Cameron cannot win without cheap energy

The PM can’t cut subsidies on renewables without splitting the Coalition. But how else can he trump Miliband’s price freeze?

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An energetic gaze
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Patrick Heren
On 4 November 2013 19:44

Electorally, Ed Miliband is on to something with his pledge to freeze British energy prices for two years. "Hard-pressed families" would welcome an end to regular price rises as well as greater certainty in their energy bills.

There is a smell, if not of failure, at least of ineffectiveness in retail competition, especially in the electricity market. As the new nuclear deal with EDF confirms, the Conservatives and Liberal Democrats have been busily piling on the costs in pursuit of a low-carbon future: it will take some smart back-pedalling by the Tories in particular to put themselves in a position to offer an effective lower-cost alternative — with or without successful shale exploration.

It may not matter much that Labour began the process when it was in power, and Ed Miliband himself was the last Labour secretary of state for energy and climate change. The Coalition picked up Miliband's ball in 2010 and has been running hard for the goals set by the Climate Change Act of 2008: that 30 percent of our electricity should be generated from renewable sources by 2020. And (though no one admits this) damn the cost.

Under the Coalition Agreement, the Department of Energy and Climate Change (DECC) is a Liberal Democrat fiefdom whose ministers and officials blame all increases in energy bills on the wholesale market.

They also blame the utilities for being greedy and uncompetitive. And they deliberately obfuscate the effects of their own policies. Yet their policies are the main drivers of the price increases and the main reason that energy markets have become less effective.

The principal method until now has been to subsidise the cost of renewables by hidden charges on ordinary consumers' tariffs, known as the renewables obligation. These subsidies, expressed in £ per megawatt-hour, are added on to the wholesale market price achieved by each generator. An onshore wind farm is paid an extra £37/MWh on top of the market price, currently £52/MWh; an offshore wind farm gets an extra £84/MWh, or a total of £136/MWh, 2.6 times the wholesale price.

Once the energy bill before parliament is passed later this year, the renewables obligation will be replaced by a system of contracts for difference (CfDs) which will fix strike prices for different forms of renewables and, importantly, new nuclear.

Every contract for difference will be negotiated with each generator by a government agency, affording plenty of scope for bureaucratic muddle.

Under the CfD, the generator is guaranteed his strike price for 20 years, or longer in the case of nuclear. If the market price is lower than the strike price he will be paid the difference via a charge on consumer bills; if the market price is higher, then he pays back the difference.

In theory this is a better deal than the renewables obligation, which guarantees a premium whatever the market price. However, any advantage obtained under the CfD system would depend on a big increase from the current wholesale price. If, as many observers believe, wholesale prices go down in the coming years, CfDs will become more expensive than the renewables obligation.

In addition, the Coalition has imposed a "carbon price floor", essentially a tax on the main sources of electricity, coal and gas. This began in April this year at the relatively modest level of £4.94 per ton of CO2, doubling in 2014 and doubling again in 2015. By 2017 the carbon price floor will be £24.62/ton.

Such figures mean little to the average person, but in the real energy market they amount to a tax on natural gas of £0.91/MWh in 2013, building up to £3.30 in 2015, £4 in 2016 and £4.50 in 2017.

Forward gas currently trades around £60/MWh, so within four years the carbon price floor will be increasing the wholesale cost of gas by 7.5 per cent. This is not negligible, but it is unique in Europe: our competitors are not similarly hamstringing themselves.

There is also the £2.6 billion/year Energy Companies Obligation (ECO). Under the rules of ECO, energy suppliers are set targets to improve the energy efficiency of their domestic customers' buildings. DECC blandly describes the financial arrangements as being funded by the energy suppliers. Of course they are-via a surcharge on all customer bills. One utility, SSE, recently said ECO would add £100 to the average bill.

There are many other costs of government intervention in energy markets. The largest of those not directly related to the cost of energy itself is the expansion of the National Grid required to transport wind-generated electricity from the north of Scotland or — the really expensive bit — from the offshore wind sector in which the government places so much faith.

National Grid is a regulated monopoly which agrees investment targets and an allowable rate of return with Ofgem. It has decided that the likely amount of investment from 2013 to 2020 should be £20 billion.

But this is a movable target: if more renewable generators require more transmission capacity National Grid will supply it. And the entire cost will be passed to the customer. Colin Gibson, the former power networks director for National Grid, calculates that in 2020 the system costs required by the future wind turbine fleet will be in the region of £5 billion a year.

Beyond this, there are the capacity auctions which the government has now decided are necessary in order to ensure that there is sufficient gas-fired generating capacity to back up intermittent wind. Companies like EDF, E.ON and Centrica will be paid to build new plants and to keep them in readiness.

Because they will have to generate at short notice they will not be the highly efficient combined-cycle gas turbines (CCGTs) which have provided nearly half of our electricity for the past 20 years, but wasteful open cycle turbines which will also produce more CO2.

Before the passage in 2008 of the Climate Change Act (Rt Hon E. Miliband, proprietor), energy company bosses assumed they would be vying with one another to build new CCGTs during the present decade. After all, why wouldn't they want to invest their companies' money in one of the largest and most lucrative energy markets in the world?

Instead, deterred by the government's rush for renewables and growing appetite for intervention, they are waiting for the next subsidy.

There is more to come when the new energy bill — much delayed as the Tories belatedly began to understand the consequences — receives royal assent towards the end of the year. The bill, as one senior civil servant observed, essentially gives the secretary of state full powers to intervene at all points of the electricity supply industry.

Of course, usually it won't be the secretary of state who intervenes, but an ever-growing band of civil servants in an extraordinary proliferation of agencies — an explosion of indoor relief for the middle classes.

The energy bill amounts to a massive toolkit for hyperactive dirigiste politicians and civil servants — a real throwback to the pre-Thatcher corporate state. The one and very critical area where the energy bill fails to intervene is in the failed wholesale market for electricity. This is odd, given the presence of Tories in the Coalition. 

The Conservatives should reflect on their past successes. Competitive gas trading was pioneered in Britain 20 years ago and successfully exported to the rest of the EU. The economic benefits were huge, though now unacknowledged.

Gas came first, then electricity. Gas was the more successful, partly because from the very beginning there were a large number of competitors and a lack of vertical integration. 

Electricity was different. It always is. As Lenin said: "Communism is Soviet power plus the electrification of the whole country." Perhaps Ralph Miliband passed this thought on to Ed.

The Thatcher and Major governments, which privatised the electricity supply industry, were wary of getting things wrong, and in the end were too cautious. They fostered an oligopoly, with the Big Six — EDF, E.ON, nPower/RWE, Scottish Power, SSE and British Gas/Centrica — organised as vertically integrated generator/suppliers.

Most of the electricity generated by the Big Six is transferred directly to their supply arms at prices indirectly set by the gas market (gas is the marginal fuel in generation). There is little competition at wholesale level and thus no incentive to compete with each other effectively at retail level.

There is a simple solution to this problem: to require all the output of every generating station to be auctioned. This would increase competition in the wholesale market, driving down prices, and break the vertical integration that bedevils the retail sector. 

There are signs that the government and, interestingly, the Labour shadow minister Caroline Flint, understand the potential in cutting this Gordian knot. It is even possible that the power to order this rearrangement is hidden away in the new DECC toolkit.

One consequence of requiring all generated electricity to be auctioned would almost certainly be to reduce the wholesale electricity price. Most people might welcome that, but it would prove embarrassing for the government. The reason is that this would make the new CfDs even more expensive for the consumer than they appear today.

Take the £92.50/MWH strike price agreed between DECC and EDF for the two new nuclear reactors at Hinkley Point. At the current market price of £52/MWH EDF would be paid £40.50/MWH by a levy on our bills. If the price came down to the German level of £44/MWH, the compensation to EDF would be £48.50/MWH. As for offshore wind, with its strike price of £140/MWH, the costs will be astronomical.

Finally, there is the question of shale gas: how much there is, how much is recoverable, how much it will cost — and will ingrained British nimbyism ever let proper exploration begin?

After three years of inaction, the Coalition decided to encourage, cautiously, exploratory drilling, starting in politically sensitive West Sussex. In the next year or so we can expect more drilling of the Bowland Shale in Lancashire, where two well-funded companies, Cuadrilla and Igas, have substantial concessions. Centrica, owner of British Gas, has "farmed in" to the Cuadrilla operation, paying £60 million to fund six wells.

The British Geological Survey (BGS) report into shale potential was published by DECC earlier this year after lengthy political delay. It mostly confines itself to an assessment of the Bowland-Hodder Shale, which runs across the country from the Lancashire coast to Yorkshire, Humberside and Lincolnshire, and as far south as Derby.

The BGS central case is that there are 264 trillion cubic feet (tcf) in place, which compares with Cuadrilla's estimate of 200 tcf in just its concession around Blackpool. At this stage, any attempt to estimate how much of this can be technically produced, let alone at an economic cost, is guesswork.

However, going by American experience, a conservative estimate is that 10 per cent of gas in place can be produced economically: 20 tcf from Cuadrilla's area, or 26 tcf from the wider area considered by the BGS.

To put this into context, the North Sea has produced 85 tcf since 1970, and remaining proved reserves are 8.7 tcf. These numbers are elastic, and depend on price, fiscal regime, technology and geology. But they demonstrate that in time Britain's shale resources should prove nearly as important as the North Sea has done.

But politically, shale is a long-term consideration. The politicians who now realise that their policies are inevitably inflating the cost of energy to the electorate also know that the benefits of shale probably won't be felt until 2020. Meanwhile they need to respond to the general disenchantment both with competitive markets and with renewable subsidies.

On the Left, many are calling for a partial renationalisation, certainly at retail level. They argue that as there is little to choose between energy retailers, whom they accuse also of price-gouging, it would be better to have one publicly owned retail electricity agency, with a monopsony in the wholesale market and a monopoly in retail.

The Tories are in disarray. On October 23, David Cameron told the Commons that he would like to scale back some of the subsidies. That will prove difficult while he is in harness with the Liberal Democrats.

The fundamental problem is the commitment, made by the last Labour government and restated by the Coalition, to derive 20 per cent of total energy and 30 per cent of electricity from renewable sources by 2020.

Cameron seems to have neither the philosophical inclination nor the political courage to offer the electorate the possibility of scaling down or removing those objectives after the next election. But without cheap energy, he cannot win.

Patrick Heren is a journalist who specialises in competitive energy markets. He is the founder of Heren Energy (now ICIS Heren)

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