Is British Gas telling the truth?
The boss of British Gas has justified its price rises by saying it will go out of business if it doesn't make a profit in winter. Is that really true?
What kind of rubbish business can't make massive profits when it faces almost no competition and is ruled by a weak regulator?
British Gas recently raised prices by 6% to the usual outcry of profiteering. Phil Bentley, managing director of British Gas, launched a typically vigorous defence.
He said that it had to raise prices or die, because its profit margin is just 5%. This means that for every £100 it takes from customers, it spends £95 and keeps just £5 in profit.
British Gas is not a rubbish business
Of course, if British Gas always made a loss it really would die. What we don't know is if it needed to raise prices to make a reasonable profit through this coming winter.
What I do know is that the whole 5% figure is a diversion from more important facts: British Gas makes its investors richer and richer at the customers' expense, in an industry that still doesn't compete effectively.
Getting past the modest-seeming 5% figure, British Gas is hugely profitable. Its residential division made £345m for its directors and shareholders in the first half of 2012 alone: far, far more than it earned in any half in the early noughties.
What would be more surprising is if it didn't make massive amounts of money.
British Gas is in a market where competition doesn't work very well and where relatively few customers switch suppliers. It charges hundreds of pounds more to those incumbent customers each year.
Despite the poor competition, the regulator, OFGEM, doesn't set price limits. It also doesn't require British Gas or the other major energy suppliers to reveal at what price they buy the gas and electricity that they sell on to us. This information would be part of the information needed to ensure that price rises were fair.
The regulator hands out pitiful fines to these businesses whenever they're caught doing something they shouldn't, even though they pull in billions of pounds from their residential customers. Large penalties are particularly important in uncompetitive industries.
OFGEM maintained that the market was working for years, but it contradicted itself recently by announcing big changes that are intended to shake things up, including simplifying energy tariffs.
How British Gas' profits have grown
Despite its seemingly modest 5% profit margins, shareholders in Centrica have made a lot of money out of British Gas Residential over the years, and their take gets larger as time goes by.
There's not much point looking at just one year of a company's profits, because almost no business has steady growth. That's why I've added up the latest three years of profits and compared them to three years of profits from ten years earlier, like this:
BG Residential profits*
These are just British Gas Residential profits, so they exclude British Gas services, wholesale and business divisions, and profits from the rest of Centrica.
As you can see, profits have tripled in the past three years compared to a three-year period ten years ago.
This hints at why focusing on the 5% figure can be deceptive. Another hint comes from the massive amount of money that shareholders have made.
Investors who bought Centrica at the start of 2003 are now close to tripling their money. With British Gas Residential being such a key part of its business, it doesn't seem possible without substantial help from it.
Profit margins can be deceptive
Let's say your corner shop makes a 5% profit margin and also that Facebook makes 5%. Are the owners of both equally rich?
If you make £100,000 and, after spending on costs, you make a 5% profit, you have just £5,000. If your friend pulls in £10 billion and makes a 5% profit, he has £500 million. You're not equally rich!
Raise prices and costs to increase profits
It follows that businesses in uncompetitive markets can easily raise both prices and spending, which enables them to keep the modest-looking 5% profit figure – but in real pound terms the directors and shareholders are making a lot more money.
Energy suppliers can raise prices for customers, increase costs as well to maintain a profit margin of 5%, but simultaneously increase the pounds they're earning.
Take staff costs. Staff at British Gas have risen from 23,000, according to the 2003 report, up to around 28,000.
To pay for all these new staff it will have raised prices for customers. This allows it to increase profits considerably, but also to stick around a 5% profit margin, which it could use to fob off journalists, the Government and the regulator.
The old “investment” argument
One argument for raising prices has always been that British Gas needs to invest. It has used this argument for years.
But these investments have not just made British Gas and its owner greener or more ethical, nor have they just maintained vital infrastructure – they have made it and its owner bigger, more valuable and more profitable.
British Gas and Centrica have many more assets today than they did ten years ago. These assets – many of them “investments” that Centrica might plead are essential or that it makes out of the goodness of its heart – add to the wealth of the company and its shareholders.
These investments aren't just basic necessities for running the business, nor can we believe that the directors are writing cheques for them merely out of concern for older customers or the environment.
Take free insulation, which British Gas has used as one of its examples of an “investment”, albeit not one of its most costly. I can't believe that this offer is remotely for selfless reasons.
To start with, it should lead to greater loyalty, which ensures people stay with British Gas on its expensive standard tariff for longer, rather than shopping around for a cheaper deal. Even more, it gives British Gas' services business an opportunity to look around your home, and sell you more insulation or other energy-saving measures.
Why did British Gas even pay Thames Water to let it give its free insulation to the water company's two million customers as well? Surely it isn't that desperate to help people?
Green investments are another opportunity for British Gas, not just some multi billion-pound cost that the Government is forcing on it. That's why the major power suppliers get to charge even higher prices than their expensive standard rates to people willing to pay a premium for wind or solar tariffs – in addition to hiring more staff, so they can raise prices and profits while maintaining a 5% margin.
Do we really believe that all these investments are merely vital for British Gas' survival? Is it vital that the business grows like it does, at the customers' expense?
Don't begrudge it
While competition in the gas and electricity market doesn't work well, it works better than in most countries, which has led to comparatively cheap prices here.
This doesn't mean prices are cheap or fair – it just means they're cheaper than many other places, where competition is lacking even more.
British Gas' owner Centrica is just doing what all companies are meant to do: trying to maximise and grow its profits. As an investor myself, that's what I'd expect it to do, provided it just uses legal means.
If anyone is to blame for shareholders making lots of money at customers' expense, it is OFGEM and its predecessor, and successive Governments that have allowed weak regulation.
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