We examine the reasons behind the dramatic rises in electricity prices following the unprecedented rises in fossil fuel prices, and why reductions in renewable prices have had no effect.
Fossil fuel prices have risen dramatically since 2021 and particularly since May 2022. The price of gas and oil in particular has soared. Gas is still used for a large part of electricity generation, as well as directly for heating. Because of the way the wholesale electricity market works, the price of gas normally sets the price of electricity.
See Ofgem for current information on wholesale prices
How the wholesale electricity market works (simplified)
Electricity retailers pay the wholesale price for electricity they sell on to retail customers. The electricity demand in any period needs to be balanced to generation. This balancing is done by a bidding process where generators bid to generate in a period. The Electricity System Operator (ESO) ranks the bids in merit order with the lowest price first, and then adds up the generation capacity until a marginal generator is found. The price paid to all successful bidders is the price paid by the marginal generator. Recently the marginal bidder has often been a gas generator.
For a more detailed explanation
Forecasts for the price cap
Domestic customers on standard variable tariffs are protected from excessive charging by a price cap, which is calculated periodically by Ofgem based on predictions of market prices for the upcoming period. In April 2022 the price cap rose sharply to 28p per unit for electricity, and in October 2022 it will rise to 52p. Consultancy Cornwall Insight predicts that the cap will rise a further 51% at the start of January to about 80p per unit, and a further 13% in April to about 90p per unit.
Ofgem cap methodology change
Historically Ofgem calculated the cap six monthly, based on forward prices wholesale price estimates. Recently wholesale prices have been volatile, and suppliers have had to pay more for electricity than was predicted. In order to avoid further supplier failures, Ofgem have introduced some changes:
- The cap will be recalculated at 3 monthly intervals from October onwards.
- A backwardisation calculation has been introduced which introduces compensation for the excess of actual wholesale prices for the previous period over those predicted in advance of the period.
These changes compensate suppliers for additional costs they have incurred and have the effect of increasing the cap more than would otherwise have been the case.
Energy Price Guarantee
Since this post was written the government has announced an energy price guarantee, which replaces the energy cap. This means that effectively the cap on electricity prices will be 34p.
For further about this announcement are here.
Some help for businesses has also been promised.
You might have thought that the simple measure of boosting onshore renewables would have been an obvious step to shorten the period that the government had to finance this intervention. The government hasn’t done this, instead it is lifting the ban on fracking, launching a new round of oil and gas licencing, and carrying on with nuclear projects. None of these actions will make any difference in the next few years to energy prices, but they will certainly cause increased carbon emissions.
Hedging
Most domestic electricity customers expect to buy electricity at a fixed price per unit, very few would accept a tariff which offered a different price for each half hour period (to the author’s knowledge there is only one such tariff). This means that electricity retailers need to find a means of fixing the price of the electricity they offer for the period of the contracts they offer, to do this they buy contracts to supply electricity at an agreed price at a future date. This practice is known as hedging. The failure of a many smaller suppliers to hedge adequately in 2021 lead to the large number of supplier failures last year.
The cost of renewables
Between 2009 and 2019 the price of electricity from solar generation dropped by 89%, and the price of on-shore wind dropped by 70%. A similar thing has happened with off-shore wind.
A similar thing has not happened with Nuclear.
Why did renewables come so cheap so fast? discusses the price drop in more detail.
This rapid cost reduction for renewables has resulted in electricity from gas costs roughly 4 times as much as from renewables.
Renewables have a high initial capital cost and low running costs. Initially subsidies were required to get the market established and get the benefits of scale. There is significant future price risk if renewables were to be funded based on future receipts, the cost of capital is substantially reduced if this risk is mitigated somehow.
Support methods for renewables
Early renewables were subsidised by the Renewables Obligation (RO) and Feed In Tariff (FIT), which are currently paid out of retail electricity bills. More recently renewables have been financed by Contracts for Difference (CfD), which now tend to reduce electricity prices. All domestic renewables are now privately funded. Given current prices some grid scale renewables are also being funded without subsidy.
Renewables Obligation
The RO requires electricity suppliers to buy a proportion of Renewables Obligation Certificates (ROCs) from generators registered with the RO scheme. ROCs are issued by Ofgem to registered generators. There is a monthly reconciliation to ensure that suppliers have either bought enough certificates or pay a penalty known as the buy-out price.
For further information see https://www.edie.net/edie-explains-renewables-obligation-certificates-rocs/
RO closed to new generators in 2017, but will continue to operate until 2037.
Each year BEIS calculates the amount of ROCs that need to be issued to meet proportions of renewables fixed in the 2015 Renewables Obligation Order (ROO). For 2022-3 the number of ROCs is set at 124.5 million. From this a rate of 0.491 ROCs per MWh is set for GB, this is a drop from 0.492 in 2021-2.
Projects remain in the RO scheme for 20 years, the scheme started in 2002 and closed in 2017, so we expect to see the number of generators in the scheme falling from now on, so the number of ROCs required will also drop.
ROCs are traded in the market, and are normally sold above the buy-out price set by Ofgem. Suppliers are prepared to do this because they receive a share of the buy-out money in addition to meeting their obligation.
The buy-out price is set by Ofgem each year by rules determined by the ROO and is linked to RPI. For 2022/3 it is set at £52.88/MWh
Feed In Tariff
Feed in Tariff is paid to domestic generators and smaller grid scale generators. It is paid regardless of how the electricity generated is consumed. The rate paid depends on when the scheme was joined and is inflation linked. The last FIT installations were done in 2019, though the rate was far lower than early installations in 2011.
Electricity generated under FIT must be measured by a generation meter. In December 2021 Ofgem published rules that must be applied when FIT registered plant is replaced or modified, essentially:
- If the generation capacity is increased, then the meter reading is adjusted pro-rata when calculating the amount of FIT payable.
- If storage is installed behind the generation meter, then it must not be possible for electricity to pass from the grid side of the meter to the generator side of the meter. (Otherwise it would measure electricity that hadn’t been generated by the plant).
For further information see Ofgem ruling.
Contracts for Difference
New renewables are supported by Contracts for Difference (CfD). Periodically there is a CfD auction where generators bid a strike price for the period of the contract. For each technology the auction is for an amount of generation. The result of the auction is a strike price for each technology. If the wholesale price does not meet the strike price then generator is subsidised from electricity bills. If the wholesale price exceeds the strike price, then the generator compensates electricity bills.
This subsidy is managed by a government owned company—the Low Carbon Company.
In recent CfD auctions prices have fallen, and record amounts of renewables have been contracted.
Since the end of 2021 the electricity wholesale price has mainly been above the strike price, so CfD has acted to reduce electricity bills. In a climate of higher wholesale prices this will continue.
See Low Carbon Contracts Company Historic Dashboard for payments for recent data.
Other electricity charges
As well as wholesale electricity costs, retail electricity bills also pay for network costs, social and environmental obligations, other direct costs, taxes and operator’s margin.
Environmental and Social costs aka Green Levies.
Environmental and Social costs are often referred to as ‘Green Levies’ and currently amount to about 12% of electricity bills. The breakdown of environmental and social charges is shown on the left.
RO and FIT schemes have now both ended, so the amount of generation in the scheme won’t increase and will start to fall, but payments are linked to RPI, so the costs will increase. These are both contractual agreements.
ECO and WHD assist those in fuel poverty to improve the insulation standards of their dwellings.
Figures derived from Energy bills: getting the balance right
Cost of failed suppliers
When a supplier fails another supplier is found to continue their supply. Other costs associated with the failure are shared between the remaining suppliers, who pass this on via electricity bills. This has resulted in a near doubling of standing charges for electricity this year. According to this article the cost of failed suppliers is estimated at more than £2.7bn.
Conclusions
The electricity market has grown to be very complex, this brief note doesn’t touch on many aspects of it. As with many things that have grown complex there is a temptation to think that it would be simpler to start again, if this is done it should be done with care.
BEIS has launched a consultation Review of Electricity Market Arrangements (REMA), which runs until October. This is far reaching, recognises some of the current problems, and could eventually achieve a more workable market, however, it is unlikely there would be any change from this for several years.