When Low Risk Means Very High Returns

The Energy Minister of the United Kingdom has complained about the excessive profits that two of the United Kingdom’s energy companies are making. Mr Edward Davey has focused his complaints (which he has made to the energy regulator) upon higher than expected profit margins that British Gas and SSE are making. These margins are in excess of 11% for the year 2012. He is right to complain. In theory utility companies should operate at very low margins. The reason for this is that they are providing what the people must buy. Demand is predictable and established.

People who invest in utility companies do not do so in order to obtain very high profits (although high profits are always very welcome to investors now) but as part of a balanced investment portfolio; the utility companies are safe options in the portfolio and for safety investors will sacrifice high returns. On the Monopoly Board the Utilities provide a safe return without the speculation of houses and hotels.

As there are only six energy companies in the United Kingdom who between them control more than 98% of the market, the utility model should mean that energy companies are making margins of between 3% to 4% per annum. Now, it is difficult to establish precisely what the profit margin of the energy companies are because they are part of a vertical supply business; the energy companies own the means of production of energy and frequently feel the fuel that they use. By juggling around the figures margins can appear small and big margins can turn into losses. It is very hard for a regulator to understand what the margins are over a short term, but over the long term truth comes out and over the long term Centrica, which owns British Gas which has 41% of the United Kingdom gas market, has averaged profit margins of nearly 9.4% over four years from 2009 2012.

Mr Davey in making his complaint to the regulator has raised the spectre that it may be time to break up this oligarchy of energy companies: in truth, the energy companies should never have been allowed to create an oligarchy. Either energy should be supplied by more than a dozen companies competing with each other or it should it should be supplied by a single company nationalised for the public benefit and run proper business and principles that take account of the needs of the nation.

Energy was denationalised United Kingdom because the state owned companies were full of inefficiencies, restrictive practices, and they had too much fat in them. Pendulums swing in both directions and now the pendulum has swung so that energy companies have overpaid executives, greedy shareholders, and no fat at all but plenty of spivs operating sharp practice.

Sometimes it is not desirable to stop the pendulum and a thorough shakeup will create a better position in the short and medium term; that is what is required now. No doubt if the energy companies are renationalised within 10 years it will need to be shaken up again but for the time being I think it important that the people, through their elected government, properly control energy companies and prevent them from making unjustified profits. It is not as though energy companies taking a risk on the demand side of their business. It is not as though they are taking a risk at all.

Investors will still invest in them and their projects because they are safe not because they produce higher than normal returns for utilities.

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