In recent years we have witnessed the central role, everywhere, of governments dealing with massive market failures, or potential failures, in critical parts of the economy and society. The most obvious crises and interventions have been in the financial sector, and in public health. But attention is also now turning to the biggest crisis of all, the looming threat of climate change. As with the pandemic and with finance, this makes the risk of systemic failure in the energy sector something that governments, of whatever ideological complexion, can no longer ignore. This may be the end for the road for market fundamentalism in the energy sector.
National
Grid faces being stripped of its role … after the energy regulator concluded an
independent body would better oversee the changes required to meet the UK’s
2050 net zero emissions target. It would also avoid potential conflicts of interest
and allow for the “greater strategic planning and management” of the
electricity system. (FT, January 2021)
The
wheel turns full circle. We are now a million miles from the “liberalised”
structure of markets and governance, with all investment choice driven by market
signals, and celebrated as such an achievement after the complex and innovative
restructuring of the UK power sector in 1990. The government has already resumed its role as
the prime decision maker on new generation investment, and nothing substantial
is built without a long-term contractual commitment on off-take that only
government or a regulated monopoly can provide. Government has become the de
facto "central buyer". The new proposal simply follows the logic of a
return to a more planned and coordinated power sector by explicitly extending
this role to transmission. Since transmission investment is frequently an
alternative to additional generation capacity (most obviously with
international interconnection), this seems entirely logical.
While
it is still not clear what changes will result from the OFGEM proposal, one
obvious deduction is that we are moving towards the creation of a new body with
a strategic responsibility for planning and coordinating all significant future
investment in the power sector. It would be hard to avoid linking this with the
existing functions of government in securing new capacity, through auctions or
other means. In its fundamentals this represents the re-establishment of the
planning functions of the old Central Electricity Generating Board (CEGB), but without
the CEGB’s functions of ownership and operation of generation and transmission.
If this interpretation is correct, and the proposals are implemented, then this
represents an essential development for which I have been arguing on this site[1]
and in other media for many years.
To
understand how and why, even with successive governments as the most enthusiastic
promoters of theoretical “free market” philosophies, we have got to this
position, we need to look at some of the basics of power sector and infrastructure
economics, and also at the climate policy imperatives.
The
Infrastructure Investment Problem
Investors
in high capital cost and immobile assets typically require long term
contractual or similar assurance. Their assets are almost always specific to one
purpose, and depend on a secure long term revenue stream. Reliance on a spot
market or short term contracts, the core components of electricity market structures
and both dominated by short term factors, are just not good enough to satisfy
private investors. This is particularly so for key investors like pension or
sovereign wealth funds who are seeking secure but modest returns. And the low
cost of capital these investors can provide is exactly what is necessary to
keep electricity prices affordable.
Along
with construction risks, the biggest risk to infrastructure investors is that,
having sunk the costs of their capital investment, future revenues are exposed
to opportunistic actions by other parties. These include government, regulators
and customer utilities, all with political or economic incentives to attack
their future revenue stream. The owner cannot transfer the asset to an
alternative use or jurisdiction, and faces expropriation of expected revenues in
the interest of lower prices to consumers.
The
two main options are inclusion in a regulated utility framework (traditionally
vertically integrated monopoly) in which reasonably incurred costs are passed
to consumers, or long term contracts with or commitment from a reliable
counterparty, usually the only plausible party being the government. In the UK, network investments have in
recent decades typically depended on the former, and generation on the latter
(via CfDs, feed in tariffs etc).
Either
remedy can work but both draw a monopoly utility, or government, into strategic
investment choices. Both are a long way from the paradigm of the fully
liberalised market.
The
Coordination Problem
Recent
complaints have focused on failure to coordinate offshore wind development with
the transmission investment necessary to bring it ashore. But there are plenty
of other examples of the need for coordination with low carbon systems, mostly
reflecting the fact that these sources are less controllable than conventional
thermal fossil plant. Factors include
the advantages of planning for diversity in the siting of wind facilities, the
need to get the right seasonal balance of solar and wind, issues around storage
and whether to treat it as supply or demand. It looks improbable that any of
these issues can be resolved either through short term price signals from power
markets, or by “technology neutral” invitations to bid new capacity.
The
remedies are either informal coordination within the sector, which risks running
foul of competition law or anti-cartel legislation, or a central direction of
what types of generation are required.
I
have previously argued that the National Grid already plays such a central role
that one solution might have been an extension to include a more formal
planning or even a central buyer role. But this may well not have been
acceptable to a private sector management, and the OFGEM proposals may lead us
to an equally satisfactory outcome.
The
Carbon Emissions Externality
Climate
change is the “biggest economic externality of all time”[2], to
date addressed only to a very limited degree by carbon taxes or emissions
pricing. Low carbon prices, only partial
in coverage, may be due to insufficient ambition or vested interest capture, but
are grossly inadequate to match any serious estimate of the cost of the
externality.
So
failure to price emissions adequately means that market solutions cannot work
on their own. Moreover the “Theory of the Second Best” implies that once we
have one major failure in the market, like the failure to price carbon, we
cannot assume that other policies, eg competition policy or a merit order[3],
normally thought of as good, will actually improve welfare rather than reduce
it. In our context even the best designed markets will produce the wrong seriously
sub-optimal outcomes, for both operations and investment, if the damages of unconstrained
emissions are not included in economic calculations.
Recent
examples include the huge coal for gas substitution in 2013/14, driven
by a temporary change in fuel price relativities, Dutch competition authorities
prohibition of collusion between utilities to reduce coal use, and the UK exclusion
of domestic gas, but not the power sector, from emissions trading.
But
difficulty in allowing the market to “price” emissions is another prime reason
why governments cannot and will not “leave it to the market” to meet its
climate objectives. Societies can no more afford systemic failure in relation
to energy and climate issues than in health or the financial sector.
……………………………..
Suggested
reading.
Markets,
Policy and Regulation in a Low Carbon Future. John Rhys. January 2016
[1]
Use the button LOW CARBON POWER at the top of this page for a more wide ranging
discussion.
[2]
Stern
[3]
The merit order, in any power system, is simply a ranking of generating
facilities in ascending order of cost, so that the cheapest are always used first
to minimise total cost. If key elements of cost, in this case the damage from
CO2 emissions, are not included, then there will be poor outcomes.
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