As the illegal war in the Ukraine continues, there is a growing discussion about the need to move away from a reliance on Russian commodities in the energy market, which presents new challenges to energy policy. The timing could hardly be worse, coming as it does during a global gas supply and demand imbalance that has seen gas and electricity prices around the world surge. The reasons for those price dynamics have been covered in previous posts – here I would like to address some of the options now facing policymakers, particularly in the UK.
“You can’t simply close down use of oil and gas overnight even from Russia, that’s not something that every country around the world can do. We can go fast in the UK, other countries can go fast, but there are different dependencies,” Boris Johnson, Prime Minister of the United Kingdom of Great Britain & Northern Ireland
Predictably, if disappointingly, every special interest lobby imaginable is now claiming that their technology is The Answer. Renewables advocates believe we must rapidly build more renewables, fracking advocates argue we need to immediately lift the moratorium on fracking to achieve energy security, heat pump advocates argue that homes need to immediately remove gas boilers in favour of (guess what!) heat pumps, of course hydrogen proponents believe hydrogen will save the day, and I have even seen technology companies trying to argue that if suppliers had deployed more digitisation they could have avoided the problems that caused so many to fail last year. Most of these arguments are not only deeply self-serving, they have no hope of delivering anything useful over the required timeframe, which is essentially the 8 months before we get into next winter.
People are also conflating various different issues, but most commentators are becoming very concerned about further price rises, with many forecasts for next winter’s retail price cap being at or above £3,000, as well as the impact of high price volatility impacting industry.
What is happening with prices?
Gas and electricity prices have become very volatile and the forward curves have changed shape dramatically. At the beginning of last year, gas prices at the NBP were sitting around 50 p/th. By the beginning of this year they had quadrupled (after a period of even higher prices in December). Now the front month contract on ICE is trading towards 300 p/th, down from 540 p/th on Monday and when within day trading exceeded 800 p/th. I’m finally beginning to agree with Ofgem’s oft-repeated slogan that market conditions are “unexpected and unprecedented” – these types of gyrations are genuinely unusual even in commodities markets.
Looking closer, the forward curve has gone from some backwardation in November, to flat in February, to massively backwardated now as the front of the curve has risen sharply. Trading liquidity looks to be pretty concentrated in the front couple of months, and it is almost certain that only traders with physical positions are currently trading. There have been suggestions that the main gas indices such as the front month TTF contract should see their prices capped, but it is unclear who could do this and on what authority. In equity markets, exchanges can suspend trading when it becomes disordered, but in physically delivered energy futures markets this would disrupt actual physical flows and add to the chaos.
It is interesting to see that EUA prices have collapsed – this is counter-intuitive in some ways since a reduction in the use of gas would suggest an increase in the use of coal in the EU, particularly in electricity generation, but there had been signs that much of last year’s increase was driven by hedge fund money which is almost certainly now taking profits and exiting the market. Even from a fundamental perspective, although demand for EUAs may rise due to gas-to-coal or oil switching, the carbon market is not a real, physical market, it is a market that was invented by politicians. If politicians become concerned that end-user energy costs are too high, they can force down EUA prices or suspend the requirements for companies to submit EUAs for various activities, which would certainly cause a de-valuation.
The same logic can be applied to the nascent UK ETS, although it is not clear that the UK held as much interest for non-physical players as the European emissions market did.
Policy choices for the Government
A month ago, when Ofgem announced a new record level for the price cap, the Government tried to soften the blow with a range of subsidy measures aimed at households. These measures were underpinned by an assumption that high market prices were temporary and that by next winter they would have started to fall. This was a view I held last autumn, but as the winter progressed, analysts began to cast doubts on whether European gas inventories could be restored over the summer, and if not, this would likely defer a meaningful price correction until the following spring. Clearly all bets are now off as a result of the war in Ukraine, and my sense is that even if Russia were to immediately withdraw, apologise and pay reparations, the damage done to its relationships with the rest of Europe will take decades to repair.
European governments have long gambled on Russia avoiding extreme behaviours to allow a somewhat uneasy relationship to be maintained where Europe relied on Russian energy and Russia relied on the money raised by selling its energy to Europe. The invasion of Ukraine has shown that the Russian government is capable of and willing to cross what most people assumed was an un-crossable line, that is the outright full invasion of another sovereign state. There is no going back from this – having crossed this line, European governments will never be able to trust that other lines may not be crossed in the future by the Russian state, and will need to protect themselves accordingly. In the near term, this is leading to a re-militarisation of Eastern Europe, something it is difficult to believe that Russia wants, and in the medium to longer term, this will lead to Europeans seeking to disentangle themselves from Russian energy.
Policy choices: gas
Only about 3-4% of the UK’s gas comes from Russia, and this can be fairly easily substituted with other gas imports albeit at potentially high prices. The vast majority of UK gas comes from the North Sea – either our own production or from Norway. So security of gas supply for the UK is not really under threat, although as a participant in the global gas markets, affordability is a concern. However the UK is not a poor country and can afford to pay what is necessary to ensure that at the national level, gas continues to flow.
Looking to the future, there are signs that the attitude to security of gas supplies is changing and that there is now a greater interest in exploiting domestic gas resources. There is suddenly new pressure to get on with fracking – there is currently a moratorium on fracking, and the two existing wells are due to be permanently sealed.
This would be a mistake – these wells should be further developed and the tolerance level for earth tremors should be raised from the current level of 0.5 on the Richter scale to something closer to 3.0…”earthquakes” of 2.5 – 3.0 occur naturally in the UK fairly regularly, and rarely do more than crack a few plates.
Apparently in the UK we experience a magnitude 4.0 earthquake every two years and a magnitude 5.0 every 10-15 years. The citizens of Groningen in the Netherlands have faced higher seismic activity as their gas field depletes, and are now willing to see production increase regardless of the greater strength and frequency of tremors which had been reaching 2.5 – 3.5 before extraction was reduced.
UK seismic hazard analysis suggests that minor property damage occurs at 6.0, so the controls on seismic activity relating to fracking are demonstrably far too conservative and should be relaxed.
However, fracking is not going to change the gas supply equation for the UK in the next 8 months, and possibly never, since we do not know for certain that there are economically viable shale gas deposits on (under) British soil. A more likely route to success would see an increase in UKCS activity, but again, not really in the next 8 months. The UK does not have any real swing production, so the only way to increase output is to drill more wells. Some projects are more or less ready to go, with field development plans established (if not necessarily approved) and routes to financing (eg through an existing borrowing base facility) available.
So on gas, the sensible policy actions are:
Negotiate firm long-term LNG supply agreements with limited diversion rights, alongside restrictions on cargo re-loading. This will ensure LNG actually reaches the GB gas network.
Approve new UKCS E&P activity, and take a pragmatic approach to issuing new licences / approving field development plans.
Remove the moratorium on fracking and raise the tremor limit to 2.0 or 2.5.
Evaluate new seasonal gas storage investments, either bringing Rough back to use, or developing another depleted/near depleted gas field, possibly one of the sites identified for carbon storage.
Of these, only option 1 would have an impact this year.
Policy choices: electricity
The picture on electricity is much more difficult as winter capacity margins are falling to worrying lows. This year’s T-1 auction for delivery next winter saw a shortfall for the first time, procuring 365 MW less than the target. As about a third of the assets that secured contracts have not yet been built, there is some delivery risk. The condition of the nuclear fleet is worrying, particularly as NG ESO has been using the average availability over the past 3 years in its Winter Outlook calculations, which is not prudent for end-of-life assets.
I have read calls for the nuclear closures to be halted, but this is to mis-understand the drivers of these closures in Britain. Unlike Germany and Belgium, British nuclear power stations are closing for safety reasons rather than political or environmental reasons, and therefore the closure plans cannot be delayed or reversed.
What can be done is to halt and potentially reverse the closures of the remaining coal power stations, at least until Hinkley Point C opens. In the near term, allowing the remaining plant to run without restrictions (ie free from environmental limits on running hours) would reduce the need for gas, which would be helpful at the margin. The incremental environmental harms can be discounted – on a global basis running a few GW of coal power for a bit longer in Britain will have a minimal impact. Of course the currently mothballed Calon CCGTs should also be brought back into use to support capacity margins next winter – the fastest way to strengthen these margins is by not closing currently running plant, and by re-opening assets which already exist, before building anything new.
The only other lever for improving capacity margins over such a time frame is a public campaign to reduce consumption. This has already started, with people being encouraged to turn down their thermostats by 1 oC. Astonishingly, the average indoor temperature in European buildings is 22oC! For most people, this is much higher than should be necessary for comfort, assuming a sensible, seasonally appropriate level of clothing is worn – turning up the heating and then sitting around in T-shirts / bare feet should be strongly discouraged and made socially unacceptable in the same way drink driving is widely considered objectionable.
“The average temperature for buildings’ heating across the EU at present is above22°C. Adjusting the thermostat for buildings heating would deliver immediate annualenergy savings of around 10 bcm for each degree of reduction while also bringing down energy bills,” – International Energy Agency
On top of this, there should be efforts, led by local councils to support people in fuel poverty, partly through advice, to ensure they understand how their heating systems work and how to use them efficiently, and also to support them with basic repairs such as fixing broken or badly fitting windows and doors, which are cheap and can immediately reduce heat waste. Since even cheap actions are unaffordable for those in fuel poverty, these repairs should be paid for through public funding.
Longer-term, we need to get a grip on heat losses in homes. So far the energy transition has focused almost entirely on subsidising renewables – this is easy to do and can show rapid progress, but we are reaching a saturation point beyond which new investments lose efficiency without other supporting investments and reforms, particularly in networks. Subsidy schemes have been poorly designed, and multiple reports have found that consumers are over-paying for the renewables built to date. Yet these legacy subsidies will continue to burden consumers for decades, irrespective of any new schemes or auction rounds – payments for the defunct Renewables Obligation scheme are set to continue until 2037.
Not only should these costs be moved from bills to general taxation, but there should be a moratorium on new renewables subsidies with the focus shifting to a major publicly funded retrofit effort to reduce heat losses in homes, particularly in social housing. This is a difficult challenge, but it is vital if the energy transition is to succeed – current concerns about affordability should provide the impetus to finally set aside the easy but expensive subsidisation of renewables, and deal with energy waste in homes.
So the policy actions on electricity should be:
Delay coal closures and re-open the mothballed Calon plants.
Advise and assist consumers on short-term demand reduction.
Suspend VAT on domestic energy bills, move green levies to general taxation, and provide domestic consumers with a direct energy subsidy for next winter (replacing the previously announced loan).
Apply a windfall tax to renewable generators that receive the Renewables Obligation and do not have a fixed price PPA.
Approve new large-scale nuclear that can be built faster than the troubled EPR (ie ABWR).
Pause new renewables subsidies and establish a clear plan for addressing heat losses in homes, with defined targets, alongside a reformed EPC which takes account of the condition and quality of building materials.
There are few real options for policymakers that will relieve market concerns over security of supply and reduce prices. They need to take those actions that can have an impact within months, and then they need to support consumers with high prices. This is hard – the war is raising prices across many sectors of the economy, not just energy – food prices are also rising, and there is a very real risk of a recession. But this makes addressing demand even more important. Short-term actions such as paying for basic repairs could be funded through a windfall tax on renewable generators who have been earning excess profits under the Renewables Obligation subsidy scheme.
It is not hyperbole to say that current energy policy needs to focus on the preservation of life: excluding Russia from the energy markets will preserve life by removing a source of funding for its illegal war; addressing security of supply and affordability preserve life because interruptions to supply and self-disconnection on the basis of cost are both a threat to life, particularly in winter.