ELECTRICITY TARIFFS IN A LOW CARBON WORLD

 

We can start from a few basic principles and realities.

 

1.     Spot markets as conceived in the UK are increasingly irrelevant and/or dysfunctional. Originally conceived to replicate the optimisation of the merit order of fossil plant, and designed by the operators of such plant, they provided price signals consistent with efficient operation of an existing collection of generating plant. The provision of signals for inducing the right quantities and types of investment were always more problematic and for some time spot markets have increasingly been seen as wholly inadequate for this purpose. However we now need to recognise that with low carbon systems based around renewables, nuclear and storage, they will increasingly be irrelevant even in the first function, that of price signals that result in efficient least cost operations.

 

2.     What should really matter to us is not pricing structures in the wholesale market per se –  more or less a legacy structure of institutional arrangements in need of serious reform - but the nature of the tariffs that get passed through to final consumers. We should try to follow the general economic principle that the structure of tariffs needs to reflect the structure of costs. Failure to do this almost invariably results in major economic distortions that come back to bite us, through adverse selection and other unintended incentives and consequences. Current and recent institutional and structures and regulatory approaches have not encouraged more cost reflective tariffs.

 

3.     Reliability planning is fundamental, particularly as electricity expands into heating and transport (EVs), where the security/reliability requirements are very different from those of “traditional” load. The old VOLL approach is no longer appropriate since we really need very different types and definitions of reliability in the new world. Addressing reliability questions, in terms of what we are prepared to pay for, is essential.

 

4.     At least for domestic and smaller consumers, politically the most important category, a very high proportion of costs rests in the provision and operation of transmission and distribution. These are network costs which are essentially fixed costs that do not vary much (on a long term basis) with the volume of throughput. These are however recovered, typically, by averaging over kWh supplied. This method is widely accepted as “fair” and equitable, but will inevitably produce some major distortions. Other approaches are possible which are more economically efficient and can do a better job on redistribution objectives. 

 

5.     Metering, communications, control and information technologies allow for a range of feasible tariff options that would have been unthinkable a few decades ago. These include supplier managed loads, choice over reliability standards, and charging by type of use, as well as more familiar ToD pricing and load management techniques. These are of much greater significance in a low carbon world when there is less flexibility in generation and therefore there has to be more flexibility in either consumption or storage.

 

6.     There have been particular concerns expressed that prices can be set by, for example, very high spot prices dictated by the marginal (gas) plant when gas prices are high, even though most of the power may be coming from low cost renewables. The analogous situations in traditional “vertically integrated” power systems arise when incremental growth is met through different generation technologies, and it can work both ways. For example load growth in some countries can exhaust cheap hydro, and utilities, if they can price at long run incremental  cost (LRMC), can then enjoy a potentially large economic rent from their legacy plant. Legacy costs or surpluses (as an offset) can of course be put with other fixed costs if it is decreed that they have to be recovered from consumers.

 

7.     Economic efficiency and the requirement for adequate revenue generation are clearly not the only considerations. Political acceptability and distributional issues are also key. There are no trivially easy solutions but there is a lot that can be done to improve matters in the future.

 

8.     My idealised solutions rest heavily on technical  assumptions about metering, communications and control systems, but might include some combination and selection from the following:

 

·      Recovery of far more of fixed cost through other “distributional” means, eg via linkin standing charges to property values (cf water), more use of rising block tariffs, and type of use tariffs. 

·      In addition to the above means, price inelastic EV charging might legitimately be expected, as a premium use, to carry a higher burden of infrastructure cost than price elastic and politically sensitive heating load, where we need low unit rates to encourage a switch to heat pumps.

·      Recognition that it is really only the “traditional” loads that need the instantaneous supply response that underlies the VOLL approach, and also dominates conventional definitions of reliability. We need different conceptions and definitions of supply reliability especially in systems that rely on storage. 

·      Consumers will place different values on reliability depending on the application, and this needs to be reflected in reliability planning and in tariffs.

·      Consumer options to designate certain uses as “supplier managed”, with an appropriate tariff incentive for a lower unit rate.

·      Differentiated reliability standards for different uses, with selected uses (eg lights, TV, computer) always the most reliable; default to this standard for less vital services available at a premium.

·      Various methods for reflecting periods of “system stress” into tariffs - eg the French “red light” approach.

·      Continued development of possible time of day or seasonal pricing.

 

“WORST MACRO-ECONOMIC POLICIES OF ANY MAJOR COUNTRY IN A LONG TIME”

Pretty poor on the energy policy front too. And levelling up is no longer even on the agenda.

 

Today’s mini-budget deserves a quick comment in this blog, not least because of the close connections with energy issues. 

 

Let’s begin with a few quotes

 

Paul Johnson, Director of the Institute for Fiscal Studies, said: 

“Today, the Chancellor announced the biggest package of tax cuts in 50 years without even a semblance of an effort to make the public finance numbers add up. Instead, the plan seems to be to borrow large sums at increasingly expensive rates, put government debt on an unsustainable rising path, and hope that we get better growth.”

FT Robert Shrimsley described it as “…  a stunning repudiation of the economic strategy of the last two Tory premiers …” and  its “dismissal of the central importance of sound public finances” as a rejection of core Conservative principles.

 

The UK is "pursuing the worst macroeconomic policies of any major country in a long time" says former US Treasury chief Larry Summers.

………………….

 

Why it is likely to fail in its own objectives

Governments cannot mandate growth; if they could we would not be worrying about it now. GDP growth would already be with us.

 

·      Under the right conditions a fiscal stimulus can boost GDP, but tax giveaways to the wealthy are among the least effective polices as wealthy people have a higher propensity to save rather than spend. They also have a higher propensity to spend on imports and to spend on foreign holidays.

·      Purely in macro-economic terms, a fiscal stimulus that benefits lower incomes is more likely to stimulate spending.

·      The economy already has severe supply side constraints, especially evident in labour shortages. But the apparent pursuit of a trade war with Europe will simply make things worse, and reduce our economic potential further.

·      Unfunded tax cuts will simply increase the risks of further currency devaluation (with sterling already 2% lower today), and inflation.

………………..

 

Energy matters too

The crisis in gas prices, and possibly in supply adequacy, matters for two immediate reasons:

 

·      affordability of energy, particularly for the poor and vulnerable.

·      sufficient gas to meet demand and “keep the lights on”.

 

A blanket subsidy for energy prices is an inefficient means of protecting the vulnerable, with a high cost for only very limited protection. The sensible strategy would have been much more targeted support, either through social security, or, better still, through so-called “rising block” tariffs which allow initial tranches of supply at a much lower price, but with a higher price for higher levels of consumption, which provides a bigger incentive to avoid waste. This would also be more consistent with net-zero objectives for the sector.

 

The practicalities of this are not helped by the many dysfunctional features of a “quasi-competitive” energy market. 

 

Finally passing up the opportunity for at least some level of windfall taxation in the sector has merely added to the already extreme macro-economic risks that we face.

ELECTRICITY TARIFF REFORM. SHIFTING THE BURDEN FROM ELECTRICITY TO GAS IS A START

 

Plans to shift green surcharges from household electricity bills to gas bills are an overdue and welcome reform. With the necessity to shift consumption away from gas to low carbon power, taxing electricity but not gas has been perverse. In particular it conflicts with policies to shift residential heating to electricity-based systems, especially heat pumps. It was one of several key recommendation of the 2019 report, on network tariffs for a low carbon future, that I prepared for Energy Systems Catapult. So it’s satisfying to see the proposed change.

However this shift is probably not enough on its own to provide a clear incentive for consumers to switch from gas to electric systems, including heat pumps, even if the present surge in gas prices is sustained. A more fundamental recasting of the structure of electricity tariffs will be essential, notably a significant change towards recovering far less of the fixed costs of network infrastructure through the kWh charge. This is a profound change, and may require additional measures to prevent the regressive effects of a larger burden on lower income households. But it can be done in ways that are consistent with equality or levelling up agendas.

The flaw in current tariffs

The incremental costs of supplying energy are the right basis for any price and tariff comparisons that consumers make when choosing a heating system. Costs should ideally include all environmental costs and these may be expressed for example as a carbon price. Energy costs are however only a part of the story for the tariffs faced by consumers. For residential consumers, up to 50% of total costs reside in the fixed costs of the networks, concentrated in the local distribution networks. The marginal cost of accommodating extra throughput is, at least in uncongested networks, very low. But the fixed cost still needs to be recovered. How best to do it poses some difficult questions in terms of reconciling considerations of equity and income distribution, on the one hand, and the efficient allocation of economic resources on the other.

Current UK practice for smaller retail consumers is simply to average most fixed costs over all units of energy sold. This seems fair, and prima facie results in those who consume most (and might broadly also be those with higher incomes) paying the most towards the fixed costs. However it distorts the economic message, that the actual marginal or incremental cost is much lower. This leads to at least two major problems.

1.       It exaggerates the incentive for individual consumers to instal their own forms of power generation, even if these incur high resource or environmental costs, simply in order to avoid network charges. There is no saving in overall fixed cost and, while individual consumers with own generation may benefit, a larger share of fixed public network costs is then picked up by others. Total societal costs increase. Incidentally, this also tends to benefit the wealthier households who are more likely to instal their own generation.

 2.       Policies for a low carbon economy rest on persuading consumers to use large amounts of extra electricity for heating (eg with heat pumps). The high unit kWh rates that result from the current practice of spreading the fixed costs over all kWh then become a very serious obstacle, particularly when the consumer choice is between electricity and gas. This is reinforced by the matter of high per household capital costs for retrofitting heat pumps.

 

For household consumer, a higher fixed charge in the tariff, and a lower unit energy charge, transforms the choice between using the low carbon solution (electric heat pumps) and traditional fossil fuels (gas or oil).  I examined this in my 2019 report, but it is worth recalculating in the light of recent price trends. Assuming 10,000 kWh per annum consumption, a coefficient of performance (COP) of 3 for heat pumps, and 90% efficiency for modern condensing boilers (both slightly optimistic), the message is clear.

 

Economics of Heat Pump vs Gas [Energy Cost Only]	elec tariff p/kwh	Elec useful heat p/kWh	Gas tariff p/kWh	Gas useful heat p/kWh	Heat pump saving £ pa
Current tariffs[1]	14.50	4.83	3.86	4.29	-54
Current tariffs and + 1p/kwh CO2 tax on gas[2]	14.50	4.83	4.86	5.40	57
Reform tariffs + CO2 tax.[3]	7.50	2.50	4.86	5.40	290
Reform tariffs + CO2 tax + permanent high gas price[4]	7.50	2.50	8.00	8.89	638

 

With current tariffs, heat pumps struggle to be competitive with gas even on running costs. A 1p per kWh carbon tax on gas, or its equivalent, helps to shift the balance (to a small advantage for heat pumps). Tariff reform has a much larger impact (2.5 times), and this is of course hugely reinforced if we assume permanently higher gas prices. This takes us at least part of the way to compensating households for the higher capital costs of heat pumps.

Disadvantages to poorer consumers

We noted above that some wealthier consumers benefit from current tariffs through the arguably excessive implicit subsidies to own generation. Other beneficiaries include second home owners with very low annual consumptions. However the regressive impact of a necessary tariff reform cannot be ignored. But there are many different options available.

One is to change the basis for applying standing charges to consumers. One proposal put forward has been to collect contribution to fixed costs through tariffs based on property values, akin to traditional approaches in water based on rateable value, or property tax band.

Another is to limit the application of the lower tariff rate to consumption for heating, but not for other purposes. Modern technology makes separate metering, as well as the detection of any metering fraud, a very plausible option.

………..

The conclusion must be that tariff reform will be an essential component of any national strategy for the decarbonisation of the heat sector.

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[1] Average kWh rate for UK, and recent variable rate British Gas tariff for gas.

[2] Set at 1.0 p/kWh as first approximation to likely impact of transferring environmental cost burden to gas. I used a higher number in the original report

[3] Assumed future average wholesale power cost of 7.5p/kWh

[4] Assumed winter gas price of 170 to 210 p/therm, deduced from recent reports

LABOUR TO RENATIONALISE NATIONAL GRID? WE NEED BETTER ARGUMENTS AND MORE COMPREHENSIVE SOLUTIONS.

There is a good case for more central direction and control for the power sector but many of  Labour’s proposals are either muddled or counter-productive.

The Labour Party is talking about plans to renationalise the Grid. The UK power sector certainly has some major problems. The utilities themselves, and current market arrangements, are neither popular with the public nor particularly effective in delivering on key policy objectives, especially on reducing the UK carbon footprint.  The institutions of the sector do indeed need a serious overhaul, but the emphasis of Labour proposals distracts from more fundamental issues that surround the difficult task of decarbonising the UK economy, and overcoming the failings of the liberalised electricity market. We need a better discussion.

The Labour party has unveiled plans to take the National Grid back into public ownership, with the stated intention of providing a correction to alleged excesses of asset stripping and profiteering at the consumers’ expense, and making the power sector more responsive to social and environmental objectives. One headline grabbing feature of the proposals has been to suggest that shareholders would receive less than full market value in compensation. Another important component has been proposals to assist poorer households with the installation of solar panels, simultaneously enabling them to cut their electricity bills and reduce overall power sector emissions of CO₂.

The background is that National Grid is responsible for the nationwide transmission network, and transmission per se only accounts for around 10% or less of consumer bills. However, the Labour proposals extend to the much larger distribution networks and the aggregate of all the “wires” business is much larger, amounting to around 30% or more of domestic consumer bills. The tariffs that pass on these network costs to suppliers and consumers are regulated by OFGEM. The regulator’s main remit is to allow the network companies to make a fair, but not excessive return, on their assets, while at the same time encouraging efficiency and ensuring a high quality service.

Excess profits? If this is a problem it is easily cured within the existing regulatory framework.

OFGEM is a technically competent body and has 30 years experience in regulating tariffs. So, although private companies may always be seeking to outwit the regulatory regime and squeeze a little extra revenue, it would be surprising if large excess profits were a major issue[1]. If this were so, it should be a comparatively easy matter to tighten OFGEM’s regulatory regime. It’s also worth noting that the original 1990 privatisation is generally considered to have brought down network costs, although this was not the biggest source of cost reductions[2] for the sector as a whole.  The structure of the tariffs through which these costs are recovered is also an important but separate separate matter and one which we address briefly below.

National Grid currently discharges its main functions very competently, so proposals appearing to punish this part of the power industry may seem perverse and unnecessary. Proposals to confiscate part of the value of what are already closely regulated assets are particularly dangerous. If pursued, this could undermine the financial standing and credibility of the entire sector, as well as the borrowing capability of government itself. A serious unintended consequence would be to deter investment in the UK power sector. Raising the cost of either private or public capital, not just for the grid but for the whole sector, would make it harder for an increasingly capital intensive sector to maintain supplies to consumers at an affordable price.

Labour has also ignored some of the manifest weaknesses in supply competition[3], which in many respects is a more obvious failure to serve the consumer effectively.  It is far from clear that competition has been of any net benefit to consumers as a whole. The supply function per se adds little in the way of value, but supply margins have increased significantly^[4] while there is little or no differentiation in the quality of service that suppliers provide, little or no innovation in tariffs, and consumer prices have to cover the additional marketing costs incurred by the supply companies.

There is however a very strong case, as Labour suggests, for using the grid and network companies as part of an intervention to promote environmental and low carbon policies.

There are good reasons for concern that markets as currently organised have some manifest failings in relation to environmental objectives. These are described in more depth on the Low Carbon Power page, but the main considerations are the following.

1.    There is a need to support investment that is a necessary component of decarbonisation strategy but cannot be delivered by the private sector in a market environment that continues to under-price the true environmental and social costs of CO₂ emissions. A National Grid charged with an obligation to deliver national low carbon objectives could provide the mechanism and the expertise to remedy this. At present all low carbon generation investment depends on government support (through feed in tariffs or long term contracts) but government lacks the expertise to do this effectively.

2.    The need for coordination of choices made in transmission and generation investment is greatly increased in systems based on renewable or low carbon investment, in order to balance types of generation with different operating characteristics, storage and demand side response from consumers. An interesting illustration is the need for diversity in contracting for offshore wind power. Capacity auctions will most likely induce bids from the  most obviously attractive sites in terms of cost and output (site conditions and available wind), but solutions that work best will depend on selection of a diversity of sites that are not closely correlated in terms of weather. Market structures will not easily resolve these choices, but the Grid is ideally positioned to do so.

3.    Current consumer tariffs are quite dysfunctional in failing to provide the right economic incentives for low carbon. They fail to reflect incremental costs in ways which can penalise low carbon initiatives for consumers (such as domestic heat pumps) and arguably over-incentivise other forms of consumer investment, including solar. Getting the right economic signals in tariffs is particularly important in a future in which we envisage a much bigger role for various forms of decentralised energy provision. These arguments are discussed more fully in a recent blog[5] and report[6] commissioned by Energy Systems Catapult, but one possible resolution could be based on the transfer of supply responsibilities to the local distribution companies, who would have a much more explicit duty to encourage decarbonisation of the sector, very much in line with Labour’s stated objectives.

The essential point is that the National Grid, and the other network companies, will need to play a vital role in resolving these issues. Nationalisation need not be the only means to that end, with alternatives including the mandating of low carbon targets, or new statutory duties. But significant policy direction, and significant government support for low carbon investment, are likely to be essential components of any solution.

Labour is failing to make its case well

Labour has so far failed to make the comprehensive case that can be made for a more powerful National Grid, or for reform of the distribution and supply of power.  It has instead chosen to focus on greatly expanding the use of solar panels. This may please the solar lobby, and could indeed be part of a sensible overall strategy for the sector, but it is prima facie questionable to risk over-promoting solar power.  For the UK at least, solar power is counter- seasonal.  Solar output is highest in summer, but energy demand is highest in winter. This implies difficult technical judgements that an organisation like the Grid is better placed to make than either politicians or civil servants.

There are some strong arguments that opposition parties should be making, but they do need to do some better technical analysis, and avoid simplistic solutions that look attractive but fail to address the real problems.

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[1] The structure of the tariffs through which these costs are recovered is a separate matter and one which we start to address later.

[2] Much more significant was the move away from British coal, towards coal imports and later towards gas as an alternative fuel. The second factor was in part coincidental with the rise of new technology in the form of combined cycle gas turbines.

[3] These were extensively criticised in the 2012 IPPR report,  The true cost of energy: How competition and efficiency in the energy supply market impact on consumers' bills. Much of this analysis remains valid.

[4] The Monopolies and Mergers Commission report on Scottish Hydro in 1994, before introduction of competition in energy supply, considered that 0.5 per cent was an adequate margin for regulated energy supply. Recent margins have been as much as 4.0% or higher.

[5] THE ROLE OF TARIFFS IN A LOW CARBON FUTURE

[6] Cost reflective pricing in energy networks