Ministers should leave the market aloneby / September 18, 2014 / Leave a comment
Published in October 2014 issue of Prospect Magazine
This piece is part of our special report on energy policy. To read the second piece in the series, click here. To read the third piece in the series, click here.
When it comes to energy, most politicians say they want lower prices and more investment. The word “and” is altogether more palatable than the word “or.” All sorts of wheezes are deployed to put off the day of reckoning. Labour leader Ed Miliband wants to freeze prices while he makes the market competitive. Prime Minister David Cameron thinks it will be more palatable if taxpayers rather than customers pay for some of the more expensive policy interventions. Chancellor George Osborne thinks that nuclear investment can be paid for with Chinese money. Meanwhile Ed Davey, Secretary of State for Energy and Climate Change, holds out the fantasy that more investment will mean lower prices, because he knows that the price of gas (and oil) is likely to keep going ever upwards, until it makes even offshore wind economic. His certain knowledge of the future is not unique—both his predecessors, Ed Miliband and Chris Huhne, held similar views.
How did we get into this mess? And more importantly, how do we get out of it? Electricity is not that complicated: it requires fuel inputs, enough power stations to cope with demand shocks, wires and billing and metering. Many countries have managed perfectly adequately for the last 100 years. Why can’t Britain do this in the 21st century too?
Luck has compounded complacency, encouraged by the economic recession, which bought quite a lot of time, as demand fell away. Then there has been a windfall on costs, which customers should have seen. Over the last two years the price of coal has been falling sharply. Indeed, coal has become so cheap that the generators have ramped up the coal burn, while mothballing newer and much less polluting gas-fired power stations. In any normal competitive market this would lead to lower wholesale prices, and in turn lower retail prices. Not so in the British electricity market. The wholesale price of electricity is set by the marginal (gas) costs and not the average (coal) costs. Whatever happens to coal prices, if the gas price rises so does the wholesale price. Lucky generators pay lower average costs for the coal, and get the higher marginal cost from the gas.
So far, so profitable. But the gas price is not going up; despite the certainty that Miliband, Huhne and Davey have had that fossil fuel prices are a one-way bet. Gas prices are going down. Wholesale prices should follow, but they are not. At least one of the so-called “Big Six” energy companies explains the reluctance to pass on these marginal cost reductions by blaming Miliband for proposing a price freeze. While there is a lot wrong with having a price freeze, it is hard to think of a competitive market in which a large company could have the luxury of choosing when customers will get the benefit of falling costs. Entrants would simply wipe it out. But then electricity is not, and has never been, a textbook example of a competitive market.
Even with cost-reflective wholesale prices, these would not translate directly into retail prices because the government has decided that customers should pay for a whole host of policies, from uneconomic offshore wind to energy efficiency programmes. Contrary to Ed Davey’s claims, these are already having a significant impact on bills. He has failed to do his arithmetic properly and, for example, add in the costs of the grid and distribution systems to connect up all his wind farms, and the back-up generation capacity to keep the lights on when the wind either does not blow enough, or blows too much for the turbines to withstand.
The result is depressingly predictable. Consumers are paying too much, and companies do not invest because of the fear, and now the reality, of, government intervention. The rules keep changing, and investors demand a higher rate of return to compensate for the political and regulatory interventions. All too predictably, the electricity market has become uninvestable without direct government intervention. Though prices are high relative to costs, the capacity margin has shrunk, and it would only take a problem with a couple of nuclear reactors in winter to cause a serious crisis. At the same time, emissions are going up—all that coal burning is increasing them. To fail on one of the three policy objectives—security of supply, decarbonisation and affordability—would be bad, but to fail on all three is terrible.
What, then, to do? Having seriously undermined private incentives, government has stepped in directly. Under the energy market reforms, launched by Miliband and faithfully followed through by Huhne and Davey, almost all investments in the electricity industry will now be on the basis of government-backed fixed price contracts. All the renewables and nuclear will receive “feed-in tariffs” (FiTs)—certain incentives to encourage the production of renewable energy—and new gas power stations will get capacity contracts. The Department of Energy and Climate Change (DECC) will pick the “winners,” which customers will be forced to pay for, since it knows fossil fuel prices and hence wholesale prices will keep on rising. It knows that energy efficiency will reduce energy demand, and hence it knows that, irrespective of rising prices, bills will fall as we use less electricity. Davey has failed to register the basic facts: that fossil fuel prices are falling; that wholesale prices are falling; and that the capacity and FiT contracts will further drive down wholesale prices. In addition, wholesale prices in northern Europe are currently about half those in Britain.
The government now decides how many of which sort of power stations to build as the central buyer. Instead of taking market risk, investors will lend on the basis of these fixed-price, government-backed contracts. It is back to the good old days of the Central Electricity Generating Board, when ministers know best. And as they inevitably discover they don’t, more rather than less intervention will probably follow. Labour wants to fix prices too.
There is an alternative. It starts with humility, recognising that politicians do not know what future fossil fuel prices will be, and allowing the market to determine the outcome subject to the carbon and security constraints. It continues with admitting that the current policy interventions are not working. It requires accepting that competition reveals costs as they are, rather than as politicians would like them to be. Above all, it requires acceptance that investors should be allowed to make a profit on their investments.
The prize is a big one. Instead of the state planning a known future, it might open the door to a market-led technological revolution. Next generation solar, electric cars, storage, smart grids, smart meters, and the application of new materials like graphene do not figure much in a DECC-planned electricity sector. None of them will come without cost, but they need not cost as much as offshore wind and all the other investments ministers are picking instead. The irony is that the political pursuit of lower prices and its chosen “winners” have driven prices and costs up, not down.