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Energysource | issue 19 17 Jan 2018 A harsh verdict: the UK cost of energy review

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In October 2017 Professor Dieter Helm published a report summarising the findings of his "cost of energy review", commissioned by the UK Government.  In this article we consider the impetus for the review, the key findings and the possible implications for the UK's electricity industry.

Commissioning of the review

Ahead of the snap general election called by the UK's Prime Minister, Theresa May, in the earlier part of 2017, the Conservative party pledged in its election manifesto to commission "an independent review into the cost of energy".  The background to this pledge is the fact that there has been growing political pressure on the UK Government to address the rising costs of energy in the UK, the blame for which, to a large extent, has been put on the various energy policies of successive Governments over the past decade and beyond.  Part of the blame has also been directed at the structure of the retail gas and electricity supply market, and that aspect was considered by the Competition and Markets Authority (CMA) in a two-year energy market investigation carried out between June 2014 and June 2016.  The CMA investigation has led to a large number of remedies being implemented, primarily aimed at the retail market. 

As discussed in more detail below, key among the alleged "culprits" for high energy prices have been the various incentives introduced to drive investment in low carbon generation.  While this is a point many involved in the electricity industry would challenge, what is inarguable is that the various policy instruments introduced into the market over time have led to a very complex electricity market structure (readers less familiar with the UK electricity market may wish to refer to the text box titled "A short history of the UK's complex electricity market").  What is also significant is that only a few years have passed since the implementation of the Electricity Market Reform (EMR) package of policies, which were intended to address the UK's energy needs, while keeping costs down.  Against this background, and facing the Labour Party's election manifesto pledges to shake up the energy industry radically, including plans to nationalise the gas and electricity distribution and transmission networks, it is perhaps not surprising that the Conservative Government decided to commission an independent critique of the policies that have formed the current electricity market.

A short history of the UK's complex electricity market

The UK electricity industry was privatised in the 1990s. The aim was always to create a fully liberalised and competitive electricity industry, and with this in mind the Electricity Act 1998 provides for a regulatory structure founded on a licensing system of four core activities – generation, distribution, transmission and supply. Ofgem, the gas and electricity markets regulator, oversees and enforces the regulatory structure. A key principle is the separation of the monopoly activities – distribution and transmission – from generation and supply. Originally, at privatisation, an electricity pool was introduced as the mechanism for wholesale electricity trading in England and Wales. In 2001 the pool was replaced with the New Electricity Trading Arrangements, which involves bilateral trading generators, suppliers and traders. This was subsequently extended to Scotland, when Scotland jointed the England and Wales electricity market in 2005, in the form of British Electricity Trading and Transmission Arrangements. However, in parallel to steps being taken to create a fully liberalised market, it was recognised that some government intervention may be required to encourage investment in a relatively new and expensive type of generation plant: renewables. Accordingly, in 1990 the Government introduced the Non-Fossil Fuel Obligation to support generators of renewable energy, which operated alongside the Fossil Fuel Levy, imposed on consumers to support nuclear power. In 2002, the Renewables Obligation (RO), a green certificate scheme, became the main mechanism for incentivising investment in renewable energy. This was later supplemented by the small-scale Feed-in Tariff scheme, aimed at supporting small-scale renewable generators (e.g. solar panels on buildings) and the Renewable Heat Incentive scheme.

In 2014, to address what was identified as an energy "trilemma" – how to ensure energy security, while reducing carbon emissions and keeping the cost down – the Government implemented Electricity Market Reform (EMR). EMR has introduced a completely new incentive framework which comprises four main elements: Contracts for Difference for low carbon generation (replacing the RO); a carbon price floor; an emissions performance standard for fossil fuel generating plant; and a capacity market aimed at incentivising generators to make capacity available as an insurance against potential future shortages.

A key point to understand about the UK electricity market is that the various incentives aimed at supporting investment in new generation are funded by levies imposed on suppliers, which are then passed down to electricity consumers through their electricity bills.

The review's remit and findings

There is a sense of déjà vu in the remit of the review. The terms of reference state that "carbon targets need to be met, whilst concurrently ensuring security of supplies of energy, in the most cost-effective way… The specific aim of this review is to report and make recommendations on how these objectives can be met in the power sector at minimum cost and without imposing further costs on the exchequer". This sounds remarkably like the energy trilemma that Electricity Market Reform (EMR) was intended to fix. However, Helm was tasked with looking at not just generation, but the whole electricity industry chain, including generation, supply, distribution and transmission, with a focus on the potential cost savings that could be achieved across the whole chain.

Having been set a wide remit, Helm has recommended quite significant changes to the structure of the electricity industry, and, in particular, the way new capacity is procured. The changes recommended in the review are aimed at addressing Helm's two key findings:

  • that the cost of energy is significantly higher than it needs to be to meet the Government's policy objectives; and 
  •  that the regulatory structure and market design is "not fit for the purposes of the emerging low-carbon market". 

In this article we have summarised some of the key recommendations.

A "legacy bank" of renewables costs

Helm notes that there is a legacy of costs associated with support for renewables, being passed down to consumers, which originates from a time when renewable energy technologies were more expensive and were supported by various incentives at a high cost to consumers.  While these costs have already been incurred, and will continue to be incurred until the expiry of the support granted, Helm recommends that such costs be grouped into a separate "legacy bank".  It is argued that while such costs will still need to be recovered from consumers/taxpayers, the advantage would be that the Government would have more flexibility in how such costs should be passed down.  It is argued that another key advantage is that such an approach would take the costs out of the market, "leaving the future market to reflect the expected falling prices for renewables".  

As discussed below, a key assumption behind the "legacy bank" approach is that support schemes for low carbon generation, such as the small-scale Feed-in Tariff (FIT) scheme and Contracts for Difference, will be replaced with a new, single mechanism that Helm argues would be more cost-effective.

Equivalent firm power capacity auction

Helm does not refrain from criticising the mechanisms that have been the bedrock of investment in renewables in the UK.  Stating that the small-scale FIT scheme and CfDs "are badly designed simply because they do not reflect the underlying cost structure", he recommends a new approach.  Helm considers that the way forward to reduce the costs of energy while meeting the UK's carbon budgets is to:

  • develop a single carbon price (see below); and
  •  create a single unified capacity auction on an equivalent firm power (EFP) basis.

Helm acknowledges that having a single mechanism to procure all capacity, regardless of technology type, would be a "radical" change, particularly given that his proposed approach would require intermittent generators to bear their intermittency costs.  It is proposed that the EFP capacity auction would be on an equivalent basis – i.e. that the de-rated contribution of intermittent capacity would be taken into account.  Helm notes that EFP is not a new concept, because National Grid already deducts the EFP contribution of existing intermittent generation when calculating the capacity level required to be procured through the capacity market mechanism.  Helm suggests that the proposed mechanism would give renewable generators a strong incentive to enter into arrangements with other parties who may offer back-up services, to develop storage options and to engage with customers on demand-side management, to increase their value in EFP auctions.  

The report notes that if the price of carbon is set at the "right" level, then there will be no need to give low carbon generators any special treatment in the EFP auction mechanism.  If, however, the Government is not prepared to set the price of carbon at the "right" level for political reasons, then an alternative might be to structure the EFP auction in a way that recognises the value of low carbon generation in reaching carbon budgets – e.g. by having a scored auction.

Helm acknowledges that the proposed mechanism would place new and emerging technologies at a disadvantage.  However, his view is that technologies should be supported through research and development support mechanisms.

Reforming existing incentive mechanisms

The report recognises that the Government may not be willing to move to the EFP auction model, at least immediately, and that in any case there will need to be a transitional period.  Helm, therefore, recommends a reform of the structure of the existing small-scale FIT and CfD mechanisms, to reflect the different financial pressures present at different phases of nuclear and renewable energy projects.  Specifically, it is recommended that capital support and tax concessions should be made available during project development and construction phases, and then at completion a refinancing arrangement should be put in place.  However, Helm considers that long-term, fixed-priced support mechanisms for the whole project life, or a substantial period of its life, should eventually be abolished. Moreover, it is recommended that a closure date for the small-scale FITs and CfDs regimes should be set now.

Network company price control

Under Ofgem's current RIIO (Revenue = Incentives + Innovation + Outputs) price control model, each network company is subject to a price control mechanism to cover an eight year period.  Helm is of the view that this approach is no longer appropriate on the basis that "the future is fundamentally uncertain and challenged by fast technical progress; technical developments are undermining the distinction between networks on the one hand and generation, demand side and storage, and supply on the other; and there are lots of opportunities to let markets reveal costs through auctions, rather than Ofgem try to predict them".  It is recommended that periodic price reviews should be abandoned, in favour of a more flexible approach.  Helm, however, stops short of recommending what that new approach might entail.  However, it is envisaged that this would be tied to the new NSO and RSO model proposed (see below), and, given the monopoly nature of network assets, it is implicit that some form of price regulation is still required.

State-controlled system operators

Arguably, it is in the context of network regulation that the report's recommendations are at their most radical, seeking to unravel a structure that has been seen as the bedrock of a liberalised market.  Helm proposes that new National System Operator (NSO) and Regional System Operator (RSO) roles should be created, and these new bodies would determine what operations, maintenance and enhancements to the networks are required.  Importantly, Helm concludes that rather than being private companies, the NSO and RSOs should be public bodies, accountable to Government, and subject to the National Audit Office and public accounts committee scrutiny and, ultimately, to Parliament.

The proposed public body model is in contrast to the current System Operator model, where the SO role is undertaken by National Grid, a private company that also owns transmission assets.  However, it is relevant to note in this context that National Grid itself is currently undertaking a review of its role1, and is considering structuring options to make the SO role more independent.  In addition, it has to be observed that the Labour party, in its 2017 election manifesto, included a pledge to transfer the ownership of distribution networks to publicly-owned local companies and over time nationalise all grid infrastructure.  It needs to be emphasised that Helm's proposed model stops short of the actual transfer of assets to the public body NSO and RSOs.

In terms of the new role, it is proposed that the NSO would take on some of the functions and duties currently vested in transmission licensees, including the duty to ensure security of supply.  

The report notes that an independent NSO could, for example, also play a role in ensuring that when new capacity is procured through a competitive auction process, an appropriate balance of different generators provides that capacity – that is, so that decisions are made not just on the basis of price, but also on the type of plant.  The report cites the recent domination of the capacity market mechanism by small-scale diesel generators as the type of scenario that the NSO could prevent.  

Helm observes that the NSO/RSO model would result in Ofgem's role being "substantially diminished", as the newly established public bodies would take on a number of regulatory functions currently performed by Ofgem.  However, he acknowledges that there would be residual regulatory roles to fulfil, but these could be undertaken by a single network regulator (together with water, transport and communications networks).  

Introduction of a "general licence"

Related to the report's recommendations for the NSO/RSO model is a proposal for an equally fundamental change: the replacement of separate licences for distribution, supply and decentralised generation with a "general" licence, on the basis that the distinctions between these activities are becoming blurred.  Helm acknowledges that current market structures are constrained by the EU's internal energy market rules (specifically, the Gas and Electricity Directives), which may still be relevant post-Brexit implementation.  However, he also notes that the breakdown of the distinctions between generation, supply and networks is widespread across Europe.

Helm does not discuss in detail what such a general licence might entail, but the proposal is likely to have the support of investors in decentralised energy, who currently have to grapple with the complexities of a licensing system not designed for smaller-scale projects which may involve generation, distribution and supply activities.

Default supply tariff

In the context of retail electricity prices, Helm explores the findings and recommendations of the recent CMA inquiry (referred to above) and recommends a new approach: the introduction of a more transparent default tariff.  Retail tariffs for domestic customers have become in recent years a highly politically charged issue. In October 2017, the Government, bowing to political pressure to "do something" about rising energy prices, committed to press ahead with a temporary tariff cap notwithstanding that the CMA expressly considered and rejected the idea of a cap that would apply to all domestic customers.

Helm's proposed default tariff would include all costs of supplying energy (wholesale price, network costs, taxes and levies, etc.), plus the supplier's margin. Helm argues that this model, where competition is all about the margins offered by different suppliers, is reflective of the fact that the other elements of the retail energy price are a cost pass-through.  Furthermore, it is proposed that the new default tariff model could be used to set the price cap being legislated for by the Government.  The report suggests that in implementing the new legislation, Ofgem should focus its price cap proposals on a maximum margin within the default tariff recommend by Helm, leaving headroom for competitors to offer lower margins or other tariffs.

Harmonising carbon prices and taxes

Helm points to the "mind-numbing complexity" of several of the seven main energy and carbon taxes identified in his review2.  Although he praises the effectiveness of the Carbon Price Floor (CPF) introduced in 2013 as part of EMR, his recommendation is that all current carbon and energy taxes be replaced with a single, harmonised carbon price.  The report lists a number of advantages to this approach, including the fact that a single carbon price would provide common incentives across the economy (including sectors such as agriculture and transport), and allow the market to find the most cost-effective solutions to reducing carbon emissions.  It is suggested that a harmonised carbon price could be introduced by extending the CPF beyond the power sector to include all the other sectors in the economy.

Conclusion

It is clear that, having been given a wide remit, Helm was determined to deliver a comprehensive review of the whole market structure, rather than treading softly to maintain the status quo.  As he himself acknowledges, his "package of measures is a major shift from the original market design and regulation model at privatisation".  While not everyone will agree with Helm's recommendations for change, there are many review findings that few industry insiders would challenge.  A damming but difficult to refute statement is that "the sheer number of interventions in the UK energy market is so great that few if any participants… regulators… ministers or civil servants can have grasped them all".  On the other hand, there may be little appetite, by either Government and industry, for a "back to the drawing board" approach, at a time when regulatory stability is a key priority for the UK.

In November 2017 the Government launched a call for evidence on Helm's report, seeking views from industry and other interested stakeholders.  It will be interesting to see which, if any, of the recommendations are ultimately implemented.  

Co-Author: Justyna Bremen, Senior Expertise Lawyer

 

1. "Industry transformation: The changing role of the electricity System Operator", National Grid, July 2017.
2. The seven main taxes on energy and carbon identified by Helm are: fuel duty; value added tax (VAT), which is levied on supplies of fuel and power; the EU Emissions Trading System (EU ETS); the Carbon Price Floor, which  is made up of the price of CO2 from the EU ETS and the UK Carbon Price Support rate per tonne of CO2; the CRC Energy Efficiency Scheme, designed to improve energy efficiency; the Climate Change Levy (CCL), which is a tax on energy delivered to non-domestic users in the UK; and Climate Change Agreements, which allow energy-intensive participants in 53 sectors to pay reduced main rates of CCL.

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