There is considerable concern about the availability and price of energy for this winter and those that follow. Cornwall Insight has been contributing to the policy discourse through our widely-referenced domestic Default Tariff Cap analysis.
As prices continue to rise above what were considered unbelievable levels until recently, the signal from the market could not be clearer, not enough energy is available. The market design behind this signal is that those capable of reducing energy use should do so and the equilibrium between supply and demand should be restored. However, energy is unique because of its fundamental requirement for society and difficulty in storing. Electricity and gas demand are also held to be inelastic, with many people wishing to heat and light their homes and businesses regardless of price. Energy also is essential for many social, medical and business processes.
A government analysis from 2016 collated several studies and found gas demand elasticity was between 0.1 and 0.28, for every 10% to 28% increase in its price, the amount of gas consumed decreases by just 1%1.
There has been widespread discussion amongst politicians, think tanks and other stakeholders of measures aimed at reducing bills for some or all households. Most focus has been on interventions that route consumer help via energy retailers through freezing the price cap, and/or cutting VAT and certain levies from the energy bill.
All ideas should be welcomed at a time of crisis, but given the stakes, any package of measures deserves rigorous testing, even if this must be done at breakneck speed. We believe potential rapid interventions in the wholesale market (in the generation space) are possible and have considerable relative merit, but as yet are missing from the emerging menu of policy options.
From a consumer perspective, such generation focussed options, if successful, would address cost challenges for businesses as well as households through one set of interventions, without overly complex and costly mechanisms for consumer delivery, or novel financing. In basic terms, by reducing the price of power procured by suppliers from sources of generation upstream, they could lower wholesale power costs in bills faced by all consumers downstream. Corrections would need to be made for commitments made by suppliers for coming price cap periods and, possibly, for fixed-price business contracts (although this is more problematic given the different choices available to those users).
Such measures might include combinations of:
- Setting a maximum purchase price for gas to be used in power generated for consumption in Great Britain and Ireland. The difference between market purchase prices and the maximum price faced by generators would be funded or guaranteed by the state. This should be accompanied by an export tax on GB power to ensure interconnector flows are not distorted by the measure. Something similar has been implemented in Spain, but we believe this scheme can be improved by socializing the cost across the tax base, rather than the consumer base and by implementing protections on interconnector flow.
- Building on the UK Energy Research Centre (UKERC) idea for a Pot Zero2 CfD we could encourage a significant share of legacy non-Contract for Difference (CfD) generators to compete in government-sanctioned auctions for CFD-type contracts where they would sell generation at strike prices capped at a level which maintain investors’ original project return expectations.
- Based on market prices on 19/08/2022 we estimate that if all legacy RO, FiT and Existing Nuclear moved onto a CfD at the baseload reference price for winter 2021-22 (£102.5/MWh) and the cost of a ROC (£59.7/MWh), the overall cost to consumers of wholesale power purchases would reduce by £44.4bn. We will be providing more information on these assessments in an upcoming issue of Energy Spectrum, our weekly bulletin.
- Given many of these legacy projects are now many years old and commenced when power price expectations were lower than they are today, one would anticipate such strike prices to be well below levels flagged by the wholesale power market today, meaning such projects would be paying over money to keep consumer bills low as we have seen with existing CFDs for new projects.
- Mandating participation in this scheme would likely lead to detrimental outcomes (legal challenge by contract/PPA counterparties and investors with fiduciary duties to shareholders), to incentivise participation, the contract terms could extend project support beyond that envisaged by schemes that these new CFDs would replace (like the renewables obligation), and provide new long-term incentives for these generators to invest in repowering recipient projects, thereby delivering greater low carbon capacity as an additional benefit to lower prices. Noting policy schemes currently do not support repowering, this will provide project owners with a bankable route to increase the contribution of highly viable sites to the nation’s net zero future.
- Systems and data changes to bring in new sources of demand side response (DSR), National Grid ESO is actively pursuing a scheme to allow DSR from Half Hourly Metered Customers to be dispatched by the Electricity National Control Centre (ENCC) this winter, this should be extended to include asset meters on electric vehicles and heat pumps, the relative number of these meters is low but the impact could be quite extensive given the size of these loads
- Ofgem could extend powers in the Generation License to mandate cost reflective bidding by all generators into the electricity Balancing Mechanism and create a quasi-pool system with a return to central dispatch
These options are part of a wider package of measures and buy us time to implement some of the longer-standing options. So, we would still need targeted support for vulnerable customers for bills, particularly gas heating bills.
We must be particularly careful any solution does not leave the most vulnerable consumers rationing unnecessarily, and we still believe that it would be useful to transition from the Default Tariff Cap to other mechanisms to support such customers.
This means there needs to be adequate incentives and opportunities provided to households and businesses to reduce energy demand and become more energy efficient. Avoiding blackouts in cold still conditions will require some level of collective response and supporting businesses that invest in energy efficiency. We really do need to get to a point where we realise that a kilowatt-hour not consumed is worth at least as much as one produced and reward those who can save or switch energy in the same way as those that produce it. Otherwise, the current huge transfer of wealth from energy consumers to producers will continue, with much of it flooding out of the United Kingdom.
These and other measures are in common discussion across significant parts of the energy industry and we believe there is goodwill for changes to happen in advance of the UK government’s Review of Electricity Market Arrangements (REMA). But we must caution pinning hopes on REMA providing radical short-term options when it is focused on providing long-term changes to meet our net zero ambitions.
[2] https://ukerc.ac.uk/publications/can-renewables-help-keep-bills-down/
[3] Thanks to Mike Coulten of Origami Energy (https://www.origamienergy.com/)
