Are wholesale gas and electricity costs behind the latest energy price rises?

Energy prices remain rooted to the top of the news agenda as four of the 'big six' companies this week announced price rises on average of 9.1%.

The suppliers were unanimous in their explanation. Scottish and Southern Energy (SSE), Npower, British Gas and Scottish Power all cited three key factors which forced their hand: rising wholesale costs (what is costs to buy the energy in the first place), rising network costs (what it costs to transport the energy to people's homes) and rising costs of government policies ('green' energy levies).

The cost of so-called 'green taxes' was the centre of attention last week after the Prime Minister and Leader of the Opposition attacked each other's record on environmental policies. This week, it was the wholesale costs that caught the critical eye of the UK's media:

The Guardian: "Ofgem puts energy suppliers' price claims under fire: Consumers hit by price increases of up to 11.1% but data suggests wholesale prices rose by only 1.7% over last year."

BBC News at Six yesterday: "The energy companies say Ofgem's figures are flawed."

Wholesale costs account for about 45% of the average dual fuel household bill every year. Yet, as energy regulator Ofgem's own figures confirm, last October they contributed £600 to the average bill. This October they accounted for £610 - a 1.7% increase.

Putting this alongside the 9.1% increase in prices that will face some customers next month has led many to question whether the energy companies' explanation holds much water.

But it's not as simple as that.

As Ofgem explains in its own guide to the figures, its estimates for wholesale costs faced by suppliers aren't perfect, and can actually be quite misleading if not understood correctly. 

For a start, the fact that wholesale costs are £610 now doesn't realistically have any bearing on what the companies have paid for their energy this winter. This is because companies tend to adopt 'hedging strategies'. This means they actually buy their energy requirements over a long period of time (one or two years normally). Since wholesale prices can be volatile, this is a way of smoothing out company costs so they're more predictable.

So the fact that last October wholesale costs were estimated at £600 compared to £610 this year isn't the relevant set of figures to use. What we're interested in is what the companies actually bought the energy for, compared to their previous purchases, to develop a picture of how much their costs are going up.

British Gas and SSE, for instance, both calculate their wholesale costs for a winter by taking the average wholesale price in the 24 months preceding the winter period. Since they're comparing prices over a longer period of time, and since wholesale costs have been generally rising since 2010, this produces a much bigger increase in cost.

This isn't obvious from just looking at Ofgem's figures, so the regulator itself put out a statement yesterday to clarify the figures, along with a new estimate which tries to take into account the companies' hedging strategies:

"Our own weekly monitoring published on our website estimates that, over the last year, the cost of wholesale gas and electricity to serve a typical dual fuel customer would have risen by around £10 to £610. However, this figure could be higher depending on the hedging strategy of an individual company for buying gas and power in forward markets.

"We have also published actual market data which shows that the wholesale price of gas for use this winter is 8 per cent higher than the price of gas for use last winter. The wholesale price of electricity for use this winter is also 13 per cent higher than the price of electricity for use last winter."

So understood in this way, the wholesale cost rises are much closer to the price rises that companies have recently announced. This doesn't necessarily mean that the firms' profits are reduced. As we found last week, all of the big six energy companies have a generation arm of their business as well as a supply arm for consumers, and understanding how their profits are faring overall demands that both arms are considered.