– Dieter HELM –  – 
Why are electricity prices so politically toxic?

1 – The price of electricity has become a centerpiece of political debate. It provides a focus for a whole set of political concerns and prejudices. It directly impacts on household budgets and hence highlights the “squeezed middle”. Electricity is provided by big companies¾hitting the “fat cats” and “monopoly capitalism”  buttons. It is essential to modern life, and just like cash machines, we fear what happens when its supply is interrupted.

2 – These general worries encourage an altogether more immediate political dimension when there are accusations of profiteering. When price rises come thick and fast, and politicians and industry warn of ever-higher prices in the future, the scene is set for more attacks on the companies and all sorts of schemes to put things right.

3 – This is the sad reality of the current debates about electricity and energy prices, and already we have a commitment by the Labour Party to freeze prices for 20 months after the election and a Coalition response of a £50 transfer from bills to taxpayers for some of the green levies, a Competition and Markets Authority inquiry and a set of short term measures to head off power cuts from the System Operator, National Grid.

4 – This is not a happy situation for the customers, the companies or the economy. If there was general excess supply—as there has been for much of the last quarter of a century—it might not matter much. But all sides of the debate agree that there is no such luxury. On the contrary, excess demand not excess supply looks more likely and there is an urgent need for investment. There is not the time to hold endless consultations about reforms cobbled together for the General Election. On the contrary, for the first time since the mid 1970s, there is the prospect that the capacity margin will at least approximate zero, and may even go negative. Short of a major economic setback, or extremely benign weather conditions in winters to come, there is the emerging prospect of a power crisis. The British economy is growing again, and a few years of 2-3% GDP growth, and rising household incomes, might make the current forecasts of electricity and energy demand look complacent.

Are the wholesale prices too high?

5- Whilst for politicians it is often convenient not to let the facts get in the way of a good story, the facts do not go away by ignoring them. The interesting – and inconvenient – thing about the current debate on energy prices is that there are lots of facts. The prices of the main fuel inputs—coal and gas—are known. The wholesale price is known, and so are the retail prices. We may not know the full costs of wind, solar and biomass, and the price of nuclear fuels is opaque, but none of these is volatile in the short term, and none should put upward pressure on wholesale prices.

6 – Whilst it is true that the burden of renewables costs has been going up, because their share in total electricity generated is rising, the same cannot be said for the average costs of coal and gas combined. Since coal has been rising as a share of electricity (from around 28% to 40%) in the last couple of years, and since coal prices have been falling, the impact of coal on the average price has been to drive it down. Put simply, average fuel prices have been falling.

7 – Why then has the wholesale price been going up whilst the average fuel costs have been falling? In most markets if input costs fall, prices fall as a consequence. In the current market design, the wholesale price is set by the marginal, and not the average, cost. The marginal fuel is gas, and gas prices have been going up—a bit. The price is currently determined by the system marginal costs of the last plant needed to match supply and demand.

8 – Worse still, as the capacity margin tightens, ever more expensive power stations need to be brought on line, and hence the wholesale price rises accordingly. All the existing power stations needed to meet demand get paid the system marginal price. Hence a rising gas price and a tightening capacity margin combine to drive up prices, even if average costs fall.

9 – This is a world in which it is lucky to own a coal power station. The marginal costs of the coal stations go down, as the marginal costs of gas go up. Hence the gap between coal input prices and the wholesale price widens and up go profits.

10 – How could such a situation arise? Why are average and marginal costs so divergent? There are several possible explanations. First, it could be that there is not enough investment generally. The incumbent power companies might not be investing in response to market signals. Second, the companies may not be allowed to invest in the most cost effective technologies. The first is about market power; the second is about prohibiting new coal power stations.

11 – Monopolies and collusive oligopolies can maintain their market power if they can deter entry – and then extract monopoly rents if they then keep the market tight by themselves limiting investment. If uncertainty about political and regulatory policies is so great as to deter investment, this results in higher returns to the existing plants.

12 – In a competitive market, abnormal returns attract new investment. In the current market conditions that would be coal – as indeed it is in Germany. But new coal has, for good reasons, been effectively ruled out in Britain as part of climate change policy. Coal is very dirty, much dirtier than gas, and emissions performance standards mean that new coal will need to be CCS ready. This changes the cost equation, as would a rising carbon price.

13 – That leaves gas. If coal is ruled out and the capacity margin gets tight, the wholesale price should rise to the energy price of new gas. But it is unlikely to do so any time soon. The reasons are several, but one counts strongly. Outside the market, through ROCs and FiTs, the government is encouraging onshore and offshore wind, and solar. These technologies have high fixed costs and almost zero marginal costs. When the wind blows and the sun shines, as the Germans have discovered, renewables could eventually cover total demand for periods of the day. The result is a zero or even negative wholesale price. A new gas station is now at the mercy of the wind and the sun¾and hence it cannot be assured that it will run base-load. Intermittent renewables render everything else intermittent too. This wreaks havoc with new gas investments.

14 – The result is that nothing much is being built except through fixed price contracts, and new gas stations will need fixed price capacity contracts too. The system becomes a complete single buyer model, with the state through the system operator determining investment. The wholesale market is no longer the economic signal for new investment, and indeed it might now drift lower – as it has in Germany.

 15 – The result is that we have a system without adequate investment approaching a capacity crunch, with existing stations reaping the system marginal price.

16 – Is this price too high? There are two ways of thinking about this. If the sole purpose of the wholesale price is to bring enough power stations on to ensure supply equals demand, then the wholesale price should be the system marginal cost. However, the merit order of dispatch can be achieved independent of the price if the objective is to ensure that the generators make normal profits – i.e. they cover their marginal costs and make some contribution towards their fixed costs. Since the coal stations will have been fully depreciated quite some time ago, prices above the marginal cost of coal are profits and the higher the gas price the higher the coal profits. The alternative way of thinking about this is to consider the price the CEGB would have charged. This would have been sufficient to cover the CEGB’s total costs and it would therefore have been independent of the system marginal cost. We return below to the implications of cost-based pricing for investment.

Are prices bound to go ever-upwards?

17 – The future direction of the system marginal cost depends upon the future path of gas prices – since coal is not at the margin. Ed Davey is sure he knows that the gas price is going to keep going up. He told the BBC in his HARDTALK interview on January 14th 2014 that: “Most people are looking at that world [in 2023 and beyond] and saying ‘well, energy prices across the world are going to be going up’”

18 – Why should this be the case? Gas is abundant on world markets, LNG and pipeline supplies are growing and to the extent that the gas price is linked to oil prices there is no reason to believe the oil price will necessarily rise. Both peak oil and peak gas theories have been widely discredited and the scale of new discoveries of both conventional and unconventional oil and gas reserves is if anything accelerating.

19 – If the gas price were to fall, this would have a variety of effects. It would render the price freeze argument at best irrelevant. Indeed the price freeze might actually encourage higher profits. The price of coal might fall even further, though in Britain the policy position on coal combined with the impact of the European LCPD and the IED directives will in any event push it to the margins.

20 – Falling fossil fuel prices would be bad news for the case for renewables. The government’s position (and that of Miliband before the election) is based upon the assumption of rising fossil fuel prices, closing the gap between fossil fuel power generation and renewables. Davey went so far in his HARDTALK interview to suggest that the wholesale price might rise so far as to render the £92.50 MWH price for nuclear competitive in the next decade.

21 – Suppose the next few years resemble the early 1980s instead (again against the then prevailing expectation). The subsidies for renewables would be larger and might effectively become permanent.

Are retail margins justified?

22 – In addition to questions about the wholesale price, the retail margin is also open to challenge. The retail margin varies between the Big 6. Some earn as much as 5% and some – like RWE – publically aspire to 5%. Why is 5% a good number? What could justify it?

23 – There are broadly two approaches to determining the retail margin. The first is to estimate the costs and add on the risk premium. The second is to compare the margins with other businesses.

24 – Starting with the cost plus risk approach, retailing electricity requires working capital, operating costs to carry out billing and customer service activities, administrative services for the levies, smart meters and related policy costs, provisions for bad debts and debt collection, and a return for the risks.

25 – The recent regulated supply price margin in Northern Ireland provides a public domain set of information on these costs. The NI supply business is small so it does not benefit much from economies of scale. It is not vertically integrated so it has to buy through the market. The regulator allowed – and the company accepted – a retail margin of 1.7%.

26 – On a comparative basis, there are few close comparators. Supermarkets have large inventories, own shops and have physical functions. They therefore have capital assets, which require a return. Supply companies do not have the comparator capital requirements (though supermarkets tend to be cash positive because they sell before paying for their supplies). Supermarkets do not typically make 5%.

27 – It is argued that suppliers have volume risk—customers may desert them—and that they face price risk and therefore have hedging and risk management costs. It is true that customers may leave. But since there are significant economies of scale which smaller entrants cannot enjoy, the reasons must be mainly to do with poor customer service, failure to control their own costs, or because the government deliberately distorts the supply market in favour of entrants. Poor customer service in a number of cases – notably RWE and SSE – has resulted in fines and penalties. The government has deliberately exempted small suppliers from cost pass through.

28 – The hedging and price risk arguments are open to challenge. They could just pass through the wholesale price and avoid the use and costs of financial risk management instruments. The vertically integrated players also have the advantage of physical hedges that entrants do not enjoy.

Is the system capable of meeting the capacity crunch?

29 – Wholesale prices are higher than needed to remunerate the average fuel costs, but lower – by a large margin – than the level needed to encourage new investment. Such an increase would induce a major price shock to consumers. Intermittent zero marginal cost generation from renewables will, if anything, drive down the wholesale price.

30 – How then to induce sufficient investment? The answer is already apparent. There need to be fixed price contracts (FiTs and capacity contracts). The wholesale price will become only one part of the total price, not the single price. This in turn means that the price paid to new power stations will be different from that paid to old power stations.

31 – The move to non-wholesale pricing will go one stage further when the System Operator makes special payments to bring mothballed stations onto the system and to prevent closures.

32 – The central claim by the architect of the current market structure—NETA—was that it would, on its own, deliver sufficient investment. They were plainly wrong.

33 – The consequence of this mistaken belief is the capacity crunch forecast for the next couple of years. Unfortunately, it is not possible to add any more new power stations before 2016 at the earliest, and there will be a significant cost to the customers and to the economy of this mistake for as long as NETA continues to determine price. Prices in a capacity crunch with the current market design might peak sharply, before falling back as the economic fundamentals reassert themselves¾provided investment is incentivized through FiTs and capacity contracts.

Has OFGEM failed?

34 – The final question is: whose fault is it that the British electricity system has got into this mess? The candidates are the architects of NETA and those who have failed to take action in time to address its manifest flaws in general and its investment failures in particular. The criticism of OFGEM to date by Miliband has focused on the claim that the institution is toothless. An alternative is that it is not the institution but its leaders who have failed. The case for the prosecution is substantial.

35 – Over the last few years, OFGEM has conducted numerous inquiries and “probes”; yet the impact has not been to alleviate the underlying problems. As “owners” of NETA, and supporters of its introduction, it is hard to admit its faults.

36 – It remains to be seen whether, under new leadership, OFGEM can move on, or whether Miliband is right in his institutional criticism.

What to do now?

37 – It is not rocket science to fix the electricity market problems. The industry is in effect a set of power stations, a set of transmission and distribution systems, and a set of supply businesses. On generation, as average costs have fallen, it is not clear why retail prices have to rise because the marginal cost of gas has risen. On retail, it is not clear why the margin needs to be 5%. These can either be addressed through more competition, or through regulation.

38 – Competition in generation is moving towards the auctioning of fixed price contracts for wind, solar and nuclear. It would be possible to extend this to auctioning of existing plant. With such auctions, the wholesale price should fall back. Note that it is currently almost twice the German wholesale price, which in turn spills out across the northern European systems.

39 – What is emerging on the generation side is something which has a number of similarities to the CEGB model and in particular a fully-fledged central buyer. The government already determines the investment in almost everything except gas and it will soon determine gas too. There is not much left of the market. If it is going to be a central buyer, it should at least try to do the job properly. Once intervention starts it tends to have its own momentum. Each intervention begets another, and as the complexity piles up so do the unintended consequences and the costs. There is now a clear choice – back to the CEGB or back to a competitive model.

40 – What is apparent is that there is not much time. The next two years are going to be tight, short of a relapse into economic recession or amazingly benign weather. There is little option now but for the system operator to intervene intensively. In the short term it is all about command and control.