Foolhardy government assumptions about fuel prices are making a transition to clean technology needlessly expensive
Fossil fuels sparked the industrial revolution and took society from laborious poverty to unprecedented wealth: An illustration from the Morgan Bible, c.1240, left, and an illustration of the Imperial Gasworks, King’s Cross, London, 1824
There is an unexpected parallel between our energy policy and the self-deception and wishful thinking exhibited by the mishandling of intelligence in the run-up to the invasion of Iraq in 2003. The Blair government ignored warnings about the reliability of sources, some of whom were fantasists, and “sexed up” whatever evidence it thought it did have. In an alarmingly similar fashion, successive British governments since the White Paper of the same year have been basing energy and climate change policy on questionable evidence, much from visionary green NGOs, dubious assumptions about future oil and gas prices and flawed reasoning about the beneficial effects of current renewable generation technologies.
The thrust of this policy — unfortunately supported by all three main parties — is to offer heavy subsidies, mostly for wind power, by means of levies on energy bills: a regressive wealth transfer from consumers to investors in renewables and to large utilities. The scale of these burdens, already significant at about £2.2 billion a year, is set to grow dramatically as we struggle to reach the 2020 targets set by the European Union’s Renewables Directive.
This makes UK energy policy the world’s biggest position in gas, since it is a bet that prices of fossil fuels will very quickly rise to high levels and stay there for the foreseeable future. If that fails to occur then renewables policies are going to look extremely foolish. Moreover, if government really believes in its own wager on renewables versus gas, why it is necessary to offer very generous 20-year subsidy contracts to developers of technologies that will be competitive within a decade?
In order to meet those EU 2020 targets for renewable energy Britain must derive at least 30 per cent of electricity consumed from renewable sources, in addition to 12 per cent of heat and 10 per cent of transport fuels. The cost of the heat subsidies is to be met from general tax revenue (about £450 million a year in 2020), while renewable transport fuels will cost motorists upwards of £1 billion a year in 2020, on top of the £33 billion of tax already levied on petrol and diesel — with economic consequences that are too little considered.
These are hardly negligible figures, but the main concern relates to renewable electricity, which has to provide about half the target quantity. We can estimate the costs from the current subsidy mechanism, the Renewables Obligation (RO), which is scheduled to run until 2017; generators registered before that date will continue to qualify for subsidies. The government hopes that the replacement mechanism, the awkwardly named Feed-in Tariffs with Contracts for Difference (FiTs-CfDs), will offer some savings; but there is every reason to doubt this because the underlying costs of the technologies have not changed much.
Using the RO costs, and the rough technology mix of the government’s central scenario, we can calculate that the subsidy required in 2020 will be in the region of £8 billion a year. This figure is astonishing but not controversial: even the Committee on Climate Change estimated that the cost will be about £7 billion a year, though Lord Turner, its then chairman, preferred to express this as an additional 2p a kilowatt hour (kWh), presumably because such a number is a halfpenny short of proverbial nothing and few people realise that the UK consumes about 330 billion kWh of electrical energy each year.
On top of the subsidy there will be grid and system management costs, which are much more difficult to estimate with confidence. However, Colin Gibson, a former power networks director for National Grid, has calculated that the systems impact of the wind power required by the targets could be in the region of £5 billion a year in 2020. Together with VAT the total additional cost to the consumer comes to about £14 billion a year, or 1 per cent of current GDP. The consequences of such a vast barnacle on the hull of the British economy should be obvious.
And it gets worse. There is very good evidence to suggest that the carbon price floor, introduced on April 1 this year, will add 40 per cent to the subsidy income of onshore wind farms and any built before 2017. This will be the result of a general increase in the wholesale price of electricity benefiting even those generators that do not pay the tax. If all renewable generators with planning consent are built before 2017, a not unreasonable assumption given the financial incentives, and that some of that in planning is also approved and built before that date, we calculate that this carbon price floor subsidy to renewables would amount to a further £2 billion a year.
Furthermore, the generators required to meet the 2020 target create a long-term cost through the commitment to subsidise the investments until the end of their lives. Even if we abandon the idea of renewables targets after 2020, as the Prime Minister has already hinted, subsidies under the RO are guaranteed for 20 years, so plant built in 2019 would be a burden to consumers until 2038. Since we can’t be certain of the construction rate it is hard to do more than give a rough idea of the total bill, but it seems likely that the annual costs in 2020 will persist for at least a decade, making the total additional cost to the economy from 2002, when subsidies started, to 2030 in the region of £200 billion. Precision in such estimates is impossible and we emphasise that this is an indicative not a predictive figure. That said, the order of magnitude is clear; current policies are very, very expensive, and almost certainly politically unsellable.
Nevertheless, there is a widespread assumption that provided our competitors also bear the costs of climate policy, all will be well economically. The only risk, on this view, is if our policies are relatively expensive. However, while this suggestion has some merit to it when the cost increases are quite modest, total costs on the scale we have just been describing are intrinsically dangerous. The fact is that developed nations are rich and the developing world is becoming richer because energy is cheap, and if we force our energy costs to rise by the premature adoption of renewables, standards of living in the developed nations must fall. This will mean rather more than a trimming of luxuries: it will entail a progressive deterioration in fundamentals such as our ability to maintain adequate healthcare or food supplies free of toxins and pathogens.
Anyone who doubts this needs to understand just how unusual the period of growing prosperity following the industrial revolution was, and how crucial the role of fossil fuels was in overcoming the limits of an economy grounded in organic energy cycles. A good place to start is E. A. Wrigley’s Energy and the English Industrial Revolution (Cambridge University Press, 2010), which shows that England only avoided the stagnation in economic production predicted by the classical economists, Smith and Ricardo, by switching from seasonal flows of energy gathered from a finite land resource to vast fossilised stocks. The key consideration was the relative cheapness of energy from these stocks: Wrigley notes that in 1851 some 128,000 coalminers were producing more than ten times as much energy as the agricultural workforce of 1.13 million. The individual coalminer produced more than 100 times as much energy as the individual agricultural worker. Productivity at this level translated, of course, into low energy prices, ensuring rapid economic development, widespread wealth and an unprecedented improvement in living standards. As Wrigley observes, there have been many sophisticated and intellectually impressive civilisations based on organic flows of energy, but while their elites were rich, “the bulk of the population was poor once the land was fully settled; and it seemed beyond human endeavour to alter this state of affairs”. He continues:
The “laborious poverty”, in the words of Jevons, to which most men and women were condemned did not arise from lack of personal freedom, from discrimination, or from the nature of the political or legal system, though it might be aggravated by such factors. It sprang from the nature of all organic economies.
When ministers or lobbyists invoke with excited approval the scale of the future green energy sector and the number of jobs that will be required to support the renewables industries they are unwittingly deploying a devastating argument against their own case. Like pre-industrial agriculture, renewables currently exhibit very low economic productivity. Unless costs fall dramatically, and soon, the resulting renewables-based economy will be similar to that of the organic energy economies of the past. Wages in the sector will be low and energy will be very expensive, restricting economic growth and the expansion of wealth. So unattractive is this prospect that we do not believe that any contemporary democracy will accept it for more than a few years before insisting on a return to high-productivity energy sources. Indeed, such resistance is already visible and will surely grow, particularly if the costs of renewable energy show no sign of improving and fossil fuels continue to be cheap or become even cheaper.
An essential pillar of the government’s case is that gas prices will remain high for several decades, leading to higher electricity prices unless we make a decisive switch to renewables. It is true that the wholesale gas price sets the wholesale electricity price, because gas is the marginal fuel. But this fact will not protect consumers under the Renewables Obligation since renewable generators receive their subsidies in addition to, not instead of, the wholesale price of their electrical energy. If the price of conventional energy increases, the total income to renewables — and cost to consumers — also increases.
The system of Feed-in Tariffs with Contracts for Difference due to be introduced by the Energy Bill is different. Renewable generators will receive a fixed price (the “strike price”) for their electricity. Broadly speaking, the prices must reflect a similar level of support to those offered by the RO to attract investment. As the Department for Energy and Climate Change puts it: “Projects that secure a CfD will gain access to long-term, inflation-linked payments, removing wholesale price volatility”, thus “substantially reducing the commercial risks faced by these projects”.
But while generators will be compensated by a levy on consumers when wholesale market prices are below the strike price, they will not be permitted to benefit when (and if) wholesale prices are higher than the strike price. The latter outcome — wholesale market prices being above the strike prices of wind, nuclear, biomass, and so on — is fundamental to the government’s argument that the new arrangement will save consumers money. We are by no means as confident as the energy department seems to be of the future direction of energy markets, and we think it most unlikely that they will reach, let alone breach, the CfD strike prices now being cooked up in Whitehall.
The obvious question is whether government should be taking what is in effect an inflexible, long-term position on fossil fuel prices. Our view is that with so much at stake only near-certainty would be an adequate justification, and yet the truth is that no one, let alone the politicised civil service, can gather sufficient information or analyse it with adequate wisdom to deliver such a verdict.
There are already signs that the generator companies have the upper hand in deals and that the negotiated prices may conceal unpleasant surprises. The current annual wholesale price of electricity is about £50 a megawatt hour (MWh). The strike price being negotiated by the energy department and Electricité de France (EDF) for the proposed nuclear plant at Hinkley Point in Somerset is said to be of the order of £100/MWh, an impressive mark-up. However, if the true cost of financing, building, running and decommissioning Hinkley Point is likely to be about £160/MWh, as some analysts think, EDF will most certainly require, and be in a good position to demand, further government support to cover the difference between the strike price and that overall cost figure.
The department expects the other major source of low-carbon generation will be offshore wind. Under the RO new offshore wind generators receive two renewables obligation certificates (ROCs), worth about £50 each, for every megawatt hour of electrical energy, plus the wholesale price of that electricity. Today that adds up to about £150/MWh. Under the new FiT-CfD system, they will have to receive strike prices close to this figure or no one will invest. Onshore wind (at around £100/MWh) and biomass (at £150/MWh) are the other bulk contributors.
Here is a rough example of what this might mean in practice. Let us also suppose that the EU renewables directive targets are met using the plant mix expected by government, in which case 15 per cent of our electrical energy consumption will come from offshore wind (at £150/MWh), 10 per cent from onshore wind (at £100/MWh), and about 5 per cent from biomass (at £150/MWh). Let us suppose that about 20 per cent comes from nuclear (at £100/MWh), as at present. In such a scenario the average cost of electricity from those sources, taking about half the market, would be inflated to about £120/MWh, two-and-a-half times the wholesale price of electricity from other sources.
Of course, in reality, the conventional, unsubsidised sector would also tend to seek higher overall prices or compensating subsidies because they would be generating less and attempting to recover their investment and running costs from lower sales.
This will hit the consumer very hard. Even the energy department admits that in 2020 as a result of its policies domestic consumers will be paying 33 per cent more and medium-sized businesses 46 per cent more. Of course government goes on to claim that these effects can be offset by improvements in energy efficiency, but no one believes this, and the fact that energy efficiency measures have to be subsidised to drive uptake suggests that they are not as effective as the department asserts.
The scenario outlined above does not seem a trouble-free path to the low-carbon future; indeed, we judge the cost impact to be so severe that standards of living will deteriorate. Consumer distress and rebellion will inevitably follow. There is, of course, another way: to continue to rely on gas-fired generation to provide competitively priced power, while significantly reducing (though not eliminating) carbon emissions. Unfortunately, this is a course the government and its advisers are determined to ignore.
Recent energy policy has spawned a proliferation of agencies including the Committee for Climate Change (CCC). Its task is to advise government “on emissions targets and report to parliament on progress made in reducing greenhouse gas emissions and preparing for climate change”. It says that it does this by providing independent advice, and by engaging with a “wide range of organisations and individuals to share evidence and analysis”.
But the CCC is anything but impartial and independent. Its role is to support existing policy, and its engagement with the wider world includes publicly slapping down anyone who questions the assumptions on which this policy is based.
Yet the CCC is not immune to the growing official uneasiness with public perceptions of the cost of low-carbon energy. In a recent paper it acknowledged that household electricity bills would rise by £100 in the medium term to 2020, but claimed that in the following decade they would rise only by £25, “with probable reductions thereafter”.
In addition the CCC posits that increases in household bills would be higher with increased gas-fired power generation: in the long term, it claims, the average annual bill could be as much as £600 a year higher than in a low-carbon world.
This is an extraordinary statement, which reflects the CCC’s unrealistic expectation “that carbon prices will continue to rise in an increasingly carbon-constrained world, and the inherent uncertainty in gas prices, which could also rise”. In fact, due to the political difficulty of imposing such costs on European industry, EU carbon prices — the only real market in the world — have collapsed to €5/tonne. To be effective in promoting clean technology, carbon prices would need to be at least €50/tonne. There is no chance of this happening.
Gas prices may indeed rise in real terms over the next half-century — this is an open market — but they may also fall. Although our traditional sources of gas in the North Sea are in decline, there is a potentially massive reserve of shale gas in Lancashire. In the world as a whole, the ratio of proved gas reserves to consumption is 63 years — statistically, such a large ratio as to be meaningless. Recent years have seen enormous discoveries of conventional gas all over the world, while outside North America shale exploration is in its infancy.
Somewhat perversely the CCC is broadly “anti-gas” as a solution to British energy needs, as the minutes of a recent board meeting reveal:
The Committee’s previous analysis shows that a failure to invest in low-carbon technologies through the 2020s and instead to invest in gas-fired generation is likely to increase future costs and risks. Including such a scenario in the gas-generation strategy is unhelpful given the need to secure supply chain investment, and for development of new low-carbon investments.
Yet the CCC’s own analysis demonstrates that switching from coal to gas in power generation would cut British CO2 emissions from electricity by nearly half — from 500 to 280 kilograms of CO2 a megawatt hour. This astonishing result would be achieved simply by shutting all coal-fired plant and replacing it with gas, something that should happen soon anyway under the EU’s large combustion plant directive.
Or at least it would happen if the political and regulatory risk created by government had not deterred investors from investing in gas-fired power stations. Until the distortions of current policy began to bite, the private sector had an excellent record of investing in gas supply, delivery infrastructure and generation plant. Now these companies hardly know where to put their hands and feet, let alone their money, and we are threatened with a quite unnecessary shortfall in generation-capacity.
Ironically, the more wind power we install, the more we need gas-fired power stations to support them because the output of a large fleet of wind turbines fluctuates uncontrollably from near zero to maximum, sometimes over short timescales. Having so comprehensively distorted the market, the government is now being forced to create a “capacity mechanism” to guarantee security of supply, for example on a cold, windless winter afternoon. This will offer companies lucrative contracts just to build power stations and make them available; they will, in Kipling’s phrase, be “paid for existing”. When they actually generate they will earn further revenue. These capacity contracts are unlikely to be cheap and will probably drive up the wholesale price of gas in Britain (not elsewhere). In addition, the frequent start-stop cycles these support gas plants experience will waste energy and create additional emissions. Such a system will be more expensive than a more carefully engineered alternative and may even be dirtier.
Putting aside coal generation on the grounds of its emissions and carbon capture on the grounds of its current cost, there is a strong interim case for gas as a relatively clean and cheap technology that can produce the wealth needed both to secure public consent and support radical clean-energy innovation for the longer term. But the department of energy continues to be lukewarm about gas, and even talks of renewables policies protecting the UK from volatile foreign gas markets. One can of course reply that it is a strange kind of “protection” that guarantees high prices, but the underlying concerns about the security of our gas supplies deserve more detailed consideration. The prolonged cold weather in March and April drew attention to Britain’s declining gas production and to the strain placed on the system at times of peak demand. This situation was prominently covered in the media, resulting in demands for increased gas storage and giving some superficial plausibility to the government line. However, the concerns about gas are exaggerated and the case for strategic, state-supported gas storage not as strong as might be thought.
Hitherto, Britain has relied on highly flexible offshore gas fields that delivered gas at short notice to cover winter demand. Underground gas storage capacity was very low by the standards of continental European countries, but these states were dependent on relatively inflexible long-distance gas imports and so found storage attractive. Despite the decline in offshore flexibility there has been little investment in storage in recent years. This was neither perverse nor stupid, but entirely rational, because the competitive, liberalised energy markets of the past two decades were able to provide flexibility in different ways that were also cheaper.
First, the ability to trade gas in real time on the spot market gives the price signals that attract supply. Second, the limited storage already in existence — especially the Rough facility, a depleted gasfield — has been made more responsive. Third, new import pipelines and liquefied natural gas terminals have been built (entirely without government subsidy). And finally, competition has spread from Britain to the continent, with the result that flexible gas supply from across the Channel is also available to the British market through pipelines.
But there’s the rub. For gas to flow from, say, Zeebrugge to Norfolk, there needs to be sufficient pipeline capacity. In late March the Interconnector pipeline was at full capacity and additional supply available on the Belgian market was unable to flow to Britain. The immediate need therefore is to expand the Interconnector, and probably in the long run to construct at least one new pipeline.
Expanding storage is another matter. Surprising as it may seem, the economic case for another facility like Rough just isn’t there. The cost of storage lies not just in the infrastructure and the frequency of cycling. A key component is the quantity of gas that must be injected into the storage facility to pressurise it, the so-called “cushion gas”, much of which will not be recovered in normal operation and some of which will never be recovered. In a big storage field, cushion gas would cost several hundred million pounds; such projects are unlikely to go ahead without generous tax treatment. That has always been regarded as politically impossible, though public opinion may change.
But at present this is academic. There is no shortage of gas available to the UK, in the short or long term. What is needed is more flexible pipeline capacity and only then new storage.
Britain’s climate change strategy was designed in the belief that renewables would develop rapidly and improve their cost and performance once widely adopted. This has proved a vain hope, and the policy is collapsing as a consequence. Their costs are simply too high, even for OECD countries. However urgent the need for cuts to emissions, they are unlikely to be realised. The reason for this is not lack of political will or the siren voices of those convenient scapegoats, the climate change “deniers”. The fundamental cause is that the policy entails the premature mass deployment of renewables technologies so expensive that their subsidies will reduce the standard of living of the developed world and offer no benefits to the developing world.
We need an innovation-based strategy if the low-carbon agenda is to survive, but this requires wealth, and wealth requires cheaper energy. Gas offers a useful bridge fuel that can address and repair the damage done by mistaken European renewables targets. It will cut emissions and keep us sufficiently rich not only to sustain public support for climate change measures but also support the innovation required to deliver plentiful, cheap, low carbon energy in the medium term.
Rent-seekers and vested interests must be resisted, but tranquil capital write-downs will be relatively easy to secure in comparison with dilution of the influence of the emotionally intense and quasi-religious green movement. These ultimately puritanical enthusiasts have crippled low-carbon policy, and exposed Britain and other countries to economic hazards that are dangerous in themselves and make innovation for clean energy all but impossible. Consumers and politicians must stand up to the greens for a whole range of reasons, not least of which is that the future of the climate is not safe in their hands.