Energy firms' profits are a sign of the impending supply crunch - and the need to build more power plants

The rising price of energy supplies has been much in the news recently, with the high profits of energy supply companies causing a lot of controversy. The regulator, Ofgem, is preparing rules which it intends to stimulate more competition in the market, while energy companies are warning that vital investment in energy infrastructure could be put at risk if the regulation is too heavy handed.

The energy industry is typical example of a sector where competition does not work particularly well.

The business of distributing energy from power plant to end user is a natural monopoly, meaning only one set of infrastructure ever needs to be built. Market mechanisms are of no use here, so the regulator sets the prices that transmission and distribution companies are allowed to charge. This system has encouraged the spending needed to maintain the networks of power lines and substations required to keep the country running. However, it leaves limited incentives for the companies to invest with a time horizon beyond the next five-year price control period.

The business of building power stations and generating electricity is more amenable to the use of market mechanisms. In theory, if generation capacity is constrained, electricity prices tend to rise. In the short term, more generation capacity will come online to increase supply. In the long term, new capacity will be built as companies see the investment in power plants as yielding an attractive return on capital. In reality, the lead time for building new generation capacity is between 3 and 15 years depending on the type of plant you build. Energy companies won’t authorise the investment unless they are sure they will get a good return – so they wait until prices are already elevated before building new capacity. This is what is happening now in the UK electricity market.

Old power plants, in particular nuclear plants, are being shut down and decommissioned. At the same time, demand for electricity is slowly but steadily growing. Prices have risen, allowing energy companies to make higher profits, but new capacity has not yet been installed.

This is the natural course of events you would expect in a system based on market mechanisms, but it leaves an uncomfortable feeling in a lot of people’s stomachs. After all, electricity is pretty much an essential good, so it feels wrong that someone can profit from people’s most basic needs – but that is a fundamental aspect of a market-based economy. The most obvious alternative – nationalised energy companies – is not really a viable answer – so we may just have to get used to energy companies making high profits over the next few years.