Oral evidence - The Economics of UK Energy Policy

Mr Phil Sheppard.

Q118 The Chairman: Mr Sheppard, welcome to the House of Lords Economic Affairs Committee and our inquiry into energy. We have taken quite a lot of evidence already. One of our witnesses, Professor Helm, who we saw early on, described the capacity margin as “currently serious … not where an advanced economy should be ... This is an extraordinary position to drive yourself to where people can think about investing in this country and wonder whether the capacity is going to be there to provide this basic necessity of electricity”. Is he scaremongering?

Phil Sheppard: He has a very specific view on the capacity mechanism. The capacity mechanism does not start until next year, in effect, so the Government have decided what level of capacity is suitable for the GB market, and we as National Grid administer some of the processes associated with the capacity market.

The Chairman: So do you think he is overstating the problem?

Phil Sheppard: At the moment, we would describe the situation this winter, for example, as manageable but tight. When it comes to looking at the capacity market and how it is described, there are definitely improvements that can be made. One of the things that the standard specifies is a loss of load expectation of three hours. That sounds like blackouts for three hours a year, which is absolutely not the case: it means that the market, with the capacity at that level, will work effectively except for three hours, and the system operator—us as National Grid—will take other actions in order to secure the system for those three hours. But when it comes to explaining that and how the mechanism works to the public and to investors, we could certainly do with a clearer explanation. Having something as simple as a de-rated plant margin by way of explanation would help to provide confidence for investors.

The Chairman: You acknowledge in your written evidence that it is “tight but manageable”, and you point to the fact that you have a variety of tools. What are those tools and are they sufficient if we get into a really tight corner?

Phil Sheppard: For this winter, we have a tool called supplemental balancing reserve, which is 10 power stations and 3.5 gigawatts of generation that is outside the market. So when all the market actions have been taken, we still have a margin of 3.5 gigawatts that we as a system operator can call upon in order to ensure that we maintain security of supply.

The Chairman: Are there any tools that you can use in the event of a very awkward situation? Let us say that some of the international supply that we receive through transmission lines fails. What is your backstop?

Phil Sheppard: That strategic balancing reserve is an extra 3.5 gigawatts. There are other instructions that we can use with distribution network operators where we reduce the voltage slightly, which reduces demand but is imperceptible to most customers. There are other tools in the market, for example demand-side response, where we would expect to be able to reduce the amount of demand, particularly in the scenario that you suggest, where prices would be very high. A lot of price-sensitive demand would avoid those tight periods.

The Chairman: So stand-by generation and things like that could be brought on, at some expense.

Phil Sheppard: Almost certainly in those situations, stand-by generators would have brought themselves on in order to maximise their opportunity. But there are other processes. For example, you can switch off the air conditioning load for a few hours and it makes no difference to the temperature in the building—the hotel or wherever these services are provided in—but it reduces the demand for two or three hours when we are going through the winter peak.

The Chairman: Do you have a sufficient number of those agreements in place to enable you to sleep at night?

Phil Sheppard: I sleep very well at night.

Lord Tugendhat: Just as a supplementary, if I may, we are talking about the UK’s capacity margin, and we have a national figure here. In practice, would the margin vary from region to region? I know that you are a national grid. None the less, given the different factors that come into play, would it vary significantly from one region to another?

Phil Sheppard: No, not at the moment. Generally there is sufficient transmission system available at the winter peak to make sure that all the generation available can be exported. It is helped by the fact that demand is very high in each region at that time.

Lord Tugendhat: So if we had a really cold snap, you would be in the same position as if the cold snap only affected parts of the country.

Phil Sheppard: Yes.

Lord Darling of Roulanish: Can I ask a follow-on from that? How quickly could your 6% margin be consumed? How much notice do you get from going from 6% to nothing? Does it happen very suddenly, do you see it happening over several hours or what?

Phil Sheppard: The way we operate the system is that, as we get close to the peak of the day, we look several days ahead at the demand and at the forecast for that demand. We have to give notice of around 48 hours for some of our products, so we are always looking at least two or three days ahead so we can work out whether we need to start warming some plant so that it is available in real time, three days ahead of its actual need.

Q119 Lord Darling of Roulanish: Okay. I want to ask you about something different. We have had a lot of evidence about the true cost of renewable energy, and I wanted to ask you about the system integration costs. Studies have been done by Imperial College and others, and to put it simply the suggestion has been made that the back-up costs that are required because of renewables means that renewables are not paying their fair share. What assessment have you made of that?

Phil Sheppard: We have not made a direct assessment of those economics. Our role as National Grid is to connect all the generation that applies to connect to us. Every year, we publish a document called Future Energy Scenarios, which looks at different ways in which the energy mix can be met—some with more or less renewables as part of that. Then we study what the changes in the system will mean for the national grid, and for customers and consumers, and what tools we will need as a system operator to make sure that in each of the scenarios that we produce the system remains operable and we can still have an economic service.

Lord Darling of Roulanish: So you are concerned about supply rather than price?

Phil Sheppard: Yes. We have a duty to be economic and efficient, but that is in the services that we procure. One of the ways in which we describe our role as a system operator is as the residual balancer. The market would normally balance 95% to 98% of supply and demand; we do that last 2% to make sure that, in real time, energy supplies are secure second by second. As well as facilitating the market, our obligation is to make sure that the services that we need in order to do that residual balancing are as cost effective as possible.

Lord Darling of Roulanish: So if I contract to buy electricity, your job is simply to transmit it and to ensure that, at the margin, there is always enough there to supply everybody who has contracted.

Phil Sheppard: Contracted both on both the demand and the supply side. Historically, we used to flex generation to meet demand. These days, we flex both sides of the equation to meet demand and supply.

Lord Darling of Roulanish: On the question of renewables, is there any limit to the amount of renewable energy you can take on to the grid? If there is, how do you go about saying, “We have got enough thank you”, or, “We need more”?

Phil Sheppard: That is one of the purposes of Future Energy Scenarios. Then we produce a very technical report, called System Operability Framework, which looks at the consequences of, for example, increasing penetration of renewables, whether it is solar or wind or whatever. The nature of how they are connected to the system, through power electronics, and the fact that much of this is embedded in the distribution network change the physical characteristics of the system. So we have to look at things called system strength and the inertia of the overall system—how susceptible the system is to interference, faults and those sorts of things, which cause disturbances.

Lord Sharkey: I wondered what you meant by inertia of the overall system.

Phil Sheppard: Effectively, you can think of a system as a big rotating wheel. As large coal-fired and gas-fired power stations close, the mass of that will reduce, so there is less spinning mass in the system and less inertia. Renewables tend to be connected via power electronics, so they do not actually contribute to inertia. There are some services that we can buy to help, but it means that the system is getting more sensitive to disturbances, so rather than having the equivalent of a very large heavy concrete wheel we are now moving towards a motorbike-type wheel. You just need to take more actions more quickly, so we need a different set of services under these scenarios. That is what we are looking for in the System Operability Framework: how the system strength changes and what tools and products we need to get there.

Lord Lamont of Lerwick: I just want to follow up on that. If, for theory’s sake, there were no renewables, would the margin of spare capacity be less?

Phil Sheppard: The de-rated capacity would effectively be the same, because when we take into account through the capacity mechanism the contribution of wind across the winter for security purposes, it has a quite different de-rating factor from conventional generation. When we look for example at the fleet of gas-fired power stations, we would assume for the sake of argument that 88% of them would be available across that winter. There is always some cycling of breakdowns, as when things break they get repaired and come back into service.

We treat wind differently. At the moment, in relation to the security standard, we would still end up with a three-hour loss of load expectations or a plant margin equivalent to that. That is one of the benefits of changing it—

Lord Lamont of Lerwick: Is the answer no, broadly?

Phil Sheppard: Broadly, no, but it is a complicated algorithm that gives us the no.

Lord Darling of Roulanish: This arises from both these questions, and the one that I asked. Does the grid therefore have a view as to what proportion should be intermittent suppliers, as opposed to nuclear or gas-fired providing a base that you can call up? Presumably you are saying that you have a view as to roughly what proportion you should have in the system at any one time.

Phil Sheppard: I would describe it differently, inasmuch as we have the view, “So if we had this level, what are the consequences? What are the tools and products we would need in order to secure that level?” But there is a point, well in the future, when we would have to procure different types of services, so rather than having a rotating large thermal plant provide the inertia we could buy an inertia service. It could be a spinning fly wheel, it could be what is called a synchronous compensator. Sorry, that is an electrical term, but it provides the equivalent of the inertia to the system. There will be that point, but it also becomes much more of a regional impact.

Lord Darling of Roulanish: So coming back to my original question, there must come a point at which you say that we have too much renewables and not enough gas, nuclear or whatever.

Phil Sheppard: We would get to the point where we would say that, in order to balance the system, it would start to become uneconomic at those levels. But we have not reached that point and will not for some time.

Lord Darling of Roulanish: But you could. You have that theoretical power if you need it.

Phil Sheppard: On 30 November, we will publish our next iteration of the System Operability Framework, which will lay out what has to happen. We will not say that there is a theoretical limit of 80% or 90% of renewables.

Lord Darling of Roulanish: I have one last question. You said that price was not your concern. Whose concern do you think it is?

Phil Sheppard: I will rephrase my answer, if I may. We are concerned about price. Part of our obligation is to facilitate the market, so we are very concerned about creating liquid markets with the tools that we use. Ofgem is ultimately accountable for ensuring efficiency in the marketplace.

Q120 Lord Sharkey: Can I ask about the different scenarios that you look at? You have explained how they vary by supply, but do you attach a different cost to each of those scenarios?

Phil Sheppard: I do not think we attach a particular cost. We look at what the condition of the economy might be. One of them is a slow progression, which means that there is not very much money in the economy and people are not very active in creating a lot more generation.

Lord Sharkey: I meant the cost of operating the system

Phil Sheppard: No, the cost of operating the system is in our balancing services. It is just under £1 billion a year, and we do not expect that to change over the next 10 years with the difference mixes, because we are always innovating, looking for different services and looking at different ways of describing services that provide that efficiency for consumers. We do not expect that to change.

Q121 Baroness Wheatcroft: You said that you sleep very well as it is, but I just wonder whether you might even sleep a little better if the proportion of our supply that came from non-renewables—non-variables—was at a certain level and our reliance on variables was therefore less, or no more than it is now. Do you have any idea where you might put that proportion?

Phil Sheppard: No. One of the benefits of having the system that we have currently is diversity. Having a good mix of different types of generation connected at different levels and spread throughout the country provides security in its own way. Having that flexibility in itself does provide some form of security of supply.

Lord Sharkey: Surely there are limits to that. In a scenario where all the electricity was produced by renewables, for example, perhaps you would not sleep at night.

Phil Sheppard: No, which is where I come back to the point that having diversity is a good thing.

Baroness Wheatcroft: But diversity could be more reliable if it was gas, nuclear et cetera rather than renewables, could it not?

Phil Sheppard: Having a mix is helpful. If there was a type fault on a particular type of plant, the fact that we have other types of plant on the system such as wind might mean that the system would not be affected in the same way, or if it is geographically spread, say with solar. All those provide benefits in their own way. It is not always the same. If you have a very large, single power station and one fault, you lose a very large, single power station for the duration of that fault; whereas if you have a fault on a single wind turbine, you have lost one turbine out of thousands.

Q122 Lord Layard: Can ask two or three questions about intermittency? First, how do you actually manage the volatility that comes from the intermittency? Perhaps you could say a little more about that.

Secondly, an issue that we have been grappling with is who should bear the cost of the back-up for the intermittency. It has been put to us that you cannot really think of this as each intermittent source having its own back-up, because that is extremely wasteful—the back-up is within the system as a whole. Somehow or other the system has to provide the back-up, but then how would you apportion the cost of that back-up between the different suppliers?

The third is that if storage is an important adaptation to the intermittency, who is going to organise that? What is your role in that, and again how is that going to be charged?

Phil Sheppard: On the first question about intermittency, if we come back to our role as a residual balancer, the market manages most of the intermittency. At the moment, when it is coping with solar and with wind, it is using gas-fired power stations and interconnectors as the way of balancing the volatility of the market. How are we, as the system operator, looking at the forecast? We create forecasts for both wind and solar, and against that we decide what reserve level we need to hold. That allows us to do that fine-tuning close to real time between what was forecast and what has actually arrived. We are doing lots of research on this, because forecasting cloud cover and the impact that has on solar is still relatively new, so we are working with universities and the Met Office to improve things like cloud forecasting and how much solar actually reaches the solar cells on people’s roofs or in the countryside.

On wind, we are looking at research that measures how wind propagates through a wind farm. The wind speed at the end of a wind farm is not the same as that at the start, so we are looking at how that affects different directions. If we have very high winds, turbines shut down, which is another form of intermittency, so we look at how that propagates through a wind farm so that we understand those variables so that we can make sure that we are holding the right level of response and reserve for that level of intermittency.

I have touched on back-up in that the market is using gas-fired power stations and interconnectors as the two preferred tools at the moment for providing back-up when solar is not available or the wind speed drops or increases.

Storage is really exciting. People talk of storage as if it is a single thing, but we think of it as 18 different services. We describe three categories. One is ancillary services, which is services to us as the system operator, which help with balancing and frequency management—the technical aspects of operating the grid. Then there are services that help with managing networks. There is a good example at Leighton Buzzard that UK Power Networks has developed, where by installing a battery associated with a circuit it can avoid reinforcing that circuit. So you can save money by using storage and avoiding having network reinforcement.

The third is probably where the biggest opportunity is: energy arbitrage and wholesale markets. That is where you store solar during the day and then release it overnight through batteries. You get a better price for it than you would otherwise. WPD, in the south-west, has a trial with two or three solar farms and is looking at that type of service.

When it comes to intermittency, against those three ranges of services you can optimise the system better, you can manage the network better and you can do a lot of time-shifting of demand, so you can fill in troughs and cut off peaks and in effect save money that way.

Lord Layard: But you are talking, certainly when you talk of storage, as though it is the responsibility of the individual supplier to manage their own storage and then just sell on to the market. Is that how you think of it? When it comes to back-up, it must be more complicated thinking about who is going to pay for it.

Phil Sheppard: That is why we have identified 18 services that storage can provide. One of them is that back-up. A lot of these services can be stacked on a single battery, so you can provide multiple services from a single installation. To be fair, we have 3 gigawatts of storage on the system today, although most of it is pumped storage.

I can give you another example of how storage can be effective. Earlier this year, we went out to tender for a frequency service—a new, less than one-second service. We had 1.3 gigawatts of interest in providing this service, and we ended up placing contracts for 200 megawatts, which will be provided by battery services. We think that will save us £200 million over the four years of the service. This type of technology, which can provide multiple services, is already entering the market. The bit that needs to be resolved for many investors at the moment, covering back-up and storage, is through the BEIS and Ofgem call for evidence on flexibility. People are asking for the network charges for storage to be simplified, for storage not to attract any consumer levies and for the definition of storage to be simplified so that it has its own category, rather than being counted as either generation or demand.

Lord Layard: Maybe others understand this, but are you saying that you are the people who, in the first instance, pay for the storage and that it is somehow being passed on to consumers in different ways?

Phil Sheppard: Of the three categories, the first is ancillary services. We have just contracted for a service that is being provided to us for managing frequency. When it comes to things like site back-up or time-shifting a wholesale arbitrage, the market will do that and will work out how to charge consumers and make money on it. That has not taken off yet because of the regime that storage currently sits under.

Lord Sharkey: As I understand it, at the moment it is the taxpayer who is bearing the cost of back-up generation.

Phil Sheppard: No. The service we are buying is not for back-up: it is providing a frequency service.

Lord Sharkey: I will put it the other way around then. Who is bearing the cost of back-up generation?

Phil Sheppard: In terms of storage? Nobody at the moment, because nobody is building storage for back-up.

Lord Sharkey: But who pays for the back-up that exists and is used when you need it.

Phil Sheppard: Ultimately, that is through the capacity mechanism, which means that consumers pay for it.

Q123 Baroness Wheatcroft: Could you help us to understand how interconnectors work? Is it a push-me-pull-you mechanism that depends entirely on where the shortages are and the flows go both ways? If so, what happens when demand strengthens on both sides?

Phil Sheppard: The regime in the UK is that the owners of the interconnectors provide capacity to the market. The market buys that capacity as it chooses to. Through an auction process, it then decides which way the energy is going to be flowing. The market is effectively linked between the UK and the bits of Europe where we have interconnection. As the market tightens, prices tend to go up and that dictates the direction of flow on the interconnectors.

Baroness Wheatcroft: So if we were facing a shortage and needed the power to come through an interconnector, the price could rise quite steeply if Europe was cold too.

Phil Sheppard: Yes. That is what happens today. For example, the interconnector flows for the last month have sometimes been to France and sometimes from France. Generally, at the peak of demand in GB is flows from France to GB.

Baroness Wheatcroft: How dependent are we at the moment on the power than comes through the interconnector.

Phil Sheppard: We have 3 gigawatts of interconnection to the Netherlands and to France. We have 500 megawatts to Northern Ireland and 500 megawatts to Ireland. It is less than 10% of overall demand.

Baroness Wheatcroft: And we are looking to increase the interconnectors to what level as a proportion of our usage?

Phil Sheppard: I think the Government have set a target of another 9 gigawatts of interconnection.

Baroness Wheatcroft: What proportion would that be of the projected use?

Phil Sheppard: We would end up with perhaps 15 gigawatts in a 50 gigawatt system.

Baroness Wheatcroft: In your evidence, you voiced some concerns about how the interconnectors will function after we withdraw from the EU. You asked for some early indications of what energy policy is going to be post-Brexit. What are the risks?

Phil Sheppard: At the moment, it is the two aspects that the interconnectors provide. One is obviously a lower cost to consumers, because the price in GB is higher than in Europe, so we tend to import from Europe as a general rule. The other is that interconnectors are part of an integrated energy market. The value from an investor’s perspective is that they understand the rules across the whole of Europe. They understand the transparency rules, how the market will work a day ahead and within a day, how the auction process works. So it also provides investor confidence.

Baroness Wheatcroft: Do you think that if we do not have certainty over energy policy, some of the projected interconnector capacity will simply not come on?

Phil Sheppard: It is not an area I am expert in, but I will happily provide a written answer if that would help.

Lord Darling of Roulanish: Can I ask a question in relation to that? Suppose you get a massive freeze right across northern and western Europe and the lights are going out here, in France and in Germany and so on. Is it possible for the French and German authorities to say, “You may have an agreement to export it, but it is not going across the channel”? I seem to remember that this happened about 10 years ago to the gas interconnector. Gas was contracted for here, but it got lost in France.

Phil Sheppard: Those are very different examples. The gas market is very different, so I would not use it as an analogy. If the lights started going out, that would be the point at which Governments would take action. As a system operator, we would just be directed to do whatever was appropriate.

Lord Darling of Roulanish: So it would be useful if Governments were getting on with each other at that time?

Phil Sheppard: In those emergency situations, I am sure that Governments would talk to each other. At least, as a system operator I hope so.

Q124 Baroness Bowles of Berkhamsted: We touched on storage a bit. Can you explain how the development of energy storage will affect the grid? There are various different scenarios. How much of it will there be, when will it be and what type will it be?

Phil Sheppard: In our future scenarios we can foresee that by the time we get to 2040 there will be as much as 18 gigawatts on a system, compared with the 3 gigawatts that we have today. There is likely to be a range of different solutions. There are some companies out there today that think they can make money by installing batteries behind the meter in domestic properties, perhaps associated with solar and an economy 7-type tariff. One of the things that will unlock that is smart meters, so that people get settled on a half-hourly basis. There is definite potential for investment in that space. For wholesale, if you already have on-site generation, there are opportunities to install storage for that. If you are a wind farm or solar, there are opportunities at distribution grid scale. A bit further on, I suspect, will be transmission scale storage. That will be a special case.

Baroness Bowles of Berkhamsted: You said, as have others, that there is no level playing field for the development of energy storage. Can you explain why that is and what can be done?

Phil Sheppard: There are several aspects to that. When the Electricity Act was passed, storage in the way we now understand it did not exist. There was a definition of generation and a definition of demand. That is unhelpful in terms of how to apply storage technology to the networks. Also, at the moment, if you are exporting you are counted as a generator and when you are importing you are counted as a demand. So in effect you can get charged twice: once on the way in and once on the way out.

The other aspect is that as you are connected to it and are being charged as a demand customer, you also attract the levies that are associated with renewables. Those three aspects would help investment certainty by sorting out the charging regime. It is important that the charging regime is still cost-reflective—you should still pay for your impact on the distribution or the transmission network, but at the moment people would argue that that is not the case where you are being charged on the way in and on the way out.

Baroness Bowles of Berkhamsted: This question is a little off from storage, but can we run electricity, and indeed heating, using renewables? How feasible is that, or do we always have the problem of the sun not shining so much in winter?

Phil Sheppard: Or at night when we have peak demands. We have made great progress in decarbonising electricity. We now have 16 gigawatts of wind and 11 gigawatts of solar on the system, and if you had asked me three years ago whether we would have 11 gigawatts of solar I would have been shocked and said no. The fact that we continue to innovate allows all this generation to connect.

We have made nowhere near as much progress on decarbonising heat and transport. Across the year we carry three times as much energy in our gas transmission network as we do for electricity, and on the coldest day of the winter we carry five or six times as much energy in our gas network as we do in the electricity transmission network. Almost all of that is associated with heat. Decarbonising heating is one of the key things that need to happen in order to meet our carbon targets, but in doing that you need to take into the account the high volume of energy that is taken through the gas network.

Baroness Bowles of Berkhamsted: So would you envisage electrical heating having a large part to play in that, or would you look for other heating such as geothermal?

Phil Sheppard: Electricity will certainly play a part in that mix, and storage also comes into that. At the moment people are talking about storage and batteries, but there are all sorts of other forms of storage, whether it is compressed air storage or heat storage. There are ways of smoothing demand. We still have relatively low demand overnight and higher demand during the day through different forms of storage, whether it is heat or electricity or storing it as a chemical. We can smooth that off and avoid the peaks and troughs, but working out how we can manage heat much more effectively in decarbonising is a major piece of work.

Q125 Lord Burns: I want to be clear in my own mind about intermittency costs. We have spent quite a lot of time in this Committee trying to chase down the issue of comparing costs of alternative ways of generating capacity. It has been suggested to us by more than one person that £10 a megawatt as the system cost for intermittency might be reasonable, but listening to you earlier I got the impression that in a sense you were saying that as things stand there really is no cost of intermittency, so the calculation does not make much sense at this stage because you can manage it. You suggested that you were not that interested in it; you were more interested in transmission than in the price. I had some difficulty knowing whether you were arguing that at this point there is no real intermittency cost, or whether you are saying that it is just that you work with it and it does not really concern you.

Phil Sheppard: The cost of balancing the system absolutely concerns us, but the market is in effect absorbing the cost, whatever that cost is—I do not have a figure that I can give you, I am afraid—of balancing the market with current intermittency. The regime that we have for subsidies that have generated the value of investment in renewables means that when the market is out of balance the market then solves that and uses gas-fired power stations and interconnectors for tuning the system. So there are costs to that, but they are all in the market today, and trying to isolate a figure for that could be difficult.

Lord Burns: I will just follow up on Baroness Bowles’ question about whether we could ever reach the point of being 100% renewable, which you answered. At what percentage does it really begin to become troublesome?

Phil Sheppard: Different markets have taken different approaches. The Irish market has set a limit. We have a slightly larger system and it is much more interconnected, so we have not set a limit. As I said earlier, we look at the tools, techniques, products, services and assets that we will need in order to manage it. At the moment we have no definitive number. I cannot give you a single number that tells you the limit.

Lord Burns: I have one final question. You have talked about the margin of capacity. How do the numbers for the UK compare with other countries? Are ours tighter than others’?

Phil Sheppard: In some ways, but again each country has a slightly different way of defining the security of supply. Unfortunately there is no international standard, no single measure, that we can apply that says that these are all broadly equivalent. Even with our numbers there is a range of scenarios to take into account; there is no single set of circumstances. What matters just as much as the number is the range of scenarios that that encompasses.

Lord Burns: But the range of scenarios here cannot be that different from the range of scenarios in neighbouring European countries.

Phil Sheppard: It can be, inasmuch as most of Europe is a single interconnected system, so they can rely much more on each other for things like inertia and security reserves. We have a different approach because we are an isolated asynchronous network and do not share inertia with the rest of Europe.

Lord Burns: That might suggest to me that we need a larger margin than other people.

Phil Sheppard: A different margin. One reason why I would be happy to revisit how we describe it is to make this type of conversation much simpler so we could say, “Yes, it’s 9%”.

Lord Burns: I am certainly a bit confused, as you can tell.

Phil Sheppard: It is quite a complex way of describing it. Forgive me, but economists like trying to describe—

Lord Burns: Like me.

Phil Sheppard: Exactly—like many of you. They like describing the value of security in one way and looking at all the different costs associated with trying to get the balance right in relation to what is ultimately right for society. We have made it very complex.

Lord Sharkey: Could I try once more on this? Is there an optimum balance in current circumstances between renewables and non-renewables?

Phil Sheppard: From a cost perspective or a security perspective?

Lord Sharkey: Either will do, or both.

Phil Sheppard: At the moment, the capacity mechanism takes into account that intermittency and the variability of output from wind during the winter peaks. So from security perspective, the capacity mechanism deals with that. It does not deal with it from a cost perspective.

Lord Sharkey: I think what I am trying to get at is that as you move the slider from renewables to non-renewables, at what point is that slider at its optimum position? I understand you to say that you can manage in its current position, but is there an optimum position for that slider?

Phil Sheppard: I have not seen an optimum position. There are many studies that will argue one way or the other, but as National Grid we do not take a view on the optimum. Our duty is to make sure that we can cope with whatever the mix is day to day, a week ahead, a year ahead.

Lord Turnbull: Can I start by following up your answer to Lord Burns? You said that the market is bearing the costs of balancing intermittency. I do not think that is our concern. Our concern is that the right players are not bearing their share of the costs. Are renewables paying the true costs, relative to what they impose on the system, or is it all being lumped in together and in effect there is a cross-subsidy?

Phil Sheppard: I do not think I can answer that question in that way, I am afraid.

Q126 Lord Turnbull: Let us go back to Lord Darling’s scenario. It is the first week in February, it is very cold all over northern Europe and everyone is struggling, your 16 gigawatts of wind are producing virtually nothing and you are not getting much out of your solar. You have what you say is this 3 gigawatts of capacity and that, through the interconnectors, others do not have much to sell to you. There is another possibility: a failure at a major plant. Is 3 gigawatts, in relation to the kind of failures you can envisage, a big number or a small number?

Phil Sheppard: Last year, I showed some visitors around our electricity control centre. It happened to be on the day of the winter peak, and there was less than 100 megawatts of wind in that scenario. The range of things that we can deal with and the reserve we hold mean that in most circumstances we will still meet demand in the UK.

Q127 Lord Turnbull: In the evidence we have received, a number of observers seem to have described the situation as the Government following a policy of actively chasing coal out of the system—running it down as fast as they can. That obviously creates a problem for you, but the problem seems to me to be less the lights going out than that you have had to create an alternative mechanism. Instead of having old, traditional-style power stations available, you have created this capacity mechanism. But have we simply changed the nature of the problem and solved it in a more expensive way by having all these different agreements with different players?

Phil Sheppard: It is not National Grid that operates the capacity mechanism; it is a government tool. We administer it, but it is a government process. Through the capacity mechanism, there are still a large number of gas-fired power stations, so they still provide inertia and services to us in terms of frequency response, managing changes in demand and providing us, in our balancing mechanism, with the range of services that we need to operate the system.

Lord Turnbull: Given that very few gas-fired power stations have come in, and a large number of coal-fired power stations have been retired, did we in a sense bring this much tighter network upon ourselves? Would you, as an organisation, have been happier had the coal retirements gone a bit more slowly, until we were more sure about the gas-fired power stations coming in to replace them?

Phil Sheppard: We are comfortable that the range of tools we have allows us to discharge the duties that we have at this point in time. Another reason why we publish Future Energy Scenarios is to look forward and say, “This is the range of tools that we are going to need in the future against these different energy mixes as they go on”. Whether it is another generation of very large nuclear, or coal closing earlier than 2025, or an increase in for example tidal as a potential renewable source, we look at all these things and make sure that as the system operator we have the tools and techniques that we need in order to manage the system that is presented to us.

Lord Turnbull: I concede that these questions do not really go to you, but your job is to make sure that the system delivers. Who pays for it, and is it turning out that we have adopted a trajectory of coal to gas to renewables that has been more expensive than it need have been?

Phil Sheppard: I agree that that is not a question for me.

Q128 Lord Turnbull: The final question is about the importance of gas. People have pointed out that one of the consequences of being a much smaller producer of our own gas, with all those fields in effect sitting there as storage—indeed some of them, like Rough, were actually used as storage—is that our gas storage is a fraction of what other countries now maintain. They have done that because of their history of not being gas producers. Are we in a position where gas storage is seriously inadequate?

Phil Sheppard: We are blessed in many ways by having such a range of different ways of importing gas into this country. Our winter peak demand on the one in 20 coldest days is going to be 470 million cubic metres of gas. The import capability, whether it is through the interconnectors to Europe or to Norway, or through LNF import terminals, of which we have three in the UK, as well as our still having offshore gas, means that we have capacity in excess of 600 million cubic metres. The market has many different ways of delivering gas into the UK, whether it is stored in LNG or whether it is through taking advantage of Europe. We still have a fair range, as you say, with Rough providing storage in Great Britain.

Lord Turnbull: Is 600 million cubic metres a big number or a small number?

Phil Sheppard: That is a very big number. It is 130 million more than demand on the coldest day of the year.

Lord Turnbull: Right, but if this cold snap lasts 10 days—

Phil Sheppard: It is still sufficient, because we can have that as a rate across those 10 days.

Lord Tugendhat: I have a supplementary question before coming to my main question. I am sorry to come back to this business about how resistant or safe we are, and it is probably a very ignorant question, but whenever there is really bad weather there are always some unexpected results. To what extent are the interconnectors absolutely reliable, whatever the weather, whatever the states of the oceans—whatever is happening?

Phil Sheppard: Every year, through the capacity mechanism, an assessment is done of the reliability of each of the interconnectors. From memory they are about 80% or 90% available. Across that period, that is the sort of level of availability you would expect them to have, and it is broadly similar to power stations. Against the fleet of power stations, you would expect some to be available 88% of the time across a winter.

Lord Tugendhat: So basically you are saying that in any foreseeable weather circumstances, we can rely on this.

Phil Sheppard: We have always had faults, whether it is on a power station, a transmission line or an interconnector. They still have their own technical faults, and they will still have some weather-dependent faults. There are some climatic conditions where you have very salty spray on insulators, those sorts of things, and that type of fault will always occur. They are very complicated devices, but the availability that they exhibit and how the market uses them mean that they are generally considered pretty reliable.

Q129 Lord Tugendhat: Let me now change the subject. You have said in written evidence that nuclear is one of the “key technologies” to help the carbon emissions targets for 2050. To what extent do you think the sector should develop beyond Hinkley? Is Hinkley the end of the road, or is it the start of a new generation?

Phil Sheppard: Nuclear is interesting. At the moment, if you go into our electricity control room you can see the amount of low-carbon generation at any one time. I was there earlier this week, and it was about 50%. We have as much as 79% with the current nuclear fleet and all the renewables. As the current generation of AGRs start to close, there is clearly an opportunity, depending on the appetite within government, for additional nuclear plant. We are, as National Grid, agnostic to particular types of technology. Our job is to connect anybody who offers to connect, and we have to be technology-neutral.

Lord Tugendhat: Would I be right in thinking that to the extent that the proportion of our electricity generated by nuclear increases, so the system becomes more flexible?

Phil Sheppard: Yes, it can become more flexible, but in effect it provides a steady, relatively flat rate of energy, which means an opportunity for things like storage, in order to do that time-shifting that we discussed earlier.

Q130 Lord Sharkey: Could I ask about the demand-side balancing reserve? First, in a typical year, how much do you actually pay companies through these schemes?

Phil Sheppard: I could not give you a figure off the top of my head, I am afraid. The demand-side balancing reserve was a time-limited product that has in effect left the market. What we have is a demand-side response—sorry to be a pedant—

Lord Sharkey: Does that explain why you cancelled demand-side reserve for this winter?

Phil Sheppard: We have demand-side services for this winter, so we have a lot of volume of that. This would have been the last winter this particular product would have been used. We would have ended up paying several million pounds for a few megawatts of a service. It was not cost effective for consumers, and for the people who bid in through that process we found other ways for them to access the market.

Lord Sharkey: You know how much that would have cost, but I think I heard you say that you do not know how much typically you pay companies through the other schemes.

Phil Sheppard: Not in aggregate across all the demand-side services. We have a range of demand-side services.

Lord Sharkey: Can you give me an idea of the scale? Are we talking huge amounts of money here or not?

Phil Sheppard: We are talking millions of pounds. For example, we have a service called demand turn-up, where at various times, if there is an excess of renewables on the system, it may be cheaper and better, rather than curtailing renewables, to increase demand. So there are services that we buy like that. I am sure we can provide a written answer that provides the detailed cost of each of the services.

Q131 Lord Lamont of Lerwick: Could you say something about the demand for energy? The Government are predicting that final energy demand will fall from 2015 until the mid-2020s and return to the 2015 levels by 2033. I am also told that domestic consumption—UK energy consumption for dwellings—fell between 2001 and 2011 by 23%, which was the third-largest decrease in Europe, and compares with an EU average of 14%. What is driving these structural changes, in your opinion?

Phil Sheppard: There are several things. One is the different uses that industry makes of energy. The change from incandescent electric light bulbs to LED has had a significant effect on demand, as has people replacing white goods in their homes, because almost all white goods now are much more efficient than they were even five years ago. These ongoing processes in the domestic arena have reduced demand and slightly changed the characteristics of the network. There is also a lot more knowledge in the industrial and commercial world about the costs of energy and how it can manage its demand to avoid peak prices. The volume of embedded generation that has been installed on the network, whether it is for your own self-consumption or selling a service to somebody, has increased. The demand off the transmission system has been dropping quite steadily since about 2008 or 2009, and we agree that it will continue to drop until such time as we start using electricity to decarbonise heat and transport, in which case it will start to climb again.

Lord Lamont of Lerwick: Could I ask you a slightly unrelated question? This may be slightly outside your remit, compared with how the grid used to operate, but does the falling marginal cost of renewables to near zero worry you from the point of view of the possible future reinvestment in the larger-scale energy suppliers?

Phil Sheppard: That is the purpose of the capacity mechanism: to address the situation when the longer-term wholesale price is too low to justify investment in new generation. The capacity mechanism provides the route to provide investor certainty in the returns they expect to see. That is the mechanism that the Government are using to overcome that zero marginal cost issue with the renewables.

Lord Lamont of Lerwick: But is that not also an argument for why the intermittency cost ought to be borne by the supplier and not be a system charge?

Phil Sheppard: It is just a way of making sure that we meet the security standard that government has set for the winter. Some forms of renewables in the future, a tidal lagoon for example, provide some certainty. It is quite technology specific.

The Chairman: Mr Sheppard, thank you very much indeed. Thank you particularly for your assurances on security.

Examination of witness

Mr Dermot Nolan.

Q132 The Chairman: Mr Nolan, welcome to the Economic Affairs Committee’s inquiry into energy. Thank you very much for joining us. Your website describes that you, “look to ensure that the prices consumers pay represent value for money. We achieve this through the setting of revenue controls and incentives for the energy companies and through the supervision and development of the wholesale and retail markets”. The CMA suggests that your remit should be extended and you should have an additional role to scrutinise and comment on government policies, and that you should have a simpler and clearer focus on the interests of energy consumers. How do you react to the CMA’s comments?

Dermot Nolan: First, thank you very much for inviting me here today. I will do my best to discuss any question you care to ask me. On that specific point on the CMA comments, the thrust of the CMA’s report with regard to Ofgem was that it felt that many of the duties given to Ofgem over the years had made its job more complex and that perhaps a more direct focus on competition—on benefiting customers through the achievement of greater competition—was the best way for an economic regulator to function, and that we should potentially narrow our functions in that regard. Indeed, there was a specific remedy that one of our primary objectives should be changed to have a specific, more defined focus on achieving our aims through competition. In that sense, we would welcome that. It is probably the main role of an economic regulator. In formulating our strategy we have tried to say that we are trying to benefit all customers in the UK. Clearly, we are trying to do our best for vulnerable customers, but fundamentally the role of an economic regulator is not necessarily to engage in substantive decisions about cross-subsidisation or transfers of income, because those really belong with policy. In that sense, I would broadly welcome that.

Secondly, you referred to the issue of commenting on government policy. The CMA said that it would be almost akin—I think the phrase has been used—to an energy office for budget responsibility; that Ofgem would, perhaps semi-regularly, comment on any particular aspect of government legislation or policy, and try to give some assessment of its overall effects from a standard cost-benefit analysis. I think we welcome that, too, but we would also say that for that to function practically, it requires the consent of government that that be so. At the moment we are dialoguing with government about that.

Q133 The Chairman: Let us take the most current investment into energy: Hinkley C. It has been widely criticised, certainly before this Committee, as being extraordinarily expensive. Did you look at that in any detail? Did you comment publicly or privately to government about that? Would you welcome the opportunity to look at that? We have also heard evidence that there are companies that have proven nuclear technology that would be able to build the same capacity at a lower cost, both to the consumer and in lower capital costs, and more quickly.

Dermot Nolan: It is a sensitive topic, clearly. I can say that we made no public comment on Hinkley C. We were not involved in the sense that the commercial contract negotiations were done by what was the Department of Energy and Climate Change, by EDF and ultimately by other companies. We were not involved as such. That was a consequence of the Energy Bill and the EMR framework we are currently in. Would I welcome it? That is a delicate question. Again, if government accepted that there was a role for the regulator, we would take it very seriously. “Welcome” is a strong word. I personally think that there is a role for a body to scrutinise such decisions. The CMA thought that Ofgem was a logical enough entity to do it and I would tend to concur with that. Ultimately, it needs the consent of government for that to happen.

I will say a bit about nuclear. These are personal views but informed by some knowledge about the situation. I will not necessarily comment on the strike price itself, which changed. When the contract was negotiated, people’s expectations of energy prices in 10, 20 or 30 years’ time were very different from what they are today. That just illustrates the way in which these things can change. I may be incorrect, but I can think of barely anywhere in the world where a nuclear power plant has ever been constructed using standard market principles in a classic wholesale market, if you will. Many nuclear power plants have been built in the past 10 years: some new ones in Japan, some in the United Arab Emirates and some in the US. They nearly all had some form of federal guarantee.

Thinking about the cost of nuclear power plants inevitably involves some exercise in judgment by the decision-maker as to what the alternative will be—in other words, what will wholesale prices be in 30 or 40 years?—when it comes to whether or not nuclear is likely to be cheaper. Any such decision is inevitably going to be wrong ex post. You cannot with precision predict wholesale prices 30 years from now. It requires some degree of judgment. Any future nuclear power stations will also have to have that degree of judgment in discerning whether or not they are value for money. The decision-maker will have to think, “What will the alternative be? If I do not build this nuclear power plant, what will the wholesale price for energy be in 35 years’ time?”, and then form a judgment about which is better.

The Chairman: But any judgment the Government make about contracts for difference over a long period of time would surely be better if it was made in the context of an independent analysis from those who are responsible for looking after the interests of the consumer in order to judge project A against project B or project C.

Dermot Nolan: I have a couple of comments to make. Whether the decision is made by an independent body, the relevant Minister or the Government generally, I would expect—and I am sure there was—a fair amount of independent analysis. When the Hinkley C contract was put in place, there were very different expectations of future wholesale prices. I would be all for independent analysis, but who the ultimate decision-maker is really is a matter for government. You can never remove the fact that it will be a subjective decision.

One thing I will say about the contracts for difference—and the CMA’s report mentioned this—is that trying to bring competitive processes into determining the strike price for contracts for difference is a very positive move. In one round of auctions for wind and another form of renewables, the strike price achieved at a competitive auction was significantly lower than had been achieved in previous rounds of renewables. If and when the Government continue with that process, the more competitive tension they can bring into that process, very much the better. The CMA commented that it would be nice to have competitive tension in nuclear but admitted that that was difficult, given that there appeared to be—how shall I put it?—only one show in town at that particular point in time.

Q134 Lord Darling of Roulanish: I have a general question. In the course of our investigation, many of us are coming to the view that whatever else this is, this is not a market in the normal sense of the word. It is not the market that was envisaged 30 years ago in that so much is determined by the Government, climate change requirements, carbon reduction, and so on. I just wonder who is looking out for the consumer, whether the individual or the industrial user. I know you came in half way through Mr Sheppard’s evidence. We were trying to get from him the appropriate balance between renewables and conventional, if you like. It just struck me that it all seemed to be cost-free; no one decides one thing or another. When I switch on my light when I get home, I have no idea where the electricity came from, whether it is renewable or from a gas-fired power station or whatever. I have no idea how the cost is made up. For industrial users, that is quite a big thing, because they say that they are paying far more than their continental counterparts. You have just given the impression that it is not really you, either. Who on earth is responsible for this? This is not a market. It is completely opaque. It is beginning to occur to me that there is a degree of opacity around many of the players in the market as to who does what. I could be entirely wrong, but if I am, could you explain to me why I am wrong?

Dermot Nolan: I will do my best and not spend too long answering you, but it is a complex question. To be blunt, Ofgem’s primary responsibility is to try to ensure that all its actions promote the interests of end users of energy—that is written in our statute—so in some sense we are responsible. We are not responsible for things such as Hinckley Point, and I will try to explain why that is the case.

Lord Darling of Roulanish: You cannot just exclude one of the biggest, most expensive projects and say that it was nothing to do with you. It is a very odd situation. You are in charge of everything else but not this whopping great nuclear power station that we are going to be paying for for the next 60 years.

Dermot Nolan: We are not in charge of renewables either.

Lord Darling of Roulanish: Narrowing the field somewhat there.

Dermot Nolan: We are indeed. I will try to explain how it works. As you will all know, when the deregulation of the electricity and gas sectors took place in the early 1990s, it was a different world. A market was set up: the wholesale electricity market. It had a transformation in the early noughties, but broadly it was a competitive market. Nuclear was pre-existing, but coal plants and gas plants were built on the basis of someone thinking, “I will enter the market with a fantastic new gas plant. I will be competitive. I will make lots of money”, and then someone else saying, “I’ll build a much cheaper one”, and it was approaching more of a standard market. There was clearly a departure from the 1970s and the CEGB and British Gas. In that sense, it had the more conventional aspects of a market. That was true at the wholesale but also retail level. Retail markets in electricity and gas were deregulated around 2002 and there was a sense in which it was beginning to resemble other markets—for good or ill.

That has changed radically, I freely acknowledge that. The Government have made various decisions, which they are perfectly entitled to do, but bringing in things such as climate change in particular complicated things enormously. From the early noughties, they started to bring in renewable subsidies, which were part of the wholesale bill and part of the charges paid for by consumers, ultimately also bringing in new nuclear. That is their choice. I cannot—will not, I suppose—say whether I think this is right or wrong. It is a choice that government has made. It has decided to intervene in the market in various ways. Has that changed the idea? Is it less of a competitive market than it was 15 years ago? Undoubtedly, yes.

Whether or not this is a long-term phenomenon, I do not know. About nine or 10 months ago, the then Secretary of State for Energy made a speech in which she said that she wished to get government out of the energy market over a 10-year period. What government should be providing is incentives for decarbonisation, possibly through the carbon price, which of course is another intervention in the market, and then ultimately withdrawing over a five or 10-year period. There was a sense that the subsidies and the contracts for difference would ultimately be removed and that renewables would see a degree of parity with other, more conventional technologies, and the Government would withdraw. That would bring it back to something akin to the early noughties. That seems desirable to me. Whether or not it will happen, I cannot say. Ultimately, that is a matter for government.

Q135 Lord Lamont of Lerwick: Would you agree that one thing that might have made it more and more complicated is that in the Government’s attempts to decarbonise, they have too many mechanisms for decarbonisation? We have the trading scheme, the renewables target and the carbon floor. Would it not be better to have one mechanism only and then the contract for difference auction could be done on a transparent, carbon-abated basis? Is not the real reason we have got in this mess because we have addition on top of addition planted on top of the pricing?

Dermot Nolan: I originally trained as an economist, for my sins. I am sure Professor Layard will correct me if I am wrong, but the most elegant way of dealing with decarbonisation is through a carbon price, which reflects the social damage of fossil fuels. An economic textbook would certainly say that it would be simplest to choose a carbon price and then have everyone compete over it. However, there are number of issues, which probably go into the realm of politics, about the potential acceptability of carbon prices, which might have to become quite high.

Speaking personally, I was never and continue not to be a fan of subsidies. I do not hesitate to say this to the Committee. We are possibly on the cusp of a great degree of innovation in the energy sector in a way that we have not seen for 30 or 40 years, and I must say that I welcome that. It could be quite an exciting time. My instincts are that the best way for that to happen is through competitive technologies against a relatively fixed carbon price, rather than, if I may say so, the technologies that race off to government and say, “I require a subsidy”. I am deeply sceptical of subsidies.

One comment I will make—almost to counter myself, but it would be wrong of me not to say it—is that solar power in the UK has been a huge surprise over the past five years. There are roughly 11 gigawatts of solar power now within the UK, much of it in the south but there is also some in northern England and Scotland. The expectation that government, regulators and many people had for this period was that we would have 3 gigawatts. There has been a huge increase. There were subsidies for it. I remember thinking at the time, “Why are we giving such subsidies?”, but you could argue—and there would be many arguments and counterarguments—that the subsidies seemed to imply some learning by doing. The costs of solar have decreased dramatically. Perhaps driven by forces in China, the costs of solar have come down by 50% or 60%. Although I do not favour subsidies, the argument could be made that for a temporary period those subsidies permitted that technology to lead to massive innovation, getting to the point of grid parity.

I agree with your general point about complexity. I agree that a carbon price is probably the best way, but that can be politically difficult. At least there is some possibility that new technologies, if they are given a temporary leg-up, will be innovative—as long as ultimately that subsidy is removed.

Lord Lamont of Lerwick: For new developing technologies—not where we have been or where we are now but in the future—would you advocate the use of CFDs to get them off the ground?

Dermot Nolan: A CFD through a competitive auction is a reasonable process to go through because the competitive auction—provided it is designed efficiently and my sense is that CFDs are currently designed quite efficiently—should ultimately, if economic theory is at least half-correct, be driving prices down as low as possible. The most innovative technology will say, “I’ll do it for this price”. That is a reasonable thing to do. These judgments are difficult, but in the long run—20, 30 or 40 years—the idea of having subsidies for new technologies is not a great place for the British energy system.

Lord Darling of Roulanish: I understand the argument that without some sort of subsidy—whether renewable obligations, CFDs or the solar subsidy that you referred to—these new technologies would never have got off the ground. You said that solar is an example of where it has actually worked. Has anyone done any work on what this market is supposed to look like when all this has worked through, when you have truly competitive renewables and competitive everything else so that you can make a genuine choice about where you contract from? When will this happy day arrive? Has anyone asked what this market will look like when, to quote the previous Secretary of State, the Government have got out of all this? At the moment, I cannot see this.

Dermot Nolan: People have done a lot of work, and there are a lot of different scenarios for what the market might look like in 10, 20 or 30 years’ time. I am not being glib when I say that almost inevitably they are going to be wrong. There are a number of scenarios. One scenario involves nuclear and carbon capture and storage, if that was developed, where you would still have fairly significant new nuclear and carbon capture and storage, which will result in relatively large power plants connected by large transmission lines. That could be one way in which the British energy system might work.

In the past three to five years, those visions have been challenged. In particular, the idea of local generation—distributed generation, as it is sometimes called—offers a potentially powerful alternative vision. It offers the potential vision whereby, with the solar and the renewables I spoke of, if storage—and this is a big if—continues to develop, we could see a very different future in which a very large faction of British people have a renewable turbine or a panel on their roof and storage as a way for dealing with the night. That is one vision. It is incredibly different from the vision of nuclear power plants and carbon capture and storage.

Which of these visions will occur I really cannot say. I do think that a relatively well-designed market—and this is why ultimately I have faith in market mechanisms—with a clear and stable carbon price should provide reasonable signals for the more efficient technologies to compete with each other. Thus I would hope to see a situation where we see further innovation in the next five to 10 years but we see the technologies that are ultimately more effective winning out. That is why I am copping out, I suppose, by saying that I am not sure precisely what the future will bring, but I would hope that we will have a market that will allow the more innovative technologies to win, and ultimately lower costs in 20 or 30 years’ time.

Lord Turnbull: I think economists can understand that you might want a market in which there are subsidies for things that the Government want to promote and taxes for those they want to restrict. Then people compete on a net basis, whether it is getting an addition or a subtraction, and the merit order is worked out on these net figures. Surely the key thing that has been added and is really destructive is that certain technologies have been given a prior right of dispatch. Their position in the merit order is being determined, in a sense, irrespective of whether they have actually earned that on the basis of subsidy or tax.

Dermot Nolan: I think you are referring to something akin to the renewables directive, which gives—

Lord Turnbull: I am referring directly to the renewables directive.

Dermot Nolan: I was just checking, and trying to be discreet.

Lord Turnbull: That seems to me to be the thing that, when you add it to the mix, has produced this rather poisonous combination.

Dermot Nolan: It does a variety of things: it gives what is called priority dispatch to renewables, which does, as you say, make them first in the merit order. We have not modelled precise figures—we could do that—but that is probably adding somewhat to costs. I am giving a view here that may be incorrect, and I may come back on it. I do not think it is the single biggest driver of overall costs. I do not know whether we will be in the EU or not and whether EU rules will apply to the energy market in 10 to 15 years, but I would also say that there is some talk within the EU of repealing and changing the renewables directive. The priority dispatch you referred to was, in one sense, to start things off.

Q136 Lord Turnbull: Should we not be aiming at cost per tonne of CO2 abated, so that gas might actually be better than solar or wind? Currently, even if it is, it cannot get in: it has to wait until renewables are dispatched and then it gets asked to come in and fill the rest.

Dermot Nolan: I would not disagree with that characterisation. I am not sure if it relates to the actual carbon emissions. The dispatch order refers to the way in which plant is called on. I acknowledge that that is an effect, but it is not a major risk to new gas development in my view. I would say that the capacity auction, which I think the person from National Grid referred to, is probably an appropriate and sensibly designed signal for new gas plant and new fossil fuel. In the medium run, I very much agree that the idea of a particular class of technology being dispatched in a preferential way is not appropriate. I would hope, personally, to see that removed over time.

Q137 Lord Turnbull: If we go back to Lord Lamont’s complication, you have one intervention which causes one problem, so you have to invent another thing to correct the problem that you have caused in the first place.

Dermot Nolan: I have a couple comments on that. The capacity auction, as I said, is well designed, but it is not unique or necessarily a function of increased renewables in the system. Capacity auctions are relatively rare in Europe, and in fact the European Commission is somewhat sceptical about them, but they are very common in various North American markets, where they have existed for some period of time in markets that did not have any particular penetration of renewables.

The whole idea of what we would call a wholesale electricity market with a capacity auction functioning contemporaneously with it is in my view a perfectly reasonable thing and might well fit the UK regardless of the presence of renewables. One of the effects of the capacity auction, when combined with a wholesale market, is that you get fewer swings—you get fewer occasional very high wholesale prices, because in the middle of January, instead of the wholesale price going to an incredibly high level, it will only go to a certain level because the gas generator will have been paid in the capacity auction. As I have said, I think that the capacity auction is reasonably well designed and is probably a decent fit for increased renewables penetration, as long as it can be made to work properly.

Q138 Lord Layard: I will change the subject and ask about the CMA investigation into the retail market. Are you satisfied with the outcome of that? Do you think that there can be greater switching and that that is important for the future? Would you in any circumstances think that the short-run price cut would have any function?

Dermot Nolan: I am satisfied with it. Ofgem referred the market to the CMA and said that it would accept the results, so I think we would be bound by it anyway. The inquiry results have received some criticisms for, as I say, not going far enough or for not perhaps being interventionist enough. I do not share those criticisms, and will come to the issue of public trust in a second. The CMA made a number of recommendations, but the core aspect that it got in the retail market was the problem of engagement: the difficulty in switching and perhaps, as Lord Darling said earlier, people not understanding what is driving costs. I will also come to that.

Most of their remedies were designed to say, “We need to make the market more transparent, we need to make it easier to switch and we need to give people more information in that regard”. There were a series of remedies, which we are now putting in place, to try and deal with that. I broadly think these are a good idea, and that they can be done and will be done in a reasonable time period. In that sense, I do not see an obvious need for a temporary price cap. The Committee may not be aware that in a report by five members of the CMA, one member did actually recommended the temporary price cap for the next three years, but even that person did say it should be temporary. I have faith that the remedies can be delivered, although will make one final remark before a caveat.

I spoke earlier about the energy sector, certainly at the wholesale level, seeing a greater degree of innovation than we have seen in many years. The same is very much true at the retail level. The smart metering programme has had some delays, but none the less it has the power to transform the way people buy and use their energy—it could have a transformative effect. Along with the smart metering system will come much easier switching, whereby people should be able to switch within one day. Along with that will come what we call half-hourly settlement, where people can, if they want, be charged different prices at different times of the day, which will make the overall demand for electricity and gas much more responsive to price signals on the market. That is quite a powerful vision. The CMA has said that if the industry is forced to embrace this technological innovation, it will ultimately lead to more engaged customers.

I talked earlier about trust. In the retail sector, public trust has been damaged in the last five to 10 years. I look back at prices and think that this is utterly unsurprising.

I spoke earlier about there being far less government intervention in the energy space in say, 2003 and 2004, and energy prices were much lower then than they are now. Renewables have added to that cost, but frankly the biggest driver is fossil-fuel price increases. So I understand the sense in which the public are sceptical about the rate of increase of energy prices, and in particular what is driving them. I was slightly dismayed by Lord Darling’s comment, because in some sense it seems to me that broadly the regulator, the Government and indeed the industry have an obligation to explain much better to consumers what are driving those kinds of price increases. If I may say so—perhaps it is glib of me to say this—we have not done that very well in the past.

On the question of going forward, if I may perhaps unfairly characterise some of the discussions about some of the increase that we have seen in energy prices, we have seen where the regulator and government say that companies are profiteering, and the companies nearly always blame it on government and the costs of renewables. If I were an energy consumer who was not the energy regulator, I would say that I was not really sure what was going on. One thing the regulator is trying to do its best at to try to explain to the people, if they will listen, what is driving these kinds of prices increases, or changes. I hope for price decreases. In the long run I would be surprised if there were any, but I want to try and bring at least some clarity as to whether it is renewable costs, fossil fuel costs or excess profits, to try to give consumers at least a degree of further trust in the sector.

Lord Sharkey: Dieter Helm did not think that encouraging switching would actually work, and pointed to what he thought was a deeper market failure. He told us that, since about 2012, wholesale electricity prices had fallen by about 30%, while retail electricity prices had not fallen at all. Is Dieter Helm right about that? If he is right, do you agree that it points to a kind of profounder market failure that cannot be addressed by putting up a website?

Dermot Nolan: If that was the case, it would be pretty profound. I have a lot of time for what Dieter Helm says on many issues, including this one, but I do not quite agree with his characterisation of wholesale and retail. Wholesale electricity prices did fall over that period, as indeed did wholesale gas prices—in fact, gas prices fell relatively more. Renewables costs rose over that period and are likely to rise slightly more in the next year. Retail prices have fallen somewhat. That shows some of the complexity in the market and some of the issues that perhaps affect public trust. The majority—roughly two-thirds—of British residential customers are on what we call standard variable tariffs, which fell—some of them from the major companies—but not by much. What we saw were very cheap offers—what we call fixed deals—which is where most of the fall in retail prices took place. That particular segment of the market was extremely competitive and prices fell by considerable amounts. There were points even up to about two to three months ago when you could get a fixed one-year deal for electricity and gas for less than £700. We saw competition at that end of the market, but probably less at the other end. I do not think that the overall sense that the market did not respond is fair. A particular segment of the market did not respond well, but I believe that some increased engagement on that is likely to be effected.

Lord Sharkey: Is this not the sign of a dysfunctional market at the very least? I think you are saying that a relatively small sector of the population was able to take advantage of special offers, whereas most consumers remained on these standard tariffs and paid far too much, at a time when the wholesale price was falling.

Dermot Nolan: Is that exhibitive of a dysfunctional market? I would say partially yes. The CMA said that this was the core of its argument: retail prices for some were falling but retail prices were not falling particularly for those who were not engaged. It said that there were various reasons why they were not engaged. Most of its remedies are designed to make them more engaged. I believe that that is a sensible thing to do. I certainly would see that the vision—I appreciate that it is easy to spout vision—for five years’ time might be of somebody walking around with their mobile phone, hitting a button, seeing where the energy price was, hitting another button, switching to another provider and then putting the phone back in their pocket. It is entirely possible that someone might not be interested in doing that, but they should at least have the ability to do so and the ease to do so. That would bring greater competition to the market and press down the standard variable tariffs.

To address your question more head on, I would say—and I think that Dieter would subscribe to this view, as would the chair of the CMA panel on energy—that the CMA studied the market very carefully. It studied the wholesale and retail price effect over a number of years. It also studied some of the interventions that Ofgem, as a regulator, and the Government had made to try to make the market more effective. It concluded that many of these interventions had not worked well and that they had tended to limit competition between suppliers and ultimately perhaps to drive up the level of prices.

Thus, the conclusion that it came to, if I may characterise it in this way, was almost that you cannot be half pregnant. You go with a competitive market and you try to make it as competitive as possible and deal with the distributional consequences—I will come to that in a second—or you go back to something quite different. One eminent British economist said that you could go back to regulated franchises with wholesale competition; you then go back to having just one supplier in that area. My own view is that that is probably not preferable, although it is ultimately a policy matter, but I think that what was said clearly was that you deal with a competitive market or you do not; halfway houses are not terribly effective. By and large, my own sense would tend to endorse that conclusion.

Q139 Baroness Wheatcroft: In financial services, the regulator has an overarching view that companies must treat customers fairly. Do you think the same can be said of energy suppliers, to the retail market particularly?

Dermot Nolan: They have such a duty in their licence. Ofgem gives licences to suppliers, to generators and to network companies. Relatively recently, about two and a half years ago, we put into the supplier licence that all suppliers, of whatever ilk or size, had a statutory licence duty to treat their customers fairly. It has only been in place for two and half years, but we take it very seriously, and that is what they are supposed to do.

Baroness Wheatcroft: Do you think they do?

Dermot Nolan: They have not in the past and some of them are still not doing it as well as they should. In the past, the faults tended to come in two main areas. One is that there were many examples of mis-selling, in the late 2000s and the early years of this decade, when energy companies did not treat people fairly and engaged in potentially deceptive advertising and deceptive selling. We took various enforcement actions against them and we have levied various fines against many of them.

The second is that a number of companies—at least half the major companies—have been through major IT changes over the last few years and have changed their IT systems. By and large, many of them did this very badly and provided very poor customer experiences. We took and continue to take enforcement action against some of those companies. Enforcement actions are clearly part of what we have to do. We have recently signalled that we will have higher penalties for cases occurring past 2014, but has the penny dropped? Probably not. It might have done for some companies, but not with the entire sector. The rhetoric that I would use when meeting energy companies—and I would say that it is exactly the same with Secretaries of State—is that they are almost in the last-chance saloon, although I know that it is also a cliché. They need to show customers that they are better engaged with them. They need, in particular, to treat relatively vulnerable customers well. So we have put in place a licence duty to treat people fairly and we have taken a couple of enforcement cases using that. When companies have said, “Listen, my IT system was wrong and you can’t blame me for that”, we have said, “Actually, you messed up. The excuses are irrelevant”. If that percolates throughout the sector, I hope that behaviour will improve.

Lord Darling of Roulanish: I want to take you up on this point about someone walking along the road, taking out their mobile phone and switching suppliers. This is not like going to the supermarket, where you tend to go every few days or once a week; you can decide whether you will go to Tesco or Sainsbury’s or wherever else and you can decide which products you will buy. Most people tend to engage with their electricity bill when it comes in, which used to be once a quarter, although it now seems to be less frequent. In any case, you cannot just think, “It’s Thursday morning. I’m going to change my supplier and I’d like somebody else next week”. It does not work like that. Most people would be much happier if they thought that somebody had got a grip on the wholesale costs and how it is all made up. Most people want greener energy but they also want to pay a reasonable price for it. Putting all the onus on to someone who is walking along and takes out their mobile phone does not seem to me to be realistic. It is a classic case of economists ignoring the fact that most people behave like rational human beings rather than properly trained economists.

Dermot Nolan: I do not think that I behave like a properly trained economist. Certainly switching does not work like that now; it is more difficult. I have been to numerous focus groups that we or consumer organisations have run on the switching process. By and large, most of them say that it is just a hassle. Regardless of that, in the next few years the regulator and the industry have to make it easier. I entirely accept that it is different from buying goods in a supermarket. You get this service regardless of whether you make a conscious choice and sometimes the easiest thing is to let it go, before finally you get some huge bill, whereas you make a conscious choice every time you nip into somewhere to buy milk. Many other goods and services are bought like that. By and large, telecoms are bought like that and, by and large, with a slight difference, insurance is bought like that.

The CMA thought quite seriously—in the end, it decided against it—about changing the structure of the market and making it like the insurance market, saying, “You have to buy every year. There will only be one-year contracts in the market and you will have to engage every year”. It did not do that, for a variety of reasons. The biggest reason was probably that, because energy is an essential service, you cannot just cut someone off; society would not accept that. It felt that that model did not work. I take the point about switching, as I said, but I come back, perhaps unfairly, to my answer to two questions before. Any competitive market is probably based on switching and making it as easy as possible.

Certainly the insurance market, which has been looked at over a number of years, is trying to make it easier to switch, but it is still a market where someone has the onus to switch. Any market where there is a requirement to engage is likely to have a degree of price dispersion in the market, in the sense that there are going to be winners and losers—I do not think you can get away from that. I hope that in five years’ time that level of price dispersion between people who engage and those who do not engage is less. If it is not less, something has gone seriously wrong. It seems to me there will always be price dispersion. That brings me back to my previous point that if society does not want that price dispersion, probably a half-competitive model is not the answer. It should probably go back to most people, frankly, paying the same price. The interventions of the last five or 10 years seem to us to have shown that trying to keep you half-competitive does not really work. Either you get people as engaged as they can be or you go back to an entirely different kind of framework.

The Chairman: Could you tell us what success looks like? At the moment you have 70% of domestic customers paying a default tariff, which is much more than the market. In five years’ time, what would that 70% be? You do not need to give a long answer; just the percentage would be helpful.

Dermot Nolan: Maybe 30% to 40%?

The Chairman: Thirty to forty? So you would aim to halve the current overpayment, through the measures that are already in place.

Dermot Nolan: Yes.

The Chairman: And if the pace of reduction was slow, or you wanted to increase it, would you be prepared to recommend other, more draconian measures?

Dermot Nolan: I would, but I would say that that would be five years away. The CMA has said that we should give competition a chance and try and make it work as effectively as possible. Roughly speaking, with smart metering et cetera, we have five or six years to do that. If at the end of that period it has not worked, it would be time for serious thought.

Lord Sharkey: Is it not the case that in markets that work properly, suppliers actually compete? It is not entirely down to the consumer to find the button on his telegram to tell him which to buy; suppliers compete. Some of the descriptions of the market we have heard today sound as though it is cartelised—a bit like many financial services. To what extent do you think that the suppliers genuinely compete for the business of their customers?

Dermot Nolan: I think they compete very actively for, if you like, the engaged.

Lord Sharkey: But 70% are on the standard tariff.

Dermot Nolan: Absolutely, and I will come to that in a second. The CMA said that it was a two-tier market. There is very active competition at that level, and the number of entrants in the market in the last few years has been quite considerable. We now have potentially up to 50 entrants. I am not sure if that will stay the same, as there may be a shake-out in the market in the next few years, but it shows that for people who are engaged there is very active competition. Indeed, the larger suppliers are reacting to that by lowering their own prices. For the two-thirds of people who are on the standard variable tariff, yes, competition is less effective. Indeed, are any of the bigger suppliers taking the strategy that says, “Right, I’m going for it; I’m going to do some sort of radically different business model”?

Lord Sharkey: Are they?

Dermot Nolan: I do not think anyone has done that.

Q140 Lord Tugendhat: Can I come to the problem from the opposite angle from Lord Sharkey? We talk about competition, but there are some services and products where I am not at all sure that the general public are interested in competition. If one looks at banks, as well as energy suppliers, everybody is always saying how much easier it should be to switch—and so it should be—and how they should compete much more, but actually most people are very reluctant to switch from one bank to another for all kinds of reasons. So long as the bank is providing a reasonable service, they are unlikely to move. Some people will, but the great majority will not. I have a feeling that, in the case of energy, most people do not particularly want all the hassle of moving, and so long as they feel they are getting a reasonable service and are not being ripped off they are going to be content. I just wonder how worth while it is trying to create a situation in which we are trying to persuade people to be moving from one to another when they do not particularly want to.

Dermot Nolan: Perhaps I am going to reiterate what I have already said when I say that it is probably ultimately a policy choice, but a competitive market relies on at least the possibility of switching. One of the points about a properly functioning competitive market, which I do not think we currently have, is that the active protect the inactive. The number of people who actually do engage in switching in some sense offers a degree of protection through the possibility that they will switch, because the company also offers relatively low prices to the inactive, if the market is functioning correctly.

To me, that seems to be a possible future. You will have people who are not that engaged, because frankly it is not an issue for them. I accept that it is not quite like changing in telecoms, where you might get a shiny new phone, as you do not get that in energy. I accept the distinction, but I go back to the idea that if one really thinks that people will never switch in energy, competition in retail is probably not the answer. Personally, I think it can still function—it functions effectively in certain countries, notably the Nordic markets. The CMA was consistent in saying, “We can try it, and technology will help us”. As I said before, perhaps if it does not work one could look for alternatives.

Lord Tugendhat: It seems that there are some things where people feel that there is a real difference between the products. There are people who see a big difference between one brand of motor car and another, and what brand they have is important and what gizmos the car offers will determine whether more and more people buy it. There are other products, of which petrol is a supreme example, where people think it is all the same anyway, so it does not matter and there is no brand loyalty at all. Then there are services like banking and energy where, again, wherever you get the energy, it is all the same. There is a deep-seated reluctance to change, and one might as well recognise that.

Lord Lamont of Lerwick: Yes, but surely public policy ought to drive competition, even if it is only a minority of consumers who wish to do it. That will affect the price of the whole.

Lord Tugendhat: I agree, but I do not think we should expect any very dramatic results.

Q141 Baroness Wheatcroft: I would like to ask you about the consultation that has just been launched on a smart, flexible energy market, which implies that that is not what we have at the moment. Quite what do you hope to achieve by it, and what areas you might be looking at? Might you look for instance at the domestic use of gas versus electricity? The thing we keep hearing about that has to be avoided at all costs is the lights going out. That might be part of the answer. Does storage come into this, and what is the role of the regulator in it all?

Dermot Nolan: The consultation we have just launched and which you referred to is actually a joint consultation with what was DECC and is now BEIS. It is government and regulator trying to look, hopefully in a joined-up way, at some of these issues.

To take your last point, storage is fundamental. What is the purpose of it? Electricity storage has no statutory existence at the moment; it is not necessarily self-evident whether it is a retail or a generation type of licence. One of the things that we could consult on with BEIS is the development of a licence framework for storage. There is also the sense, which I think was mentioned by the previous witness, that storage feels discriminated against. Every technology feels that, but there is probably something in that for storage in that it pays twice under current arrangements for the way it is charged for the network. There is a need to see whether storage in particular can be put on to a sounder licensing framework that permits it to develop and to develop relatively efficiently. Storage is not the only technology there; the things we are looking at include what we call the role of aggregators. Aggregators are entities that engage in various combined demand-side response and other kinds of activity together to offer services, perhaps to large companies.

What we are trying to do with this, and it is only a consultation, is to look at the wholesale market and see what new kinds of technologies will be coming into the market, how can we encourage that kind of innovation, and how can we see whether or not that innovation will be effective and potentially ultimately provide lower charges for all customers. In doing so—and this is probably one of the core tasks of a regulator—how can we ensure that any new technology is on a level playing field? One of the core tasks for any set of generators is to pay for our entire network and to ensure that people are paying relatively cost-reflective charges. That, frankly, is horrendously messy. It was messy enough when there were only gas and coal generators and nuclear. It will be much messier going forward.

Possibly the biggest task for the regulator and government in the next few years, certainly in this area, is to try to encourage new technology, in which there are huge signs that there will be very significant changes, while ensuring that it does not distort things and that any new technology has neither a massive advantage nor disadvantage compared with other technologies.

Baroness Wheatcroft: So you would hold to the view you expressed earlier that subsidy of any of these things would be a bad idea?

Dermot Nolan: Broadly, that is my view. I accept that ultimately that is a matter for policymakers, but I would hope to be functioning in a subsidy-free environment.

Baroness Wheatcroft: Could you say a bit about the domestic users of gas and electricity?

Dermot Nolan: I might say something about gas. The consultation is not driving particularly at gas and electricity usage. I will say something about gas, which may not answer your question but I think it is important to say. One of the biggest challenges—if not the biggest challenge—facing the entire British energy system in the next 30 or 40 years is what to do about gas and what will happen to our gas network. It is taken for granted that in order to meet the carbon budget for 2050 we will have to decarbonise our electricity system, which we are certainly on the path towards doing. If we want to meet that target for 2050, we will also have to substantially decarbonise our heat system. Without overegging the pudding, it is hard to see a situation in which there is no radical change to the way gas is used in the UK if we wish to meet that target. That is why one of the biggest challenges for the energy system is what will happen to the natural gas network. After all, 84% of British residents receive their heating from gas. What will happen to that by 2050? There are some major questions to be grappled with over the next five or 10 years.

Baroness Wheatcroft: I think you are the first person giving evidence here who has mentioned that. Can you explain what you think might happen?

Dermot Nolan: I am sorry, I did not mean to spring a shock on anyone. I am reasonably sure that it is a major issue. Gas is a major contributor of carbon, not necessarily gas in the usage of electricity but the heat. The overall climate change targets tend to focus on electricity, heat and transport. Much of the progress—and I use that word in a non-loaded way—has been made in electricity; less so in heat and transport. The gas network contributes an awful lot of carbon emissions. I will caveat my comments, but I want to be reasonably clear on this.

Let us take the example of Norway. Despite producing vast amounts of gas, Norway does not use any of it to produce electricity or for heating. Nearly all its heating is electric heating, which is why its electricity load per person is three or four times ours. If Britain replaced its gas network and moved to a system where all the UK had electric heating, we would need an electricity system roughly three or four times the current size. That is quite sobering.

In 2050, some of the challenges vis-à-vis gas are relate to what we will do with the gas network. Various solutions are being thought about, including something called hydrogenising the system. I will not pretend that I understand all the physics behind it, but it involves using what I suppose would be called green gas or some form of hydrogen to keep the gas network. None the less, that is likely to be expensive and potentially intrusive—it might involve visiting people’s homes. There are other things, such as the development of what we call heat networks at a local level, which are occurring throughout the country.

Baroness Wheatcroft: Geothermal.

Dermot Nolan: Yes. They are developing in various places. Some experiences are positive, some negative. They are not necessarily regulated, and I am not necessarily asking for such regulatory powers, but I have had a number of queries asking, “Why is there a regulator for the provision of gas heat and not in this area? This does not seem fair”. There are a number of ways in which this challenge might be met. But I do think—and I do not say this lightly—that it is the biggest challenge facing the British energy system, but it is a long-run challenge. When I talk about the carbon budget, I am talking about the carbon budget for 2050. But that is only 34 years away.

Q142 Baroness Bowles of Berkhamsted: Could you explain a bit about your powers and what you do—they may not exactly balance—to ensure energy security? Your website says, “The legal framework in which we operate makes clear that the interests of consumers include the future security and sustainability of energy”, and that you approve demand-side response tools, such as not turning the voltage down so low that nothing works, I presume. Do you have a role in deciding what adequate spare capacity is, so that the lights do not go off?

Dermot Nolan: Yes, we do. That is part of a troika—if I may use that word—involving us, National Grid as the system operator and, ultimately, the department. National Grid is the system operator, and I focus mainly on electricity here, although it is also the system operator for gas. It has a licence from us that is tasked with keeping a sufficient degree of energy security using the standard set down by the Government. So the security standard for electricity is explicitly set down by government. National Grid is tasked with maintaining it and we are tasked with regulating National Grid in maintaining that, approving or not approving any costs that it incurs in so doing.

In practice, that means that the standard is very much set down by government. We regularly meet National Grid at various different levels within the organisation to look at security. Is it meeting that security standard? How is it meeting it for any given year? Is it doing so in a cost-efficient fashion? In that sense, we are deeply involved in that area.

Baroness Bowles of Berkhamsted: In what terms have the Government set this security capacity? If everyone is saying that there is not enough, it does not seem that they are lobbying government about it.

Dermot Nolan: I do not want to speak for National Grid. Mr Sheppard has just gone—

Lord Burns: Not very far.

Dermot Nolan: Indeed. That is set down. It is called loss of load expectation, which means almost nothing to most people—not including me, I hope. The Government set down the standard and say, “On average, we want you to maintain a security standard for electricity in the system that says for three hours per year you might have to take particular actions to manage any constraints on the system”. Typically, that means that we are talking about a margin in electricity of roughly 4% to 5%. That is what is set down by government. If the Government wish to change that, that is a matter for them.

As I said, we meet National Grid and the department regularly. In all the work that we and National Grid do, we are inherently very conservative in our assumptions when it comes to meeting that standard. I am quite aware that that standard has come down to lower levels over the past few years. This winter I think it is back up to 6.6%.

I spoke earlier about the capacity auction. I am hopeful that with the capacity auction, which is relatively well-designed and is designed explicitly to bring on new forms of generation, that margin is likely to increase somewhat in the coming years. I do not think we have ever got very close to the lights going out. None the less, a capacity auction and the resulting stability for investors will be more positive in electricity in the next five to 10 years.

Baroness Bowles of Berkhamsted: I am quite curious as to how you convert three hours a year into 4% or 5%. I am sure there are all kinds of probability things going on in there, but a 4% or 5% margin sounds quite a lot, while three hours a year does not.

Dermot Nolan: Can I come back to you? I could explain this verbally now, but could I come back to you in writing on that?

Baroness Bowles of Berkhamsted: I would be interested to see that, yes.

The Chairman: We look forward to your answer.

Q143 Lord Burns: When we started this inquiry, one of the questions that a lot of us were asking ourselves was whether energy prices, both in retail and in industrial places, are higher in the UK than in other advanced industrial countries? If they are, why are they? Do you have a shortish answer both on the comparison and on why?

Dermot Nolan: By and large, our electricity prices are higher than most of our neighbours’ at wholesale level—although not at retail level, which I will come to. They are certainly higher than in France and Germany or in the Nordic countries. Some other countries have higher electricity prices, but ours are now above the EU average, which they were not 10 years ago. Our gas prices are below the EU average. If you look at overall energy costs for a company, which depends perhaps on its electricity/gas mix, electricity usage is relatively higher than gas. That is the short answer.

I talked about wholesale/retail. The situation is complex because of the way other countries deal with these policies. Germany is the classic example. It is still very coal-based. By and large coal is somewhat cheaper than gas—given carbon, which I will come to—but Germany has made a specific intervention so that nearly all the costs of renewables, which are very considerable in Germany in that it has huge amounts of penetration of solar power and wind, are borne by domestic customers and small and medium-sized enterprises. Large energy users bear none of the costs of renewables. If you look at the relative costs in Germany, the costs for large energy users are much lower than they are for our large energy users. But if you look at the residential costs in Germany, despite the lower wholesale price the residential costs paid by the ordinary German consumer are about a third higher than ours. That is electricity.

One final point is that our carbon price has an effect. The original EU ETS was designed to have a particular price for carbon—I spoke earlier to Lord Lamont about the price of carbon. We have a carbon price floor that is considerably in excess of that, which has an effect on our electricity price and increases it. That is a choice we have made, and we also get £1.4 billion or £1.5 billion a year of tax revenue. How one balances the tax revenue against the increased industrial prices is a matter for government, but that, without question, is pushing electricity prices somewhat upwards. People did not expect this, because seven or eight years ago there was a perception that the carbon ETS price would be much higher than it currently is. But it does not bite in the UK, because we put in our own carbon price floor. That is certainly driving up our electricity prices.

Lord Burns: The second question is in place of the general one: “What do you regulate and what are your powers?” I am slightly confused about this, because on various things you say that it does not really fall to you. Could we approach this the other way and ask what your other interventions have been in this market in recent times? What are the things where you could say that you made a difference?

Dermot Nolan: I will pick three areas. One is networks—the actual electricity transmission and distribution lines. We set price controls for those and we regulate them directly. We did so traditionally every five years, and now we do so every eight years. In some sense, that might be our core activity: we specifically set a price. We changed our methodology on price controls about three or four years ago, and we are studying the results of that, but that is a fairly major intervention. It was designed partially to make networks, which after all never interacted with consumers, more responsive to them and to deal with issues of safety and outages better. That was one area.

A second is the wholesale market. By and large, the rules of the electricity wholesale market have not changed that radically in the last few years. They were set up about 12 years ago, and the CMA said that it thought they were broadly fit for purpose. Most of our interventions in that area have dealt with how different kinds of generators access the cost of paying for the network. Although I spoke about the challenge of heat, one of our biggest challenges, which will probably lead to some form of intervention in the next few years, is dealing with how the network is financed by these new kinds of generators. I know I am taking some time over this answer, but one thing that will be an enormous challenge is how to pay for the network when more and more generators will seek to go off-network.

I spoke earlier about a potential, very interesting, future in which you could see someone with a solar panel or a small wind generator and a bunch of batteries in their backyard, and they would say, “I’m now self-sufficient in energy”. A business could also do that—potentially a large business. They say, “But I still want it to be connected to the grid to make sure that if something really drastic happens I can still have a supply of electricity. But I should not be charged for the grid itself. I should only be charged for the marginal cost when I want that particular point in time”. This is already happening. We are getting applications for what we call derogations from grid charges. It is innovative and interesting, and some local authorities are bringing these kinds of projects forward. We have made some of these kinds of interventions in the past, but major potential interventions will be needed to say how we finance this grid and how we find a mode of charging that actually makes sense. I know that not everybody is off-grid, but if 50% of people are off-grid and say they will only pay for the marginal cost, we will not be able to finance the grid.

Lord Burns: You have to have a capacity charge.

Dermot Nolan: We do, but people are looking for derogations from that too. Finding a model that allows innovation but still ensures that the essential nature of the electricity and gas grid, particularly the electricity grid, is paid for will be a major challenge for us in the next three to five years.

Thirdly, in the retail sector, which is the other area that we regulate, we sent the market to the Competition and Markets Authority. That might seem like an easy thing to do, but it was thought about over a lot of time and it was a major intervention. We felt that trust in the retail market had failed to a large extent, and there were also pretty fundamental questions at the time about the structure of the market, in particular what you would call the generation and the retail sides of the market. What have traditionally been known as the big six firms were all the same firm. Two or three years ago there was a strong belief that they should be separated. The CMA looked at that very carefully and said, “No, there is no particular justification for doing this”. That in itself was an intervention that has for now settled that issue.

The other kinds of interventions that we make in the retail market are broadly, I suppose, trying to increase competition between firms, although obviously we have not got all the way there, but also trying to ensure, with reference to the earlier comment by Baroness Wheatcroft, that retail companies treat their customers fairly. I have said in public before that energy is an essential service. What we are trying to capture there is what seems to me to be a societal view that energy, despite the idea of a competitive market, has something about it that requires a greater degree of protection than for standard markets. That is one of the interventions we try to maintain.

The Chairman: Mr Nolan, that brings this session to an end. Thank you very much for your helpful answers.