Sparking reform to the UK’s energy sector

Answer

Amid the current energy crisis across Europe, the new prime minister, Liz Truss recently announced a number of potentially short-term, supply-side targeted measures to help alleviate the recent, dramatic increase consumers are facing with their energy bills.

The government is also considering a number of longer-term structural changes to Great Britain’s (GB) energy markets and the regulations underpinning them to ensure that the UK can achieve its net-zero target by 2050, while navigating the increasingly choppy waters of the energy trilemma.

These changes are relevant to all businesses operating and investing in the UK and this article explores the recent announcements and three potential interventions that may have a wider impact on GB’s energy markets and energy regulation.

Energy price cap freeze

On 8 September 2022, Prime Minister Liz Truss announced a significant intervention for energy bills.

From 1 October 2022, the price cap, which currently means that average household energy bills should be no more than £1,971 per year (by capping the unit rate for electricity and gas on a volumetric basis), will be adjusted so that a typical household will pay no more than £2,500 per year for the next two years. This is instead of the £3,500 per year (and potentially much greater from January 2023) average bill that would have applied if the government had not intervened. 

Liz Truss announced in addition, broadly equivalent support for certain businesses and non-domestic energy users, such as public sector entities and charities for an initial period of six months, with a review date commissioned in three months’ time to consider a possible extension among other matters.

Importantly though, the government didn’t propose to fix the wholesale price of electricity or gas, meaning that the ‘market’ price of electricity and gas consumed by customers will remain much higher than usual relative to pre-2020 prices, but with suppliers of such electricity and gas only being permitted to charge most customers the lower retail unit rate set by the government, with the government then keeping suppliers whole for the difference.

Reflecting this approach and with the aim of seeking to minimise the difference payments it’s required to make to suppliers (with such payments needing to be funded through borrowing and general taxation), the government also announced:

• a number of measures to increase domestic production of oil and gas, with the aim of increasing energy security and driving down prices in the longer term;
• the creation of a £40 billion Energy Markets Financing Scheme to address the extraordinary liquidity requirements (ie, increased collateral requirements and cash calls given high energy prices) faced by energy firms operating in the UK;  and
• a number of potential interventions in GB’s electricity markets to partially decouple the link between the gas wholesale price and the electricity wholesale price and reduce demand.

We explore the background to why these interventions may be required and some of the options being considered below.  

Calculating wholesale electricity prices

Like most Western economies, the current GB electricity wholesale market is based on marginal pricing. At a high level, this means that:

• all electricity generators, from renewable generators to oil and natural gas generators are supposed to bid into the market by establishing their price in relation to their specific production costs. For non-fuelled renewable energy generators (such as offshore wind), these are usually the cheapest as they have no fuel costs and thus can generate electricity at near zero cost;
• the bidding follows on from the cheapest to the most expensive energy source, with the cheapest energy being purchased first; and
• once all electricity demand is satisfied, the price paid to all generators is that of the last producer that electricity was brought from. In other words, the last and most expensive unit of generation required by the GB electricity demand sets the wholesale price for electricity in GB.

Reflecting the above and taking into account current market dynamics including high demand and a scarcity of appropriate fuel sources, generating stations that have lower production costs (for instance renewable and nuclear energy generators) are, in some circumstances, potentially generating (and are likely to continue to generate while gas prices remain high) greater profits than the owners of such generating assets originally anticipated when they made financial investment decisions in relation to such generating stations. This has been referred to by some as being a ‘windfall’.

This is particularly the case for some types of low carbon generation, which were built and financed off the back of the Renewables Obligation and the Feed-in Tariff regimes, with the regimes being designed to provide investors with a robust financial incentive to build and operate renewable generating stations in addition to the wholesale price of electricity.

Shifting to contracts for difference

One option the government is actively pursuing to reduce the impact of marginal pricing is via the Energy Supply Taskforce entering into financial Contracts for Difference (CfDs) with the owners of certain low carbon generators (particularly owners of nuclear-generating stations and renewable generating stations accredited under the Renewables Obligation or Feed-in Tariff regimes).

Under these CfDs, generators would agree on a long-term basis (possibly up to 10 or 15 years) a wholesale electricity strike price (with the government or an entity wholly owned by the government such as the Low Carbon Contracts Company) and also agree a payment mechanism. This mechanism simply put would entail that if the wholesale electricity price on an agreed index dropped below the agreed strike price, the government would cover the difference, but if the wholesale price was greater than the strike price, the generator would pay back the difference to the government.  

One advantage CfDs would provide such generators is revenue certainty over a lengthy and continuous period. Generators would potentially secure a high (relative to historic pre-2020 wholesale prices) fixed price for their electricity for long period, but with this price being lower than the current predicted electricity wholesale price for the foreseeable future. The CfD model is also well understood within the energy sector; a form of CfD has been used in GB since 2014 to incentivise the construction of low carbon generation, with the model and risk allocation being accepted by developers, funders and banks.

Such arrangements would also potentially result in significant savings for consumers and taxpayers (by reducing the quantum of difference payments that the government needs to borrow to pay). The UK Energy Research Centre has estimated that should the CfD strike price be quite high and around 23% of renewable generates enter it such arrangements, savings could reach around £5 billion per year (equivalent to £70 per household). They also have the benefit of being able to be implemented fairly quickly and avoid the need for permanent structural changes to the GB energy market infrastructure which would likely be met by commercial resistance and take a longer period of time to implement.

One likely issue that may arise in implementing this measure though is that the government will have to persuade low carbon generators to enter into such CfDs. Under current arrangements, renewable generators have the potential opportunity to make very high returns in the short to medium term and it remains to be seen whether they’ll voluntarily swap this for revenue certainty for a potentially longer period. There are also a number of complexities that need to be worked through in relation to generators that have forward sold their electricity (such as nuclear generators) and other more detailed points, including the regulation of non-physical derivatives

What is clear, however, is that there’s a significant amount of political and societal pressure for a solution that involves low carbon generators, with a potential backlash should they not be amenable to this measure, including more severe policy interventions (such as a windfall tax or direct government intervention in wholesale electricity prices) if insufficient generators enter into CfDs voluntarily.

Subsidising the cost of gas                                                                        

Similar to the approach above, another supply side intervention that’s been promoted by various commentators as an effective measure to reduce wholesale electricity prices quickly is to set a maximum purchase price for gas for use in the power sector. The difference between the market purchase price of gas and the set maximum price would then be funded or guaranteed by the government.

This proposal would have the potential benefit of driving down the wholesale electricity price directly and quickly for all generators, as the clearing price would reduce to reflect the lower gas fuel costs. It’s also been recently implemented in various forms in several European countries. Such a solution would though require additional regulation to disincentive generators and traders from capitalising on the lower gas fuel costs and exporting electricity generated in GB to countries that GB is connected to via interconnectors (such as France, the Netherlands and Belgium) to accrue greater returns. It also has the potential to create a number of unintended consequences.    

The demand side

Another solution that has been mooted in various news sources as being considered by the government (but was not formally announced on 08 September) is:

• a public information campaign encouraging people to reduce energy use at home this winter; and
• potentially an incentive scheme layered on top of this to incentivise people to use electricity and gas at non-peak times.

This is on the basis that demand reduction will likely reduce wholesale electricity and gas prices and reduce the risk of energy rationing in the coming months.

However, given the recently flattened pricing signals for consumers and the historic reluctance from the government to focus on demand-side solutions for political and delivery reasons (including trying to prevent the UK slipping into recession), it remains to be seen how much effort the government will put into demand side solutions and how effective they’ll be.

The bigger picture

• The government has already announced a fundamental review of electricity market arrangements in GB and that it’ll conduct a review to ensure that the UK achieves net zero in a way that’s pro-business and pro-growth; and
• The ‘British Energy Security Strategy’, announced under Boris Johnson’s government, indicates the likely travel of direction. The UK will look to heavily reduce its reliance on importing foreign natural gas to meet its current energy demands, while at the same time improving its capacity to generate increased energy through domestic renewable and nuclear projects.

As a result, it’s clear that irrespective of current events there’ll be significant and long-term changes to GB’s energy markets and regulation, with nothing off the table. 

Summary

Given the government is actively considering additional measures to implement, it’s clear that further announcements will be made shortly (and potentially on an ongoing basis) to deal with the current energy crisis facing consumers and businesses in the coming weeks and months.

Any such government proposals will have to strike a careful balance between providing adequate shorter-term financial support to consumers and businesses, while maintaining investor confidence in the energy sector and the UK’s ability to pay for the interventions.

It’s also clear that the current crisis, combined with more historic factors, will result in the public and political support necessary to enact longer-term measures that will permanently change energy market dynamics in the UK.

Michael Goulding is a solicitor at Burges Salmon LLP.