Explainer: How can energy profits and wholesale prices both be on the rise?

2022-09-24 19:56:54 By : Ms. Gao Aria

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ESB IS THE latest energy company to announce a large after-tax profit in the first half of this year, raising questions about how parts of the energy sector is continuing to make so much money while wholesale electricity prices soar.

The ESB Group’s profits after tax and exceptional items (ie unusual costs or revenues reported separately to ordinary expenses) tripled in the first half of the year compared to the same period in 2021. Profits reached €390 million compared to €128 million, though profit before tax and exceptional items fell slightly from €363 million to €357 million.

ESB isn’t alone in this – Bord Gáis Energy, for example, also recorded a 74% rise in its adjusted operating profits in the first half of the year from €22.7 million to €39.5 million.

But we know that the cost for suppliers of buying wholesale electricity soared during that period. Wholesale electricity prices more than tripled in many markets compared to the same time in 2021.

Many customers’ gas and electricity bills have been hiked up this year – sometimes several times – as some of the wholesale price is passed on.

But the sector is facing significant struggles, as evidenced by the departures of multiple energy suppliers from the Irish market this year so far.

So how are some energy companies continuing to record profits while the rising wholesale cost looms large?

In the case of the ESB Group, there are degrees of corporate separation between ESB itself and the company known as Electric Ireland which provides customers electricity.

“When we buy our electricity, we buy it from a supplier – that’s Electric Ireland, or all the other various suppliers – and they have to go and buy it on our behalf from the wholesale market,” said Dr Niall Farrell, an energy economist at the ESRI.

“It’s the generators that are making the profit, not the suppliers – and only some generators,” he said.

ESB was the main player in Ireland’s energy game for decades, with the market only opening fully to competition in 2015.

To prevent it from exerting too much control over the market now, different aspects of its operations are kept separate from each other.

“If we didn’t have the sort of regulation that we do have, it could be a case where they could use that large position to exercise market power and that could work out badly for consumers,” Dr Farrell said.

“The way it’s operating at the moment is sort of ring-fenced, which means that the supply arm doesn’t talk to the generation arm. So if you’re getting those profits on the generation side, you can’t go over the other side to talk to your friends in the supply section and say, ‘these are the profits we’re making’, and then take that into account in your prices.”

Electric Ireland, the ESB Group’s supply business, is the body that engages with customers about energy bills, while ESB Generation and Trading works on the generation side of the energy chain. 

“The generation is separate. That means that if I’m in the supply company and I’m looking at my customers and I’m trying to buy electricity from the wholesale market, I have to think about what the price is going to be over the next few months and then charge my price accordingly.”

The ESB Group’s financial statement lists several categories of profit that it took in between January and June.

The major increase was seen in profits after tax and exceptional items, which are unusual income or expenditure, such as restructuring costs, that are reported separately to other, more ordinary expenses.

Profit before tax and exceptional items was down slightly year-on-year from €363 million to €357 million.

Dr Paul Deane, a senior researcher at the MaREI centre in Cork, said the drop in operating profit reflects the separation between ESB’s different arms.

“Some are doing reasonably well. For example, their revenue is certainly up there in generation, but then in other parts of the company, in terms of how they deliver electricity and supply electricity, they’re down,” Dr Deane said.

The ‘exceptional items’ are important for understanding the discrepancy between the jump in one profit and fall in another.

“Exceptional items are really movements of money on paper, they don’t necessarily represent physical transfers of cash back into the company,” Dr Deane said.

“The reason why the exceptional items for ESB have gone up is because they would have a lot of contracts in the future for oil and gas, which they need for their electricity business. The value of those contracts has gone up but that doesn’t transfer into financial return, because they still need that oil and gas, they’re not going to stop generating electricity,” he said.

“It’s more of a synthetic movement of finances rather than physical flow back into the company.”

Electric Ireland is far from the only electricity supplier in Ireland. While other companies may not have the same type of competition regulations to follow, there are other factors at play.

“There are other large firms like SSE Airtricity and Energia and they don’t have this sort of ring-fencing arrangement, because they’re private firms and they have a smaller position in the market,” Dr Farrell of the ESRI said.

“They can potentially offset the prices and the next question is, well, why aren’t they? They probably are doing it to a certain extent but they’re probably retaining some profits as well, [though] it’s hard to know, because you can’t see their balance sheets.

“Then we’re seeing small suppliers going out of business because they have to match these prices. They have to buy at the cost that everyone is else is buying but they have no access to generation, they run on tighter margins, so they seem to be going out of business.”

Households, businesses and farms have been hit hard by hikes to energy bills.

The government has promised that it will use Budget 2023 to try to alleviate some of the pressure but fears remain about the burden that the cost of energy will continue to bring, especially for those least able to afford it.

The Taoiseach said today that the government “can look forward to a much higher dividend” from ESB as the after-tax profits tripled, while the Tánaiste said it is “right and proper” that Government should take back some of the big profits that energy companies are making.

In Europe, the EU has announced plans for a “deep and comprehensive” reform of the electricity market, with measures such as a cap on electricity producers’ profits and decoupling the price of gas and electricity.

The idea of a windfall tax has been front and centre – a once-off tax that would target companies that have made unexpectedly large profits.

Dr Farrell cautioned that a windfall tax could lead to generators having less leeway to “cross-subsidise with the suppliers, and then we might see an increase in prices, counterintuitively, if that plays out that way”.

“We also still have the problem where we have small suppliers going out of business because they don’t have these generation assets to help them out.”

He said another option could be to impose adjustments to the market structure, such as the ones being considered by the EU, to reduce windfall profits and bring prices down by targeting periods where prices are high as a result of gas prices going up.

“The effect of reducing windfall profits and bringing down prices a little bit would definitely help. It would solve the problem to the extent that the windfall tax would solve it and perhaps gives another few nice side effects because if you have lower windfall profits, then the cross-subsidisation aspect doesn’t play out as much and it helps the small suppliers, because they think they can perhaps be a bit more competitive on the supply side,” he said.

He also pointed to the risk of unintended consequences of a windfall tax.

“Every time you tweak the market or make a change, you’re opening up the possibility of something happening that you didn’t expect. The more changes you make and the more complex the interaction you’re dealing with, the more likelihood there is for an unintended consequence.

“I think that likelihood is much greater with a windfall tax than say, for example, the market intervention, so that’s another bonus aspect of those interventions.”

Whatever the approach taken, the government will need to ensure that the benefit is felt by those most in need, Dr Deane of UCC said.

“We need to protect the people and families on the lowest incomes who need the highest level of protection and that needs to be a fundamental principle of dealing with this whole energy crisis,” he said.

“By giving targeted measures to people, that allows you to give more money then to those families rather than diluting it across a large number of families, some of whom may be able to do well [without it].”

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