Friday, September 16, 2016



Recognition of the limitations of the market in the energy sector is rapidly becoming universal. The Comment in today’s FT by Martin Wolf, possibly the most widely respected economic commentator in the UK, hammers this point home. The immediate focus of Wolf’s article is the Hinkley decision, but his arguments have a much wider resonance. For the energy sector, and the power sector in particular, the problems (and the market failures) run even deeper than those for infrastructure projects in other sectors. And governments can no more stand back from systemic failures in the energy sector than they can in money, banking and finance.


“This decision had to be taken by government. No competitive market process would have reached such a decision or even been allowed to reach such a decision. ….  But if government or its agencies are to take such decisions, they must also take them well. …  Regulatory regimes must be designed to address the complex attributes of sectors with significant externalities. Decisions in such sectors are often very lumpy and politically difficult. They cannot — and will not — be left to decentralised market processes.” [Martin Wolf. FT. 16th September 2016]

This is an excellent summary of what I have argued at greater length in the page on low carbon power. The essential feature of infrastructure, from the perspective of any private or institutional investor, is that the asset is immobile, has few or no alternative uses, and depends on revenue streams over a long period. Moreover infrastructure usually relates to essential services whose management and conduct is subject to various forms of policy and regulatory intervention. It is no accident that the historical development of public utilities has been strongly associated with regulated monopoly, which protects the utility as much as the consumer, with vertical integration, and with long term contracts and government guarantees. These all offer the investor some protection against political or regulatory opportunism, and the temptations to expropriate the investment once the costs have been sunk.

In addition the power sector has some particular market failures of its own. The case for and value of almost all low carbon investment stems from its contribution to reducing emissions and hence limiting the damage of climate change. In the continuing absence of effective and reliable means of pricing CO2 at levels consistent with the policy imperatives of mitigating climate change, there is no way that any private investor can capture this value from any of the existing market processes.

Supply security might in principle be susceptible to a “market” solution, but the NETA reforms in 2000 effectively removed the previous mechanisms that had been designed to incentivise new capacity. Energy only wholesale markets, essentially the lynchpin of current market structures, cannot reward capacity properly, and their weakness is reinforced by the increasing proportion of plant on the system at zero marginal cost. Capacity markets may be part of the solution, but these have to be implemented by some party, the government or its agent, who can specify how much is required and then monitor, control and pay for its delivery.

Existing markets were largely designed by and for fossil fuel fuel generators, the CEGB and its successor companies. They depend on the particular technical and economic features of fossil generation – flexibility, and fuel driven marginal costs – to replicate the merit order in a market driven optimisation of plant scheduling and dispatch. The conditions for this to work successfully cease to apply in situations with more complex technical constraints, such as plant inflexibilities (nuclear) and intermittency (solar or wind).

And of course there are also the many questions linked to the operation of complex transmission and distribution networks, to the influence of external sources such as interconnection, to the use of storage technologies and to the much closer engagement of consumers within future systems. We should also add the strong possibility that technical factors, especially around renewable technologies and storage, will lead to a power sector with much more decentralised operations and decision taking, alongside a continuing need for large scale transmission and interconnection.

Identifying the need for some central and strategic decision making is just the first step. Improving the quality of those decisions, and their execution, is vital. There is a strong case for an agency at arms length from government, and hence more removed from political pressures. It is also easier to build the essential technical and commercial expertise within such a body than within a government department.

The wisdom of the Hinkley decision itself is a more controversial question. Entities such as the Committee on Climate Change or the Energy Technologies Institute, charged with examining approaches the UK’s low carbon targets, tend to positions that assume significant components of nuclear or carbon capture.  There may have been serious questions for EdF around the choice of Hinkley technology, and for the UK government around the negotiation of the price, but, assuming delivery, there is no hard evidence that this is a bad deal. The frequent comparison with current wholesale prices is largely irrelevant since it is quite clear that these are unsustainable as the basis for rewarding investment in a future low carbon power system. The government process may not have been impressive, and it may be quite seriously sub-optimal, but it has at least now made a pressing decision, and we should hope that the Hinkley venture is as successful as the French nuclear programme of the 1980s.

The wider questions, looking beyond Hinkley, are around what institutional changes may be required, in order to exploit rapidly changing technology options, implement the policy imperatives of sustainability and security, and make effective use of markets. All this is calling for a new “system architecture”, a comprehensive re-think of the way the sector is regulated, new market designs, and how networks are managed at local, national and trans-national levels. Expect to hear a lot more about system architecture!

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