Energy costs are big news. In the UK, they have been high on the political agenda for years, though the 2022 energy crisis exacerbated the challenges: its long shadow has left millions of households saddled with ‘energy debt’ of unpaid bills, as well as further dragging down the international competitiveness of heavy industry. This Commentary steps back to look briefly at some of the bigger system questions around energy bills, and suggests five strategies to alleviate them.
First, by one macroeconomic metric – the national ‘energy cost share’ (ECS) of consumer bills (domestic and business) in relation to GDP – the UK and EU haven’t been out of line with other countries, at least until the energy crisis. Our paper last year identified a relatively narrow range of ECS, with total consumer energy expenditures typically varying around about 7.5% of GDP amongst developed economies. The ECS in Europe was no higher than in the US, which has much lower energy prices, but is much more profligate in its use of energy.
In a subsequent paper published earlier this Autumn, we subjected that proposition to a rigorous econometric analysis, with a much wider set of countries. We find that the hypothesis of a limited ECS range holds broadly across developed countries (i.e. the ECS is almost independent of long-run energy price, and the variations observed are statistically insignificant). Over time, high energy prices drive adjustments, on both demand and supply, which tend to bring the ECS back within the stable range. Countries which had earlier subsidised energy to keep it cheap were actually worse off in terms of ECS, their structural energy-inefficiencies being deeply embedded.
Unfortunately though, most of the adjustment timescales are long – our first paper estimated, around quarter of a century. The adjustment processes involve innovation, enhanced efficiency – and structural changes, including outsourcing of energy intensive production (which has an influence, but which we estimated, generally not sufficient to undermine the basic conclusion). The recent paper confirms the high inertia in responses; the measured ‘half life’ of adjustment (time after a price shock to adjust half-way back to the long-run average ECS) in developed countries is around 12 years. The pain of the 2022 energy crisis has a long way to linger.
Moreover, the idea of constant ECS does not hold for most developing countries, which have higher ECS, which also grows with their energy price (at least when measured on purchasing-power-parity basis) – and their adjustment timescales seem even longer.
What bearing does this have on the current debates about energy prices? First, in no way does it mean, don’t worry; 12-25 years is far too long to endure the impact of disproportionately high energy prices without ameliorating measures. Moreover, the studies mostly measure response to global price shocks; the 2022 price shock and its aftermath have dominated in Europe, particularly the long cost tail of seeking to wean off Russian gas.
So we should first disentangle the problems of energy-intensive, tradeable industry (EITIs), arising from comparative energy prices, from the concerns about domestic energy bills. Historically, the UK has tended to interpret economic principles of ‘efficient’ cost allocation as meaning equal prices, or at least equal distribution of costs, across all consumer groups.
In reality, for energy-intensive industry, comparative international energy price is the primary issue, including attracting international capital as well as the competitiveness of traded goods.
For domestic and service sector (eg. public and commercial) consumers, it is the overall bill that matters – and specifically, for households, the affordability of energy within overall household discretionary expenditures.
This latter means caring both about household energy efficiency, and distribution. Our recent paper – as well as more specific policy evaluations (such as a UCL evaluation of UK public sector loan schemes) – confirms that direct government energy efficiency programmes have had a clear impact in reducing energy demand (they can be both more rapid than pure price-induced reactions, and reach efficiencies that price alone cannot). Affordability necessarily also concerns how energy costs fall across consumer groups, especially since the better-off are generally more able to afford, access, and implement measures that may take more up-front investment but save energy over time.
So how does the UK response to date match up, and what are the main strategic options to manage energy prices and bills in the course of transition?
The remainder of this Commentary points to five areas for priority consideration (there are, of course, others).
1) Cost allocations and domestic bills
First, cost allocation. The system still carries significant legacy costs associated with launching the transition, in particular, the ongoing contracts under the Renewables Obligation scheme which dominate current the policy costs. Moves earlier this year to reduce industrial energy prices by exempting many energy-intensive industries from the bulk of such costs made sense.
The UK has been a real outlier in terms of the cost of electricity relative to gas, which a.o. impedes the move towards the efficiency of heat pumps. For the long-run economics of transition there is a strong case to spread the legacy costs across electricity and gas; however the welfare implications, and politics, of adding to domestic gas bills was untenable. Following policy reversals on attempts to reduce winter fuel payments for pensioners, the UK budget last week moved much of the legacy ‘Renewables Obligation’ support off bills, and on to general taxation – a sensible fix, but not a sustainable long-term approach to managing system costs.
The price of electricity also impedes the shift away from oil towards electric vehicles – which also implies a change in accounting mindsets. The Secretariat of State committed to reduce household bills by £300/yr, whilst seeking to accelerate the move to EVs. As long as ‘household energy bills’ are understood (and measured by Ofgem) as gas and electricity, it is untenable to expect them to fall if and as they incorporate a whole new sector of consumer demand, ie. personal transport. It makes no sense to exclude the cost of driving a gasoline car, but then include the cost of driving electric – which increasingly represents a net energy cost saving. Household bills must be understood, and reported, to either include personal transport or not.
The combined efficiency and emission savings afforded by electrification, across heating, transport, and many industries, underline the need for reforms which also support that wider transition.
2) Post-contract renewables
Second, we need focused attention to the treatment of assets coming off their support contracts. Over 5GW of renewables will be coming of RO support contracts within eighteen months – in 2027. In principle, one might expect that this could provide a stream of low-cost renewable energy, with the capital paid off – from generators which moreover made handsome and unexpected degrees of profits through the energy crisis.
The reality is of course more complex. But to the extent that there is a stream of paid-off renewables, consumers currently have no direct visibility of this; and if these renewables operate in the wholesale market, they will not bring down prices for anyone. Also as outlined in our briefing paper on post-contract renewables, their future prospects are actually varied and uncertain. At present, the government has no coherent approach or strategy for making best use of these past investments. If indeed the country has a forthcoming stream of cheap ‘post-contract’ renewable energy, the government needs to consider how to make best use of these for consumers – whether for energy-intensive industries, or to visibly help alleviate fuel poverty.
3) System flexibility and use of surplus renewables
Third, the cost of building and operating our emerging electricity system will depend heavily upon making the best use and efficient operation of renewable energy assets overall. Our paper on Generating Surplus identified the scale of potential surplus generation already by 2030, particularly at times of strong wind output, even without transmission constraints. Even with proposed built-out, increasing amounts of renewables output risks being shut out by transmission constraints and unused – which is potentially, an economic (and environmental) waste.
The key to making best economic use of renewables in these circumstances is to enhance system flexibility, most obviously through increasing storage capabilities over various durations. We need to also ensure that storage is located and used efficiently to enhance the use of renewables within a given region, i.e. with respect to location and transmission constraints. We have seen an extraordinary pace of innovation and cost reduction in batteries, and a wide variety of technologies hold promise for longer duration storage as well. If the government wants to make best economic use of renewables, then enhancing flexibility, at multiple levels in the system, needs to be given priority equal to, and alongside, increasing renewables capacity.
4) Energy efficiency revisited
Fourth: the budget announced the end of the ‘ECO’ energy efficiency scheme. This was launched a decade ago in the context of a misguided ‘Green Deal’ assumption that domestic consumers themselves could be the engine of household energy efficiency investments (see also the ex-post critique). ECO was therefore focused on more expensive measures, for poorer households – a focus which has proved systematically problematic. But the more that some or all households are relieved from high energy costs, the more important become overt policies for energy efficiency.
The net loss or gain from ending the ECO scheme will largely depend on the design of the ‘Warm Homes Plan,’ due to replace it. There are also ways of targeting low-interest loans to enhance buildings efficiency which avoid the mistakes of the Green Deal. Again though, the requirement is broader. Increasingly, the built environment is no longer just a source of demand, but a source of value within the wider energy system – in which ‘fabric first’ is not always the best approach, either for the occupants or more widely.
5) Low interest loans
Finally, most elements of a low-carbon energy system are capital intensive: they are more or less expensive, depending on the time horizon considered, and in particular, the interest rate. The energy crisis and its follow-on repercussions have driven inflation, which in turn has driven up UK interest rates as the Bank of England uses the traditional (and mandated) tool to curb inflation.
This creates a double problem. Mark Carney amongst others already identified the ‘tragedy of horizons’ of short-termism in financial markets, relative to the long time horizons of climate change. Our studies of energy cost shares underline that energy is also a very long-term sector, and as pinpointed in a recent paper on ‘beyond externalities’, the capital intensity of low carbon assets at a time of higher interest rates brings a paradox. Energy costs contribute to inflation; whilst higher interest rates in general curb inflation, in the case of energy & infrastructure investment they exacerbate it, by driving up the cost of investment (and hence contract prices). The UK government needs to look carefully at the monetary rulebook to consider the case for using lower-interest loans to accelerate a lower-cost energy transition.
To conclude: the previous energy shocks were global and mostly driven by oil, driving structural changes on both supply and demand which helped to bring national energy-cost-shares back within the long term sustainable norm. The recent energy crisis is different – and plays out alongside ever more potent impacts of climate change. The UK’s recent measures may reduce the pain of high prices, but cannot mask the need for more far-reaching transitions, with deepened electrification across sectors. Yet the UK remains an outlier in the price of its electricity, especially relative to gas at end-use – a discrepancy which will only worsen as and when European gas prices recede. The measures taken this year do not solve the underlying problem; they are just modest steps on a much bigger journey.