Ofgem ‘discovers’ how not to meet EU carbon targets

We follow up January 2010’s special theme on energy policy with a discussion of the findings of Ofgem’s final report from ‘Project Discovery’ (03/02/10). Discovery was aimed at examining the energy security challenges facing the British energy system in the years out to 2020 and beyond.

The published report has provoked much comment in the media, significantly because the report lays out the case for increased intervention in the operation of the UK’s liberalised electricity and gas markets.

The report essentially does two things. First, it lays out a set of concerns about the current operation of energy markets in the UK. Second, it discusses a number of options for reform of the current market arrangements to address the identified concerns.

Five concerns are identified. The need to finance large amounts of investment against a difficult macroeconomic background; uncertainty about carbon prices to support low carbon investment; insufficient incentives for investment in peak capacity; political risks surrounding international gas supplies; and worries about the impact of higher prices on households and businesses.

Five reform options are presented, some of which substantially overlap. These options range from Targeted Reforms (Option A) which seek to make the current market work better (a minimum price for carbon, improved incentives for demand-side response and better short-term price signals), through to a Central Energy Buyer (Option E). This would see a single entity buying all energy and capacity required by the market, including for low carbon and renewables.

Enhanced Obligations (Option B) adds stronger obligations on suppliers and the system operator for security of supply and a centralised renewables market to Targeted Reforms. Enhanced Obligations and Renewables Tenders (Option C) adds the replacement of the Renewables Obligation with tender auctions for new renewable generation to Enhanced Obligations. Capacity Tenders (Option D) extends the previous option to include tenders auctions for all new capacity.

The report ends by suggesting that Ofgem does not think doing nothing is an option and that some change to the current arrangements is necessary, however it does not specify exactly what combination of the suggested reform options it prefers.

In commenting on Ofgem’s report it is important to say that it does a good job in laying out the options for reform. It is also the case that the report is quite careful to state the pluses and minuses of different reform options. While this is welcome it is inherently risky because any presentation of options which puts all options side by side can mistakenly give the impression that all options are equally sensible. This is far from the case.

Some ongoing reform of market arrangements in energy is the norm. The UK has a 20-year track record of evolutionary learning in its electricity and gas markets. Experience within the UK and from around the world continually reveals information on improvements to wholesale and retail market design and to the regulation of monopoly networks.

Energy markets are highly technical and therefore independent sector specific regulation is meant to ensure that decisions on market design and regulation are only taken after careful cost benefit analysis and at arm’s length from the political process. This immediately suggests that Targeted Reforms could be perfectly consistent with the practice of regulation as we have known it since privatisation.

However we should be much more sceptical about some of the other policy options. The Central Energy Buyer model would mean an end to the competitive electricity and gas model that we have in the UK. It would involve the government deciding of how much and of what type of capacity should be added to the electricity system. It would return the industry to the model which existed under the Central Electricity Generating Board (CEGB). The CEGB, as privatisation and its aftermath revealed, resulted in systematic over-investment in expensive technologies, which cost the UK as a whole, and energy consumers in particular, dearly.

The presentation of this reform package in the same table as Targeted Reforms is rather like presenting the Community Charge as one of five equally sensible options for raising local government finance. There is simply no evidence that such an option does work or would work in the UK.

Looking at Ofgem’s five concerns, the Central Energy Buyer would be likely to exacerbate the financing problems and lead to significantly higher prices than any of the other options. Happily, as the report notes, it would probably be illegal under EU Electricity and Gas Directives. These Directives were, of course, inspired by the very success of the UK’s existing electricity and gas markets.

This brings us into the policies that comprise the middle three reform options. Here there is room for a much more interesting debate. Targeted Reforms can address concerns about energy security in the absence of government decarbonisation and renewables targets. What remains difficult is the sheer ambition of these targets. 2020 is not that far away and any new arrangements will probably only be having an effect on investment decisions taken in 2012-2013 with capacity coming online after normal construction periods, which in the case of nuclear power will be at least five years. What Discovery clearly says is that if the UK is serious about its current targets, government policy has to change.

This is no more than a statement of the obvious. Two things are wrong with government policy in the UK (and across most of the EU): the lack of a proper carbon price and the lack of a sustainable support mechanism for renewables.

The requirement for a high minimum price for carbon runs through all of the reform options for the energy sector in Discovery. Indeed it is worth saying clearly: no political party in the UK is serious about climate change if it does not have the implementation of a high economy-wide carbon price at the centre of its decarbonisation policy. This would have two desirable consequences for the energy sector, first, it would allow mature technologies to compete on the basis of the cost with which they can deliver low or lower carbon generation and, second, it would encourage the efficient use of carbon by buyers of energy services. Until we implement a proper carbon pricing system, either across the EU or in the UK, carbon emission reduction per se is not the focus of ‘low carbon’ policies. Indeed, decarbonisation will remain subordinate to a rather poorly targeted industrial policy for energy.

In terms of the concerns identified by Discovery, proper carbon pricing would help with financing investment, deal indirectly with some of the international political risks and keep energy prices down.

The general inadequacy of the government’s support mechanism for renewables has two aspects: its failure to delivery capacity in the required quantities and its cost effectiveness. Both are well documented: the UK is simply not going to meet its EU target for 2020 unless a miracle happens (in terms of technology cost reduction or the unblocking of onshore planning processes) or an absurd sum of money is spent to speed up delivery.

The current subsidy level is overly generous: offering recycled revenue windfalls to existing renewable generators and arbitrary technology banding levels to support the more expensive technologies. The Renewables Obligation (RO) already carries a significant risk premium due to its clearly unsustainable nature and thus fails to offer incentives capable of delivering sufficient capacity. The RO has to be reformed if the UK is serious about cost-effective renewables delivery. Capacity tenders, as Discovery suggests, for large-scale renewables offshore would seem to be quite a sensible way forward.

That said, no feasible reform option is likely to deliver the 2020 renewable energy target (which implies up to 40 per cent of electricity from renewables). Given that this target is not about decarbonisation (or indeed energy security) but really about EU industrial policy, it is the target itself that should be called into question, especially given the apparent lack of real EU sanction attached to UK failure to meet it.

What Project Discovery rightly highlights is that it is government policies that are major sources of uncertainty for investors in the energy sector. The UK’s decarbonisation and renewables targets are simply not backed up with sufficient, credible financial incentives to ensure their delivery. This creates competition between backers of individual low-carbon technologies for special arrangements to ensure their financing, resulting in delays as investors wait to see which technologies will be favoured and by how much. Meanwhile investors in gas supply and gas generation, which will supply the residual market, are left to guess what the impact of government policy might be for them.

In the end, to paraphrase GK Chesterton, the danger in the reaction to Project Discovery is that if politicians stop believing in markets in energy they won’t believe in nothing — they will believe in anything. Politicians need to focus on correcting the government failures in the energy sector. Then they can let well-functioning energy markets do what they do best: equilibrate supply and demand at least cost.

Dr Michael Pollitt is an Assistant Director of the ESRC Electricity Policy Research Group, Judge Business School, University of Cambridge. He is also an Economic Advisor to Ofgem.