Why Energy Prices Are Higher & Why The "People Before Profit" Slogan Understands Neither People Nor Profit

 

People habitually talk about the right quantity of things - they are always going on about whether there is too much of something or too little - not enough being done to tackle climate change, too much sugar in our diets, not enough taxation of the rich, too much currency in circulation - the list goes on. It must be tiring always trying to attribute the proper quantities of everything in life.

The one doing the rounds at the moment is that there is too much profit being made by big energy companies - often accompanied by the misguided "People before profits" slogan. To see why the "People before profits" slogan is misjudged, you first have to see that, imprudent political meddling aside, a business can only survive in the free market if it is profitable. And a business can only be profitable if it can sell its goods or services at a higher rate than the cost of producing them. Businesses that can do this provide not just benefits for its owners, shareholders and workforce, but primarily for society too, by providing value to consumers at prices they are willing to pay. That is, the businesses have taken raw material (human talents and ideas, labour and material resources) and transposed them in a way that makes them more beneficial and valuable to society. It requires abject foolishness to utter the words "People before profits", because profits are about people, where, in terms of value, the one is not distinguishable from the other.

In a competitive market, without government impediments, profits can keep increasing only up to a point, after which they become exhausted, because new competition emerges to ensure that, by and large, the prices are charged in line with supply and demand and consumer preference. If an industry contains diminishing profits, then it is becoming inefficient - and everyone can understand this. But if an industry contains so-called 'excessive' profits (short-term shocks aside), many people become habitually myopic to the opposite truth; that the industry probably has too few providers, and there are likely potential suppliers who can compete in the sector and make smaller profits but still thrive.

Of course, the relationship between proper quantities, proper prices and proper profits is hamstrung by government price fixing, taxes and subsidies, but we'll return to that in a moment. What conditions the analysis is whether or not the good or service is a fungible one – by which we mean whether or not that good or service is easily replaceable in competition. The trouble with energy is that it is not a fungible good in the same way that beer, food, clothes or cars are. If you need to heat your home, you can't suddenly decide to substitute the narrow range of options and the relatively small range of providers able to produce the infrastructure to enable you to stay warm. Whereas, if you're thirsty, and you find that beer is too expensive, you can buy some other drinks instead. Similarly, if the price or BMWs or leather jackets became undesirable, there are plenty of other alternatives you can seek, like Fords, Vauxhalls, wool or denim. The only competition for your energy is from a very small range of big firms offering other tariffs. A small range of big firms that provides a service (like energy to millions of people) is a very hard group to break into, as competition for such a service is hard to generate. It's very costly to start up a rival firm to provide energy to millions of people.

It's true that energy companies are currently making big profits, but the picture the 'windfall tax' proponents are trying to create is inadequate, over-simplistic and misleading. In the first place, these profits must be offset against huge industry setbacks during the pandemic, in which the sector saw huge losses as the price of energy slumped when most people weren't travelling or and trading as much. If you think the huge surge in profits is simply down to greed, then you ought to wonder why the energy firms weren't greedier before the pandemic. If there are shortages in energy (Ukraine conflict, pandemic, etc), meaning that supplies might reduce and prices would go up, then wholesale prices are going to go up too, so one of the main reasons the energy companies are charging us more is because they are paying more.

But there's even more to it than that. Because of the volatility of the industry in recent times, many smaller energy firms have collapsed, which, of course, is a factor in increased profits for the bigger firms able to sweep up their custom. Part of the cause of their collapse was the government-imposed price cap, which meant they were not able to increase their prices in line with supply and demand. Furthermore, the profits of energy firms are not just made by the energy provided to consumers - the profits continued to soar despite a price cap that kept the price of energy below its marginal rate. Many of the profits we have been reading about have come from traders buying and selling commodities and seeing their value increase by the volatility of the market.

The upshot is, energy prices are caused by a number of complex factors - supply, demand, global (in)stabilities, future projections, and the minutia related to raw materials and provision of those materials in generating those supplies. People may bemoan what they think are high prices and excessive profits, but finding something hard to afford does not enable you to claim that it is too expensive. We can say why something is expensive, and we can acknowledge that the price is too high for some people to afford, but neither of those things means it's too expensive. A £5000 Porsche might be unaffordable to a jobless man, but that doesn't mean £5000 is too expensive for a Porsche.

Price caps, taxes and subsidies muddy the waters, because price caps mean goods and services are not sold in line with supply and demand's prices; taxes mean businesses are bearing more than the full production costs of their operation; and subsidies mean businesses are not bearing the full production costs of their operation. The plethora of articles that compare the relative prices and profits of energy in various countries, are fairly pointless, as they are oblivious to the complex distortionary effects created by respective price caps, taxes and subsidies in the respective nation's economy.

Further reading on this subject: 

On The Economics Of High Oil Prices (And Why They Can Be Good)

Theresa May Shows Economic Ignorance Of The Worst Kind

From The Independent:

"The UK’s Big Six gas and electricity suppliers saw billions wiped off their stockmarket valuations after Theresa May outlined plans to go ahead with a cap on energy prices."

This is on the back of Theresa May's foolish announcement of a draft bill to impose an energy price cap for consumers in order to “bring an end to rip-off energy prices once and for all”.

Alas, because Theresa May is unapprised of basic economics, she seems to have it in her head that the nefarious energy firms are enjoying excessive profits at the expense of their customers. Here's where she is going wrong (any Corbynites who have the same idea about rent controls should grab a pen and paper too).

The word ‘excessive’ is a strange one when talking about profits, because excessive is a term that is relative to a perceived value or number. If the average height for a woman is 5ft 5in, and your sister is 6ft 2in, her height is excessive compared to the average. But ‘excessive’ profits in the market simply mean higher than expected, where expected means marginal revenues equal marginal costs of the standard textbook order we are more used to (most firms make a lot less profit than you probably imagine).

If an entrepreneur is making higher than expected profits, it indicates that he or she evaluated future projections better than competitors did - or if there’s a lack of competition, it indicates that he or she innovated ahead of others in the market. To do this you need to find a gap in the market that isn’t being filled, or identify better than others scarcity of supply or abundance of demand that are not being matched in equilibrium. Such entrepreneurs are the ones most likely to bid up the prices of goods that are not priced high enough, or not in sufficient supply, and push down the price of excessive outputs.

That’s short term. In the long run, though, we don’t want businesses to make excessive profits above the average cost of capital, because it means there aren’t enough competing forces for price efficiency. Competitors are the ones pushing the boundaries of innovation in order that they obtain their share of the profits, and in doing so they are contributing to increased value, better technology, more efficiency, and greater well-being and prosperity.

And that scenario is pretty much always what you see in a competitive market, because in the short term when profits are higher than expected due to some niche being found, or innovation-based success being enjoyed, there is room for others to enter that part of the market and add more value to society (you can click on my Energy part of the side bar to read why there are quite naturally only a few big players in the energy industry, and how they are not charging 'rip-off energy prices' as our dearly confused politicians seem to think). 

I wish our politicians would bear in mind this next important thing too. Most people don't know what it's like to be a large employer, so they hardly ever put themselves in the position of the corporation. They foolishly think that corporations have plenty of spare capital knocking around that can be confiscated and used to ramp up wages and pay people what politicians and their supporters have avowed that they 'deserve' (price caps are merely an indirect form of confiscation).

But even if it were not the case that corporate profits aren't that high, there is an even bigger picture that has to be factored in. Investors in large capital projects are not just the ones making the biggest risk of no return, they are the ones that stand to lose the most if the venture fails.

Good large scale investment is much harder than it sounds - you not only need a good assessment of the current market landscape, you need a solid eye for future landscapes and the concomitant probabilities that accompany that evaluation. This is even more of a compelling point when you remember that average profits hover around the 5%-7% mark. Time you factor in the large amounts of planning, building, and other capital investment to get the project off the ground, many entrepreneurs face a risk of a huge loss for a relatively small gain.

Given the foregoing, it's also easy to see how government policy designed to cap prices or extract high levels of tax from these companies makes the reckless assumption that the company's income will carry on at the same level - often failing to realise that some way down the line, price fixing and heavy regulatory protocols do a lot of invisible harm to businesses - harm that is off the radar - because, like the butterfly effect, the long chain of events that precede it are not tracked by the naked eye, and engender lots of tangible costs down the line that make prospective investment more precarious that it needs to be.

I wish politicians of all party colours would learn the very basic economic principle that you cannot impose these burdening interferences on the signals of supply and demand without changing a lot of behaviour and creating a lot of market disincentives that will have the knock on effect of harming the consumers they think they are helping. and make the marketplace more unstable for prospective investors. 

The New York Times Manages To Get This One Entirely Backwards

Some people really don't think things through very well. The New York Times ran with a story that celebrated the fact the solar industry employs far more Americans than wind or coal: 374,000 in solar compared with 100,000 in wind, 160,000 in coal mining and coal-fired power generation, and narrowly behind natural gas, which employs 398,000 workers (in gas production, electricity generation, and petrochemicals).

The article writer was trying to insist that this must be a good thing for solar power, because it demonstrates how important solar power is in creating jobs. Alas, anyone who understands economics would not reason this way - they'd instead reason that solar power presently shows itself to be a pretty unresourceful and inefficient part of the energy industry.

And once you then compare number of workers to energy output as a percentage, things look even worse for solar energy. 398,000 natural gas workers amounts to 33.8% of all electricity generated in the United States and 160,000 coal employees amounts to 30.4%, whereas 374,000 solar workers amounts to just 0.9% of total electricity.

If you try to break that down to electricity generated per worker, then coal generates 7,745 megawatt hours of electricity per worker, natural gas is 3,812, and solar is a measly 98 megawatt hours of electricity per worker. That is to say, producing the same amount of electricity requires 1 coal worker, 2 natural gas workers and a whopping 79 solar workers.

To put that into perspective, it would be like having three large supermarket chains across the country, producing the same output, but Supermarket A does so with 300,000 workers, Supermarket B does so with 600,000 workers, and Supermarket C doing so with 23.7 million workers, and the state subsidising Supermarket C because it thinks it provides better value than A and B.

Solar energy is, at present*, showing itself to be a wasteful and inefficient method of producing energy, but people won't get why until they understand that jobs are a cost of doing something, because they are the price we pay for people's labour.

I encourage any readers who deny that jobs are a cost to email me immediately, as I have plenty of opportunities for you to partake in some 'cost-free' activities. You can come and wash my car, do the dusting and hoovering, and while we're at it, my bathroom could do with a good clean too. And, of course, you won't want paying for any of that because according to you those activities do not have any costs attached to them.  

* I say at present, because there probably will be a time when solar power is the predominant and most efficient energy technology

The Myth That We're Running Out Of Resources

In response to my last blog on the fallacy of destroying the planet there have been a few misapprehensions floating around. Consequently, I feel compelled to tell you that we are not running out of resources. It's a myth, and quite a big one, as most people (apart from most geology experts and most economists) seem to believe it. For that reason I'm not surprised the above blog post turned out to be quite contentious.

The fallacy of depleting resources is usually comprised of a misunderstanding of the word 'resources' and the word 'reserves'. Usually when people tell us we're depleting the earth's resources at a precarious rate they are confusing reserves with resources.

Here's the difference. Reserves are the materials that have been planned for use in the coming decades, consistent with current mining technology at current prices. Depleting our reserves is quite normal. Resources on the other hand are of a much greater quantity - they are all the potential reserves that haven't been factored into the forecast of reserves. And those, we are not going to run out of. One of the reasons potential reserves remain as resources is because beyond a few decades we don't know how much we'll depend on them or what future our innovations will do for us in terms of our being weaned off current dependencies.

People who warn us that unless we are careful we are going to run out of resources are misunderstanding both numbers and resources, namely regarding what we've planned to use and what we actually have the potential to use. To give you an analogy. My wages give me an indication of what I have to spend each month. If I have a particularly expensive month, that doesn't mean I'm always going to be short of money, because future pay days will be forthcoming. My wages this month is my reserve, and my future potential earnings are my resources.

I did some research on this matter a few months ago, consulting the works of several experts in this field - and they all said the same. They are the source of much of what I've said above. People with a green agenda, like George Monbiot and the Green Party, tell us differently - they tell us that we are in dire straits. What do you think is more likely: that the experts have got it wrong, or that amateur, agenda-driven green people have not grasped the difference between reserves and resources? Please note, I am not aiming this point at people who are merely green-conscious - for they are often caring people without a hidden agenda or a self-serving ideological drive.

Anyway, let's suppose you're still not sure who to believe. There is, as it happens, an economic way to test who is right out of the experts vs. the greens, and that is with the world's best mechanism for measuring the supply and demand levels of resources. I'm talking about prices. Prices are the key. If there were precarious times ahead with scarcer quantities of  paper, oil, gas, manganese, copper, zinc, bauxite, tin and chromium - you wouldn't find prices continuing to drop, you'd find them increasing, particularly if demand increases. But the reason they continue to fall is twofold - in part because supplies are not scarce, but also because newer technology reduces the demand. Remember too, all supply and demand markets are transitory - we don't continue indefinitely to rely on the same resources with the same level of demand. As I pointed out in this Blog post:

Because of the limitation of the earth’s resources, supply-side initiatives in the free market engender innovation, which creates value, but also brings about a change in the way we use the earth’s resources. For example, we used to burn a lot more coal than we do now. Currently the technology for electricity, gas, and solar energy has weaned us off coal dependency, which means we use less of it. Another example is paper. We used to use a lot more paper. Currently the technology for digital interfaces (laptops, mobile phones, iPads) has weaned us off much of our paper dependency (with much more still to come), which means….. you guessed it…. we use less of it. So when we see economic growth, and increased prosperity, as well as people continually being lifted out of poverty because of it - that growth is not defined as a calibration of any single resource we consume - it is the value created consistent with how the market most efficiently allocates the ever-changing use of varying resources.

When resources do actually become genuinely scarce (remember, 'resources', not reserves), the prices rise, which provides a signal to consumers that they should use less of them, and to manufacturers that they should look to alternate technologies. Or if possible, that suppliers should find ways to produce more of the scare resources. Thankfully, as far as I know, there isn't a single known resource in the world that we are predicted to run out of - not just because we have so much in terms of potential supplies, but also because there isn't a single resource that we are going to have to depend on for longer than our capacity to wean ourselves off it.

One last thing, all this doesn't mean we have to deny that bad things are happening and that people are misusing our planet in all sorts of cruel, careless and wasteful ways. But what we must never do is what it is easiest to do - to look at incidents of bad things happening and make that the entire argument. Of course if you only focus on the bad then pretty much everything is negative. But it just won't do.

What's always needed is a proper cost-benefit analysis that factors in everything - that is, all aspects of human progression, and all aspects of human retrogression (or to the best of our ability). The moment a balanced view is attempted, things change a great deal - and I must admit, I find it bizarre, given the incredible progression-explosion that has occurred, that people find it so easy to focus so much on the costs.

Don Boudreaux has a neat illustration for this progression explosion - what he calls "The Hockey Stick of Human Prosperity"- so named because if you graphed the living standards and life expectancy of humankind over the last few millennia, they would mostly be flat until the exponential advances that occurred in the aforementioned progression-explosion in the past two hundred years.

It is vital to emphasise just how good the hockey stick illustration is in conveying two important things - not just in conveying the benefits of becoming advanced at the point in human history at which the hockey stick's heel and toe curves upwards, but in conveying just how comparably bereft human beings were for so many centuries when they were without the things we take for granted. One can see the astonishing progression-explosion not just by how much we've reaped the benefits of capitalism, industry, science and technology in the past two centuries, but by the absence of these things in every century that pre-dated the Industrial Revolution, and in all the present day countries that lack the qualities of free enterprise, and a basic political structure, stable government, rule of law, and the conditions and technological capabilities to lift them out of poverty as quickly as we'd like.

Why We Don't Need An Energy Revolution

"Pessimism won’t do. We need an energy revolution."

No, no, we do not. The Guardian's Zoe Williams is worried about human-induced climate change, and insists we should invest in alternative green technology - except by 'invest' she means throw taxpayers' money at it. I have good news for her - she can relax, because the situation will resolve itself through market forces. Here's the rub of the situation. Humans are causing climate change, but they are also penalised for their carbon externalities through green taxes and numerous regulatory measures. That is to say, because prices have been changed to account for the increased emissions, the only investment that is needed is investment that is more economically viable that the current prices.

The imminent effect of those price changes will tell us the best course of action. If, for example, our ability to augment our solar capacity enables that venture to be price competitive against our current carbon industries then consumers will respond to it. If it doesn't, they won't (that point alone illustrates how State interference can only impede the process). The costs (present and future) of staying with our current carbon trends have already been factored into the increased prices of our externalities. We don't need to throw taxpayers' money at it at all - because people's preferences for economic viability will drive this, as already happens in virtually every other market process.

Don't Try To Fix What Isn't Broke

I didn’t plan on writing a Blog post this lunchtime, so let’s make it a quickie. Just now I’ve been listening to Jeremy Vine on BBC Radio 2 lightly grilling one of the executives of one of the big six energy firms (sorry, didn’t catch the person’s name, nor his company, as I missed the beginning). The issue is based on this bit of news - quoted from The Guardian:

“The energy watchdog, Ofgem is predicting that energy suppliers will make £106 per household over the next year – almost 5% more than it forecast a month ago. Dermot Nolan, the chief executive, said he wanted to see this reflected in lower bills as falling wholesale power prices increase company profit margins. "If the market is operating efficiently, you would expect to see competition pressing down [household] prices."

Yes and no. While it’s true that if the market is operating efficiently you would expect to see competition pressing down prices, that fact is also counterpoised by the reality that scarcity of supply chokes the market mechanism more than most people understand. Due to the market knife-edge on which energy supplies sit, energy companies cannot easily risk insolvency by simply lowering customer prices conterminously alongside wholesale price drops, because energy companies do not buy in accordance with the fluctuating wholesale prices we observe in the domestic sector – they make huge investments over several years, during which the market is susceptible to significant fluctuations (this alone shows the idiotic short-sightedness of Ed Miliband’s popularity-mongering energy price freeze proposals).

Competition makes an industry healthy, but I have a feeling that, while it’s completely understandable, in the energy industry consumers are often to blame for not making the most of competition. In the food industry, if Budgens becomes too expensive, people switch to Tesco; if Tesco becomes too expensive they switch to Aldi. It is easy to switch food providers – all you need to do is drive to a different supermarket. But while it is similarly not that difficult to switch energy providers, the time, research, asymmetry of information, and technical nous required (many people still don’t operate a computer) to take full advantage of competition is often prohibitive unless people are willing to invest the time to be price sensitive (a luxury not everyone has). If a survey was conducted that recorded the number of people who’ve switched supermarkets compared with the number of people who’ve switched energy suppliers, I’ll bet the former is astronomically higher than the latter.

Let me paint you a Guardian-reader fantasy that will probably seduce and titillate: Ed Miliband becomes Prime Minister next year and passes a law insisting that all providers enable customers to benefit from similarly low prices. That would be better for the energy market, right? Wrong. Imposing the lowest tariff on your own consumers stops competitors offering more competitive (and innovative) strategies. And not being able to attract new customers at a discounted rate relative to your existing customers disables the very quality of competition in the first place. Also, energy suppliers would not be able to compound their discounts to larger customers whose energy use far exceeds the ordinary domestic home. Uniformity drives out the best methods of ingenuity – and the continual misunderstandings about energy prices, profits, and what drives them, leads to this fruitless “If it’s not broke, don’t fix it” preoccupation.

Energy & Prices: Another Shambles From Ed Miliband's Labour

Regarding the 'energy price freeze' and 'energy price hike' issue - the Prime Minister is right on this one - Ed Miliband is behaving like an incompetent buffoon whenever he talks about the markets. Dozy Ed uses ill-informed terms like 'the right kind of market' and a 'broken market', which only serve to mislead people who can be convinced that politicians can have any genuinely positive control on prices (recall what happened when the old socialist Labour government tried to have prices set - it was a disastrous economy).

These are the three questions that should be asked;

Q1) Are energy prices really too high?

Q2) Are the energy companies making too much profit?

Q3) Should the market be interfered with by the government?

Whichever way you answer 1 and 2, the answer to 3 is a categorical no. If you answer no to Q1 then Q2 is also no, necessitating no market interference by the government (or shadow government) in the shape of a price freeze. If you answer yes to Q1 then it is likely that the answer to Q2 is also yes - the energy companies are making too much profit. Surely, then, the government should get together with Ofgem and regulate the prices to make energy more affordable, shouldn't they?

No, here's why. The primary purpose of a regulating body like Ofgem is not to get in bed with the government - it is to relinquish monopoly control (like that of British Gas in the 80's and 90's) and to protect the interests of consumers by ensuring a freely competitive market. And that is the prime argument against government interference - the free, largely unfettered market has an 'invisible hand' that guards against monopolies and excessive profits (provided there is just the right amount of light regulation*) - it doesn't need any other outside interference. In other words, if the principal goal really is to protect the interests of consumers by helping to bring about the best prices, then Ed Miliband should be after more competition not a price freeze.  In fact, I say this half-jokingly, but if politicians really do believe that energy profits are over-excessive, then why don't they strive to re-nationalise electricity and gas, and reduce the prices for consumers while at the same time generating a profit for the government?  More's the point, if that holds true for gas and electricity why doesn't the government nationalise everything - cars, clothes, beer, food - and make profits galore? I think we all know the reason why - and it is the same reason why, contrary to the photo below, they shouldn't get involved with the free market economy - supply and demand are what dictate prices.

If the energy companies do not have the government in their pockets, and if they really are earning excess profits, then provided there aren't too many regulatory barriers, this should create an opportunity for potential competitors to enter the market and charge less while still making a profit, because the very nature of a free market is that competition drives prices down to the level of the costs of the most efficient supplier. Ironically a price freeze would have two negative effects - it would cause a knee-jerk price rise prior to the freeze, but it would also deter those aforementioned more competitive businesses from entering the market, which then reduces supply, and harms consumers.

David Cameron is right on this issue - if any particular energy supplier seems too expensive, customers should look to switch to other suppliers who can offer a more reasonable tariff. If the government is to have any use in the free market, it is to ensure that Ofgem is doing all it can to protect the interests of consumers by ensuring a freely competitive market. If your own energy supplier seems excessive, then switch suppliers; if all energy suppliers seem excessive then there is either a cartel, or there is state collusion, or it just simply is the case that energy provision has an expense to justify such prices. The first two don't reflect well on the government or shadow government, and the third one does not justify any market interference. Whichever way we cut the cloth, Ed Miliband is talking rubbish here; what's needed is not a price freeze, it is a sensibly regulated but otherwise unconstrained market that generates competitive prices amongst suppliers and customer choice.  

With a freely competitive market economy it's a win-win. If prices remain high in a fiercely competitive market then you at least know that costs of providing energy are high, or demand is excessive, and excessive profits aren't being made; and if energy can be supplied at a more reasonable price by a competitor then you'll see prices go down.



* I say largely unfettered, because, of course, there will always be a small need for regulation in order to prevent cartels, monopolies, information concealment and fraud. Cartels fix prices, manipulate marketing, and set production, which is bad for consumers. Monopolies have too much market power in prices and services, and they prevent smaller firms from competing, particularly if the monopolising company has buying power that is attractive to the shareholders of smaller firms looking to compete, and is able to swallow up the competition.  Information concealment is detrimental to investors and consumers. And no one needs telling why fraud is bad. This is why some regulation is always needed; but make no mistake about it - too much regulation, which is what we mostly find from the left, is always bad for suppliers and consumers on the whole. What's offered from the left as economic medicine is actually in most cases poison.