Energy company profits: are the Big Six's claims "misleading"?

With British Gas and nPower following SSE's lead in announcing above-inflation rises to the average energy bill over the past week, it was little surprise that the issue again dominated yesterday's Prime Minister's Questions.

While there were heated exchanges in the Commons about how to deal with these price hikes, both the Prime Minister and Labour Leader Ed Miliband agreed that, in David Cameron's words, "bills in this country have reached a completely unacceptable level." 

However some in the energy business have suggested that this consensus is unfair. nPower, for example, have protested that:

"The reality is that the profit we made last year was 5% of our total income — 95% was spent on the huge costs involved in generating and transporting the UK's electricity and gas, and supplying homes and businesses across the country."

Critics have hit back that this itself doesn't represent the true profit being generated by energy firms. The Telegraph, for example, reports that:

"Critics also say it is misleading for companies like British Gas to represent [a] chunk of the bill as purely wholesale 'costs' when that cost actually includes some profits for the power generation or gas supply arm of Centrica."

According to the Guardian, the profits made by energy firms through the power generating and supply arms of these businesses is as much as 24% of turnover, much higher than the 5% quoted by nPower.

How energy companies are structured

Collectively, the 'Big Six' energy firms (British Gas, SSE, nPower, E.ON, EDF and Scottish Power) account for 98% the retail market (which sells gas and electricity to households and businesses). However each of these companies also has an 'upstream' arm involved in generating electricity, sourcing and storing gas, or transporting energy between locations.

The Energy and Climate Change Committee has published details of which companies are involved in which activities: 

Each of the 'arms' of the business is held by a parent company, often under a different name (British Gas is owned by Centrica, nPower by RWE and Scottish Power by Iberdrola).

What does this mean for profits?

The Energy and Climate Change Committee compiled the profit margins for each slice of the Big Six's business, which Ofgem have required them to publish since 2009 in the form of Consolidated Segmental Statements.

More up-to-date figures for 2012 are available from the energy companies themselves, and have been collated by Ofgem.

These show that there is considerable variation between companies, with profit margins ranging between a 1.4% loss and a 6.6% profit in terms of the Big Six's supply businesses, and between 6.8% and 35% profits in terms of their generation arms. The overall profit margin across all segments in 2012 was 7.2%.

What about investment?

The profits recorded in these Consolidated Segmental Statements represent the operating profit: the difference between the income generated by the business and the cost of operating it.

The Energy companies themselves have argued that to look at the profit margin in isolation ignores the financial pressures created by the need to invest in new energy infrastructure. According to industry body Energy UK: "No other industry is facing the investment challenge of the energy sector."

The Government has set a target of £110 billion in private investment in building new energy capability over the next decade, which would require an average investment of £11 billion per year. This is significantly more than the £4.6 billion of profits generated by the Big Six in 2012, although as we saw with the new nuclear plant confirmed for Hinckley Point earlier this week, the capital is likely to be provided by a consortium of investors, rather than through energy companies alone.

Conclusion

Neither the 5% profit margins quoted by energy companies nor the 24% alternatives put forward by their detractors are inaccurate in their own terms, although nor does either give the full picture. While on average 3.6% of a consumer's bill went towards profits for the Big Six in 2012, these companies made a profit margin of 21.6% on average when it came to their generation businesses. Overall, the 7.2% profit made by the parent companies overseeing all these operation might represent the bigger picture.

Whether or not these profits are 'excessive' - as Sir John Major suggested earlier this week - depends a great deal on whether or not the energy companies' claims that the profits are required to fund investment are accepted. While the projected scale of investment required certainly dwarves the current profit raised by the Big Six, it isn't necessarily the case that increases in profits are solely funding infrastructure spending. 

A significant proportion of profits are also spent on providing dividends to shareholders. For example, in 2012 Centrica spent £816 million on shareholder dividends (around 34% of profits before tax, or 60% of profits afterwards), which the company has said reflects "our policy of delivering sustained real growth in the ordinary dividend, and is a reflection of the significant increase in earnings we have delivered during the year." Friends of the Earth has also claimed that dividend payments have risen significantly in recent years across the Big Six companies.

UPDATE (22/11/2013): This article originally used the EBIT measure of profit declared in the consolidated segmental statement presented to Ofgem by Centrica as the baseline for the calculation in the final paragraph of the proportion of profits going to shareholders. After discussing the issue more with readers and experts, it was agreed that the profits declared in the company's annual financial statement was a better comparator, as this includes revenues generated by Centrica that would fall outside the remit of the consolidated segmental statements, such as profits from the company's energy storage and services arms.