Cost of energy review: independent report

From:    Department for Business, Energy & Industrial Strategy
Link to download report: PDF
Independent review undertaken by Professor Dieter Helm CBE puts forward his proposals on how to reduce costs in the power system in the long-term whilst ensuring the UK meets its climate change targets.

Executive Summary

1. This review has two main findings. The first is that the cost of energy is significantly higher than it needs to be to meet the government’s objectives and, in particular, to be consistent with the Climate Change Act (CCA) and to ensure security of supply. The second is that energy policy, regulation and market design are not fit for the purposes of the emerging low-carbon energy market, as it undergoes profound technical change.

2. Since late-2014, the prices of oil, gas and coal have fallen significantly, contrary to the modelling and forecasting of both the Department of Energy & Climate Change (DECC) and the Committee on Climate Change (CCC). Since then, the price of renewables has been coming down fast too, as have the costs of addressing intermittency, as a host of new battery and other storage and demand-side options become available. Productivity increases should have been putting further downward pressure on the costs of transmission, distribution and supply. New technologies should mean lower, not higher, costs and much greater scope for energy efficiency. Margins should be falling as competition should be increasing. Yet in this period, households and industry have seen limited benefits from these cost reductions. Prices have gone up, not down, for many customers.

3. These excessive costs are not only an unnecessary burden on households and businesses, they also risk undermining the broader democratic support for decarbonisation. In electricity, the costs of decarbonisation are already estimated by the CCC to be around 20% of typical electricity bills. These legacy costs will amount to well over £100 billion by 2030. Much more decarbonisation could have been achieved for less; costs should be lower, and they should be falling further.

4. Many of these excessive costs are locked in for a decade or more, given the contractual and other legal commitments governments have made. These include Renewables Obligation Certificates (ROCs), feed-in tariffs (FiTs), and low-carbon contracts for difference (CfDs) granted to early-stage wind and solar, larger-scale nuclear, biomass, and offshore wind. Since the ROCs, FiTs and low-carbon CfDs are formal contracts, they are taken as given in this review. The task is to find ways of minimising the burden these impose, and making them transparent, ring-fenced, and separated out from the market, where costs should be coming down.

5. The burden on households and businesses would have been even greater had there not been a financial crisis in 2007/08 which held down demand, and a parallel continued decline of the energy-intensive industries. Had the crash not happened, GDP would be perhaps 20–25% higher in 2017 (assuming no sharp fall in GDP in the immediate aftermath of the crash and 2–3% GDP growth since then). There would then have been a serious capacity crunch and much higher prices. As it is, the UK has flirted with dangerously low capacity margins despite the GDP effect, and this drives up prices as the more expensive marginal plant is drawn onto the system to match demand.

6. In the current decade, the government has moved from mainly market-determined investments to a new context in which almost all new electricity investments are determined by the state through direct and often technology-specific contracts. Government has got into the business of ‘picking winners’. Unfortunately, losers are good at picking governments, and inevitably – as in most such picking-winners strategies – the results end up being vulnerable to lobbying, to the general detriment of household and industrial customers.

7. As a consequence of Electricity Market Reform (EMR), the government now determines the level and mix of generation to a degree not witnessed since these were determined by the nationalised industries – notably the Central Electricity Generating Board (CEGB). Investment decision-making has been effectively quasi-renationalised. This is a direct consequence of EMR. The government, not the customer, has become the client.

8. In determining not just the level of new capacity, but also the composition of the low-carbon portfolio, the government started out with some of the most expensive technologies first, and it could be argued that since then it has at times been exploring even more expensive options. The result is that British households and businesses are locked into higher renewables and other low-carbon generation costs than they need be to achieve the decarbonisation objectives for decades to come.

9. These state-backed contracts have been supported by the return to formal modelling and forecasting by DECC (now BEIS, the Department for Business, Energy & Industrial Strategy) and the CCC. In the case of DECC, the results have at times been spectacularly bad. In particular, in the first half of this decade, DECC focused on its forecasts of high, rising and volatile gas prices, and therefore it could conclude that the wholesale price of electricity would rise to over £92/MWh by the early 2020s. It was confident that because fossil fuel prices (and particularly gas) were going up, households would be relatively better off as a result of its policies by around 7% by 2020.

10. The EU Renewables Directive and its particular definition of renewables has been a major contributor to raising the costs above those necessary to reduce carbon emissions to meet the CCA. A further contributor is the inefficient way in which the carbon budgets have been addressed, notably by not moving against coal earlier.

11. The overwhelming focus on electricity rather than agriculture, buildings and transport has added to the cost. Agriculture in particular contributes 10% greenhouse gas (GHG) emissions, and the costs of reducing these emissions are much lower than many of the chosen options because the economic consequences of a loss of output in agriculture are small. Agriculture comprises just 0.7% GDP and at least half its output is uneconomic in the absence of subsidies. With the development of electric vehicles (EVs) it is apparent that transport can contribute more. The CCC could have paid more attention to the lower marginal cost of abatement in these sectors.

12. Keeping costs down is all the more important as the electricity system faces a series of major challenges over the next decade. Not only does it need to meet the carbon budgets, it needs to do this in the context of major retirement of existing capacity, the investment requirements to handle the intermittent renewables, the coming of electric transport, and the wider demands of a digitalising economy. These challenges are on a scale and magnitude not witnessed since the reconstruction of the electricity industry immediately after the Second World War.

13. The energy sector is going through a technological transformation as electricity becomes an increasingly dominant form of energy. Previous structural breaks have come from single technologies, like the coal-fired power station, the gas turbine, and the civil nuclear power stations. This time there are structural breaks which span the whole economy as it digitalises, the transport sector as it electrifies, and the generation, transmission, distribution, supply and the demand for electricity. We are moving towards a decarbonised, digital, smart electric energy world, offering the prospect of ever-lower costs from cleaner energy.

14. The CCC neglects some of the opportunities of these technology impacts in its time horizon to 2050, arguing that any new technologies will have to be deployed before 2030 if they are to make much impact before 2050. This, together with the assumption that gas prices will rise by 30% by 2030, is a key rationale for the roughly linear profile of emissions reductions from now through to 2030. If the objective is limited to the CCA 2050 target, then the carbon budgets overegg the early stages, and make the trajectory between now and 2050 more expensive than it needs to be. Indeed, with such early action in the linear trajectory, it may turn out that decarbonisation is achieved much faster.

15. Tempting though it is to many observers to predict how this transformation is going to take place, and profitable to many lobbyists to persuade government that their specific technologies and projects are the right answers, the design of energy policy and the interventions to achieve the objectives should be driven by the uncertainty about the detailed shape of the decarbonisation path. In order to achieve the prize, it is important not to try to pick winners, and to focus on the framework within which the private sector brings new ideas, new technologies and new products to the end-user. Avoiding detailed intervention is a key to keeping down the cost of energy.

16. Since 2015, a number of reforms have begun to reverse some of the more grossly inefficient dimensions of current policies. The greater use of auctions has begun to bear down on excessive costs, but there is a long way to go. The decision to exit coal by 2025 is a belated but welcome step to recognise that switching away from coal is the cheapest way to decarbonise. It should have been the first option.

17. Notwithstanding the significant cost reductions from the auctions so far, existing energy policy is not fit for these new purposes. It remains complex and expensive, and it is slowing down the transition to a decarbonised economy.

18. The measures necessary to reduce the costs include: the unification of the capacity and FiTs and CfDs auctions on the basis of equivalent firm power (EFP); the gradual reforms of the structure of FiTs and CfDs in the transition to their eventual abolition; and further enhancements to competition in the wholesale and balancing markets. There should be significant reforms of the regulation of transmission and distribution focused on the role of system operators at the national and local levels, and the replacement of the specific licences for distribution, supply and decentralised generation with a general licence. A default supply tariff should be required and the margins published. Finally, carbon prices and energy taxes should be harmonised.

19. This package of measures is a major shift from the original market design and regulation model at privatisation, and moves on from EMR. It would create a simpler, more competitive structure fit for the new purposes. Instead of low-carbon technologies being grafted onto the fossil fuel-based system, the new world is radically different, backed up by new smart technologies, data and smart energy networks and services. A common carbon price would significantly lower the cost of decarbonisation and greatly enhance incentives.

20. As the fixed system costs gain an increased share of total costs, it will be government that ultimately decides the allocation between customer classes of these fixed costs. The legacy costs are also fixed. The scope for protecting the poorest customers will be increased, and the government should consider a universal basic allocation of fixed costs.

21. The fixed costs also permit a more efficient allocation to the industrial sector, and particularly to those companies facing international competition. In addition to exemptions from the legacy costs, consideration should be given to the relative burdens on industry and households from the rising proportion of fixed costs. However, neither should be exempt from the carbon price.

22. These measures require significant institutional reform. The system operator model should be further developed, with an independent national system operator (NSO) and a series of regional system operators (RSOs) playing a bigger part.

23. Ofgem’s role in regulation should be significantly reduced as the NSO and RSOs assume some of the duties currently placed on distribution network operators (DNOs) and Ofgem, with much greater use being made of competitive tenders and auctions. The licensing regime at the local level should be simplified, abolishing the increasingly anachronistic distinctions between generation, supply and distribution, which are being overtaken by the new technologies that are emerging.

24. The comprehensive long-term framework set out in this review is a practical and evolutionary package, and will deliver benefits not only over the coming decades, but in the immediate future too. Immediate benefits would come from revisiting the transmission and distribution price reviews, introducing a default tariff for supply focused on the margins, and reforms to the FiTs to capture the refinancing gains after existing commitments have been fully met.

25. This long-term framework, coupled with these immediate measures, is the least-cost way of achieving the objectives, with the prospect that the 2050 carbon target could be met at lower cost, and could even be met early, to the benefit of households and industry.

26. Not to implement these recommendations is likely to perpetuate the crisis mentality of the industry, and these crises are likely to get worse, challenging the security of supply, undermining the transition to electric transport, and weakening the delivery of the carbon budgets. It will continue the unnecessary high costs of the British energy system, and as a result perpetuate fuel poverty, weaken industrial competitiveness, and undermine public support for decarbonisation. We can, and should, do much better, and open up a period of falling prices as households and industry benefit from the great technological opportunities over the coming decades.




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