House Of Lords Inquiry: The Economics of UK Energy Policy

The House of Lords Economic Affairs Committee is conducting an inquiry in the Economics of UK Energy Policy. The Global Warming Policy Forum (GWPF) has submitted the following written evidence.

Executive Summary

Despite relatively low wholesale prices, electricity consumers in all sectors of the UK (domestic, industrial, commercial and public sector) are facing the prospect of sharp price rises. This is largely as a result of the direct and indirect effects of unilateral climate and energy policies. Electricity capacity margins are tightening and there are few signs of the necessary investment in firm generating capacity, needed to meet peak demand and keep bills low. Britain’s recent decision to leave the EU should promote a wholesale re-evaluation of its decarbonisation policies.

At present, no new generating capacity can be built without government subsidy. This extraordinary failure is in large part due to market distortions arising from the promotion of renewable sources of energy, which require high levels of subsidy and impose significant network costs. Government forecasts now show that an extraordinary 43% of the price businesses pay for electricity will be made up of the direct costs of climate and energy policies by 2020. These costs are damaging to Britain’s energy-intensive industries in particular. As a result, the UK will import a greater number of goods from countries such as China, which overwhelmingly use coal-power generation for the manufacturing of products; the unfortunate reality of a unilateral approach.

A hugely significant development in the energy sector has been the dramatic fall in the oil and gas price. Lower than expected fossil fuel prices have undermined the prospects of renewable technologies becoming competitive. As a consequence, decarbonisation policies should be reviewed on the basis of up to date price forecasts for all technologies. Such a review should facilitate the removal of any barriers to investment in cheap and reliable sources of energy. It should also prioritise lowering bills for households and businesses. At a domestic level, Britain should urgently amend the Fifth Carbon Budget, which was rushed into law before the consequences of ‘Brexit’ become clear. Britain’s decision to leave the European Union means that all relevant EU legislation also needs to be reconsidered.

What are the key economic challenges for the energy market which the Government must address over the next decade? Has the market and the Government responded effectively to changes in external circumstances, such as significant shifts in technology and prices?

1. A key economic challenge will be to respond to the highly significant and largely unexpected fall in fossil fuel prices. Impact assessments of renewable energy policies have to this point been reliant on high fossil fuel price projections. One such example is the EU’s 2030 Climate and Energy Framework, which assumed oil prices of $115 per barrel in 2020, $121 in 2030 and $143 in 2050[1]. Similarly, when assessing the impacts of the Fifth Carbon Budget, the Committee on Climate Change (CCC) assumed that oil, gas and coal prices would rise by 19%, 32% and 9% respectively, between 2014 and 2030[2].

2. Fossil fuel prices have developed quite differently from these projections. The oil price is currently running at almost 60% below the 2014 forecast used by the CCC. Gas prices likewise are running at or below the minimum level predicted by the ‘low scenario’ used in the CCC paper, entitled Sectoral Scenarios for the Fifth Carbon Budget – Technical report. This was not published until November 2015, but still used DECC’s out of date 2014 fossil fuel price projections. The report estimated that under a low fossil fuel price scenario, the overall cost of meeting the Fifth Carbon Budget could be 80% higher than the central scenario. This cost is estimated as 0.9% of 2030 GDP[3], but only accounts for an extra 5% reduction in emissions. The actual cost could be higher even than this upper estimate; the low price scenario assumes an oil price of $88.50 in 2016, far higher than current prices. Due to the way in which Contracts for Difference (CfDs) operate, lower than expected wholesale prices end up increasing the cost of government intervention in the energy sector. A striking example of this has been the Hinkley Point C nuclear power station. The lifetime cost to consumers of this power plant is now expected to be £29.7bn, over four times higher than initial estimates of £6.1bn[4].

3. Good governance often requires recognising that when the facts on the ground change, it is a good time to have a rethink. The new Department for Business, Energy and Industrial Strategy should review the Fifth Carbon Budget accordingly, with a new impact assessment that takes into account the latest price projections, and acknowledges the important implications of Britain’s decision to leave the European Union.

4. Another important challenge will be to maximise the economic benefits shale gas extraction in the UK. This is an important opportunity to reduce the cost of energy, lower emissions and bring much needed economic development to poorer parts of the country. Between 2007 and 2012, energy-related carbon emissions in the United States fell by 450m tonnes[5], the largest fall amongst the countries that the International Energy Agency (IEA) surveyed at the time. Fatih Birol, IEA Chief Economist, attributed this reduction largely to a ‘major shift’[6] from coal to gas in the power sector. Unfortunately, the UK is lagging far behind the US, largely due to delays caused by the planning system and environmental regulations. While these controls are important, the Government should make sure they do not obstruct progress in this area, and should develop innovative ways of supporting this industry.

5. A crucial obstacle to be negotiated will be the increasing burden of renewable energy sources on the electricity network. This burden comes not only in the form of direct subsidies, but also in increased network costs. These could be as high as £5bn per annum by 2020/21[7]. These network costs reflect the enormous technical challenges of integrating numerous highly intermittent, small scale forms of generation with the National Grid. An example of this can been seen in the Beauly-Denny power line, designed to connect wind energy in the Highlands to the Grid. This single power line, which cuts through some of Britain’s most spectacular terrain, comes at the cost of an extraordinary £820m[8].

Are returns for private investment in the sector adequate or excessive?

6. At present, no new generating capacity can be built without government subsidy. This market failure means that returns for private investment in the energy sector are wholly dependent on a system of subsidies and incentives designed to promote particular sources of energy. Specifically, the Government promotes investment in renewable sources of energy above cheaper and more reliable methods of generation. This system has revolved around EU targets for renewables, which are supported by domestic policies: principally, the Levy Control Framework (LCF).

7. Despite the lack of progress to meet EU targets, policies designed to promote renewables represent bad value for energy consumers and should properly be described as ‘excessive’. For example, if gas-fired power stations had been installed instead of new renewable capacity, UK consumers would each have made an average annual saving of £214 in 2015, according to a report by the Centre for Policy Studies[9]. The UK’s Renewable Energy Strategy is considered the most costly of all EU-derived legislation[10], with a current annual cost of about £5 billion a year, rising to about £7.6 billion (the Levy Control Framework limit) a year in 2020, and continuing for decades afterwards. Though in fact, the UK Government’s own impact assessment suggests that the LCF limit may be breached, with renewable subsidies expected to cost the government £9.1bn[11] in the 2020/21 financial year.

8. The large sums of money spent subsidising renewables are justified primarily on the basis of making a contribution towards carbon dioxide emissions reductions. However, it is an uncontroversial finding[12] that there is a sizeable excess cost of overlapping regulations in EU climate policy.  Böhringer et al. (2016) found that the overall cost of meeting the EU’s 2020 GHG targets rose by 11%[13] because of the presence of additional targets for renewables. Given that costs vary greatly between member states and because the UK bears a disproportionate burden (25% of the total cost) of supporting renewables, it can be safely assumed that an equivalent figure for the UK would be significantly higher. This has the important consequence that a significant proportion of the cost of supporting renewables achieves no reduction in CO2 emissions and merely represents a wealth transfer from energy consumers to the renewables industry.

9. Moreover, the cost of renewable energy subsidies is unreasonably excessive compared with the estimated social cost of carbon. According to a recent analysis[14] by John Constable and Lee Moroney, small-scale solar energy in the UK costs around $380 to mitigate one tonne of CO2, while offshore and onshore wind cost $274 and $137 respectively. In contrast, a paper by Ross McKitrick et al. (2016) estimates[15] that the social cost of carbon is as low as $3 to $30 per tonne of carbon dioxide.

What is the relationship between high energy costs and the loss of industrial capacity in the UK? What measures should be taken to address this?

10. High energy costs are having a damaging impact on Britain’s industrial capacity. Future energy policy should aim to provide positive incentives, rather than discouragement, to potential investors both in firm generating capacity and in the UK manufacturing sector, which requires cheaper energy prices to remain competitive.  Substantial reform of energy policy should be seen as a necessary condition for an industrial strategy of the kind Theresa May envisaged when creating the new Department for Business, Energy and Industrial Strategy.

11. Since the ETS and all of the EU’s legally binding climate policies only cover a single continent, it inevitably creates carbon leakage as it imposes carbon costs that are higher than in all other regions. In response, businesses in the UK and Europe are often forced to close or move abroad in the face of foreign competition, meaning production ends up taking place elsewhere – as are CO2 emissions. This a problem that particularly affects energy intensive industries; a November 2015 study by ECOFYS for the European Steel Association (EUROFER) found that proposals for post-2020 ETS reform could cost the steel industry €34 billion over the next trading period, adding €28 per tonne of steel produced[16]. Other energy-intensive industries are likely to face a significant compliance cost during the next trading round of the EU ETS. The EU’s own impact assessment found that direct carbon costs for the cement industry could be as high as 7.6%[17] of the industry’s turnover during the 2021-2030 trading period. While these significant costs are likely to be tempered by compensation packages, these forecasts do illustrate the substantive risks of staying within the EU’s Emissions Trading System and highlight the importance of preventing carbon leakage to Britain’s future ‘industrial strategy’.

12. Risks to competitiveness are potentially magnified by varying compensation rates across different European countries. Germany, for example, has a more comprehensive system for compensating for carbon costs that covers a greater number of firms and offers more generous reimbursement by transferring the cost to domestic consumers. Outside the EU, the UK will need to make an extra effort to ensure its energy-intensive industries remain competitive both with the rest of Europe and globally. However, the German method of transferring the burden to households is unlikely to be politically acceptable. Cuts in overall policy cost seem to be the only avenue likely to succeed.

What preparations could be made to cope with the risk of a shortfall in energy supply? What would be the cost to the economy of the breakdown of the existing system?

13. The UK’s falling electricity capacity margins are a significant cause for concern. In January 2016, the Institute of Mechanical Engineers estimated that the UK could face a 40-55% capacity shortfall[18] by 2025. While some have disputed the precise figure, the problem is widely recognised as one of growing urgency, and is implicitly granted to be such by the government’s creation of the costly Capacity Mechanism, amongst other instruments.

14. The Carbon Price Floor and EU environmental regulations have been significant drivers of this problem, within a complex of causes. Specifically, the EU’s Large Combustion Plant Directive (2001/80/EC – LCPD) and its successor the Industrial Emissions Directive (2010/75/EU – IED) have forced many coal-fired power stations to close. These older plants had to choose to close or clean up by 2015 under the LCPD (and by 2023 for the IED), by reducing the emissions of sulphur dioxide and oxides of nitrogen. This policy combined with the Carbon Price Floor to produce a perverse incentive for opted-out stations to use up their remaining allocation of operation hours rapidly, before the CPF reduced their profit margins. Furthermore, the EU renewables targets resulted in market distortions that destroyed investment signals for firm, reliable conventional generation.

15. Leaving the European Union can help the UK to manage its urgent security of supply challenges. Outside the EU, the Government would have the opportunity to allow longer lifetimes for existing power plants through repealing the Industrial Emissions Directive. Given falling capacity margins and, to date, no demonstration of carbon capture and storage at scale, this may be essential in order to maintain the UK’s security of supply. However, it would nonetheless contradict the UK’s independent commitment to phase out coal by 2025; a policy that may also need to be reviewed. Membership of the European Economic Area (EEA) could prevent the UK from undertaking vital reform in this area. For example, entry into force in the EEA of the Industrial Emissions Directive is pending fulfilment of constitutional requirements by Iceland, Liechtenstein and Norway pursuant to Article 103 EEA.

16. Keeping old power plants on grid is clearly not a long term fix; the priority needs to be in securing investment in additional generating capacity that is reliable, and free from intermittency problems. However, such actions may be essential in the short term to allow enough time for new capacity to come on stream, and to avoid spiralling balancing costs. Scrapping the Carbon Price Floor could have a more substantial impact, as it is likely to incentivise investment in Combined Cycle Gas Turbines (CCGTs). The government has indicated that it sees CCGTs as essential to meeting the capacity shortfall, but there is only one currently under construction: Carrington, near Manchester. This has a capacity of only 900MW.

What alternate ways of pricing energy should be considered to reduce the burden of high energy bills, in particular on less well-off consumers?                   

17. Rising energy prices are testament to successive failures in energy policy and to the urgency of reform. The Government has forecast[19] that electricity prices for medium-sized businesses will be 77% higher in 2020 than they  were in 2014 due to Government policies[20]. As a consequence, an extraordinary 43% of the price they will be paying for electricity will be made up of the direct costs of energy and climate change policies.

18. However, these direct costs alone do not tell the whole story. The problem of intermittency, associated with renewables, has increased the need for expensive balancing services. In this way, the dual effects of an increasing renewables share and declining conventional capacity both contribute to the mounting cost of managing Britain’s particularly tight capacity margins. This cost is reflected in rising Balancing Services Use of System (BSUoS) charges, which have risen by a factor of three in the decade from 2001 to 2012 and are now running at over £1bn per year[21]. Other network costs have also risen due to the significant expense of connecting renewable energy projects to the National Grid. Assuming the quantities of wind energy in the National Renewable Energy Action Plan, the aggregate system management cost attributable to renewables will come to £5 billion a year[22] by 2020/21, a figure rivalling the cost of direct subsidies. This increasing burden of renewable energy on the electricity network points to a clear avenue for reform: the need to move away from a system of unilateral targets and renewable subsidies and towards a technology-neutral approach. This could deliver low-cost carbon dioxide reductions, while also recognising the need for more reliable forms of energy.

19. Resiling from the Renewables Directive (2009) would be an important first step towards achieving this objective, as it would abandon the renewables targets that have been so expensive for consumers. However, in order to capitalise on the opportunities that this would provide, the UK should also examine the Levy Control Framework (LCF) which is currently the primary mechanism for delivering upon EU targets. While abandoning commitments to the Renewables Directive would not retrospectively cancel subsidy entitlements, it would allow the government to stop adding further to this major market distortion that is currently destroying price signals for investment in firm generation.

20. Unfortunately, much economic damage associated with unilateral targets for renewables has already been done. The 2030 EU Climate and Energy Framework has moved away from a system of binding targets for renewables and energy efficiency, to a more flexible system where targets are only ‘indicative’. Nonetheless, the package will allow the Commission to propose mechanisms in order to achieve the targets, and the European Commission has stated that it aims to increase the target from 27% to 30% by 2020[23]. The cost of following such a target would be high. A report[24] by Enerdata©, commissioned in 2014 for the now defunct Department for Energy and Climate Change, found that achieving a 30% renewable energy sources (RES) target would increase the cost of meeting the 2030 GHG emissions target by 37%. This is illustrative of the cost of the government ‘picking winners’; the added cost burden will achieve no additional CO2 reduction, only a wealth transfer from energy consumers to the renewable energy industry. Decisions taken post-Brexit can allow the UK to avoid new renewables targets under the 2030 framework and instead focus on managing security of supply challenges and reducing bills for consumers.

21. Energy efficiency and conservation policies have been suggested as a way to widen capacity margins and ameliorate the impact of rising electricity prices on bill-payers. This was indeed the plan of DECC, which published optimistic forecasts[25] of the savings to energy bills that conservation measures could make. However, the evidence is that these measures prove to be very expensive and dubiously effective, and this is particularly the case for EU policy. Böhringer et al. (2016) found that the presence of a 20% reduction target for primary energy use within the EU’s 2020 climate and energy package, causes losses in real consumption that are five times higher[26] than the cost of meeting CO2 targets alone. Looking ahead to the 2030 package, the government has been advised[27] that the presence of a 30% energy efficiency (i.e. conservation) target increases the cost of carbon dioxide abatement by well over 300%. These figures may seem severe, but they represent a significant academic consensus that the cost of using energy efficiency or conservation measures as a means to reduce carbon dioxide emissions is particularly high. The UK Government should extract itself from the 2030 climate and energy framework in order to avoid this substantial and unnecessary expense.