Over the past few days I have been invited to comment in the mainstream press about the current energy crisis, both in terms of security of supply and high costs. These two legs of the trilemma now dominate the news as people rightly worry about eye-wateringly high increases in the price cap, and the growing risk of blackouts. Regular readers will know that I have been warning about supply risks for some time, and that ignoring the energy security and affordability aspects of the trilemma as we have done in recent years is a recipe for disaster.
Price cap increases creating real hardship
Cornwall Insight has published a shocking forecast for the price cap over the winter and beyond indicating that households can now expect to spend more than £4,000 per year on their energy, four times the amount they were paying when the cap was introduced. Ofgem has also decided that rapidly changing wholesale prices mean the cap must be reviewed more often, and so from October, it will be revised quarterly instead of semi-annually. Of course, this will benefit consumers when prices begin to fall, but unfortunately there is no immediate prospect of that happening.
The huge increases for October will be confirmed by Ofgem later this month, but there have been widespread calls for the cap level to be frozen. This is to fundamentally mis-understand what the cap is for and what a freeze would mean for the market.
Knee-jerk reactions must be avoided
Former Prime Minister Gordon Brown, writing in the Guardian, says that instead of “allowing Ofgem to announce an increase on a scale that will send shock waves through every household”, the government should prevent the cap from being raised, “assess the actual costs of the energy supplies being sold to consumers by the major companies; and, after reviewing the profit margins, and examining how to make standing charges and social tariffs more progressive, negotiate separate company agreements to keep prices down.” He also believes that if energy companies cannot absorb these additional costs they should be temporarily nationalised. Elsewhere in the article, he mistakenly says Norway is planning to keep its gas supplies for itself this winter – confusing Norway’s policies on gas and electricity.
These views are echoed by Scotland’s First Minister, Nicola Sturgeon, who agrees that the price cap increase should be cancelled, and that “there should be serious work with the energy companies to tax windfall profits and to restructure the factors that lead to the cost of energy right now”.
The Labour Party has come up with a less radical but still dangerous plan. It wants to see the cap being frozen, but financed through an extension of the windfall tax on oil and gas producers in time, backdating it to January, and in scope, to exclude the deduction for new upstream investments. Of course this would dis-incentivise the very increases in production that are necessary to stabilise wholesale prices in the medium term. Labour’s plan only covers the period from October to April, although wholesale prices are not expected to re-balance over that period.
While many of these plans may attract popular approval, they risk harming both the retail market and the prospects for new oil and gas production. People are upset that “energy companies” are making “record profits”, but the companies making these profits are not for the most part the companies selling to the domestic energy market, and they have already been subjected to a significant windfall tax.
A closer look at the so-called “record” energy profits
Companies which sell gas and electricity to households have not been making record profits. In fact, despite gaining 200,000 additional residential customers British Gas Energy saw operating profits drop by 43% in the year to 30 June 2022. Overall, the Centrica group of which British Gas is a part made £1.3 billion of operating profits, of which £421 million came from the upstream business (up from a loss of £47 million in 2021) and £485 million from its stake in upstream oil and gas company Spirit Energy (£122 million in 2021) which is being sold, £278 million came from the mid-stream trading business (loss of £40 million in 2021), and £98 million from British Gas Energy (down from £172 million in 2021).
Losses within British Gas Energy from the price cap and inheriting un-hedged customers under the SOLR process were off-set by lower customer demand due to warmer than expected weather, which allowed surplus gas and electricity to be sold back to the market at higher prices. Business customers represent about a quarter of revenues with the rest being from the domestic market. Centrica lost around £500 million in the SOLR process, and while it should be able to recover around two thirds of these costs, it was still a large funding requirement for the business to absorb last year.
These factors have allowed Centrica to re-instate its cash dividend, something it suspended in 2020 to conserve cash when oil prices collapsed with the onset of the pandemic. But before anyone cries out that this rewards greedy fat cats, it is worth remembering that Centrica shares are widely held by pension and insurance funds.
In fact, Centrica has already been contributing more broadly. It has provided £7 million to the British Gas Energy Trust, which helps fund debt charities, and provide grants of up to £750 to help any customer – not just British Gas customers – who are struggling to pay their bills. It has also given £6 million to the British Gas Energy Support Fund which helps British Gas customers, and it has repaid all of the covid furlough payments it received from the Government. It also expects to pay £600 million in windfall taxes although these are not included in the 2022 accounts since the relevant legislation was not passed until after the balance sheet date.
We can see from the data, that Centrica’s record profits in the past year have been almost entirely driven by the upstream business. This illustrates the point that energy suppliers are not seeing record earnings except in the rare cases that they also happen to have upstream oil and gas production businesses. Shell also falls into this category, but has far fewer supply customers.
The question is whether Centrica should use these upstream profits to subsidise prices to domestic gas and electricity consumers. Clearly Gordon Brown, Nicola Sturgeon and others believe it should, but let’s examine what would happen if it did. British Gas would be in a position to undercut the rest of the domestic market, and cash-strapped consumers would flock back to the former incumbent. In a single stroke, 20 years of building a competitive supply market would be undermined, and once back with British Gas, many of these customers wouldn’t switch again.
Of course, the Government could try to force British Gas to first subsidise the market and later give up these customers, but that action would attract legal challenge, and rightly so – it is not the job of Centrica (or its pensioner shareholders) to subsidise the domestic supply market. Any such action would have long-term adverse consequences for the energy market, and the British economy more broadly.
“Rather than critiquing the methodology of the cap, it may be time to consider the cap’s place altogether. After all, if it is not controlling consumer prices, and is damaging suppliers’ business models, we must wonder if it is fit for purpose – especially in these times of unprecedented energy market conditions.
It is essential that the government use [sic] our predictions to spur on a review of the support package being offered to consumers. If the £400 was not enough to make a dent in the impact of our previous forecast, it most certainly is not enough now. The government must make introducing more support over the first two quarters of 2023 a number one priority. In the longer-term, a social tariff or other support mechanism to target support at the most vulnerable in society are options that we at Cornwall Insight have proposed previously. Right now, the current price cap is not working for consumers, suppliers, or the economy,” – Dr Craig Lowrey, Principal Consultant at Cornwall Insight
Potential approaches to minimise the adverse impact of the energy crisis
So what is the answer to the immediate crisis? The only real solution is for the state to subsidise energy costs for consumers – the questions are how and by how much. The first three points on my list would save around £400 on a £4,000 bill – not enough by itself, but a start with the £400 support package already announced, although more help will be needed.
Overall, the Government should:
Move all green levies to general taxation
Suspend the UK ETS and other carbon taxes
Set VAT on domestic energy bills to zero
Buy out the SOLR costs so that these are no longer recovered from bills – this will reduce standing charges and directly help consumers reduce the amount they pay through lower consumption
Abolish the price cap and replace it with a social tariff funded by the state (through increased borrowing in the near term)
Change the way wholesale electricity prices are set so that renewable generation is paid on a cost-plus basis and everything else is paid on the existing marginal cost basis with a weighted average setting the price paid by consumers
Extend the windfall tax to renewable generators subsidised under the Renewables Obligation and selling under floating price PPAs, and require all holders of CfDs to activate them as soon as the first phase of the project starts to be commissioned, backdating these start dates as necessary
Encourage (and provide financial support if necessary) to local councils so they can support people with the following measures:
Opening “warm hubs” where people can go during the day to avoid heating their homes
Provide advice on how to access support for help with energy bills for example from charities and utility hardship funds
Provide advice on how to reduce energy use in the home, including assistance with adjusting heating controls, turning off devices that are otherwise on standby, addressing draughts and cooking using less energy
Assistance for people whose energy use could be reduced through simple home improvements such as basic repairs and addition of insulation (ie advising how repairs and other remedies can be funded such as by energy companies through the ECO, or by charities)
Practical advice for households
BEIS, Ofgem, Citizens Advice and Energy UK have developed guides for households to help with the current high costs of energy, based on input from charities and consumer bodies on the most common questions they are asked.
Beyond the domestic sphere, the Government needs to consider each segment of the business world to ensure as much support as possible is extended, particularly to small businesses and energy intensive industries, both of which will find the looming winter price increases very difficult to absorb.
Talk of “freezing the cap” needs to stop, as must complaints about energy company profits. Upstream producers, as can be seen from Centrica’s results, have had a difficult few years before this one, and it is vital that they re-invest profits in more upstream production (which is provided for in the windfall tax). Ultimately the only way that prices will come down is when global gas prices come down, and that will only happen when new sources of supply come on-stream globally to replace Russian gas.
Security of supply is looking increasingly shaky
The other problem that is beginning to get attention is that of security of supply. I have been warning about winter supply risks arising in the mid-2020s since I first began writing about the topic six years ago. Replacing thermal and nuclear generation with intermittent renewables creates a risk when wind output is low, and renewables penetration has reached levels in various countries including Britain where it is becoming difficult to meet demand when there is no wind.
We have now had three Capacity Market Notices this summer – two on 18 July and another 11 August. That we have struggled to meet demand in summer is worrying, and we have been relying on coal and imports to meet demand. This winter we may face the additional stress of exporting to France, and as IFA-1 is expected to return to full service (2 GW versus 1 GW currently) these exports will reach 4 GW in total. We are consistently importing 1 GW each from the Netherlands and Belgium and 1.4 GW from Norway, however the Norwegian government is considering the possibility of linking exports to hydro levels, restricting them when water levels are low.
It had been reported that the Norwegian Parliament would be recalled this week to discuss these proposals, but the debate is now expected to take place in mid-Sepember after initial proposals from the Government were rejected by Speaker of the Norwegian Parliament. The Parliament is not due to return from its recess until October, so it will be recalled early for this discussion, however opposition politicians have expressed concerns at the delay. As reservoir levels in the south of Norway – the region to which the interconnectors are linked – are at lows not seen since the mid-1990s, any restrictions could be in place for some time.
Despite repeated public statements of reassurance from the Government, a leaked analysis published by Bloomberg last week suggests that a “reasonable worst case scenario” could see a capacity shortfall of about a sixth of peak demand, even after the emergency coal plants have been dispatched (these are the units that were due to close this year but have agreed to remain open to provide back-up capacity if needed).
“We have one of the most reliable and diverse energy systems in the world, and unlike Europe, we are not dependent on Russian energy imports meaning households, businesses and industry can be confident they will get the electricity and gas they need,” – BEIS spokesperson
The reassurances from BEIS are sounding hollow, and indeed rather than boosting confidence, are making the Government look increasingly detached from reality. Possibly there is a reluctance to spook the market, but if the market already expects rationing and possible shortages, then these statements simply make the Government appear to be in denial, which is the opposite of reassuring. Businesses are scrambling to hire back-up generators, hardly the action of people confident in energy security.
Potential solutions to the security of supply risks this winter
Rather than pretending everything is fine, the Government should act to boost capacity margins:
Ensure all of the closing coal units that can remain open this winter, do – so far deals have been done with Drax and EDF, but there has been no confirmation that the unit at Ratcliffe will remain open. If an agreement has been reached, the market should be informed, as it has with the others, and if not, all efforts should be made to secure one
The two mothballed Calon CCGTs should be returned to service as soon as possible. The Government should consider offering these units the same terms as the T-1 capacity contracts for this winter to de-risk the position for the owners
The Government should negotiate an arrangement with the Norwegian government whereby Britain would run out-of-merit generation throughout the rest of the summer and into the autumn in order to support exports to Norway, in exchange for assurances that Britain can import from Norway should a system stress event leading to possible load-shedding occur
The Government and National Grid ESO should work with large energy consumers to ensure that demand reductions can be secured (and appropriately compensated) if necessary. Emissions limits for back-up generation using fossil-fuels should be suspended for the duration of the winter
The Government and National Grid ESO should also develop plans to call on the public to shift demand in times of system stress for example through appeals to change the timing of the evening meal, turn down electric heating for a period of time, turn off all non-essential lights and appliances and so on. Similar appeals have been used with some success in Texas and elsewhere this summer
Claims that everything is fine are all very well, but concrete action will be more compelling, and a good deal more useful should capacity shortages occur.
Time to re-shape energy policy around the trilemma
When the UK began its energy transition, it explicitly recognised the need to balance de-carbonisation with affordability and security of supply, however as wholesale prices were low and installed capacity was high, affordability and security were taken for granted.
Energy security has been slipping away year by year as conventional thermal and nuclear generation has been replaced by intermittent renewables, without the bulk seasonal storage technologies needed to manage that intermittency being deployed.
A price shock has more dramatically taken away affordability to a degree that millions of people are facing fuel poverty this winter.
In the short term, the current energy crisis is an emergency and needs to be treated as such. There are no good options, but the harms of creating new subsidies need to be set off against the harms of widespread poverty and the likely closure of many small businesses.
Longer term, we need a return to energy realism. Not all generation is equally useful, and simply building ever more wind capacity will do nothing to address security of supply issues arising from low-wind weather conditions, particularly as electrification of heating and transport will boost demand. These are painful lessons – it’s important we learn them.
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