UK energy policy – where did liberalization go?

2 September 2014

The UK's intervention in the energy markets in favour of low-carbon energy sources is tantamount to renationalization. By Steve Kidd

I suggested a few months ago that the costs of the pro-renewables policies in Europe are at last getting recognised by the authorities and we could at last be seeing a gradual movement back in favour of nuclear (March 2014, 'European energy policy - will doors open for nuclear?'). Nevertheless, there remain some substantial challenges appearing in new and maybe unexpected quarters. For example, there is the new energy strategy in France which suggests a reduction in the nuclear share of electricity generation to 50% by 2025 (but without any obvious plan to get there). On the other hand, Russian actions in Ukraine suggest that the energy security argument in favour of nuclear in Europe remains as strong as ever. I also touched on this in July's comment in the context of the need to diversify Europe's supplies of natural gas to new suppliers ('Russia and Germany - new opportunities today?').

The Unit cartoon by Alexey Kovynev: "The quantity of mechanisms is not a problem. The problem is choosing the right one."

On 25 June 2014, Jan Mládek, the Czech Republic's minister of industry and trade, wrote to European Commissioner for energy Günther Oettinger, expressing a view in favour of nuclear power shared by ten European countries. Citing market failures that prevent new nuclear build from supporting European goals for energy security, sustainability and emissions reductions, it demands a level playing field for all low-emission sources in the EU. Its timing is rather good and should fit in nicely with some expected support from this year's International Energy Agency's World Energy Outlook, which will have at least one major chapter devoted to nuclear power's continuing important role.

One section of the Czech letter relates specifically to an area where the United Kingdom has taken several policy actions in the recent past. It reads, "It should be recognized that numerous market failures are currently preventing (nuclear) investment coming forward and this should not be overlooked by the Commission. Nuclear energy which requires capital-intensive and long-term investment should be supported by market mechanisms to create a predictable investment framework."

The UK was one of the first countries to undertake electricity sector liberalisation (starting in 1989) and, although there have been ups and downs (the bankruptcy of the nuclear operator British Energy and its rescue by EDF stand out), the experience has been closely observed elsewhere. The UK is now encouraging new nuclear investment through a contracts-for-difference (CfD) mechanism, in which it sets a minimum guaranteed price for electricity. If that rises above standard market rates, the utility keeps the difference; if it falls below, the government provides compensation. The UK is also gradually levelling a playing field that has formerly been very generous to renewables (which so far has largely meant onshore wind but has now spread to offshore wind projects too). Although the lead nuclear project (Hinkley Point C with EDF Energy as operator and main investor) isn't yet certain to go ahead, the belated support for nuclear from all the main political parties is certainly welcome. Definitely better late than never.

There are, however, significant concerns about UK energy policy which threaten to cast a shadow over what is currently happening. This is quite apart from the investigation by the EU Commission which has yet to report on whether the new UK policy in favour of nuclear constitutes illegal state aid.

"There is an increasing feeling within influential business and academic circles in the UK that energy policy since 1989 has been a costly failure and that more recent policy changes don't help"

There is an increasing feeling within influential business and academic circles in the UK that energy policy since 1989 has been a costly failure and that more recent policy changes don't help; indeed, they could make matters worse. Rising energy prices have become a big political issue, with widespread concern about an increase in energy poverty amongst vulnerable consumers. The UK is actually relatively well-endowed with energy resources (still good reserves of coal, oil and gas) and has been a leader in nuclear technology in the past. So why all of these problems?

Costs are rising not because of market prices (European natural gas prices are relatively low today despite the continuing conflict over Ukraine and problems in North Africa) but largely because of government support for renewables, which is gradually feeding through to energy bills. The concern is that these costs will rise further as more offshore wind farms and eventually new nuclear come on stream, both of which have guaranteed prices more than double current wholesale power prices. Meanwhile US energy costs continue to fall owing to the exploitation of lots of unconventional oil and gas, to the competitive benefit of US industry and the detriment of companies here and across Europe. And unless shale gas can be seriously developed in the UK, the nation will continue becoming ever more reliant on imports of gas, some of which is liquefied and relatively expensive.

Despite all the effort and money devoted to the issue, greenhouse gas emissions in the UK government's figures are down only fractionally over a five-year period, and this fall can mostly be attributed to low economic growth. Coal consumption has been rising, as in Germany, and rising in the absence of an effective carbon price, which is certainly a perverse result of a supposedly environmentally- friendly energy policy. Vital investment in power generating capacity is down because incentives required to bring in private capital have been forced out of the system. The government's latest remedy is to force National Grid to buy back-up generating capacity via a capacity payments mechanism to ensure that the lights will stay on.

"With such a large number of policy measures, and all of the bureaucratic apparatus that they require, the UK seems to be effectively renationalising the whole electricity system."

With such a large number of policy measures, and all of the bureaucratic apparatus that they require, the UK seems to be effectively renationalising the whole electricity system. The CfDs and the capacity mechanism will be core components. But there are also new reviews of gas policy, the introduction of a smart metering programme (which is attracting huge scepticism), relaunch of the Carbon Capture and Storage (CCS) policy, the Emissions Performance Standards (EPS) and the floor price of carbon mechanism. A whole host of other policies and interventions are either being developed or implemented.

From an economist's point of view, CfDs and capacity mechanisms suffer from lots of problems. To act providently, the government is required to have very considerable knowledge. It needs to be able to accurately predict the path of future electricity prices and the ability to pick the technologies and projects with which to negotiate that path. Predicting the future price depends upon knowing the future path of costs, notably for gas. Government ministers appear to be amazingly confident of their 'knowledge' of the increasing levels and volatility of future gas prices. A realistic government would question the assumption that gas prices will inexorably rise when all the evidence is that gas-to-gas competition is breaking the link to oil prices. Most gas producers would say today that the price trend is down, not up. Forecasting future gas prices is hazardous at the best of times, but it is much more so when there are major changes in the structure of world gas supplies. Yet this is what is required to set the right strike price level.

As the CfDs are long-term contracts, they embody central government procurement on behalf of electricity customers who will be forced to pay for them. The central buyer can decide what to buy (which generation technologies), and what subsidies will be paid for each 'winner', based on what are in effect 'strike price plus' contracts. In the case of nuclear, government officials' public statements are confusing and could yet tie the government in knots with the EU Commission. There have been repeated statements in the House of Commons and elsewhere that "there will be no subsidy" for nuclear, while at the same time there have been claims that nuclear will be on a level playing field with other low-carbon technologies. But subsidies of different levels are being and will be paid for all the other technologies in the low-carbon category. This raises interesting questions about how government decides a subsidy level on a case- by-case basis, how 'no subsidy' can be defined as 'equal subsidy,' and even how different subsidies for each low-carbon technology could be equalized. This is a real hornets' nest, and might be an irresistible target for nuclear opponents to try to stir up.

The capacity payments mechanism adds further complications. On behalf of the customers, the government will be procuring capacity not just via the CfDs but also via the capacity payments mechanism. So there will effectively be two different capacity mechanisms, each of which is assumed to address different market failures. In principle, if the two failures are different, new investments should be amenable to both (unless they uniquely accrue to specific technologies). The CfDs essentially enable nuclear to be procured alongside renewables. The capacity mechanism arises out of two issues: the need for power stations (predominantly gas-fired) to back up wind power when there is no wind, and the fact that the intermittent nature of wind makes the requirement for operation of gas power stations also intermittent. That means that suppliers of gas, and investors in gas-fired power stations, cannot be sure if and when they will run. So the CfDs answer a nuclear problem while the capacity mechanism answers the gas problem. Each technology has its own special 'sticking plaster', courtesy of HM Government.

The result is two different procurement mechanisms to solve a single problem, namely not enough generation capacity. This is one mechanism too many – it should have been possible to come up with a single unified system to cope. This situation is made a lot worse by wind farms avoiding having to pay for the system costs they so obviously cause. They do not provide (or pay for) firm capacity, with the result that all forms of electricity generation – even baseload supply like nuclear – are now threatened by the risk of becoming intermittent if annual renewable shares rise to 20% and above.

"I argue that it is indefensible that the government is guaranteeing index-linked prices and guaranteed revenues to private companies at a starting point way above the current wholesale price for 20 years"

There will be major political issues in the future if nuclear and offshore wind projects go ahead today on the back of what later seem to be very high strike prices. I argue that it is indefensible that the government is guaranteeing index-linked prices and guaranteed revenues to private companies at a starting point way above the current wholesale price for 20 years (or in the case of new nuclear for 35). How is this better than the arrangements the UK had under public ownership of electricity generation and supply before 1989? With performance incentives that allow suppliers and consumers a share of the benefits if the providers succeed in bringing costs and prices down, where is the competition in the system?

Despite so many initiatives and proposals, the British energy market is arguably no nearer to having a stable long-term energy and climate- change policy in place than in the past. There is much uncertainty about how onshore wind, offshore wind, nuclear and gas will fit together in the energy mix, together with concerns about security of supply and fuel poverty. The three policy objectives of energy security, cost & competitiveness and the reduction of emissions will remain, but for the last five years since the passage of the Climate Change Act of 2008, the priority in the UK (as in Europe) has been firmly set on the reduction of emissions. This now needs rebalancing, especially when new offshore wind power is being commissioned at a ridiculous £150 per MWh. Business in general is bothered both by level of costs and by the way in which energy policy has been politicized, adding to uncertainty and increasing risks. The level of lobbying by different interest groups has become intolerable.

Perhaps the biggest market failure, from a long-term perspective, is insufficient investment in future technology. Perhaps the best thing the UK and other developed countries could do to help resolve a global problem is to invest in world-leading science that can help produce new ways of producing, storing and consuming energy. Some of our best scientists need to be incentivised to find a way to create an energy system that meets the UK's national goals.

Steve Kidd is an independent nuclear consultant and economist with 17 years of work in senior positions at the World Nuclear Association and its predecessor organisation, the Uranium Institute.

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