Published originally in a letter to the Financial Times, keep reading at UCL’s European Institute

Congratulations to the Oxford Energy Forum for convening a Special Issue for us geeks in the field – “Electricity market design during the Energy Transition and the Energy Crisis”.  Published on Friday 12th May, my own contribution, ‘Disentangling the debate on electricity market (re)design and ‘split markets’’ builds on and summarises recent work with colleagues at our Institute (UCL ISR) on ‘Navigating the Energy-Climate Crisis’.  It has built up to a series of four working papers, along with a recent policy report on decarbonising electricity for industrial electrification, published with the Aldersgate Group who supported the work along with the Institute of New Economic Thinking.

My OEF article summarises the fundamentals: why a single market based on short-run operating costs has caused problems and is not, on its own, adequate for the energy transition.

To be clear, the European Single Electricity Market does a great job at what it was designed to do—reflect, on a short-run basis, the cost of bringing on generation to meet demand at a specific time, anywhere across Europe.

But therein lie the problems. Firstly, it is a short run—very short run, marginal-cost-on-all market. The price in that market, received by all generators selling into it, feeds through almost all electricity consumption.

Secondly, most electricity systems are already split in terms of generation investments. Both nuclear stations and renewable energy technologies have in reality been financed primarily through additional mechanisms to support investment. Indeed, the most efficient mechanisms are those providing long-term price security, such as fixed feed-in tariffs or contracts-for-difference.

Moreover, these generators have very low operating costs. The figure below shows the British electricity ‘merit order’ structure (ranking based on generators’ short-run operating costs per unit output: vertical axis) plotted against their average annual output (for renewables) or available capacity (for thermal plant) in 2022 (horizontal axis). It is essentially what economists term a marginal cost curve – but strikingly, aside from biomass, it is not remotely continuous: compared to the average demand (33.5GW), the system was split almost evenly between plants that cost very little to run, and gas generation. The market structure, of course, meant that gas set the price; econometric studies show that in 2021, gas set the electricity price 98% of the time in Britain despite being only 40 per cent of generation.

Therein lay the great energy ‘winter of discontent’, and the reorientation of the UK government’s Review of Electricity Market Arrangements towards a wider range of fundamental questions. Namely, do we want short-run marginal prices applied to all generation and all consumption, or do we differentiate—and if so, why and how? And, if investment structures reflect long-run marginal costs – ie. the cost embodied in the contracts that financed the construction – should these to relate to consumer pricing—and if so, how?

In the current structure, all generators get the price required to ‘clear’ the market – ie. to bring on the most expensive generator required to meet demand in any given hour. In economic terms: ‘pay as clear’.  So most of the time renewables get the price of the most expensive fossil fuel plant required to meet demand.  But we are starting to see more periods when there is enough trenewables (plus nuclear) to meet demand – at which point, the market price collapses close to zero – known as ‘cannibalisation’.  If these sources just sold in to the electricity market at their operating cost they would never recover their capital costs. If they are guaranteed an output price, they bid negatively to make sure they can generate and so still get that guaranteed price. Competitive electricity markets are already beginning to see short periods of negative prices, alongside the wild high prices seen for much of 2022.

In economic terms this gap between short-run and long-run marginal costs will only increase, certainly in volume terms. In both the UK and the EU, non-fossil generation is expected to account for more than 75 per cent of generation by 2030—within seven years. The currently fossil-fuel-price-setting marginal cost curve element of the figure above is not only migrating rapidly to the right, it is on a trajectory to phase-out, reflecting the operational costs of fossil fuel generation.

The short-run prices are really important, for example to encourage storage – but how long can the disappearing fossil fuel tail continue to wag the dog of a renewables-based electricity system?

To read on and discover our analysis of the problem and proposed solutions to electricity market redesign, click ‘here’ for the Oxford Forum summary, or for detail, visit our working papers series: the evidence of historical prices (WP1); the revenues from the Energy Crisis (WP2); the underlying economic challenges (WP3); and what we coudl do about it (WP4).

The defining feature of the UK Energy Strategy is its incoherence. It doesn’t know what problem it is trying to solve – and thus fails to solve any. By largely ignoring energy efficiency and kicking the only possible short-term supply option into the long grass, by “consulting” about cheap onshore wind through “local partnerships” in a “limited number of supportive communities in England” – it most certainly won’t help families – or companies – struggling with energy bills for the coming winters.

The most credible element is on offshore wind, the great success story of the past decade. After the government effectively blocked most onshore in 2015, we’ve shown we can go offshore where capacity has grown sharply in recent years.  Up from almost nothing fifteen years ago, we are approaching 25 GW of wind overall, generating a similar percentage (almost 25%) of UK electricity split almost equally between offshore and onshore generation.  The strategy ups the offshore target for 2030 from 40 to 50GW.

That’s very ambitious but possible. At that level, wind (including existing onshore) would supply around two-thirds of current UK electricity demand, but UK demand is projected to rise with electric vehicles and heat pumps.  Wind generates more in winter, when energy demand and gas prices are highest.

But offshore wind involved very big and complex kit from only a few suppliers, it usually takes 3-4 years from contract to completion, and the pace of expansion could stress supply chains and drive up costs. If it were all concentrated in the North Sea, there would be immense challenges for the grid – both transmission, and in managing the peaks and the troughs. Wind is best when distributed more widely.

The cowardly failure in the Strategy concerns onshore wind. It is not only our cheapest energy resource – onshore wind would typically cost about third to a quarter of what people are now paying for their electricity. It is, along with solar, the only one that could make a dent in the short term. Any energy company or local authority can buy a wind turbine off-the-shelf.  It would take a few weeks or months to install.  But getting planning consent would take years – because the planning regulations were redesigned in 2015 to stop it. To “consult” with a “limited number of supportive communities” on our cheapest and quickest option for clean, cheap energy is hardly a Churchillian response to our national energy crisis.

Solar PV

50GW of solar PV – about four times current levels – was being floated, but doesn’t in the end appear in the Strategy. When the government first introduced incentives for solar, the capacity rocketed from 1 to 10GW within barely 3 years, so 50GW could be possible within a few years.  50GW PV would supply around 20% of UK currently UK electricity demand. There is little solar in mid-winter, but it would be a great complement to wind energy and take pressure off gas during long summer wind lulls, and annual needs particularly if the UK developed inter-seasonal gas storage – another silence in the strategy.

Nuclear

The Strategy proposes 24GW of nuclear power capacity by 2050, from 6.9GW at present. The initial proposal is to commit one new plant, likely the £20bn Sizewell C project in Suffolk, before the next general election. That illustrates the problem – or rather three – facing nuclear.

• It is slow. Based on all our past experience, a new big nuclear would take a decade. If it takes an energy crisis for the government to actually take a decision, sobeit, but it wont help to solve the crisis.
• It is expensive. Nuclear depends on public subsidy, with the government committed to taking a sizeable financial stake to make it viable.
• A nuclear fleet would need to be flexible, to ramp up and down with the swings of demand, wind, and solar, which further undermines the economics.

The Treasury might be pressured into forking out for Sizewell, but don’t expect them to underwrite 24GW, let alone see any of that built in this decade.

Energy efficiency

Energy efficiency was ignored in the Press Release for the UK Strategy, but – after a curious delay in publication – appeared up front in the Strategy itself.  On the surface, it’s an impressive list.  On closer inspection, it is almost entirely a reiteration of existing bits and pieces; fragments of support for what, before it was wrecked during the early 2010s, had once been a significant national effort to bring our antiquated buildings stock up to modern standards.  If the government can set out a 30-year strategy for nuclear, why can’t it manage even a 30-month strategy for energy efficiency even with the impetus of a major national crisis?

North Sea oil and gas

The Strategy confirms plans to issue licences this year for production from existing discoveries, considered as “pretty much ready to go” if oil and gas companies would exploit them. If and when those do get onstream, they won’t significantly affect the price since producers sell on international oil and gas markets –they’d hardly touch these assets otherwise. And there is a reason why UK output has been declining – we’ve depleted a lot of our reserves, and it will get harder and/or more costly to get more out. We can stave off the decline a bit.  And in the aftermath of the IPCC reports on climate change, it is – rightly – a tough sell trying to tell the world that we need to move away from fossil fuels, whilst aiming to squeeze out every drop from the North Sea.

Shale gas

Proposals to re-open the door to fracking – somewhat muted, it seems – upset environmentalists. Probably, they shouldn’t be too worried, apart from the wider signal it sends.  A decade ago many European countries opened up for shale exploration and almost nothing came of it.  You need to drill dozens, maybe hundreds of wells just to find out exactly what is down there and what it will take to get it out.  Whatever the government does, don’t hold your breath for shale to be – if and when anything actually emerges – anything more than an uneconomic trickle.  It sure won’t help with our energy price crisis.

Rationing?

The government has reassured us all that the government will not consider rationing gas supplies, unlike some European countries that have set in motion contingency plans.  The UK situation indeed differs, because our supplies are mainly divided between North Sea – Norway, and our own – and global trade in liquified natural gas.

But our pockets – and the Treasury – should be worried.  In the Russia-EU standoff, if either side really cuts off the gas, all hell will break loose in the international markets, and we would have to outbid both the EU and Asia for gas supplies.  That wont be pretty.  Indeed It could look like the oil shocks of the 1970s which rocked the entire global economy, and slashed GDP growth globally. The UK would be just a bit player in that, and the energy strategy does nothing for that scenario either.

Conclusion

The ultimate irony of a Strategy borne of a crisis is that by the time most of its proposals see fruition – if they do – the crisis will be long past. Global energy markets will have completed their gyrations and returned to normal, and Putin may no longer be in power.

But a lot of consumers and companies will have suffered horribly. We also risk undermining much that the UK has achieved on climate change. By failing to focus centrally on a joined-up strategy to solve these twin crises together, it fails to offer the energy sector the consistent signals that investors need, and may even worsen the short-term bills crisis, whilst our international credibility teeters on a knife-edge.

This blog was written on 7 April 2022 and appeared in abbreviated form in the Financial Times on 11 April 2022, at https://www.ft.com/content/3fe73617-5f8f-4b70-8856-ca53e2ec92b3

Some of the causes of sky-high energy bills are unavoidable – there is little that most governments can do about the wholesale price of gas itself. Fossil fuel companies make huge investments that take years to mature, breeding periods of moderate prices followed by supply squeezes when prices rocket. Gas prices softened over the previous decade and the arrival of the pandemic in 2020 depressed demand.

Regions without domestic gas supplies or which have depleted most of their gas reserves in recent decades get a lot of their gas by importing it. European periphery countries, including the UK and many parts of the Mediterranean, assumed they could rely on global supplies of liquefied natural gas. But tankers from the big gas producers such as Qatar can turn to Europe or Asia depending on who pays the highest price. Now there is a scramble, and Asian demand dominates.

The knock-on effect to energy bills is amplified in the UK and other countries in Europe where electricity is organised through wholesale markets (in which generators bid to operate if the price is right) and in which most homes rely on gas for heating. Average home energy bills in the UK, which rose to over £1,200 (US$1,630) in 2021, are predicted to shoot up by around 50% in 2022. Up to half of the rise will come not from the gas you burn, but from the impact of gas on electricity prices.

So why is a gas price crunch being felt just as strongly in electricity bills? After all, gas generates less than half of electricity – under 40% in the UK and only about 20% across the EU. Renewables generate over a quarter of UK power, nuclear and imports another quarter. The cost of generating power from wind and solar has tumbled over the past decade globally, falling by over 40% for onshore wind and by far more for solar and offshore wind.

The last fixed-price government contracts offered for offshore wind energy in Britain – hardly the cheapest of renewables – were under 5p per kilowatt hour (kWh). That’s less than a quarter of the typical domestic tariff (what most people pay for electricity at home) that consumers are set to face in 2022. Households are paying for their electricity several times what it now costs to generate and transmit it from the cleanest energy sources at scale.

The design of electricity systems has failed to catch up with the revolution in renewable energy. Competitive electricity markets, established in many countries to try and minimise costs, are actually suffering the greatest price rises. This is not because governments elsewhere use taxes to subsidise electricity (though some do), but because in wholesale electricity markets, the most expensive generator sets the price.

Since renewables and nuclear will always run when they can, it is fossil fuels – and at present, unequivocally gas, plus the cost of taxes on CO₂ pollution – which set the price almost all the time, because some gas plants are needed most of the time, and they won’t operate unless the electricity price is high enough to cover their operating cost. It’s a bit like having to pay the peak-period price for every train journey you take.

If renewables are now so much cheaper, why can’t consumers buy electricity directly from them and avoid paying the gas and carbon costs?

A new golden age

Energy markets aren’t designed to cope efficiently with sources like renewables which cost a lot to build but far less than fossil fuels to run. Governments offer long-term, fixed-price contracts to generators for their output of renewable energy. This has been the biggest driver of investment, while competitive auctions of these contracts, to companies keen to build renewables, have slashed building costs the most.

In contrast, households and other small consumers can rarely buy fixed-price contracts more than a year or two ahead, given the uncertainties in wholesale prices along with governments encouraging competitive switching between suppliers. The electricity generated from renewables contracts is fed into the rest of the system, which balances the variable output from renewables by generating more or less from conventional sources. That adds about around 1p per kWh to the cost of renewable electricity in the UK and Europe. Even accounting for this, the gap between cheap renewables and expensive final electricity is becoming unconscionable.

A decade ago, many energy experts projected a “golden age of gas”. Countries are likely to continue burning gas for some years. But with the drive to cut emissions and the advent of cheap renewables, electricity is likely to dominate the energy system in future, powering heat pumps, electric vehicles and more. This golden age of electricity cannot arrive as long as the price of electricity is decided by fossil fuels and their carbon costs.

What would electricity markets appropriate for renewable energy look like? In research I led with colleagues on electricity prices, we proposed a green power pool which would aggregate long-term contracts with renewable energy generators and sell the power on to consumers. The price would mainly be set by the actual investment costs of generators, rather than gas-driven wholesale markets.

When there isn’t enough renewable power being generated or stored – like on cold and calm winter days – the green power pool would buy electricity from the wholesale market for limited periods and quantities. To minimise those costs (and emissions), contracts could give discounts to customers who can use electricity outside of peak times, or those with two-way electric vehicle connections who can sell power back to the grid.

It won’t happen overnight. It won’t cut bills tomorrow. But new electricity needs a new market – one which cuts energy bills at the same time as decarbonising the energy system.

Op-ed, as appears in:

https://theconversation.com/renewables-are-cheaper-than-ever-so-why-are-household-energy-bills-only-going-up-174795