POST BREXIT WE CAN GET BACK TO SOME OF THE OTHER BIG CHALLENGES FOR THE ENERGY SECTOR

This comment is also published on the Oxford Martin School website.

The Energy Institute’s second Energy Barometer annual survey of energy sector professionals shows the two issues of most concern to this group as policy uncertainty, and also lack of investment. Chaotic post-Brexit uncertainties will accentuate the first problem and probably the second. However these are already important and difficult issues, with features that require exploration of the wider context of infrastructure investment. In the Oxford Martin School Programme on Integrating Renewable Energy, one of our early objectives has been to identify the areas of market challenge/ market failure in progressing to a low carbon economy. There are several potential market failures of concern to investors in energy infrastructure that are particularly acute in the context of seeking to decarbonise the power sector. They go a long way to explaining these two professional concerns for the sector as a whole. Solutions almost certainly demand a new system architecture.

Historical Background

Until comparatively recently, ie around 1990, the almost universal form of organisation for the power sector in most developed economies (and indeed elsewhere) was vertically integrated monopoly. This meant either state ownership or a private sector with strict monopoly regulation. Economists explained this through two characteristics of the sector. First this was an industry that embodied complex control and coordination issues to a degree that made it unsuited to the unbundling of the different functions of generation, system operation, network management and supply. Second, infrastructure investors putting their money into long-lived immobile assets, without alternative uses or markets, and dependent on revenue streams over 30 years or more, tend to demand, as a pre-condition, protection against any risks to their revenue stream, but especially policy or regulatory risks outside their control. Historically this was achieved through a monopoly, public or private, typically regulated on a “cost of service” or “rate of return” basis.

The first characteristic was partly overcome in the 1990 UK unbundling and privatisation. A clever market device (pricing at system marginal cost) replicated the very effective use of the merit order principle by the old CEGB (in which generating stations are deployed in ascending order of cost against fluctuating consumer load). A bidding system produced a half-hourly price and replicated the old “central controlled” optimisation of efficiency.  Even so the system operator retained significant command and control functions through the various industry protocols.

The second characteristic is more deep-rooted. Transmission and distribution remain subject to traditional style regulation. There are issues but they can be managed within a regulated return framework. Generation and supply are more problematic. The big players in generation reacted quickly to competitive markets by vertically integrating into supply, but even this has been insufficient to support new investment without more certainty at the end of the revenue chain. The result is that the only new investment in the sector is supported directly by government – as with new nuclear, or indirectly through feed-in tariffs and the new capacity auctions. And of course government has been sucked back into all major strategic decisions.

 Analysis of the Challenges

There are misconceptions about appetite for risk in the private sector – in this instance infrastructure investors such as pension and sovereign wealth funds.  These funds have a lot of money, and look for a modest but safe return. They will, unsurprisingly, not tolerate the non-diversifiable risks[1] associated with investment in a sector where revenues are at the mercy of a regulatory or policy regime, ie the entire economic value of their asset can be expropriated by an opportunistic government or regulator for the benefit of voters.  New generation assets, including pipe networks for carbon capture, and investment in storage or load management systems, may require billions to be sunk in non-moveable assets which have no alternative use, are not mobile and have very limited access to alternative markets.

Policy uncertainty is a good if incomplete description of these risks, but the difficulties are further amplified and compounded by some new features. Our analysis has identified several factors that accentuate and amplify these familiar concerns. These arise from the major transformations of the power sector envisaged as essential to cope with the challenges posed by climate change. Five are particularly important.

1. The price of carbon fails to reward low carbon investment. The EU ETS does not do the job. It does not offer long term security. It was captured in its early stages by special interests demanding excessive quotas. Its mechanisms have been too inflexible to respond to recession or to the advent of additional non-market national and EU-wide policies which further undermine the carbon price. In consequence, even if all else were satisfactory, there is no near term prospect of a market, unaided, delivering low carbon investment. This is a major factor that has driven government interventions to date, but by no means the only factor. For the UK Brexit simply adds an additional uncertainty.

2. Energy only markets promote efficient operation of existing fossil plant, but were always insufficient to reward new capacity investment without some additional intervention. This weakness is increasingly amplified by the zero marginal cost effect induced by an increasing proportion of low carbon plant with sunk capital costs and near zero operating costs. Zero wholesale prices accentuate investor concerns over revenue streams.

3. The wholesale market looks broken in more fundamental respects. It is losing contact with its original function of replicating the merit order and promoting efficient operation. So its position as the lynchpin in the market structure of the generation sector is now questionable; and new problems in coordinating system operations may result in reversion to greater reliance on the system operator and less on wholesale markets.

4. Given the very different and complex features of new low carbon generation and other low carbon technologies, the importance of a balanced mix both for operational and reliability reasons may further undermine the notion of reliance solely on markets to produce the right balance of investments, not just in generation but in storage, demand side management and interconnection.

5. The fifth factor is a retail supply market that currently fails to provide price messages that incentivise demand side and decentralised responses. This market needs a very different competition architecture to stimulate the innovations in the supply function that will be essential to ensure consumers (and “prosumers”) are properly integrated into a low carbon economy.

Conclusions

De facto, much of strategic decision making and major investment across the power sector has moved from the market back to the public arena, with more central or local coordination. This reflects both fundamentals of infrastructure investment and the nature of low carbon systems. At the same time we need more competitive structures to produce innovative solutions in downstream retail supply. Search for an improved “system architecture” will be an increasingly urgent priority if we are to deal with policy uncertainty and lack of investment, and meet all these challenges.

Reforms and transformations are likely to include a technically competent body.to handle strategic decisions for the industry, redefinition of the consumer offering and of reliability standards and protections, and re-orientation of market competition to promote innovation in supply.

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[1] Large funds cope with normal “market correlated” risks through diversification, but infrastructure investments tend to have very large and very project specific risks where the counterparty may have both opportunity and incentive to renege.