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Rupert Darwall: Energy Policy And The Return Of The State

Rupert Darwall, Reform

Energy policy represents the biggest expansion of state power since the nationalisations of the 1940s and 1950s and is on course to becoming the most costly domestic policy disaster in modern British history.

By committing the nation to high cost, unreliable renewable energy, its consequences will be felt for decades to come. Energy is an iceberg policy: its implications for the demise of a competitive market in electricity – the final achievement of the Thatcher years – are poorly understood and tend to be consigned to footnotes and annexes of policy documents.

Like its predecessor, the Coalition Government has three policy objectives: 

* Keeping the lights on;

* Keeping energy bills affordable; and

* Decarbonising energy generation.

These do not require the policies the Government is implementing. Indeed, energy policy militates against having cheap, reliable energy. Worries about the lights going out have intensified as the country becomes more dependent on the weather for its electricity. The market is the best way of providing reliable and affordable electricity. Converting the electricity system to wind and solar power does neither. Even on favourable assumptions, these are inefficient ways of reducing carbon dioxide emissions.

In reality, the over-arching goal of Britain’s energy policy is an arbitrary form of decarbonisation in the form of an extremely costly European target for renewables generation (principally wind and solar energy) which Tony Blair negotiated at his last European Council in 2007. Because policymakers have not been honest with themselves and the public about the implications of the renewables target, policy has not been assessed against potentially more efficient options, notably the state providing the finance to achieve its objectives and putting the investment it deems necessary onto its balance sheet. The result is that the energy sector is being transformed into a vast, ramshackle Public Private Partnership combining the worst of all worlds – state direction of investment funded by high cost private sector finance, with energy companies being set up to take the rap for higher electricity bills.

The politics of high and rising electricity prices make it convenient for policymakers to blame market failure for what in reality are policy-driven outcomes. Political and media attention has focused on retail competition culminating in Ofgem’s reference to the Competition and Markets Authority. Compared to generation, the retail market is a sideshow, but it too is subject to increased regulation, narrowing the choice of tariffs suppliers offer.

In terms of costs, wholesale competition in generation (around 50 per cent of costs) is far more important than retail competition (around 7 per cent of costs). Indeed, a key justification for retail competition is to drive wholesale competition between competing generating companies and competing generating technologies. Adopting a fixed target for the amount of energy to be derived from renewables requires the Government to take control of electricity generation. This is because subsidising zero marginal cost, weather-dependent electricity destroys the ability of the market to function properly. Thus in thirty years, the wheel of energy policy has turned full circle, reverting to what it was before Nigel Lawson’s seminal speech in 1982 which argued that the market should replace central planning.

Although less dramatic than privatisation, the return of state control is as important. With one caveat, the restructuring and privatisation of the electricity industry in the last two years of the 1980s represent the Gold Standard of public service reform. It delivered what its proponents promised: 

* Investment in efficient generating capacity;

* Huge increases in labour productivity; and

* Once the regulator and the market had broken the generating duopoly, a sharp fall in prices.

Lawson had criticised central planning because it involved “guessing the unguessable” – energy demand and energy prices decades into the future. This view remained axiomatic in subsequent government policy papers, notably Alistair Darling’s 2007 Energy White Paper and a joint Treasury/DECC assessment published in the final months of the Labour Government. It was finally jettisoned by the Coalition in its Electricity Market Reform (EMR). It justifies the return of state control on the basis of presuming to know that the price of fossil fuels will rise continuously, a view rapidly overtaken by falling coal prices and opportunity opened up by fracking and the shale gas revolution in the United States.

Unlike privatisation, the EMR hybrid of state control and private ownership is far from optimal and is structurally unsound. In response to the narrowing margin between peak demand and generating capacity, the Government is using sticking plasters to keep the lights on, principally by paying businesses not to use electricity unless they generate it themselves. The fundamental problem is structural. Whilst the public focus is on the profits the Big Six energy companies derive from supplying electricity, their losses from generating electricity from conventional power stations tend to be over-looked – indicating the under-water economics of the sector.

The Government’s answer is to create a Capacity Market to provide price supports for the generating capacity needed to keep the lights on. Thus virtually all forms of electricity generation – zero, low and high carbon – end up benefitting from subsidies and price supports in one form or another. However the political sustainability of this is questionable. At a time of public concern about the cost of energy, when energy company profits can easily become a lightning rod for public anger, the optics of indefinite price supports and subsidies for all electricity generators do not bode well for the longevity of the policy. Even the perception of investor doubt about its durability undermines the policy’s effectiveness by deterring investment, raising the cost of capital and electricity prices, further exacerbating political risk. It is hard to see EMR’s hybrid form of state control lasting as many years as the market-based policy it replaces.

The evolution of energy policy is an object lesson in the impact of poor policymaking. A flaw in the original design of electricity privatisation – the creation of a generating duopoly – undermined confidence in the way prices were set in the wholesale market. The decision by the Prime Minister in 2007 to adopt a demanding top-down target resulted in a cascading sequence of policy mistakes with ever more serious unintended consequences. Four key policy lessons can be drawn from this experience:

1. There is a big political premium in getting the initial conditions right. Although privatisation worked, uncompetitive initial conditions helped create the impression that the benefits went overwhelmingly to shareholders. Securing competitive conditions at the outset improves the post-privatisation politics, reducing the political incentives to intervene.

2. Using economic regulation as a tool of government policy is incompatible with having a competitive market. Instead economic regulation should be tightly focused on expanding competition and providing a substitute for competitive pressure via periodic price cap reviews.

A better way is to treat electricity as if it were entirely competitive and not subject to economic regulation, and use policy instruments such as taxation, welfare, public spending and traditional forms of regulatory interventions.

3. On energy security, there needs to be a compelling justification to override the economics of free trade. Historically, appeals to energy security have resulted in the very energy shortages energy security was meant to avoid. In the case of EMR and its precursor policy, the failure to evaluate stockpiling as a means of boosting energy security is evidence that energy security is used as a cover for other objectives, as it was when it was first used by the Government to try to prop up the coal industry.

4. Policy needs to take account of the dynamics of the whole system and the location of cost along the value chain. Competition-based remedies for distortions created by ongoing policy interventions are not a substitute for changing those interventions.

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