Mr Power, the man who really presses the buttons

Energy policy is about to take centre stage again, and a key consideration will be how best to reduce the UK’s carbon dioxide emissions. While the government will be keen to claim the credit for any moves to reduce CO2 emissions from the electricity sector, in fact the power to determine whether or not such measures are successful will lie in the hands of the industry’s economic regulator, Ofgem. The government therefore needs to ensure that Ofgem’s actions are transparent, and, vitally, that it is accountable for the impacts of its decisions on the environment.

Led by Alistair Buchanan, Ofgem regulates the gas and electricity industries. It has two main functions: setting market rules for trading, and regulating the monopoly activities of network companies. In theory, this system of independent regulation should ensure that the electricity industry operates free from the vagaries of political decision making.

No more politically driven, command and control technology choices, or knee jerk political responses to perceived threats of, for example, the lights going out. The market, as designed by the regulator, will determine the most attractive option for generating electricity. In addition, monopolies will be regulated to ensure efficiency and cost effectiveness for consumers.

It is, however, increasingly obvious that the rules Ofgem has put in place for the electricity trading market, and its regulation of the monopoly network companies, are directly or indirectly inhibiting the achievement of the government’s targets for carbon dioxide emission reductions.

Ofgem has a range of ‘duties’ conferred on it. The primary objective is to protect consumers; subsidiary duties include ensuring security of supply, and the consideration of environmental impacts and sustainable development. In addition, it must take account of Social and Environmental Guidance, issued by the secretary of state, which, amongst other things, states that ‘the government expects the Authority to seek to facilitate the achievement of the social and environmental objectives, targets and aims set out in the [2003 Energy] White Paper.’

Market rules dictate the riskiness and economics of generation, and the design of incentives for monopolies dictate how network operators view the operation and development of their networks. How the regulator chooses to balance its duties is fundamental to the final design of the rules it puts in place. Ofgem therefore has a central role in the shift to a sustainable energy system.

The implicit hierarchy of the different duties means that there must always be trade-offs, with all other objectives subordinate to the primary objective of protecting the interests of consumers. This is inevitable, but it means that the weight given to subsidiary duties is vital, as is the interpretation of the interests of present and future consumers. In practice, it seems that Ofgem has understood this to mean ensuring that prices are as low as possible in the short term, rather than considering the long-term interests of future consumers, including the state of the environment they inherit.

Ofgem and the market

Ofgem’s recently published corporate strategy shows a fervent belief in the power of the market to deliver everything from sustained low prices to security of supply. The problem is that the market cannot solve everything, especially where long-term environmental issues are concerned.

Current trading rules reward cheap, flexible, large-scale output, and the market is deciding that it makes sense for coal-fired generation to continue, despite the government’s carbon dioxide reduction targets. The level of coal-fired generation now stands at its highest level since 1996 (see figure), contributing to the recent rises we have seen in CO2 emissions. Worse still, companies view new, large-scale coal-fired generation, albeit potentially slightly less carbon intensive, as the most viable option for future power stations.

The small-scale generators, often utilising renewable energy sources, are crucial for a low carbon energy system. These generators find it difficult, if not impossible, to participate in a trading market which inevitably entails high transaction costs.

If they do participate in the market, but fail to deliver as much power as they originally predicted (or, alternatively, if they deliver too much), they must pay a penalty. This penalty is intended to reflect the costs entailed with keeping the system ‘in balance’. However, given the low levels of intermittent renewable generation on the system, it is questionable whether the levels of the penalty truly reflect the marginal impact that such under- or over-delivery really has on the security of the system.

It is not surprising, then, that the design of the market contributes to the riskiness of these new technologies and makes them an unattractive option when considering new generation.

There may be valid, short-term economic reasons for the design of the market. Electricity prices have tended to be relatively low, although the overall benefit for domestic consumers is less clear than the reductions in prices for large consumers. However, the longer-term implication is that the market and its emphasis on short-term cost considerations will keep the electricity system locked in to large-scale, mainly fossil fuelled, plants for decades to come, when what we need is more low carbon, often small-scale generation.

Ofgem and the network monopolies

Ofgem’s second major function is to regulate the monopoly activities of the network companies. On the surface, this should be an uncontentious role. However, the design of the controls that Ofgem has applied to the network operators has acted as a barrier to the deployment of small-scale, decentralised, often renewable, generation, connected to the distribution network.

The rules have changed a little since 2005, ostensibly to encourage new generation to connect to distribution networks. However, there has not been an increase in the rate of connections, nor in the interest shown by developers in putting forward new projects.

So while Ofgem has recognised the importance of its regulatory rules in encouraging greater levels of decentralised, low carbon generation, it has failed to devise these rules in a way sufficient to achieve this.

Ofgem’s unsophisticated view of the role of the market in encouraging or inhibiting technological change neglects the need for a long-term strategic shift in both generating technologies and infrastructure to reduce CO2 emissions.

Ofgem has not been without criticism for its attitude to environmental and sustainability issues. The Environment Audit Committee was particularly scathing of both its approach to market design and network regulation as long ago as 2002. A requirement for Ofgem to at least think about the implications of its decisions for sustainable development was subsequently put in place. However, the impression remains that Ofgem thinks briefly of environmental and sustainability issues, before inevitably discarding them in favour of its overwhelming preference for short-term cost issues.

The Sustainable Development Commission is currently reviewing Ofgem’s role in delivering a sustainable energy system. It seems inconceivable that its final report will do anything other than conclude that Ofgem’s sustainable development duty is little more than a fig leaf and that its performance in helping achieve a shift to a low carbon economy is woefully inadequate.

Clearly something needs to change if we are to have a lower carbon electricity system. Cost issues are of course important, but they should not drive Ofgem’s activities to the exclusion of all else. The change could come from within Ofgem — although it seems unlikely that institutionally it would be willing to shift its approach sufficiently. The alternative is that the government reasserts itself over the regulator and clarifies the priority it accords to the development of a sustainable energy system. The government could either adjust Ofgem’s duties to ensure that environmental issues are given more weight in decision making, or it could strengthen the Social and Environmental Guidance already in place to direct Ofgem to take more account of long-term environmental issues, including CO2 emissions. The latter method could be achieved without legislation.

So far, the government has failed to intervene with Ofgem’s activities, preferring instead to hide behind the mantra of independent regulation. However, given the current rise in CO2 emissions and the looming failure to achieve its 2010 CO2 reduction target, the time has come for the government to act and to show the courage of its convictions when it comes to reducing CO2 emissions.

Bridget Woodman is a UK Energy Research Centre research fellow at Warwick Business School.