Money to Burn
Nigel Williams, 8 June 2011
The Scale of the Issue
As is well known, energy costs are rising. The next questions from a business perspective are by how much and how easy is it to cope with. In the Blue Book, the Office for National Statistics publishes calculations for contributions to the economy by each business sector. The most recent data, from the 2010 publication, relate to 2008. In the ‘Combined Use’ matrix are estimates of each sector’s intermediate consumption, meaning the things they buy from other businesses in the course of their own production. Four subsections are predominantly energy-related, namely “Coal extraction”, “Coke ovens, refined petroleum & nuclear fuel”, “Electricity production and distribution” and “Gas distribution”. The total of a business sector’s purchases from these categories gives a reasonable estimate of its energy costs. The table also shows “Gross operating surplus and mixed income”, which is the difference between a business’s sales and its costs. For ease, I shall refer to it as “surplus”.
The graph shows energy costs as a proportion of surplus for the sectors with the highest energy costs relative to their profits in 2008, not showing the energy sectors themselves. If, as set out in Chain Reactions for the chemicals sector, energy costs approximately double by 2020, these are the reductions in surplus that businesses will be required to handle. Two aspects need bearing in mind. The costs are estimates. It may be that some payments from an energy supplier are for something other than energy and likewise some energy may be bought from other sectors. The figures are also aggregates. Not every company in a category will have the same profile of energy costs and surplus and some will be affected more or less severely. The graph shows sectors in which a combination of high energy costs and narrow margins will have consequences for an average business.
In case the details are not easily readable from the graph, the fourteen selected business categories have energy costs for 2008 close to their surplus or much higher. In descending order, they are Iron, steel and other metals, Shipbuilding, Structural clay, cement and lime, Ceramic goods, Rubber products, Air transport, Inorganic and organic chemicals, Dairy, Paper, Paper products, Glass and Textiles.
How to cope with an increase in energy costs
Trust that the costs will rise less than predicted
One of the consequences of subsidies can be that prices rise to take advantage. The subsidised customer pays a similar amount, while the producer receives what the customer pays plus the subsidy. Sometimes the reverse is true with taxes and surcharges. If the customer is unable to pay any extra but the same money needs to pay both the supplier and the levier of tax, then the basic price may reduce.
Concentrate on the less affected products
A company may choose to vary its products, favouring those that return a higher margin. If energy costs have gone up, that entails shifting the portfolio towards products that require less energy. There are two difficulties: the production needs to be reconfigured, potentially requiring new investment; customers need to be found for the new products. It is easier to continue selling the existing products largely to the same customers. For some producers, there is the possibility that the current increases in energy costs will lead to new demand for energy-savers. Again, Chain Reactions has examples of products with the potential to reduce the use of energy.
Absorb the new costs
The company can try to absorb all the costs in its operating surplus. This is the easiest option in one sense, being entirely under management control. It is clearly unattractive to business owners. For some sectors, the high level of energy costs relative to surplus allows for very little absorption before the business becomes unprofitable.
Cut other costs
Other costs may be reduced. Cuts in salaries or prices paid to suppliers save some of the money that needs to be found to pay for energy. Obviously this has adverse consequences, upsetting the workforce. Suppliers have their own concerns, finding money to pay for energy. Reducing the prices paid to suppliers is likely to make a contribution only where the suppliers are less intensive users of energy.
Traditional good business practice
Other business means may be found to increase margin. The classic three are to raise prices, cut costs and increase profitable turnover. Businesses will be looking to do this anyway, without needing the stimulus of a windfall extra cost. The potential to increase prices is limited by competitors, since customers may switch away from a supplier when a cheaper alternative is available.
Reducing Energy Use
The last options are the environmentally beneficial ones of reducing energy use or switching to sustainable sources. For the sectors illustrated in the graph above, the new costs have the potential to push businesses to the break-even point and below. Their priority will be with the most cost-effective of available means. The government’s gamble rest on how great a proportion of the savings demanded these beneficial means can deliver. The combined use matrix for the Blue Book will provide the means to monitor their success.
Abandon Ship?
If no combination of these measures is enough to defray the extra costs of energy, then other more serious options start being considered. Where the remaining surplus is too small to justify continued production, then the owner can choose to relocate the plant or to close it down. Relocations have happened in the past where cheaper labour has been available overseas. Cheaper energy provides another economic justification. It is an expensive option at first but will be considered if existing production is more expensive in the long term. After relocation, the UK government has far less influence over the quantity of fossil fuel used in production. Membership of the EU customs union restricts the import tariffs the UK may levy on imports on the basis of embedded carbon.
The last possibility is for production to cease altogether. For some products, such as leaded petrol or CFC propellants, alternatives have been found and few people have mourned their near-total disappearance. Not every product can be so readily replaced. When sectors such as paper, sugar, ceramics and dairy production are threatened by the combination of high energy costs and low margins, it reveals how great a social adjustment may follow from the choice to reduce dependence on fossil fuels.
