Another new year brings another look back at the past 12 months and a time to consider what the energy market outlook might be for 2020. This time last year, my predictions for the top five energy themes for 2019 were:
- The retail price cap;
- The retail landscape more broadly;
- Network charging reform;
- RIIO-2; and
What I didn’t predict was a major blackout and a general election – although once the election was called I did expect a decisive win for the Conservatives, although I thought the majority would be around 40 – more on that later.
The other thing I failed to predict was the sudden panic about the “climate emergency” and rush to enact “net-zero” policies. This is probably the single biggest energy story of 2019, with politicians around the world scrambling to show “leadership” while being angrily berated by a Swedish teenager.
Changing retail energy markets dominated 2019 energy news
Predictions for 2019 were about half right…
So how did I do? Overall I’d score myself 3/5. The retail landscape was definitely in the news throughout the year with more supplier failures and further pressure on Ofgem to stabilise the market. At the same time, Ofgem has abandoned its plans for a database of disengaged customers to facilitate targeted marketing by competing suppliers, signalling a shift away from the previous focus on having more suppliers and more switching as the sign of a well-functioning market.
There were also significant corporate actions among the Big 6 suppliers with SSE selling out to OVO Energy, a deal that received regulatory clearance in December, and E.On taking over and breaking up npower.
As in 2018, a large number of suppliers defaulted on their Renewables Obligations (“RO”), 42 of them this time, leaving a shortfall of £97.5 million. Late payments mean that non-defaulting suppliers are likely to face a mutualisation cost similar to last year’s £58.6 million, in addition to covering a shortfall in capacity market payments of around £33 million.
This adds to the pressure on smaller suppliers who must not only budget for their own costs, but increasingly for the costs associated with defaulting competitors. This situation is not sustainable, and Ofgem is starting to act, with proposals to move to monthly rather than annual RO payments – I predict there will be more to come, and the state of the retail market will continue to dominate energy newsflows until some meaningful reforms take place.
Network charging reform was another important theme for the year with the ongoing work on the Targeted Charging Review (“TCR”) addressing reforms to the residual component of network charges, and the Significant Code Review (“SCR”) relating to forward-looking charges and network access. In December, Ofgem published its final decision on the TCR as well as an update on the SCR, about which I will be writing in more detail soon.
As has come to be expected, providers of flexibility, who have been benefitting from the enhanced economics associated with connection at the distribution level have complained that the proposals risk destroying the economics of flexible energy provision, however, as the need for flexibility is driven by the growth in intermittent generation, these claims are largely without foundation. Providers of flexibility will, in the long term, be able to secure the necessary returns to make investments viable, although there can certainly be problems in the medium term as reforms to different parts of the market happen at different time. I see this as another ongoing theme in 2020.
My final correct prediction was Europe. In late October the European Commission confirmed its original decision to grant state aid approval to the Capacity Market meaning that its operations could be restored, however this news was more or less drowned out as within days the Government had called a General Election to be held in December. The Conservative Party won a decisive victory in what was dubbed the “Brexit election” on a clear “Get Brexit Done” platform.
While it still isn’t really possible to say what Brexit looks like in practice, it’s now clear that it is going to happen, and probably soon. In energy terms, it’s still hard to see Brexit having the same significance as it will in other sectors, but another interesting aspect of the large Conservative majority could be closer to home. There are suggestions that a major reform of the civil service is on the cards, and this could potentially have a profound impact on the energy sector.
Currently, only 17% of “fast-stream” civil service recruits have science or engineering degrees, and civil servants in Whitehall typically change roles every 18 months or so. Energy is a highly technical and complex sector, and would benefit from staff with analytical backgrounds who are able to build expertise over a number of years. Such individuals could introduce levels of much needed rigour and avoid some of the poor policy decisions that have been seen in recent years.
…but there were some big misses
Speaking of poor policy decisions, we come to my first dud prediction which was the price cap (also a dud in policy terms). While several suppliers have cited the cap as a contributing factor to the financial stresses, there has been no real pressure to reform and no major, newsworthy revisions to the cap level. The cap remains a bad idea and should be abolished as soon as possible, but I don’t think it will be a major theme for the coming year (hopefully saying that with confidence will be the kiss of death for the policy!)
Finally, RIIO-2….although 2019 was planned to be a year of preparatory work for RIIO-2, I did expect some news flows given the significance of the mooted changes. Instead things were surprisingly quiet other than in May when Ofgem confirmed its methodology for calculating the cost of equity of the network companies – a move that would cut the baseline return on equity by 4.3% in a like-for-like basis. Naturally the network companies expressed their displeasure saying the move, which could save consumers some £6 billion in network costs, would inhibit their ability to deliver on clean growth plans.
The changes that are likely to emerge in RIIO-2 could significantly change the networks landscape with the role of Distribution Network Operators (“DNOs”) expanding to take more account of their impact on the wider electricity system and evolving into DSOs – Distribution System Operators with a more active role in managing frequency control.
One aspect of the regulatory framework that is changing is around innovation, where DNOs will be expected to fund their own innovation projects rather than receiving funding through the Network Innovation Competition. While tis change will enable innovation that did not qualify for funding to go ahead, network companies operate in a highly regulated environment where innovation can be difficult to implement. It remains to be seen whether this change will help or hinder the development of new approaches needed at the distribution level to support a more flexible electricity system.
Ofgem’s final view on the RIIO-2 price control allowances is expected by the end of the year.
As noted above, I failed to predict the blackout (along with just about everyone else, although the underlying causes are not new and could have led to a major blackout at any time, given the right conditions) and I also didn’t see the ramping up of climate hysteria coming.
The energy market outlook for 2020 builds on 2019 themes
My top five themes for 2020 build on those of 2019:
#1 Climate and net zero
The shouting about climate and net-zero is likely to continue in 2020. At the time of writing, Australia is being blighted by truly terrible wildfires during their hottest summer on record while Indonesia is experiencing devastating flooding. Australian Prime Minister Scott Morrison is attracting ridicule by claiming the wildfires are not a result of climate change, however, back in June, Professor Andy Pitman of the University of Sydney gave a presentation at the Sydney Environment Institute saying that in Australia, droughts are not increasing, and there’s no drying trend in one hundred years of data.
It’s unfortunate that “climate change” is being used to explain the wildfires in particular, when careful attention should arguably be given to whether more mundane environmental management such as controlled burning of undergrowth during colder seasons could prevent such catastrophic fire events. It is to be hoped that once the current crisis is over, climate change is not used as an excuse not to re-visit this question and that practical and immediate steps are taken to protect life and property in the future. As Morrison and others have noted, wildfires are not new, but what has changed in recent decades is the approach to land management and controlled burning.
Closer to home various city councils have declared a “climate emergency”, although what they hope to achieve other than some virtue-signalling is unclear. What is clear is that it is currently not technically possible to have an energy system with net-zero carbon dioxide emissions, other than possibly in some very specific cases such as Iceland with its geothermal resources. Trying to decarbonise the entire economy would be eye-wateringly expensive, and the public would tire of the sacrifices required quite quickly.
There are other dangers along this road. The rush to deploy batteries is depleting lithium and cobalt resources, and their extraction is highly polluting of local water sources. The large-scale production of biofuels risks undermining biodiversity, and even windfarms have been shown to adversely affect bird and bat populations.
Policymakers should try to resist the pressures of the shouting and remember that climate is only one part of the environmental story – poorly thought-out policies may have undesirable consequences down the line. This is also something investors and market participants should remember…those poorly designed policies can be subject to abrupt and potentially expensive change, as owners of diesel cars in the UK will attest.
#2 Retail energy markets
The retail energy space is clearly dysfunctional with significant aspects of policy being driven by flawed assumptions that the supply business is highly lucrative and that the main sign of a “broken” market is a low level of supplier switching. In fact the supply business is far from lucrative as the events of 2019 have clearly shown – suppliers find it hard to differentiate their offer, customers are largely dis-engaged not least because the purchase of kWs of gas and electricity is boring, and suppliers face huge regulatory burdens that are complex and expensive to manage. The costs of failure are borne by other market participants and ultimately by consumers.
Reform is sorely needed, but as noted above, I’m not confident it will materialise in the coming year. What is more likely is that there will be more RO defaults and more supplier failures.
#3 Network charging reform
As noted above, network charging reform is likely to remain in the energy news in 2020, with Ofgem’s minded-to decision on the SCR expected in the summer. The markets are busily digesting the final decision on the TCR issued in December, as well as the latest working paper on the SCR. The impacts of these changes are wide-ranging, and will affect the economics of some projects significantly. Also important, alongside the charging piece is the work National Grid is doing on changing the revenue streams available to providers of flexibility, in its re-design of its balancing toolkit.
#4 Negative electricity prices
2019 saw three significant instances of negative electricity imbalance pricing, and even day-ahead prices briefly went negative in December. I will be writing about this in more detail soon, but the increasing proportion of zero-marginal cost generation on the system makes negative power prices more likely.
The phenomenon is already well established on the Continent, and a combination of excess renewable generation, network constraints and a lack of bulk electricity storage combine to make negative prices, and indeed price spikes, more likely. I expect that 2020 will see more such events and that unless careful thought is given to generation economics with meaningful reform of the current dysfunctional subsidy frameworks, there could be trouble ahead.
#5 Oil and gas
Energy news tends to be quite electricity-dominated as this has been the easiest area to de-carbonise and has therefore seen the most newsworthy changes in recent years, however there are also interesting things going on in oil and gas markets that are worth keeping an eye on.
Oil prices stood well below the 10-year average as the decade ended, and the fundamentals remain weak although recent events in the Middle East have seen prices reach 7-month highs amid speculation that US$150 /bbl is possible in the case of further US-Iranian conflict
“As we enter a new decade, the energy complex feels like it is all cascading towards a race to the bottom. All energy commodities are competing for a share of finite downstream demand, whether it be in industry, refining, power generation, or petrochemicals. At the same time, continued growth in renewables, efficiency gains, and increased penetration of EVs [Electric Vehicles] and hydrogen will limit the overall call on fossil fuels,”
– S&P Global Platts Analytics
Electric cars are increasing their market share, and the American shale revolution shows no signs of slowing, with the US now producing more than Saudi Arabia. On the other hand, political tensions in the Strait of Hormuz and now in Iraq and the actions of Opec have worked to support prices. Oil price volatility is set to continue.
Wholesale gas prices are at their lowest levels in a decade, driven by a continuing global oversupply, and prices are set to fall further – James Huckstepp, an analyst at S&P Global Platts, expects NBP prices to fall by a further 30% to an average of 27p /th in 2020 due to increasing volumes of LNG as the US ramps up exports and Russia seeks to defend its market share of European gas markets.
2019 saw a huge, 169% year-on-year increase in the volumes of LNG imported into the UK, and not only were pipeline imports from Europe reduced, but the UK began to export to the Continent, something that has continued into January. This will be another trend to wach over the coming year, particularly against the backdrop of Brexit.
My wildcard prediction is that the seeming energy of the new British Government translates into something meaningful for the sector. The long-promised Energy White Paper could materialise, and the prospect of civil service reform throws up tantalising possibilities. That really would be something to write about this time next year!
I think that if we get a more robust BEIS Select Committee OFGEM may find itself on the defensive. It is easy to argue that many of the problems we have stem from their regulatory failures: the hash that is the retail market, the failure to bring forward new dispatchable capacity (part blame goes to the EU, but capacity mechanism prices don’t support newbuilds in part because of the rules on dispatch priority in the first place), and the complete Horlicks that is developing over price volatility and wholesale pricing, including negative prices. Meanwhile, the blackout actually revealed a whole lot more regulatory failure by OFGEM – inadequate standards for backup/spinning reserve, inadequate standards for admitting new generators onto the grid, inadequate standards enforcement on RoCoF protection of embedded generation, inadequate standards on metering embedded generation (so there was no clue about the effect of LFDD) and modelling of DNO networks. They’ve got all this on their plate:
The actions relate to:
o reviewing the standards that the ESO is required to operate to for securing the electricity system against credible disruptive events;
o improving the transparency of the processes the ESO uses for estimating requirements for back-up arrangements to replace power losses and for validating the performance of providers of back-up power;
o improving the robustness of the processes for testing compliance of generators with a technical industry code, and the ESO’s approach to carrying out those processes and modelling the performance of complex generators.
o reviewing the timetable and scope of planned industry changes to the sensitivity of distributed generators’ protection settings to the impacts of network disturbances;
o reviewing the regulatory and compliance framework for distributed generation and options to strengthen it, including consideration of licensing smaller generators which would require government action;
o considering options to improve the real-time visibility of distributed generation for DNOs and the ESO.
Demand disconnection arrangements:
o reviewing the effectiveness of demand disconnection arrangements; and
o considering requirements on network and system operators regarding customer treatment during outages.
In addition, we have identified a number of issues with the ESO’s existing processes and procedures for managing system operation in highly complex and changing conditions. Given the changes which are required in the energy system to achieve Net Zero we believe that the core roles of the system operators are worthy of review.
I have to say I find it difficult to envisage splitting out frequency control on a regional basis, unless the plan is to island networks.
Happy New Year!
This is a pretty comprehensive list and I agree with it, and would also add a section on the retail market including better regulation of suppliers, action on market access for new entrants and a streamlining of the regulatory burden (which would involve being robust with BEIS in terms of what needs to change on the legislative side). Doing all of that would require a lot more staff for a start, and as with financial regulation, they need to look at pay structures to ensure they get the right people.
I don’t think the idea is to split frequency control to the DSO levels – I think it’s more to do with making DSOs consider their impact on the transmission system in a way they haven’t in the past.
P.S. Happy New Year!