UK Electricity Market Reform: a political compromise

The UK government's forthcoming draft Energy Bill is eagerly awaited by utility companies, investors, and consumers alike. An initial glimpse into the Electricity Market Reform has been given by the Energy Secretary Ed Davey, revealing a pragmatic and temporary solution to the UK’s energy challenges.

The rationale for the Electricity Market Reform (EMR) is to ensure sufficient scale and pace of investment in low-carbon generation, adequate security of electricity supply, and affordable energy costs for customers: what could be termed the sacred energy trinity.

EMR comprises a four-part package of CfDs, carbon price support, emissions performance standards, and a capacity mechanism.

Ahead of next week’s formal publication of the Bill Ed Davey confirmed on November 22 the provision of a cap under the Levy Control Framework (LCF) and the absence of a decarbonisation target for the electricity sector. Both have direct implications for low carbon investment in the UK over the next 20 years:

•            The LCF provides support for low carbon renewable generation. The Treasury has agreed on a cap of £7.6 bn (in real 2012 prices) and £9.8 bn (nominal 2020 prices) up to the 2020/21 financial year that can be passed onto consumers through the existing renewable energy levy part of their bills. As a point of reference this is a three-fold increase on the current subsidy cap for low carbon electricity for the 2012-13 financial year of GBP2.35 bn. The government estimate of the actual increase in the average household energy bill is GBP95 by 2020 (GBP20 in 2012), but Datamonitor notes that this estimate would be higher if it included the 20% over-run allowance permitted under the LCF and if the government’s suggestions for single tariff reform are realized.

•       The widely discussed 2030 decarbonisation target for the power sector will be absent from the bill. However, the bill will provide for a target range to be set in 2016.

In addition, and slightly overshadowed by the previous two points, is the fact that the bill will follow the recommendation of the Energy and Climate Committee and will establish a government-owned private company to act as the single counterparty body under the CfDs. Further, the government confirmed that it will action a capacity market, which may see auctions for capacity held from 2014 to cover peak demand in the winter of 2018/19.

From the low-carbon generators’ viewpoint, on the one hand the LCF is a positive announcement as it provides certainty as to the level of support that will be available. Similarly, the announcement of counterparty under CfDs that will mean enforceability of contracts will also provide reassurance to investors considering entering into CfDs – and it would mean that the government will not be directly liable for compensating generators.

However, on the other hand, the decision to postpone setting a de-carbonisation target sends clear signal to low-carbon generators – nuclear and wind alike – that the government considers new gas-fired generation to be part of the UK’s future energy landscape.

The Committee on Climate Change (CCC) summed the issue up when it said that the lack of a carbon target will leave “a high degree of uncertainty for investors and does not address widespread investor concerns raised in recent months”. 

Gas-fired generation investors, however, will feel reassured, but will wait for the government’s Gas Generation Strategy to be published in December to understand in more detail how the government plans to integrate gas with low-carbon generation by approving new gas-fired plants. Also of note for anyone interested in energy security is the extent to which the strategy will address the controversial issue of fracking.

The government has stated that the bill will “provide certainty to investors in all generation technologies and provide protection to consumers”. The government also aims to achieve a target of 15 per cent of electricity generated from renewables by 2020.

Datamonitor does not believe this last goal will be realised. The carbon price is still too low (a clearing price of 6.62 euro was realised in the UK’s latest EU ETS allowances) to stimulate investment in low-carbon generation.  Although it is true that the bill has the potential to help the UK to increase its share in renewables, it will not allow it to achieve its renewable targets – a de-carbonisation target arguably would have. 

Further, legally binding carbon reduction goals remain. The CCC has set the levels for carbon budgets from 2008 – 2022, advising reducing  emissions of all greenhouse gases by at least 34% by 2020 (relative to 1990). These targets are potentially incompatible with a substantial increase in gas-fired generation should renewable investment be lacking.

Clearly Prime Minister David Cameron is leaving the possibility open in 2016 to treat carbon reduction goals with pragmatism, elevating the UK’s energy competitiveness ahead of environmental concerns.

The elephant in the room is the lack of consideration for demand side reduction. Improving energy efficiency, increasing the use of renewable heat, insulation, and electric vehicles are just a few of the ideas that have been recommended to the government.

In summary, in the next few months there will be a thirst for more detail to give investors certainty. Low carbon generators will be somewhat reassured by this glimpse at the Bill, but will be desperate to know what price will be decided on and how much latitude the government will give to new gas generation in 2016.

Consumers will see their bills rise whatever does, or does not happen. The Bill is the result of heated political negotiation within the coalition government and the compromise that has emerged can be summed up as “more clean energy yes, but not too much, and not at any cost”.

The sacred energy trinity will not be achieved by the Bill – however it is a useful compromise in view of the inherent problems of coalition government. The future energy generation mix must be one that is balanced across the range of fuels to achieve energy security at a reasonable cost. This will certainly be at the expense of carbon reduction targets, but the political reality is that carbon reduction targets are the most adjustable part of the equation in voter’s minds.

Written by Yasmin Valji

Analyst in Datamonitor's Energy team

Follow Yasmin on Twitter: @YasminV_DMEN

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Ofgem: domestic proposals aim for engagement

Ofgem has launched a consultation on the revised Retail Market Review proposals for the domestic market, updating those put forward 12 months ago. This is a timely move given the recent wave of price rises from UK suppliers, but Datamonitor believes Ofgem should educate consumers about market dynamics and set realistic expectations, rather than calling for simpler tariffs and so curbing innovation.

The changes to the Retail Market Review (RMR) address outstanding concerns related to consumer engagement with the energy market, with a focus on requiring suppliers to give customers: "simpler choices; clearer information about products, prices and available savings; and fairer treatment."

The proposals are twofold: driving transparency and reducing suppliers' ability to make excess profits from disengaged and so-called "sticky" customers. Ofgem has also made the proposals more serious by reserving the option of calling in the Competition Commission for a Market Investigation Reference.

The review calls for simpler tariffs, which Datamonitor believes is unwise: simpler tariffs will reduce consumer appetite for tariff innovation, an important element in the success of a future large-scale smart meter roll out in the UK. Indeed, the roll out will require nuanced tariffs designed to influence customer behavior and ensure the benefits that smart meters promise.

The measures also include limiting suppliers to four tariffs per fuel, meter, and payment type; the end of multi-tier tariffs in favor of a standing charge and unit rate; and personalized information on bills regarding potential savings if the customer switched to a competitor's cheapest tariff. In addition, Ofgem is putting forward Tariff Comparison Rates to allow market-wide comparison, an improved Annual Statement complete with personalized information arming the consumer for engagement in the market, and the requirement to treat customers fairly.

One of the most common observations when retail prices rise is the disconnect between profits from retail accounts and group profits reported by suppliers. Retail margins are modest - usually around 4% - whereas overall profits are significant, often driven by profits from upstream business units. Suppliers' wholesale businesses benefit from the difference between going market rates and their cost of supply, achieved wherever a supplier has a portfolio of well-managed and well-hedged power stations and gas fields.

But profitable upstream supply is not always guaranteed (as anyone with a combined cycle gas-fired generator facing negligible or negative spark spreads will attest), and utilities are still obligated to deliver value to shareholders and invest in power stations and gas fields to ensure ongoing security of supply.

Additionally, any argument for a supplier offering a cheaper retail rate given its level of supply-side profit is effectively an argument for cross-subsidy between business units, which could be construed as loss-leading and anti-competitive, as it would disadvantage smaller suppliers without their physical assets to act as a hedging strategy.

Recent allegations about improper NBP trades by whistle blower Seth Freedman will not help suppliers, even though there is currently no evidence that UK retail suppliers were involved in any way. Whatever the outcome of FSA and Ofgem investigations into this issue, and whatever the size of the material impact on end consumers, this will remain a consumer relations headache. Indeed, many consumers may form the impression that wholesale costs themselves are unreliable, and therefore every effort must be made to highlight the reliability and improve the perception of suppliers' wholesale market operations.

While there are no direct measures that can effectively address the issue of suppliers' group-wide profits, communication and consumer education about market dynamics and setting realistic expectations for consumers would be a much better starting point than holding back tariff innovation. Datamonitor believes that the biggest risk with Ofgem's proposals is creating unrealistic expectations that the proposals will be able to apply any material downward pressure on prices.

Written by Rhys Kealley

Lead analyst in Datamonitor's Energy team

Follow Rhys on Twitter: @RhysKealley