Alex Henney (EEE Ltd)[1] – Supplementary written evidence

What goes around comes around – what to do with the electric market

Freeing in industry in 1990

When it was owned by the government the British electric industry was not run just for the benefit of its customers.  It was overmanned to suit the unions; the Central Electricity Generating Board (CEGB) bought plant in advance of requirement to provide equipment manufacturers with work; until Mrs. Thatcher broke the National Union of Mineworkers, it bought British deep mined coal which was not only expensive but was also unhealthy for the miners; and there was a decades long extravaganza with expensive nuclear power. The CEGB was a classic case of “lobbyist capture”. In my mind, and those of many others involved at the end of the 1980s, privatising the industry and introducing competition would subject it to the discipline of the capital markets, and get the industry away from government and all the resulting inefficient influences.

This aim was achieved for seven years.  The first benefit was that the cost of nuclear power was revealed; the programme to build more than Sizewell B was stopped; and over 5 years British Energy radically improved its performance.  The next was that the National Grid and the two big generators National Power and PowerGen downsized by more than 50%.  Finally there was a significant programme of building combined cycle gas turbines which displaced coal.  The Department of Energy was shut, and most officials with industry knowledge left the civil service.

New Labour gets fiddling

So far so good.  But with the election of New Labour in 1997 political interference returned with ever increasing enthusiasm and ever reducing competence.  First came a gesture by Peter Mandelson to halt licensing of CCGTs to protect coal, which achieved nothing. Next came the ill-judged restructuring of the Pool, which had its faults but not the one which it was blamed for. It did not as claimed by the government and Offer facilitate the exercise of market power – that was due to the control of pricing by the duopoly of National Power and PowerGen (subsequently joined by Eastern Electricity, which became TXU Europe). The New Electricity Trading Arrangements for England & Wales (NETA)[2], as an ill-judged and superficial change. Contrary to its billing, NETA did not reduce prices – they reduced six months before NETA was introduced because of a combination of overbuilding of CCGTs in response to National Power and PowerGen keeping prices up, and of the fragmentation of ownership following the part-forced and part voluntary divestment of 13GW of plant by National Power and PowerGen.

The next step in ending the market followed Tony Blair’s wish to save the planet which developed over the years from 2002 when he published “The Energy Review”.  Concurrently the government introduced the Renewable Obligation (RO) Scheme, which required suppliers to have a proportion of Renewable Obligation Certificates (ROCs) which were bought and sold at the margin in an ersatz market arrangement.  The RO scheme suffered from “naïve marketism” – an ideological belief in the efficiency of “markets” (in this case a pseudo-market) regardless of practicality.  The objective of increasing the contribution of non-market viable renewables generation is a public policy objective, not an economic objective.  Thus its financing should not be impacted by the volatility of any market, let alone of three markets – the energy market; the CO2 market; the RO “market”[3].  The main facility being built – windmills – are very capital intensive, and their output is not correlated with the driver of the market, the price of gas.  The consequence of these uncertainties, together with the uncertainty of the RO recycling scheme and the unlikely (but not inconceivable) possibility of a collapse in RO prices, piled artificially contrived bureaucratic risks upon the politically contrived risk of the EU ETS, and both upon a genuine (but irrelevant) market risk. These risks not only unnecessarily increased the cost of capital, but also made it difficult for new entrants to develop project financed schemes (as they have done in Germany). In consequence only companies with large balance sheets could join the game.  In contrast, a feed-in tariff meets the low-risk financing requirement that is appropriate for a scheme based on public policy; provides the basis for project finance; and is simple; and is cheaper – the German feed-in tariff scheme was about 15% cheaper, but cost has never been of consequence to DECC.

The government fiddled with the scheme making seven changes over the period to 2010.  Along with renewables, led by Blair, the government reversed policy on nuclear and in the May 2007 White Paper on Energy proclaimed that it “believes that new nuclear power stations could make a significant contribution to tackling climate change.”

In 2007 at the Spring European Council, and against advice, Blair signed up for the UK to achieve 15% consumption of all energy from renewables by 2020, which was the most demanding target of any member state and required the UK to spend about a quarter of the total cost of the EU meeting the 2020 objective for carbon reduction.  The 15% target was subsequently converted by Secretary of State Ed Miliband into achieving 30% renewables in the electric industry.  This could only be achieved with a great deal of wind, some pseudo biomass (namely new cut woodchips from the US which under many circumstances increases CO2), and token PV in our gloomy climate. While New Labour talked a lot it did not achieve much and did not achieve the targets which it set.

The Coalition gets serious about wasting money and destabilising the electric market

The Coalition continued with the same policy objectives but decided to discontinue the ROC scheme and replace it with contracts for differences which would also be used for nuclear, and would introduce a capacity auction to provide financial support for the dispatchable thermal plants that are needed to provide backup when the wind does not blow and the sun does not shine.  The Coalition called the project “Electric Market Reform”, but in reality it was “Electric Market Replacement”. 

The consequences of the policy are that we are:-

• Building the most expensive nuclear plant in the world costing £16bn (or £24bn including interest during construction) for 3200MW, throwing very generous profits at EDF

• Subsidising residential solar panels in our gloomy climate with subsidies which make nuclear look cheap

• Subsidising expensive (£95/MWh) - and for offshore, very expensive (£155/MWh) – wind which costs respectively two and three times the current wholesale price of electricity, and sending vast sums of money overseas. A blog “The UK Offshore Wind Industry”[4] analysed Renewable UK’s report “Offshore Wind Project Timelines”.  The paper analyses the subsidies payable to wind farms already operating or which will commence operation under the RO regime, and those under construction and likely completed by 2022.  “With output of 62TWH p.a. gives an annual subsidy of £6 billion…and all guaranteed for 15 years…The share of UK companies Centrica and SSE only amounts to 17%, meaning that the vast bulk of subsidy will be sent abroad…The wind industry creates very little added value, while Siemens and Vestas dominate the manufacture of turbines.”  When the “market” income from the subsidy is added to the subsidy we get to a total of £10bn p.a., which the author opines “the UK simply cannot afford.”[5]  Secretary of State Davey likes to publicise how much “investment” his policies have attracted in a similar manner to the way Prime Minister Brown boasted of the Public Finance Initiatives for hospitals which are now  causing financial distress for many hospitals.

Davey has claimed “The UK is the best place in the world for doing business in offshore wind”, and we are “leading the world.”  We are definitely leading the world in subsidies.  But we are in a one horse race – other countries are not so unwise as to follow our expensive example.  The author regards all of this as “the economics if the mad house”

• Throwing subsidies at wood chips from new cut trees in the US which often actually increase CO2 emissions and destroys the environment[6].  Journalist David Rose went to North Carolina to see the operation by Enviva cutting down mostly hardwood trees to make into more that a million tons annually of pellets that are transported 3800 miles to Drax in Yorkshire to generate £62M in subsidy in 2013.  Drax’s head of environment admits the wood fuel produces 3% more CO2 than coal and twice as much as gas[7]?  DECC falsely claimed to Rose that Drax only uses wood “unsuitable for sawmilling because of small size, disease or other defects”

• Banking on the unproven prospects of Carbon Capture and Sequestration (CCS) which is a saga that started in 2003.  Recently E.On in the Netherlands pulled out of developing perhaps the most favourable project of installing a post-combustion system of 250MW on a new coal plant it is building at Maasvlakte; after a decade Vattenfall is reported as stopping research on CCS; the costs of renovating and installing CCS to the 30 year old Boundary Dam power plant in Saskatchewan is very high, and incurs a parasitic loss of about 32% of the plant’s power and there is a thermal efficiency loss of at least 25%

One of the notable features of the wind effort is that it does not achieve what it claims on the tin by way of mitigation of CO2.  As the wind output goes up and down so the plants balancing and offsetting the wind must go down and up.  If the plants are not controllable hydro, but are (mostly) thermal as in Britain, their thermal efficiency will reduce and their output of CO2 will increase beyond their normal level.  This is shown for Ireland and the US in an article I wrote with Dutch physicist Fred Udo[8], in which we recommended that there be an independent – a genuinely independent – review of the effectiveness of windmills in reducing CO2 emissions.  I sent it to the then Minister of Energy, and got a three page reply from DECC. This demonstrated that DECC did not understand the issue and furthermore it had no wish to undertake any study, let alone an independent one[9]. DECC has no interest in evidence based policy, only policy based evidence. And notwithstanding the statements made about reducing CO2 the real target appears to be to increase renewables production to meet the EU 20/20/20 Directive - the means has become the end.

The financial effects of a significant level of subsidised renewables on thermal plant are:-

• Reduce the running hours of thermal plant

• Increase wear and tear from frequent stops and starts of the plant that balances the variability of wind[10]

• Reduce the level of the market price – the German Ministry of Energy estimated a reduction of €9/MWh in 2012.  One of the consequences of subsidising the output of windmills is to create negative prices (64 times in Germany in v2014) – the higher the subsidiy the lower the price will go – which are not beneficial to thermal plants

These changes caused financial distress to owners of thermal plant as shown by Sorgenia in Italy (5GW), which went into administration, and RWE in Germany which lost money in 2013 for the first time since the war and E.On.  In recent years the share prices of both companies have performed poorly compared with the DAX. 

              At the beginning of 2008 the German DAX stock index peaked at 7949 then, following the financial crisis of the autumn, it more than halved to 3710 at the beginning of March 2009, to recover to 9870 at the beginning of 2015.  Over the period the DAX increased by 24%.  Between the beginning of 2008 and 2015 the share price of both RWE and E.On reduced by about 70% and by about 75% relative to the DAX.

While the massive loss of value is due to several factors – highly priced gas contracts, the government’s decision to close nuclear plants, and reduction in consumption - part is due to the effect of renewables.

The Levy Control for 2020 is budgeted at £7.6bn (2011/12 prices) most of which is for electricity decarbonisation measures which DECC estimates[11] will add an average £92 (2014 prices) on household energy bills by 2020 of which about 4/5 will be on electricity.  This figure understates the total cost to households because what they do not pay for directly in their energy bills they will pay for indirectly in the higher cost of goods and services.  Domestic consumption is 36% of total consumption; allowing (perhaps generously?) for 5% going into goods and services exported, then the 27.4M electric consumers will pick up about £210 in 2011/12 prices. 

DECC’s Impact Assessment for 29% renewable electricity assessed the present value of its cost up to 2030 as £39bn offset by carbon savings valued at £6bn leaving a net cost of £33bn”[12], which does not seem a good deal.  Now with Davey’s ill-founded story that since oil and gas prices were every going up, hence renewables and nuclear would be cheap has been shown to be unfounded[13], we should surely reconsider our generation policies.

In “A Crisis in UK Energy Policy Looks Inevitable”, investment analyst Peter Atherton opined:-

“The UK looks increasingly certain to be heading for a crisis in its energy policy in our view. The crisis is likely to come to a head via either:

1) a huge spike in wholesale prices as the power market anticipates a short term shortage of physical capacity; or

2) a longer term shortage of dispatchable generation capacity that puts security of supply at serious risk, or

3) through spiralling consumer costs that will inevitably force a future government to renege on its policy commitments; or

4) sharply rising profit levels reported by developers coinciding with rising consumer bills which become politically unacceptable to the government of the day.

There is a high probability in our view that several of these catalysts could combine together to create a ‘perfect storm’ of a crisis within the next decade. If this happens then there will be three casualties in the crisis – the government of the day, the consumer, and those investors who have thus far funded the policy.”

The demise of the market and what should be done with it?

We have reached the situation where DECC determines the type and volume of new plant that will be built and much or even most of the income that renewables and nuclear plant will receive.  As auction is run where it determines the volume of other plant required, which determines the plant retired and new (generally gas) plant built.  Then at the retail level the suppliers have to a degree been turned into welfare organisations with social tariffs and energy efficiency initiatives, and the green deal.

Real commodity markets achieve several related economic objectives.  In the short term they provide a signal indicating shortage/surplus, and hence how much plants of different costs should produce.  They also provide an incentive to be efficient.  Over the longer term they provide (with judgment and luck) an indication of the need to close and to open plant and to innovate all in a decentralised manner.  Finally they remunerate capital investment.  Our arrangements do not qualify as a commodity market.

While markets can accommodate normal commercial risk, they are not good at handling political risk and the effect on the share prices show investors can be hit hard.  The story of the last nearly two decades is that politicians cannot resist interfering with the electric industry, and have undermined the generation market[14]. The government got Ofgem to refer the retailing to the Competition on Markets Authority in June 2014.  In September 2014 Miliband wanted to legislate to fix prices, and the share prices of Centrica and Scottish & Southern Electric dropped by 20% relative to the FTSE 100 over four months.

After oil and gas prices reduced, in January 2015 a Treasury spokesman was quoted that “The government is conducting studies of the industry”, and Labour wrote to Chancellor Osborne claiming that the government consistently refused to act on evidence that consumers were being ripped off.  Labour had an Opposition Day Motion on 14 January proposing that Ofgem be given the power to cut prices.  Step by step regulation by the back door has been ratcheted up both of generation and supply.

In “The road to re-regulation”[15] Professor Dieter Helm arrives at the same conclusion about the move to regulation and points out that an increase in regulation undermines competition.  He observes “Contrary to the mantras trotted out on all sides about it being a competitive market, most is not.”  Helm argues for a fundamental review to address “whether to build a proper working electricity and energy market, or to re-regulate and go back to state planning and state price‐fixing. Either is probably preferable to the current position.” He points out the case for full nationalisation is that “without competition there is not much point in paying a private sector cost of capital, when the state can borrow at much less. Why pay EDF and the Chinese nuclear companies around 10% real rate of return for 35 years, when the Treasury can borrow at around 2%?”

I suggest we forget a market and accept that the government will determine the generation mix.  If we wish to keep the industry in private ownership we could set up a  central buying authority that would plan the system, select plants by auction, and ensure that they receive a regulated rate of return as they do in some US states (such as those in most of the south) where there is no wholesale market.  The capital investment is remunerated with an allowed rate of return plus an opex cost for maintenance, and the payment for fuel is passed through. There could be a short-term energy ersatz price market at the margin to provide a scarcity signal for customers to respond to, and to provide a bonus to generators which out-perform at times of shortage.  All of the costs for all of the plants would be “blended” to create a time-of-use Bulk Supply Tariff priced roughly on a marginal basis as the CEGB did.  So we will have come full circle and the politicians can mess around without requiring expensive restructuring arrangements.

21 January 2015

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