tariffs.
What has caused the increase?
Wholesale energy prices have increased significantly around the world since the middle of 2021. This has a number of causes.
As the world emerged from Covid-19 lockdown, demand for gas went up. But the amount of gas available could not keep up, leading to skyrocketing prices in European and Asian gas markets.
The International Energy Agency (IEA) pointed to a series of disruptions in supply, as well as lower than usual gas storage in Europe.
Colder than average weather last winter also led to increased demand in some areas of Europe.
Then in 2022, Russia’s invasion of Ukraine caused more difficulties in energy supply as countries reduced or ended their gas imports from Putin’s regime. While the UK does not directly import a lot of its gas from Russia, the country remains one of the world’s biggest gas suppliers, and so the impact of the conflict is felt through global gas markets as demand increases in other countries the UK imports from.
Because the UK needs to import gas from elsewhere, it is more exposed to changes in overall gas prices.
Who does the increase in bills affect most?
Those on lower incomes are disproportionately affected by the price cap increase.
According to the Office for National Statistics, for the poorest 10 per cent of households, 54 per cent of their average weekly spend is on “essentials such as housing (including electricity and gas), food and transport”. The richest 10 per cent spend just 42 per cent.
The poorest spend seven per cent of their disposable income on gas and electricity, while the richest only spend two per cent.
How are prices set in the UK?
Energy suppliers buy from the wholesale market, where prices can be extremely volatile. In order to guard against these rapid fluctuations, most energy companies ‘hedge’ their purchases, which means they buy energy for future use, sometimes years in advance.
This means that they are less affected by the unpredictable fluctuations in market price.
In the UK, the Office of Gas and Electricity Markets (Ofgem) is the government regulator for energy markets and bills. It analyses the energy markets and looks at the costs energy suppliers have, which then makes up the energy price cap.
The price cap is intended to protect consumers from these volatile markets, by creating a maximum price that people can be charged for their gas and electricity use. It limits the amount that energy companies can charge for their default tariff. This doesn’t mean there is a maximum bill that someone could be charged, as that depends on individual energy consumption.
This cap was reviewed every six months, but Ofgem has announced it will now be updated four times a year. In practice this could mean prices increasing more rapidly as supply issues continue.
The price cap also sets a maximum supplier profit margin (before interest and taxation) of 1.9 per cent. However this does not mean that suppliers will actually earn 1.9 per cent in profit in practice, because the price cap profit margin is based on Ofgem’s estimates.
What do our bills pay for?
The largest cost in a typical energy bill is wholesale costs – the price of the gas or electricity that is sold to the energy provider. In a dual energy bill, which is most common, this usually makes up around 51 per cent.
Then there are network costs, which pay for pipes and cables that bring energy to homes and businesses, as well as charges for balancing the network. According to Ofgem, this is about 18 per cent of your typical bill.
Then we get to policy costs. This is the amount of money that pays towards government policies such as supporting renewable generation, energy efficiency measures, and assistance for vulnerable households. This is reduced in the most recent energy cap adjustment.
Policy costs have been controversial, with some Conservative politicians blaming so-called ‘green levies’ for being partly behind the latest increase in bills. This is not the case, with energy levies actually reducing from 12 per cent to eight per cent of your typical bill in summer 2022.
Operation costs, which cover energy company profits and running costs, and the capped profit margin make up about 11 per cent, while the final 12 per cent is made up of administrative costs such as VAT and customer payment allowances.
What about other fuels?
The price of electricity and gas bills is regulated by Ofgem through the price cap, but other fuels used to heat homes are not controlled in the same way.
Around five per cent of UK households use heating oil for their central heating, and buy directly from suppliers. Prices have increased about 50 per cent since the start of 2022, according to Boiler Juice, which tracks costs.
So how are energy companies making so much money?
Many energy companies have made increased profits during the energy bill rise, and there have been growing calls for taxing of profits to reduce the burden on consumers, or nationalisation of big energy providers.
The UK Government announced a one-off windfall tax, the energy profits levy, in May 2022. It expects to raise about £5bn from the tax in its first year. However, it will not be backdated, so a lot of the profit made by big energy firms such as Shell or BP will not be included.
Part of the reason that companies are making so much money is that while energy providers are finding only small profits or even losses in supply business, many also take part in energy generation and trading. So they have benefitted from the high prices for oil and gas in the wholesale markets.
Why can’t we use our own green energy?
Many consumers are on ‘green’ energy tariffs, which they believe come from renewable sources. But these bills have been increasing as well.
This is because the energy supplied to homes in the UK comes from the National Grid. This means green energy companies cannot always control where the energy that comes from and how it is produced.
The National Grid pools all the electricity and effectively sends it to homes and businesses when it is needed. The grid needs to remain ‘balanced’, which means when energy is used, the same amount must come in. This is achieved by topping up the grid’s energy supply when demand outstrips supply, and ‘storing’ energy when there is a surplus until it is needed.
Less than a third of the UK’s energy in the National Grid comes from renewables, with gas providing more than 40 per cent.
This means renewable energy is affected by the same wholesale price rises as other types of energy.
Green energy companies are so-called because they usually buy from renewable suppliers.
What can people do if they’re worried?
Ofgem rules mean energy suppliers have to sign up to offer payment plans for people who are struggling to pay their bills, and many offer payment holidays and deferrals if you contact them.
The UK Government announced the energy bills support scheme, which is a £400 discount on energy bills for eligible households from October over the course of six months.
The Scottish Government launched home energy efficiency programmes for those who are struggling with fuel poverty.
Citizens Advice Scotland can offer assistance and advice on what to do if you are falling behind with bills.
Photo Credit: iStock/Tim Parker