Crisis and opportunity in UK energy policy

An interesting recent research note by Liberum Capital highlighted the problems at the heart of UK energy policy and the very real risk of a crisis in electricity supply. This was of course not new news, while at Matrix I published a research note outlining the same problems – ‘The Ghost in the Machine’, 24 November 2009 – and the threat has been widely reported, but the Liberum report was a good piece of integrated analysis tying together the physical situation and the current reality for investors. At the end of the day, whatever energy sources we want to use, we need investors to invest in new plant and infrastructure and right now they are not likely to do that.

The background is relatively well known. The 2003 EU Directive committed member states to a 20% reduction in average greenhouse gas emissions and endorsed a target of 80% by 2050. The UK Climate Change Act went further than the EU target and set the 2020 and 2030 targets in law. The previous government committed the country to massive expansion of renewables, particularly off-shore wind – a technology that can only provide intermittent power, is unproven at scale, and staggeringly expensive. The off-shore wind industry believes it can achieve a long-term cost of energy of £100/MWh by 2020 – compared to the current wholesale cost of power of c£50/MWh – but many think this is optimistic. Even if it isn’t it assumes a massive increase in power costs that need to be paid by the consumers, either directly or indirectly through subsidies.

At the same time a significant proportion of UK generating capacity is set to close due to a combination of the Large Combustion Plant Directive and the need to retire ageing nuclear plant, most of which have already has their lifetime extended far beyond the original estimates. Although the supply margin, the difference between total available generating capacity and peak load is currently ample, it is likely to decline quickly as older gas plants are mothballed as the current spark spread (the ratio of gas to power prices) is insufficient to justify either operating the plant or investing in refurbishing them at the end of their twenty year design life. Liberum estimate that the margin between available dispatchable capacity and peak demand in the winter of 2015/16 could get below 10% which is tight. At this level the risk of the lights going out somewhere increase. On 12 December last year the National Grid had to call on all available capacity to meet demand, which is fine as long as everything works as it should but the problem will come when there is a coming together of a sequence of unlikely events, any of one of which in itself wouldn’t cause a problem. Most large blackouts, aircraft crashes and industrial accidents are caused by long chains of unlikely events coming together (see this for a time line of events behind the 2003 blackout in NE USA and Canada).

In the words of the Liberum report governments (the current and the previous) have been playing Russian roulette with energy policy. There is a serious risk of an electricity supply crisis, either in the 2014 to 2017 time frame or post 2020. This could manifest itself as the lights going out or as a spike in wholesale electricity prices with consequent effect on retail prices. With one in five households in energy debt and six million households in fuel poverty, retail energy prices are already a major social and political issue.

The country has effectively placed a very large bet on energy prices increasing – a bet that according to Liberum will cost £161 billion by 2020 and £376 billion by 2030.

The Electricity Market Reform (EMR) was designed to address the problem and unlock the massive amount of investment needed to build new plant and energy infrastructure. It all but nationalises the electricity supply industry as all investment decisions will be dependent on prices set by government through the CFD-FIT mechanism. Right now the EMR is having the opposite effect on utilities and investors with most being unable to make any UK investment decisions and several stating they would rather invest elsewhere. OFGEM, SSE and Centrica have all criticised the current policy situation.

So how do we get out of this urgent mess?

We need to rebalance energy policy and recognise that massive deployment of renewables, particularly off-shore wind, is premature and not the least cost solution. Technology transitions in any industry, but particularly the energy industry with its inherently long time-scales, have to be driven by significant advantages and a major driver of change is cost. Renewables do not have that advantage and we have been pushing a rock uphill with subsidies before the technology is ready. We also need to rebalance energy policy by recognising that what we need are energy services and not energy – and that energy efficiency is a major resource that needs to be equally represented at the table of energy policy makers as the energy supply industry. It is not just an add-on, a ‘nice to have’, or mandatory schemes, but rather should be the central plank of energy policy.

We need to accelerate energy efficiency in all sectors of the economy. Energy efficiency needs to be promoted for what it is, the lowest cost, quickest to deploy and cleanest source of energy services. A 2012 report form the Fraunhofer Institute shows the average Levelized Cost of Energy (LCOE) for various renewable technologies in Germany and Spain, which range from a low of €75/MWh for on-shore wind through to €130/MWh for off-shore wind and €180/MWh for the more exotic concentrating solar and storage. The number for the existing fossil and nuclear grid is €60/MWh. Fraunhofer don’t report on the equivalent LCOE for energy efficiency but averaging various studies from around the world including this one by the ACEEE shows that the LCOE of energy efficiency is in the range of €20 to 45/MWh. In addition to these costs there are the additional system costs inherent in deploying renewables (and nuclear). These were highlighted in a 2012 report by OECD – these range from, depending on the degree of market penetration of renewables and nuclear, from $0.6/MWh for gas to $83/MWh for solar PV. In stark contrast, energy efficiency brings with it system wide benefits in the form of, reduced investment in transmission and distribution, reduced line losses and capacity savings,which have been estimated by ConEd for a commercial lighting upgrade, distributed generation and demand response examples. For commercial lighting the system benefits, excluding the energy saving and the environmental benefit, is c.$36/MWh. So renewables bring extra costs and efficiency brings extra benefits. We need to recognise system wide costs and benefits.

We should also remember that energy efficiency has contributed more energy services over the last forty years than any other energy source – and that is without us really trying apart from the decade of the mid-1970s to the mid-1980s.

The Electricity Market Reform (EMR) needs to include market based mechanisms which encourage consumers, and aggregators, to develop and implement energy efficiency and other demand side projects (i.e. distributed generation (DG) and demand response (DR)) and share in the system wide benefits described above. Right now it looks like the capacity market mechanism within EMR won’t do this and proposals in Europe put forward by grid operators seem to be aimed at carving out all the benefits of demand side response for the grid operators.

We need to put more effort into building capacity in energy efficiency and energy management in three areas; the demand side (i.e. end-users at all levels from the board to the shop floor), the supply side (i.e. of energy efficiency goods and services), and the flow of finance into energy efficiency.

We also need to develop mechanisms to deploy Combined Heat and Power (CHP) and District Heating (DH) schemes. CHP and DH schemes lead to significant improvements in overall energy efficiency and should be supported in preference to intermittent renewables. This can be done in a way that engages communities in their own energy supply much more, something that will bring other social benefits as well as local economic gains. What is needed here, as in energy efficiency, is small amounts of support to aid the development of investment grade projects in industry and the built environment.

We also need to step up Research and Development (R&D) of energy storage technologies which will become more important as a tool for managing demand fluctuations as well as intermittent supply from renewables. R&D in energy generally also needs to be ramped up.

In the short-term (2 to 4 years which may be too long for the 2015/16 potential crisis) there are a number of gas-fired plants that could be bought back into operation but even that is not straight-forward. Most have been ‘deep mothballed’, which means as well as changes to the physical plant the staff have been laid off or redeployed. Taking a large power plant out of deep mothballed state requires something like two years but in order to do this there has to be a financial return to the operator and at the current spark-spread it is not worth doing it. Government will have to do a short-term deal for operators to make this happen outside the main EMR – sooner rather than later.

Finally, however controversial it may be, we do need to develop indigenous shale gas resources. This needs to be done in a transparent way using the best technologies.

The trope about the Chinese word for crisis being made up of the characters for danger and opportunity comes to mind. (Interesting enough in checking this there is some question of whether it is actually true but anyway….). The dangers of the UK’s energy policy are clear – power cuts would cause huge social and economic disruption, possibly including social unrest – riots in the streets – and undoubtedly lead to big political shifts – probably even the downfall of the government of the day. The opportunity is to re-boot UK energy policy by:

• moving away from a supply dominated policy environment towards an energy services view-point
• really recognising the powerful effects of improving efficiency and the system wide benefits
• truly putting energy efficiency and the demand side at the heart of policy
• building capacity in the demand side of energy efficiency, the supply side and the flow of finance
• engaging communities in developing and operating the supply of energy services.

Getting this right might not do much to reduce the risk of a short-term crisis (2015/16) but it would help avoid the medium term risk (2020), most importantly doing it a least cost to the consumer, as well as bring benefits of increased productivity, reduced costs, reduced levels of fuel poverty as well as reduced emissions.