The Secret of Cheap Energy: Fire Chris Huhne

The global price of gas should be falling, but our "greenest ever" government is busy driving up the cost of heating our homes

Patrick Heren

Given the norms of modern political contest, it is not surprising that at the last election in 2010 the three main parties offered almost identical energy policies — or rather, climate change and energy policies. Each promised an enormous shift to low-carbon electricity generation by 2020, with more to come by mid-century. Each promised a green bank and a massive increase in energy conservation. Each vowed to encourage carbon capture and storage projects, and to prevent construction of any but the cleanest coal-fired power stations.

The only disagreement was that Labour and the Tories both wanted to build new nuclear power stations, to which the Liberal Democrats were completely opposed. And there was one important aspect of Britain’s energy on which all three party manifestos were silent: natural gas, which provides 40 per cent of the UK’s primary energy and nearly half of its electricity generation.

A Liberal Democrat, Chris Huhne, emerged as Secretary of State for Energy and Climate Change. His three junior ministers are all Tories, but of the modern sort who seem not much interested in one of the great achievements of past Tory governments: the competitive and privatised gas markets. Nor do they seem to understand the problems with the unfinished liberalisation of the electricity market.

In office, Huhne initially maintained his party’s anti-nuclear line, but the weight of Conservative and civil service opinion prevailed. Senior officials have long maintained the view that nuclear was the only way to keep the lights on and carbon emissions down.

The Department of Energy and Climate Change (DECC) is less than five years old, and was established not out of concern for Britain’s energy as such, but to meet the prevailing public anxiety about carbon emissions and global warming. The old Energy Department, which had dealt with the growth of the North Sea, the miners’ strike and the privatisation of power and gas, had been disbanded in 1992, its offices handed over to MI5 and its residual functions allocated to the Department for Trade and Industry. The degree of Labour government interest in energy matters can be judged by the fact that the portfolio was held by nine undistinguished junior ministers in 11 years.

In the absence of an Energy Department, the innovative and competitive British energy markets developed almost without direct government involvement. The basic principles had been laid down in the 1980s: separation of transmission from trading and equal access to transmission networks, overseen by independent regulators. Much of the work of governance was done by the gas and electricity industries themselves, with the regulators holding the ring. The result — emphatically in gas, less so in electricity — was pragmatic, cost-effective and competitive.

Competition brought gas prices down to unprecedented levels, the benefits of which were passed on not only to gas consumers, but also to electricity users. That is because private investors invariably chose to invest in combined cycle gas turbines (CCGTs) rather than coal or alternatives. The plant was cheaper and quicker to build, and the fuel was abundant. The construction of more than 20 CCGTs over a dozen years was the only significant addition to the UK’s stock of power generation.

But the gas industry was much simpler to liberalise than the power sector. Lenin famously said: “Communism is Soviet power plus the electrification of the whole country.” Not even Mrs Thatcher and her ministers were prepared to allow the fortunes of British power supply to be left wholly to the vagaries of commerce. Unlike the plans for gas, the electricity privatisation structures—as is only to be expected when ministers and civil servants involve themselves in market design—were flawed from the beginning.

Perhaps the most revealing aspect of the initial attempt to sell off the electricity supply industry in 1988 is that Cecil Parkinson, then the Energy Secretary, thought he could include the nuclear stations. A couple of weeks after seeing his prospectus, the message came back from the City: nuclear power, no thanks. They had swiftly seen through the long-held official claim that nuclear power was competitive with fossil fuel. They had also understood that with ownership would come open-ended liabilities for decommissioning, spent fuel, etc.

Privatisation went ahead without the nukes. The sale of the fossil and hydro-generators was, on the face of it, immensely successful. But the new market had been designed deliberately not to send price signals that reflected the surplus of supply over demand. The mechanism that ensured the post-privatisation dividends and share prices of the new companies was called the electricity pool. This was dressed up to look like a market, with trading desks, trading screens and plenty of turnover. But it was a supply-side-only market, where only generators bid in prices, which were accordingly comfortable for all concerned. End-users and retailers were excluded.

Meanwhile, the more modern atomic plants were bundled into a company called British Energy, which successfully floated in 1995. But the company’s viability was based on a dubious premise — the unrealistically high prices in the electricity pool. When in 2001 the pool was replaced by a two-way market, the price of electricity fell below £20 per megawatt hour (MWh) and British Energy’s nuclear-generated electricity became uneconomic.

The government of the day had to act fast. It would not try to recast the energy market to eliminate price risk. But neither would it allow British Energy to shut down. The subsequent emergency restructuring cost the taxpayer £5 billion over three years, while shareholders were fortunate to get away with 2.5 per cent of their pre-crash equity. The government also took over the liabilities for decommissioning, spent fuel, etc: in the long term these are impossible to quantify, but £100 billion is a reasonable estimate.

That expensive fix will last until the remaining reactors reach the end of their working lives after 2020. While he was merely a posturing opposition politician, Huhne indulged the fantasy that old nuclear capacity would be replaced by renewables. But the Coalition Agreement expressed support for new nuclear power plants “provided that they are subject to the normal planning process for major projects…and also provided that they receive no public subsidy”. The problem is that generating companies, even enthusiasts like EDF, will not build nuclear plants without extensive government guarantees. As well as the long-term liabilities, they are concerned about electricity price volatility.

The British market price of electricity moves in close alignment with the spot gas price, because gas is the marginal fuel for the big generators. By the time the Labour government had completed its “rescue” of British Energy in 2005, the gas price had nearly tripled from its 2002 low, and nuclear generation was again profitable.

The existing electricity market is better than the old pool, but it is not fully transparent. It has allowed the Big Six companies to flourish by transferring nearly all of their generated electricity directly to their marketing arms. Transfer prices are produced on a spot market conducted at the margins of their business, and closely aligned to gas prices. This makes it difficult for new entrants.

The solution favoured by many observers — including the Commons Select Committee on Energy and Climate Change — would be to reform the wholesale market, probably by requiring every generator to offer all of its output on to a new and more open type of electricity pool, from which all marketers would buy their supplies. The Big Six could continue to market as well as generate electricity, but they would be buying it on the same terms as everyone else.

Although Huhne has instituted a programme he calls electricity market reform, he has shied away from reforming the wholesale market. Instead, his department has ploughed on with elaborations of the green energy price-support schemes first brought in after Labour signed up to EU-wide policies to promote renewable energy. These policies include the large combustion plant directive, which will lead to the closure of much of Britain’s coal-fired generation capacity by 2016. More importantly Labour pledged that 20 per cent of electricity would be generated from low-carbon sources by 2020.

Since 2002 the principal delivery mechanism has been the Renewables Obligation (RO), which obliges suppliers to buy a specified percentage of renewables, or hold Renewable Obligations Certificates (ROCs) equal to that percentage. The current annual RO is 12.4 per cent, or twice the actual availability of renewables, which means that suppliers have to make up the shortfall by purchasing certificates at £30/MWh. The current market price of electricity is about £50/MWh, which must be added to the cost of the certificates.

The RO principally favours onshore and offshore wind investment. Other low-carbon energies, particularly nuclear, have not benefited. And the consumer has borne the cost of the RO. At the time of writing, the full picture of what the government wants is not clear. But it is pursuing five strategic aims:

1. New contracts to support low-carbon energy. The principal one is the feed-in tariff, which guarantees the generator a set premium over the market price. This received its first trial with the solar feed-in tariff scheme that DECC has just scaled back amid much protest from the solar industry. In the case of nuclear, this will probably be allied to a Contract for Differences (CFD). The CFD is set at a fixed price: a premium as measured by an agreed market index would go to the counter-party, who would in turn make up any shortfall to the generator. No decision has been made about the counter-party, but it is almost certain to be a state agency.

2. Carbon Price Support (CPS). The EU Emissions Trading Scheme has failed to deliver high enough carbon prices to make low-carbon energy competitive because member states lack the will to impose the requisite degree of carbon rationing. CPS is proposed as a supplement to current and forecast ETS prices, administered by the Treasury. It would raise the carbon price to £16 a ton in 2013 and by degrees to £30 a ton in 2020.

3. An Emissions Performance Standard (EPS) to set against the most polluting electricity generation. The EPS as proposed would have no material impact. The Commons select committee commented that the future prospect of the EPS being tightened introduces additional political risk.

4. A generation capacity mechanism designed to ensure energy security. Again, this is likely to be too late to impact on the need to replace the coal and nuclear plant closing in the short — and medium — term. The actual replacement capacity provided by private industry will be largely gas-fired.

5. Enhanced energy conservation measures.

While the government likes to pretend its policies are based on market mechanisms, Huhne is actually planning comprehensive department-led permanent intervention throughout the energy industries. Feed-in tariffs, carbon price support and emissions standards levels will all be set by civil servants or through new quangos. Every decision will be politicised. If you doubt that, just look at the way in which the solar feed-in tariff has fluctuated in 18 months. The last time the government was that involved in the minutiae of energy industry decision-making, it put the nation in hock to the National Union of Miners, while investing unwisely in the wrong nuclear technology.

And to what purpose? The principal beneficiaries so far have been wind generators. As is now beginning to be generally understood, the more wind turbines we install, the more gas generation we will need to keep on expensive and wasteful standby to back it up. Nuclear power would undoubtedly be encouraged by a combination of feed-in tariffs and CFDs, but the public mood post-Fukushima has not yet been tested: Germans, admittedly a more panicky race than the British, have decided to close down all their existing plants by 2020.

The financial benefits of these various low-carbon support mechanisms accrue either to the big utilities, in the case of offshore wind and nuclear, or to wealthy investors, in the case of onshore wind, solar and the rest. The cost is borne by the ordinary energy consumer.

When Huhne claims his policies will protect consumers from undue price rises on the international gas and oil markets he commits the cardinal sin of believing price forecasts that suit his argument. In fact the global gas price is likely to fall under pressure from growing competition across Europe, abundant supplies of liquefied natural gas, and the promise of shale gas in the US. Huhne is determined to talk down the potential of shale, but all geologists know that it is a long-term game changer.

And if that depresses you, remember this: Britain met its Kyoto target because of the dash for gas. 

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