It’s now been a week since the momentous decision by the British electorate to turn its back on EU membership, and the markets have responded with predictable volatility. The questions we are all asking, alongside the obvious ones about what form our exit will take, is how long will market volatility last, what will be the impact on the UK investment climate, and whether we are facing an extended period of economic contraction.
As this is a largely unprecedented situation, by definition there are few clues as to what lies ahead. Some draw a level of comfort from the experience of Switzerland in 2014 which voted to amend its constitution to introduce preferential treatment for Swiss citizens in the job market, in conflict with the EU’s rules on Free Movement of People. Quarterly GDP fell in the quarters after the vote, but subsequently recovered, and while the Swiss franc fell slightly against the US dollar, it strengthened significantly against the euro throughout 2015, forcing the Swiss National Bank to abandon the currency cap and highlighting the franc’s ongoing status as a “safe-haven” currency.
There has also been some commentary around the impact on the Swiss energy market, as the vote meant that negotiations on electricity trading between Switzerland and its neighbours were suspended. Particularly affected were negotiations relating to flow-based market coupling, which according to the article linked above, has had a double-digit adverse effect (in CHF) on the Swiss energy market.
What next for the UK energy market?
The UK market continues to face many of the same challenges it did before last Thursday. A narrowing supply balance, high consumer costs, a decarbonisation agenda that has seen the roll out of a new generation of small diesel units winning capacity contracts, investment uncertainty for both conventional generation and renewables in a changing subsidy environment.
The government now has an opportunity, free from the constraints of EU directives and state aid rules, to define the future energy market that is right for the UK. So what are the choices available to the government, and what should they do now? This is an opportunity for creative thinking from stakeholders across the industry to set out their view on the way forward.
As described in a previous post, I am sceptical that the current smart meters programme will deliver the objectives of the government. The obsolescence risk alone convinces me that this programme is premature, and by abandoning it much of the £11 billion price tag can be immediately saved. The risks of delaying the scheme to a future time when it is more affordable and the technology is more mature seems to carry minimal risk and so is an obvious first step.
Reducing electricity costs
Against a backdrop of wider economic uncertainty, the government has an opportunity to reduce the realised costs of electricity to both domestic consumers and industry. At a time when economic stimulation is needed, measures to increase the attractiveness of the business environment in the UK would be welcome. Such measures would also put more money in the pockets of consumers, with the potential to boost spending. The government could seek to do this in a number of ways:
(i) Carbon Price Floor
This 2016 study illustrates that while across the majority of industries a £20/tonne carbon prices has a modest impact on input costs, it is nevertheless a negative impact. Analysis carried out for SSE by KPMG suggests that abolishing the CPF would reduce electricity bills in 2020-21 by 4% for households, 5% for a small-sized business, and 3% for energy intensive industries which currently benefit from CPF relief. The tax is reportedly worth £1.5 billion per year to the Treasury, so the wider economic benefits are likely to offset this relatively small reduction in government income.
(ii) Hinkley Point
I do not necessarily see the commitment to Hinkley Point C as a “real” cost in the sense that I am doubtful the project will go ahead in light of the serious problems at Flamanville, and EDF’s understandable (in the circumstances) reluctance to take FID. However the state’s commitment to the project reduces the amount of investment available for other schemes. Cancelling the project will not meaningfully impact the future supply balance given the low probability of the plant opening on time, or even at all, so releasing the commitment would make sense.
(iii) Renewable subsidies
Technology-related energy subsidies increase electricity prices, and the government has done a poor job of controlling costs as evidenced by the projected £1.9 billion overspend on climate levies under the Levy Control Framework. While there is an argument that renewables, having an effectively zero marginal cost of production, will eventually push down electricity prices, this would only occur once construction costs have been recovered, and so is not relevant in the near term. The government should re-evaluate the subsidy regime, and consider suspending subsidies altogether (see below).
(iv) Renewable rollout
The rapid rollout of renewables has had a number of unintended consequences. In addition to the cost-escalation escribed above, the addition of renewable generation is increasing the costs of balancing the grid and gives rise to additional investment needs in transmission infrastructure. Any future incentives for renewable generation should take this into account, avoiding any further instances where renewable investors are able to realise generous returns while at the same time imposing additional costs on the wider management of the power system. However the government decides to amend the subsidy regime, it is vital that it sets out the framework and associated budget for the next decade in order to secure investor confidence.
(v) Seeking security of supply at the lowest cost
Security of supply is clearly critical for the smooth running of the economy, and it is incumbent on the government to ensure that the lights remain on, and at the lowest cost achievable. There should be no reliance on unproven (CCS) or unlikely (Hinkley Point) technologies or projects. A 1.5 GW CCGT would cost approximately £800m (based on the reported costs of the Trafford project), and there are numerous “spade-ready” projects around the country.
Savings from cancelling the smart meters programme could be sensibly deployed to incentivise construction of new gas generation as required. Removal of the carbon price floor should help to ensure the remainder of the UK’s coal fleet remains open into the next decade, bridging the gap to deployment of new gas generation. Gas is significantly less polluting than coal, and so incentivising fuel switching is a cost effective means of promoting decarbonisation, albeit over a longer timeframe than current policy would envisage.
(v) Investment in the future energy market
In addition to investing in additional generation to ensure security of supply, the government should continue to invest in new technology for the market of the future, with the aim of long-term security of supply, at low cost, and in an environmentally responsible manner. However, the government should take care to focus on development of existing technologies rather than the creation of new ones, for example, whilst the benefits of CCS and nuclear fusion might be extensive, these technologies are very far from any sort of commercial application, whereas there are a number of storage schemes that could be meaningfully supported to the benefit of the future energy landscape.
Following Brexit, the UK will no longer be required to implement REMIT and various operational arrangements under the Electricity Regulation and the EU Network Codes, allowing the government to balance the needs of the UK market with sensible, cost-effective regulation that will underpin cross-border trade. Pressure from the EU to change the settlement period in the UK electricity market from 30 to 15 minutes can now be resisted, unless there is an over-riding economic benefit to the change.
The Brexit vote has inevitably plunged the country into a state of uncertainty, however it is now the responsibility of the government to seize the initiative to re-shape the energy industry to meet the needs of the country. Affordability, security of supply and environmental sustainability should continue to be at the heart of energy policy, alongside creation of a stable investment environment.