Last week’s announcement by Britain’s energy and climate secretary Amber Rudd on curbing subsidies could well be the high water mark for renewable energy. Between 2004 and 2014, average domestic electricity prices in Britain increased by 75 percent after inflation. The rise provoked a consumer backlash. In pre-election manoeuvring, politicians had cast around for a villain, putting the Big Six energy companies squarely in the frame. The energy regulator Ofgem helpfully obliged and referred the sector to the Competition and Markets Authority (CMA) in March last year. In its report earlier this month, the CMA found that the main drivers of domestic electricity price increases from 2009 to 2013 was not profiteering by energy companies, but the cost of government-imposed social and environmental obligations and network costs, which in large part reflect the extra grid costs of integrating wind and solar capacity.
The social obligations come from the government uses energy companies as a disguised extension of the welfare state. Energy price increases have a highly regressive impact. Gas and electricity take up nearly ten percent of the household spending of the poorest ten percent of the population, compared to about three percent for the richest ten percent. Gas and electricity is the largest item of expenditure after housing for the poorest ten percent. Worse is to come. The Office for Budget Responsibility projects environmental levies will rise from £3.6bn last year to £13.6bn in five years – nearly four times the £3.5bn expected to be collected from banks via the bank levy and bank surcharge.
To assess whether the retail market was working properly, the CMA estimated what efficient costs would be and a ‘fair’ return on capital. It concluded that domestic customers paid £36 a year – equivalent to three percent on a typical combined gas and electricity bill – if retail markets had functioned more efficiently. This arose, the CMA says, from weak customer response giving suppliers unilateral market power. Companies can’t be blamed for their customers’ behaviour and the CMA criticized Ofgem’s kneejerk response of restricting consumer choice which it says constitutes an adverse effect on competition.
By contrast, the wholesale market works well in the short term in selecting generating capacity based on spot energy prices. The generating ‘merit order’ means that as demand rises, higher demand through each day is met by sequentially switching up the curve of generators’ variable costs which are chiefly determined by the cost of that generator’s fuel input – mainly gas or coal. Because the price received by the last generator sets the price for all generators, those further down the merit order are able to recover their fixed costs. This mechanism is crucial for investment incentives. Unless investors can see a realistic prospect of recovering their fixed costs, they won’t invest in new generating capacity.
However the policy of subsidizing wind and solar capacity prevents the wholesale market from fulfilling its longer term function as a capital allocation mechanism. Although retail electricity prices are rising sharply, incentives to invest in new thermal generating capacity – especially in gas-fired power stations – have been destroyed. The energy input of wind and solar comes from the weather and doesn’t have to be paid for. When the wind blows and the sun shines, they are at the bottom of the merit order, displacing coal and gas power stations. Large, random amounts of zero marginal cost wind-generated electricity make it virtually impossible to earn a return on conventional power stations.
Heavy asset write-downs indicate that investors do not expect to recover the costs of past investments. Decarbonization policies that boost renewables are thus making investment in reliable capacity less profitable and more risky. This is the crux of Britain’s looming energy crisis. The Coalition government recognised the problem. As part of Electricity Market Reform, it created a Capacity Market to subsidise the availability of spare capacity. But the first Capacity Market auction conducted in December did not result in investment of the type and scale required. Thus, at present, there is no mechanism to get sufficient investment into new gas-fired capacity, a situation worsened by EU policies on sulphur emissions which are forcing the closure of older coal fired power stations.
An efficient approach to cutting emissions of carbon dioxide would have been to impose a single carbon price across the economy. This was the policy initially adopted by using the European Emissions Trading Scheme and letting the market find the least cost way of cutting emissions. Instead Britain has a mix of subsidies and consumer levies which the CMA says may be more expensive, more complex and harder to design, the outcome being a sub-optimal balance between the conflicting objectives of affordability, reliability and boosting renewables.
Even here, the government has not implemented policy in the best interests of consumers. A key advantage in replacing the Renewables Obligation, which forces electricity suppliers to source an increasing proportion of demand from wind and solar, with Contracts for Difference (CfDs) is that competition could drive down the wholesale price guaranteed to investors. Yet the government over-rode competition and just handed out CfDs, over-paying investors by up to 58 percent and adding one percent to customers’ average electricity bills.
Predictably the renewable energy lobby criticized Ms Rudd’s announcement. But they had it coming. More renewables mean higher electricity bills. It was entirely predictable that policy-driven electricity price rises would, at some point, become politically unsustainable. The only question was when. Investors will react by demanding a higher risk premium for investing in the sector, which in a sector with a huge ongoing capital requirement will also push up electricity bills. A functioning electricity market cannot exist with a high proportion of highly subsidized intermittent renewable capacity. Ministers are still some way from recognizing that the fundamental choice is between using state-backed finance neutralise political risk or making wind and solar pay for the costs they cause and rely on the market instead.
However the government’s direction of travel is clear. The energy secretary also told the House of Commons energy and climate select committee last week that meeting emissions reductions targets is more important to her than meeting Britain’s renewable energy target. Ms Rudd’s move is the first step towards energy policy sanity. If she wants to keep the lights on and electricity bills down, it won’t be the last.
