Why are UK home energy bills going through the roof?

Typical household energy bills in Britain will rise above £3,500 in October and could exceed £6,000 by April. But why are they suddenly going up by so much and what can be done to mitigate the impact on households and the wider economy?

Why are bills soaring?

The simple answer is the price of gas had already shot up over the past year but it started to climb at an even faster rate in recent weeks.

Over the past decade the price of gas has traded between about 20 pence and 75 pence a therm in the UK wholesale market. By January 2022, after Russia had started to squeeze supplies to Europe last year and as demand rebounded from the pandemic, gas rose to around 200 pence a therm. It went up again after the invasion of Ukraine in late February.

But since June, when Russia slashed supplies to Europe by restricting flows on the Nord Stream 1 pipeline, prices have more than doubled to 555p a therm.

At these price levels a 10 per cent rise in the price — as happened over the last week — is like adding the entirety of a normal year’s wholesale gas cost on to your bill again. That is why forecasts for the price cap have started to jump by such large amounts.

Another factor is the recent move by regulator Ofgem to pass on rises in wholesale gas and electricity prices to consumers faster. Previously, the price cap changed twice a year in April and October. Now it will change every three months with the next rise due in January in the depths of winter.

A month ago Ofgem criticised Investec, the investment bank, for suggesting the cap would be above £4,000 by next spring. But the wholesale market price rises since means the consensus forecast is that an annual bill for an average household will exceed £6,000 per annum by April. Before the crisis, a typical household bill was around £1,200.

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How long will this last?

One of the most alarming aspects in recent weeks is how much forward contracts in the wholesale markets for gas delivery months or years in advance have started to climb.

Traders are now expecting extremely high gas prices to persist through 2023 and possibly into 2024. They anticipate there is little prospect of Russia, which before the crisis made up 40 per cent of supplies to Europe, returning to its one-time role as a reliable supplier to the market.

The UK does not have large gas storage facilities like other European countries, which have been filling them over the spring and summer for the winter ahead. Plans to reopen Rough, the UK’s largest storage facility mothballed in 2017, will come too late for this year.

Assuming Russian supplies remain restricted and storage is drained over the winter, supplies across Europe will start from a lower base. While Britain is not directly reliant on Russian gas, shortages in the rest of Europe will still have an impact on UK prices as competition for supplies from elsewhere increases.

Norway supplies about 40 per cent of the UK’s gas and the rest of Europe with about 25 per cent of total demand. There will also be competition with Asia for seaborne cargoes of liquefied natural gas.

In a restricted Russian supply scenario, the most likely way for prices to fall eventually would be if demand drops sufficiently but that would imply a deep recession.

What can the next prime minister do?

Proposals that once might have appeared bold — like cutting green levies or removing VAT from energy bills — increasingly look like window dressing.

Before the crisis, wholesale gas and electricity costs comprised less than half of bills. The rest was made up of taxes, levies and the cost of maintaining pipelines and networks. By April, wholesale costs will probably make up more than 80 per cent.

This leaves next prime minister, whether Liz Truss or Rishi Sunak, with some difficult decisions. The immediate need is to shield consumers from bills that could exceed £500 a month by April without government intervention. But doing that for all 28mn UK households would be eye-wateringly expensive.

One proposal from Scottish Power under consideration is to cap the typical bill at around £2,000 per annum for two years at a cost of £100bn, which would be funded by government-backed borrowing to either be repaid through bills over 10 to 15 years or absorbed into general taxation. If gas prices keep rising, that estimate would be too low.

Encouraging energy conservation measures would also help given that the price cap is the unit price of energy. That means lower consumption could bring the annual bill in below the estimates based on a typical household’s usage. So far the government has refused to push energy saving measures, unlike other European countries.

Should the government be bolder?

Some have suggested more radical solutions, arguing that the UK needs to move on to a “war footing” given the scale of the crisis.

Dale Vince, founder of energy retailer Ecotricity, has proposed mitigating high prices and cut them at source by capping the price producers in the UK North Sea receive. He argued it would “solve half of the crisis at a stroke” as about 50 per cent of the UK’s gas supplies are domestic.

The industry would fiercely resist such a move but, in theory, if the price cap was imposed at a high enough level it would still leave producers comfortably profitable. Moreover, Truss, who is the favourite to be the next prime minister, has said she opposes measures such as additional windfall taxes and wants to “maximise” North Sea oil and gas production, even though output peaked two decades ago.

Removing the de facto ban on onshore shale drilling has also been floated, but enjoys little public support, including in Tory-leaning rural areas.

Another possibility exploring with Norway a return to long-term oil-linked gas contracts. Oil currently trades near $100 a barrel, while gas prices in the UK are close to $360 a barrel of oil equivalent and above $500 a barrel in mainland Europe.

Others have argued the UK needs to accelerate plans for the “degasification” of the UK economy and contend that net zero targets are no longer only about the environment but the country’s economic resilience.

But that would require huge investment in domestic supply chains, building out wind, solar farms and nuclear power, as well as an overhaul of the UK’s housing stock, as the vast majority of homes are heated with gas. Such a transformation would take many years.