The Government is taking action on high energy costs based on yet more interventions into a market that has already suffered from too many bad policy interventions. However, it has also signalled that it wishes to look at changes in the market, especially the retail end, including the cessation of the price cap first set by Ofgem in January 2019[1]. For that to happen the market has to work, but most political lobbying is for greater state intervention (Labour on the left and Reform on the right both want this) rather than effective markets. This is despite the fact the primary cause of the problems has been centrally planned policy decisions. It would make sense to think about a future market design now, especially for the electricity sector, rather than just reacting to the crisis – ideally a market that puts customers and demand at its heart rather than centrally planned decisions based primarily on sources of energy and generation.

The role of firm contracts between electricity retailers[2] and generators for renewables could form a critical part of the future market. The concept was raised by Helm in his Cost of Energy Review of October 2017 under the term Equivalent Firm Power (EFP) contracts, but as part of a centrally planned set of activities with little reference to the position of end customers and the role of retailers as buyers of electricity and their necessary contribution to the wholesale market. The concept has been considered internationally, but on a piecemeal basis as in contracts for solar output in Chile.

This opinion piece sets out how the concept could be used to return the electricity market to more effective operation while bringing back the issues of reliability and security of supply and affordability through competitive behaviour in the market, to replace yet more policy and regulatory interventions based on central planning. It presents how market power can be returned to end customers and to the retail sector.

The Problem

Record high energy prices, Government interventions to reduce bills and high risks of blackouts this winter have been caused by bad policies and regulations over 20 plus years. The pursuit of renewable energy power generation without regard to the principal customer requirements of reliability and affordability of energy supplies has caused the problem. Gas is necessary for power generation in the UK when the wind does not blow, and alternatives (battery storage, hydrogen) will be neither physically nor economically feasible for some years. Yet policy makers, regulators and suppliers have not ensured physical or commercial security of gas supplies, leading to the crisis when Russian supplies to the international markets were cut. Additional and excess wind capacity serves no purpose when the wind does not blow, leading simply to high bills for customers and excess profits for wind power projects.

The Government is taking action to keep bill increases down and to secure gas supplies in the short to medium term. However, the current market is rendered inefficient by the highly complex policy and regulatory interventions aimed at maximising renewables outputs. As Helm put it in his 2017 Cost of Energy Review: “The scale of the multiple interventions in the electricity market is now so great that few if any could even list them all, and their interactions are poorly understood. Complexity itself is a major cause of rising costs, and tinkering with policies and regulation is unlikely to reduce costs”.

If energy prices are to be affordable again in future and if energy supplies are to be secure and reliable, then the Government’s short-term interventions have to be made redundant by sustainable changes to the market, especially in electricity. What policy and regulatory steps can help deliver a more competitive market that also recognises the need for reliability and security of supply?

Central Planning or Markets

Any market development also needs to address other policy objectives such as the netzero targets, which differ between the political parties. Policy “initiatives” over 20 years have distorted energy markets to such an extent that it is far from clear what an efficient market would look like and what messages it would give. Central planning has led to inefficient investment decisions for the third time in 60 years (excessive coal fired plant in the 60s, inefficient nuclear in the 60s and 70s, excess renewables and inadequate dispatchable plant on the 2000s).

Examples of the problems caused by central planning, bad policies and poor regulation include:

• Retailers allowed to operate without contract cover over times of volatile and high prices. The “renewables only” retailers boast of only having renewables contracts (see Bulb), thereby exposing themselves to high prices when the wind does not blow. This is the opposite of any prudent retailer in any business as retailers on low margins can never cover substantial risks. In the original market design suppliers (retailers) always sought to be 100% covered at peak times when marginal prices could rocket. This was a part of the original privatisation and de-regulation. The price comparison website Power Compare puts it succinctly: “The problem with some energy suppliers are that they do not buy energy in advance”[3]. Why has the regulator allowed this bad practice which inevitably led to bankruptcies such as that of Bulb?


• The policy approach to the increased risk to reliability has been the capacity market mechanisms. These have manifestly failed as the blackout risk has increased[4]. They also aimed at spreading the cost of maintaining reliability over the whole market, allowing any market participants who cause the reliability problem through their contracting behaviour to escape the cost. The capacity mechanism gives no incentive for the generators to secure energy supplies, thereby again increasing the reliance on short term prices and their volatility.


• Curtailment fees paid to wind energy producers are a symptom of excessive investment in wind power capacity, the costs to be carried by end customers in order to protect shareholders.

Market Design

The basis for a new and better market in electricity exists: renewables are now fully competitive and do not need further subsidies or preferential treatment in the market. The plethora of policy and regulatory interventions of the last 20 years can and should be eliminated except where they are embedded in contracts – although the stranded costs in such contracts need to be addressed. This has implications for the balancing mechanism and dispatch rules. A new market design should aim to return the day ahead market and balancing mechanism to their original intent of matching short term discrepancies between supply and demand not covered by contracts. The contracts should be the predominant instruments in the wholesale market given the value that customers ascribe to reliability.

Principles of Electricity Market Design

The wholesale electricity market should be designed to be where retailers and generators meet to match supply and demand. It should not be a generator dominated market, but centrally planned interventions have focussed only on the generation side of the market, primarily to incentivise investment in renewables, with a price cap as an inefficient way of handling policy failures. Retailers should require affordable and reliable supplies of electricity for their customers, unless their customers specifically want unreliable supplies only from renewables and are happy to accept disconnection when the wind does not blow, as Octopus is reported to be considering for customers with smart meters.

The principal wholesale market should be the contract market, not the balancing mechanism or contracts imposed by government policies. Contracts between retailers and generators (or traders) should be based on the customers’ needs and therefore on what retailers require to be competitive, but of course must take account of what generators can make available.

The original market design of baseload, mid-merit and peaking supplies is outdated. The concept of baseload is threatened by excess capacity of intermittent renewables, but it is guaranteed by the policy of maintaining and expanding nuclear generation. If renewable geothermal generation was ever viable in the UK, then that too would need to be baseload. For now, however, the baseload market is best defined by the level of nuclear output, and this would logically be a mandated contract for retailers.

Pure peaking or emergency capacity will continue to have a minor role when demand spikes beyond what can be managed, or when generation failures occur. Demand side measures are already in place in the market as a competitor for peaking plant.

This leaves the large gap in the middle. Low cost, zero marginal cost renewables are desirable for retailers to meet customer demand, but they should not be viewed in isolation as they do not provide reliable electricity as required by almost all customers. The nature of this central sector of the market can be illustrated from the Government’s Energy Trends publication for Quarter 2 of 2022[5], published in September 2022. 80% of the electricity produced in the quarter in the UK came from renewables (39%) and fossil fuel sources (41%). Gas dominated the fossil fuel sources with 97% share.

Intermittent wind and solar output contributed 27% to production, with the other main renewable source being bioenergy at 10%- the wood pellet fired plant at Drax[6]. Therefore two thirds of the production in this middle market segment was dispatchable, and this would suggest prima facie that there is still scope for more intermittent renewables, and this is the assumption behind government policy in the British Energy Security Strategy of April 2022. However, this is a centrally planned view, and is not tested by any market behaviour. How would electricity retailers contract for reliable production? How would they balance the intermittency (available only 20-30% of the time and not necessarily when required) and capital costs of wind and solar with the costs of dispatchable plant with higher marginal costs? A market would allow a range of participants with differing views to progress to an optimal solution. In a market each participant stands to win or lose depending on their strategy and costs, while no central planners are likely to lose their business or jobs.

Intermittent renewables need to be twinned with dispatchable generation for contracts with retailers to be meaningful, for optimal decisions on the mix of intermittent renewables and dispatchable plant to be attained and for there to be a market in reliability to replace the failed capacity market mechanisms.

A regulatory obligation on retailers to contract firm for electricity, and for renewables generators to offer firm contracts in conjunction with dispatchable plant (typically gas-fired, Drax biomass fired. pumped storage hydro or other storage when it becomes viable at grid level, or small modular reactors if they prove to be dispatchable) would enable reliability, competitive supply and, indirectly, security of upstream supply. This would in turn reduce the reliance on volatile markets and short term prices of energy in the day ahead market while the balancing mechanism would return to its proper more marginal role. The end customers would face reduced risks as the current risks placed on them would be handled upstream.

By moving to this approach over a reasonable period the government could unwind its current interventions in the energy markets and dismantle quickly all the policy and regulatory interventions that have bedevilled effective market operations.

Dispatch

Dispatch would follow the contracts with contracted wind and solar with zero marginal costs having priority. Uncontracted renewables would have to compete in the day ahead market as participants seek to optimise their positions each half hour and respond to unexpected fluctuations in supply or demand. This would give the opportunity to phase out curtailment fees to wind power generators which are imposed through the market on all end customers.

The excess wind capacity that is currently curtailed would be available for electricity storage opportunities that can compete for the dispatchable business in the same way that pumped storage hydro does. The market can therefore be used to test the viability of these storage options.

Sustainability and Climate Change

Many of the policy interventions of the last 20 years have had the objective of reducing CO₂ emissions through incentives for renewables. The latest Government consultations such as the Review of Electricity Market Arrangements (July 2022) and the Review of Net Zero (September 2022) encourage the identification of yet more interventions that will increase the market distortions and complexity and further increase costs, as pointed out by Helm back in 2017 and quoted above.

The simplest solution would be to sweep away the complexity and replace it with a simple carbon tax on electricity production. Setting this would be more political than technocratic, as it impacts on affordability and the competitiveness of UK industry. Given the competitiveness of renewables, how low can this be set on fossil fuel based production in order to prevent the export of business, manufacturing and jobs to other countries that rely on coal fired electricity generation? Eliminating 40% of electricity production from gas is not easy and would prove very costly.

Barriers

There will be stranded costs – there always are when the failures of centrally planned policy interventions lead to affordability problems for end customers. Government policy will need to consider who pays these: customers, taxpayers or shareholders, as is already evident in the ideas on controlling the effects of one-sided contracts for differences through a renewable energy price cap[7].

Vested interests will resist the changes. Every policy intervention has created an interest group that benefits from the intervention and will feel threatened. However, market distortions harm end customers, and their interests should predominate.

The above proposals are neutral as to energy sources apart from nuclear, but they favour renewables as a low cost and zero marginal cost form of supply – as long as they can be linked with dispatchable plant with secure energy supplies. The design does not lead to an increase in fossil fuelled fired generation, but places that generation in a competitive market where the most efficient plant is contracted, and it faces competition from other sources such as storage. The market would provide information on the costs of moving to netzero, instead of government policy makers relying on models with questionable assumptions re future costs, customer behaviour or scalability of technology.

 

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[1] Note that Chancellor Hunt’s announcement on 17 October limiting the time of the Energy Price Guarantee may see the energy price cap reinstated in April 2023.

[2] The terms retailer and supplier are often used interchangeably. Retailer is used in this document as the direct interface with customers in the supply chain. Other parts of the supply chain can also be seen as suppliers.

[3] The UK Energy Industry Explained – Wholesale Energy Prices (powercompare.co.uk)

[4] Reported as early as 19 August: National Grid Plans for Winter Blackout Scenario – Powerstar

[5] This is illustrative only as the ratios vary in real time, and are summated in half hourly segments and then in longer periods. Market participants looking forward have to make judgments on a range of variables such as wind resource and fossil fuel prices. No forecast or model can be “right”.

[6] Note that the Drax biomass plant is considered renewable and receives “green” subsidies. This status is controversial given concerns re CO₂ emissions and reports of deforestation. See Drax: UK power station owner cuts down primary forests in Canada – BBC News

[7] UK looks to cap renewable electricity generator revenues | Financial Times (ft.com)