Trimming the hedge, without a power cut

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Trimming a hedgeImage source, Thinkstock

"Why isn't my energy bill going down?" I asked, in the headline of my previous contemplations.

This one has a slight variation: "Now that my energy bill is going down, why is it not going down further and faster?"

Such is the power of this blog that two of the Big Six power providers announced cuts in the first two working days since it was published.

Admittedly, E.ON's cut last week might have had something to do with it too. That, and political pressure with a general election heating up the cost-of-living issue.

E.ON's cut to the gas bill was 3.5% immediately. Centrica, trading as Scottish Gas and British Gas, went for a 5% gas cut, or £37 on the average annual bill, from late next month.

Now, ScottishPower is saying the flexible tariff on gas is falling 4.8%, or £33 on average, from a bit earlier next month.

Compare that with the price of wholesale gas, down by around 25% in recent months, and you may wonder why you're getting less than a fifth of that price cut applied to your bill. Why?

Commercial secret

The simple bit of the explanation is that only around half the gas bill is for the supply of wholesale energy. The other costs - of distribution, customer service, VAT, levies and profit - don't benefit from the wholesale price cut.

Ofgem's numbers show how it stacked up before this latest round of modest cuts to an average £773 bill; wholesale gas 51%, network costs 18%, social and green levies 3%, the supplier's costs 12%, VAT at 5% and profit at a healthy (if you're a shareholder) 10%.

But being only half of the bill doesn't explain the whole of the shortfall in this cut. A lot of that explanation is shrouded in commercial secrecy, because it has to do with hedging strategies.

Companies buy gas forward, meaning they make contracts to pay a set amount at a given price six months from now, and another tranche from wholesale suppliers in one year, and again in two years. They also buy some on the spot market, for delivery very soon, which is the most volatile price. That gives them a portfolio to spreads their risks.

And while these companies know a lot about each other's business, the key bit they don't (or shouldn't) know is each other's hedging strategies and positions.

The main reason for hedging is to protect themselves against a sharp rise in prices. They've seen that happen lots, and the political uncertainty around Russian gas supply hasn't calmed their nerves.

But when the price falls, they are contractually bound to pay the higher price. And depending on how much they have bought up to two years ahead, they are constrained in how much they can afford to pass on today's lower prices to their customers.

You'll note that it's good news for oil and gas upstream producers if hedging has locked them in to supplying at the higher prices for up to two years.

Price freeze

SSE, based in Perth while trading as Scottish Hydro and Southern Electric, went out on a limb in late 2013 with a promise of freezing prices to January 2016. It was a bold move. We don't know if it was backed by a willingness to absorb any losses from higher prices over that time, or if there was a big push to hedge - buying a larger tranche of energy supplies that far into the future.

If it's the latter, meaning they've hedged in a big way, then SSE will find it more difficult to afford the move to lower gas prices, in reaction to at least three of its competitors. But the way the market works, they're now under a lot of pressure to follow.

As these hedged positions become clearer, and more forward gas is bought at lower prices, then companies should be able to offer further cuts, beyond those announced in the past week.

Or to quote SSE's official position (while not having much else to say for now): "Energy companies like SSE buy up to two years in advance to protect customers from volatility in wholesale prices. But rest assured - if we can lower prices or extend our freeze we will."

Power cut

What, though of electricity? The big three who have moved so far aren't saying anything much about electricity (though ScottishPower points out it's got a new dual fuel fixed tariff, significantly lower than last year).

Image source, Thinkstock

It has also fallen in price. David Hunter, at Schneider Electric, tells me that a Megawatt hour of power supplied in 2015 but bought last January would cost around £56. It's now looking like £44. And the same unit supplied a year from now is £45.

So why the lack of any cut to bills? The same issues apply, but in different proportions. Here come the Ofgem figures for the breakdown of the average (£610) electricity bill; wholesale power 39%, network 25% levies 10%, supplier costs 13%, VAT 5% and profit (a more modest) 6%.

So electricity wholesale costs have come down by nearly quarter (accelerating in more recent months, as the oil price has dropped by more than half). That's a smaller drop in price than gas, and it accounts for less of the bill.

Moreover, the cost of other elements of the electricity bill are under more upward pressure, including the cost of green levies, the risk of a tightening of supply constraints as power stations are closed without capacity to replace them (meaning a risk of price spikes), and for renewing and re-orienting the grid distribution network (a project that's costing several tens of billions of pounds).

What both gas and electricity have in common is the risk of political interference with the market. With the election coming, Labour could impose a price freeze.

That's why, according to market analysts, utilities will probably have loaded their forward hedging more heavily towards the longer time horizon. That is: the portfolio is likely to have a bit less six month contract, and more of the two-year variety.

If they're right, and more energy supply has been locked into last year's higher prices, the companies have less flexibility on reducing costs, and that remains the case for a longer time.