September 27, 2022
Reform wholesale electricity pricing before the next crisis
Professor Brian Sturgess, Chris Hill, and Oliver Ontiveros

Introduction

 

British consumers of electricity, households, businesses, and institutions were facing months of energy hell before the new government’s decision to cap household energy bills at an average of £2,500 per year from October 1. The proposed support package to alleviate energy inflation for businesses has yet to be fully announced, but it is equally important. Households contain voters, but businesses will have to deliver the government’s new economic growth priority. Politicians across Europe including the UK have been dishing out many populist solutions to the energy crisis– abolish green levies, freeze household energy bills, remove VAT, restart fracking, increase gas production in the North Sea, reopen coal mines, windfall taxes on oil and gas companies, but none of these are compatible with net-zero targets. All are short-term to promote the idea that politicians are doing something to ease the energy cost-of-living crisis before a move to the promised land when electricity is generated mainly by renewables at close to zero marginal cost and the country’s energy sources are also secure from international conflicts.

 

If this policy of freezing the price cap had not been introduced the Office of Gas and Electricity Markets (Ofgem), the energy regulator, predicted that from October the typical household gas and electricity bill could have risen by 75% from £1,971 per annum in April to £3,549. Before the government’s intervention industry forecasts were suggesting a further doubling by next Spring. [1] It is well understood that the major cause of rising energy bills is soaring gas prices, due to Russia’s use of energy as a geo-political weapon complementing the trend expansion in the demand for gas as a temporary decarbonization stop-gap (See Stagflation and Net Zero[2]), but there is little transparency in the government’s plans. The Institute for Fiscal Studies (IFS), a think tank, has suggested that the proposed intervention is inefficient and untargeted and could cost taxpayers somewhere between £60 to £100 billion in the next twelve months based on 2019 consumption levels. [3] However, neither these figures nor government estimates really add up. A crude analysis of the proposed price cap based on the average household consumption of electricity alone of around 3.7 MWh of electricity shows that there is something seriously wrong with the regulated pricing mechanism and independent estimates of the taxpayer support needed, although the government is reluctant to provide a figure.

 

Making a very crude assumption that half of this consumption across the country is generated by renewables at an average cost of £48/MWh and another half by gas-fired generation at the inflated price of £446/MWh, ignoring other sources such as nuclear, and adding an appropriate mark-up produces a more realistic average electricity cost per household of £1,523 per year, 50% of what October’s price cap would have cost and 61% of the government’s announced price cap freeze. In Scotland, where renewables and nuclear accounted for a much higher proportion of electricity generated, over 80%, the difference between the price cap per household and the average cost of producing electricity [4] is even greater.[5]

 

Before the Russian-Ukraine conflict, many industry experts and economists realized that the price cap was inefficient, unnecessary, and based on ‘arbitrary and implausible’ assumptions of the strength of effective competition in the supply of energy by Ofgem.[6]This regulatory failure resulted in supplier bankruptcies as gas prices edged upwards in 2021, but we go further and argue that the increased reliance on generating electricity from gas has had a major impact on the wholesale price of electricity and this would have broken the price cap eventually even if the war in the Ukraine had not happened. The rise in the significance of gas in the UK was due to government policies that look problematic in retrospect: running down nuclear, phasing out coal and the over generous subsidization of investment in renewables with a marked underinvestment in storage capacity. 

 

In this paper we argue that the United Kingdom is evolving from a hierarchical vertical linear electricity system to a decentralised complex system. However, as the electricity system’s structural complexity increased, there has been no attempt to modify a broken regulatory system where the politically sensitive price-capped retail price for energy is based on distorted national wholesale prices which no longer reflect actual local market supply or demand conditions for electricity nor provide the correct market signals necessary to attract investment to meet net-zero targets. In this respect, a more significant announcement by the government before the price support measures was the decision by Kwasi-Kwarteng, now Chancellor, to review the current operation of electricity markets, [7]with proposals to be submitted to the Department of Business Energy and Industrial Strategy (BEIS) on the Review of Electricity Market Arrangements (REMA) by October 10. In this respect we explore the implications of scrapping the current price cap completely based on a national wholesale market price and moving to market based zonal or nodal local wholesale pricing systems that reflects the system’s growing complexity. Reforming national wholesale pricing will take the political pressure out of electricity prices and allowing targeted assistance to tackle fuel poverty while still encouraging investment that will facilitate net zero, reduce average prices and encouraging economic growth.

 

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