UK energy crisis - time to split the power market?

Last week I tweeted out a link to some terrifying analysis by Carbon Brief, challenging UK politicians to read a thread by Dr Simon Evans on the aggregate scale of the bills UK households will face, showing that our household energy and fuel costs are set to be larger than the education and defence budgets combined, and nearly as big as the health budget. That spurred a discussion which led me to endorse the idea of splitting the UK electricity market into a Clean Power Market and a Fossil Power Market. if you want to know why, read on...

[If you have read this piece already, scroll straight to the end and you'll find an additional section based on feedback during the first day since publication]

Some context

A bit of context for non-UK readers - the UK has an energy price cap system in place for domestic consumers which does not prevent the passing-on of wholesale price increases in gas and electricity to consumers, but does slow it down. As a result, the average UK utility bill has already increased from around ￡1500 per year to ￡2000, but is about to go up to ￡5000. Needless to say, most households do not have ￡5000 lying about, and the result will be hardship, recession and, for many, a straight-up inability to pay.

So last week I challenged UK politicians, who so far have been tinkering around the edges of the looming catastrophe, to engage with the Carbon Brief analysis:

Of course no politicians engaged, they are much too absorbed in the current Westminster soap opera. But what could they say? It is clearly much too late to make any physical changes to the UK energy system before this winter. There are already millions more households in energy poverty, and millions more will inevitably join them. A big part of the response by government is going to have to be some form of financial transfers - indeed that has already begun. The government has announced a one-off ￡400 for all, and up to ￡1200 for the less well-off, along with ￡6.6 billion of home efficiency upgrades. But this won't be big enough or fast enough, and more direct payments/rebates will without doubt be required.

But there must be more to fixing the crisis, other than just doling out the cash.

Labour, Greens and the other economic illiterates

The energy debate has certainly moved towards center stage. Last week Labour leader Sir Keir Starmer announced that he proposed to freeze the energy price cap, and pay for it by upping the existing windfall tax on UK energy companies. It would be hard to think of a more thoroughly stupid idea: a ￡60 billion annual subsidy for energy consumption, funded by taxation, flowing directly to energy companies, and entirely insulating consumers from the energy price signal that would otherwise drive them to improve efficiency.

The UK Green Party has, as usual, called for the nationalisation of energy companies. Apart from the fact that nationalised energy companies generally have an appalling environmental record - something Greens are meant to to care about - it is an obvious economic non-starter. For a start, they come across as utterly clueless about the different parts of the energy supply chain: fossil fuel producers (coining it, but with a minority of operations in the UK), renewable energy generators (coining it unless they are selling via a CfD); fossil fuel generators (buying fuel at an exorbitant price and selling power at a tiny margin); and retailers (buying both wholesale power and gas at exorbitant price and selling it at a tiny margin); hedge funds (making vast amounts of money or going bankrupt, depending on whether they make the right market calls). Secondly, they clearly don't understand that nationalising profitable businesses would cost a ghastly number of ￡ billions in compensation. And finally, it would not even solve the underlying problem of exorbitant prices on the international gas markets, which would still be passed on to UK consumers via energy markets and interconnections.

Others have called for the government to nationalise just North Sea gas and sell it to households on the cheap. Again, it would cost as much in compensation as direct subsidy of households or nationalisation, with the added costs of undermining the UK as a destination for Foreign Direct Investment, eliminating any chance of future investment in domestic gas supply, and doing nothing to reduce electricity prices (since power generators would still have to buy overseas supplies to meet demand at the margin, which is what sets power prices).

Angry old white men

Then there are those who see the current crisis as a fabulous opportunity to further their long-held agenda of discrediting renewable energy, heat pumps, EVs, and the UK's 2050 net zero commitment - and promoting fracking and nuclear power. (For the record, I am in favour of both UK fracking and nuclear power, but neither of them can be deployed remotely fast enough to help with the coming winter's utility bill bomb).

For this group, gravitating around the Angry Old White Men (AOWMs) of Net Zero Watch (the former Global Warming Policy Foundation, whose policy on global warming was successively to claim that it wasn't real, wasn't anthropogenic, wasn't harmful, wasn't possible to stop, and any attempt to deal with it would bring down the economy), the current energy price spike is to be blamed squarely on the UK's push for renewable energy. For them, wind is a "mediaeval technology", despite the fact that modern wind turbines are designed for a 60-65% capacity factor and are 1500 times more powerful than the ancient wooden windmills they only vaguely resemble - as I have been having fun on Twitter pointing out:

I have also been having fun this week reminding Sir Dieter Helm of 2012, when he was busily promoting natural gas and fracking as the answer to all the UK's energy problems, citing concern about the cost of wind power. My letter to the FT about his error has turned out to be eerily prescient: "Sir, Dieter Helm is right to focus on the issue of the risk that energy price rises pose to the UK’s future competitiveness. But, to use a phrase attributed to Winston Churchill, it looks as if he’s “killing the wrong pig” [...] Surely anyone really worried about the UK’s future competitiveness would be comfortable paying a modest increase in energy costs... to shield a significant part of the country’s energy supply from the scenario of higher European gas prices."

In any case, it takes an extraordinary brass neck to blame a crisis caused by a 10x increase in natural gas prices on renewable energy. The UK's rapid growth in wind and solar is practically the only thing that has actually reduced the country's dependence on natural gas in the past decade - given that the UK has not really had an energy efficiency policy to speak of since David Cameron instructed his colleagues to "get rid of all the green crap" - a decision which was costing UK households ￡2.5 billion per year even before 24 February.

It is important to point out that this is not to say the solution to this winter's energy cost crisis lies with wind or solar power. Of course they will be at the heart of any resilient, low-cost, clean energy system of the future (together with a whole bunch of complementary technologies, none of which is particularly costly but which are less mature) - as I have been saying for decades - but their build rate cannot possibly be accelerated to make any difference at all this winter. It is as foolish to claim wind and solar are the solutions to the current crisis as it is to claim they are the cause.

It's about the energy efficiency, stupid

In the energy culture wars, electricity gets all the attention. It's hard to miss a wind turbine when you drive past it, and around the world nuclear power stations are bound up in countries' self-image as powerful, technologically advanced nations (except in Germany and Austria, where they are seen by many as a source of shame). And most people have no concept of what proportion of energy we consume as electricity (about 20%) vs heating, transport, industry and all other uses(80%).

The biggest utility bill for most households in the UK is, however, usually usually the gas bill, not electricity bill. The UK is uniquely dependent on gas for heating - a legacy of having all that North Sea supply. This is in stark contrast to the French, who went all-in on the nuclear self-image to the point where it electrified much of its heating - which is going to be a huge problem this winter given that half of its nukes are down, but more of that later.

The only thing that can possibly reduce people's heating bills in time for this winter is energy efficiency. For those on the right of the Conservative Party, energy efficiency is Kryptonite. A series of failed policies - Green Deal, Zero Carbon Homes Plan, Green Homes Grant, Renewable Heat Incentive, Energy Company Obligation - has left them insulation gun-shy. Worse, energy efficiency is regarded as morally suspect, conflated with sacrifice, rationing and therefore socialism. It means turning down thermostats and being cold at home, leaving the car at home and having to walk everywhere. There is no sense in these quarters that through innovation, investment and digital intelligence, energy efficiency can be a a win-win-win for the economy, for comfort and for the environment.

And it's true: while we can certainly reduce our gas use by turning the thermostats right down, get much below 19C and you soon have a noticeably chilly and unpleasant living room or office. The trick is to look for real energy efficiency - things that reduce energy demand without compromising comfort - and they really are not hard to find, particularly if you make the modest of investments. It's amazing how much can be achieved by reducing drafts, maintaining HVAC systems, not heating offices when people are working from home, not heating annexes and basements, inflating tires to the correct pressure, and so on.

In the UK, since 2006 it has been illegal to fit non-condensing boilers. However, the vast majority of UK boilers are run at such high flow temperatures that they don't actually condense. A bit of science: boiler exhaust contains water vapour. If you cool it below the dew point (55C), this vapour condenses, releasing the latent heat of evaporation which is captured within the boiler and used to heat your home. Very clever. But, to work, the water temperature leaving the boiler has to be set at or below 60C, preferably as low as 45C - and then you might have to leave your radiators fully on all day, but so what? You'll be saving a tonne of gas, emissions and money.

But boiler installers in the UK almost without exception set water temperatures at 75-80C. Why? Because they want to install a boiler in four hours, not get complaints that the radiators are not hot, and not have to return to tweak settings. The home owner doesn't know that the boiler should be working at a lower temperature, doesn't understand how thermostats, timers and boiler temperatures interact, and just wants hot radiators and nice warm rooms. The gas utility is happy because it sells more gas to the hapless home-owner. The boiler manufacturer is happy because the boiler, cycling on and off all the time, breaks as soon as the warranty has expired, triggering a new sale. And the whole boiler and gas industry is delighted because heat pumps can't work (at least not efficiently) at 75C, so a nation of heating systems running hot is primed to be told a lot of nonsense about how hydrogen boilers are the answer. Don't believe it? It's true, as a quick browse of boiler manufacturers and installers website will show:

Frankly it is scandalous - and should be the first port of call for a government wanting to save gas, emissions and pounds this winter. If you are reading this and wondering how to set up your own boiler correctly, the Heating Hub has written a great piece and NESTA have developed an interactive tool to walk you through the process. Do it today.

Some quick wins

First, we should of course accelerate the move of green charges from electricity to gas bills. Given that the UK's power is now 60% zero-carbon, and the thing we need to reduce is the use of gas, it makes no sense whatsoever to put the costs of the transition - such as they are - on electricity rather than gas. It won't do much to reduce electricity bills, since green charges amount to less than 10% of a pre-price-spike bill, but as the Tesco ad says, every little helps. It is being discussed, it is being fiercely resisted by the oil and gas sector and their AOWM fellow-travelers, but it has to happen - and it should be done right now, before this winter.

And yes, offshore wind farms that were developed on the back of CfDs but that have used a loophole to make more money selling their power on the open markets while these are higher than the strike price should be "encouraged" to trigger their CfDs and stop reaping excess profits. I am not usually in favour of forcing people to do things that are legal against their financial interests - but perhaps they could be excluded from future licensing rounds if they don't play ball. In any case, the problem needs resolving.

A (very brief) primer on UK power markets

Beyond these quick wins, before we talk about ways of pushing down electricity bills, we need to dive a short way into how the UK power market works. I'll try to keep it simple because, well, it could get very boring. If this next bit is too simplistic for you experts, feel free to write a detailed explanation and I'll happily link to it.

Most of the electricity in the UK is traded. What this means is that suppliers offer power into a the market and buyers bid for it, specifying how much they want to buy and at what price. The entire market clears at the highest price required to fulfill all the bids - in other words if someone has to run a very expensive diesel generator to meet the last bit of demand for which someone is prepared to pay, that is the price that all generators receive. If you can generate power much cheaper, congratulations, you just made lots of money. It's a bit more complicated than this, with the spot market clearing every half hour, while some other contracts deal with the day ahead, three days ahead, making sure that there is enough backup and so on, but you get the picture.

Over the course of 2021, as the world bounced back from Covid, gas prices began to climb. Then, early this year, two things happened. The first was the Russian invasion of Ukraine, about which we all know. The second was the collapse of French nuclear reactor output, with around half of their fleet offline either for planned maintenance or because of corrosion and cracking, or operating at reduced power because they risked boiling French rivers during the heatwave. Normally France generates a few GW excess power to sell at low prices to its neighbours, including the UK; this year is is sucking in power from other countries to meet its nuclear shortfall - forcing French power prices up to the highest levels in Europe and driving EDF to bankruptcy and re-nationalisation.

At times the UK has been sending 3GW to France, the maximum capacity of our interconnectors, keeping French air-conditioners on during the summer's fearsome heat waves. The problem this has caused in the UK is that it has pushed gas into the role of marginal source of supply for many more hours of the day than normal. So it's not just that UK power consumers are using gas which costs 10x more than it did two years ago, but that they are also using more of it. If you want to blame someone for your high electricity bill, it's not just Russia, it's also France (remember this next time a French Minister threatens to cut off power to the Channel Islands).

Back to the power markets. The energy price bomb has revealed a massive weakness in their design. As we all know, wind and solar are now cheaper than any other source of power, certainly cheaper than power from gas this year. Around 10GW of wind and solar are now sold under Contracts for Difference (CfDs), which pay the generator the same amount irrespective of wholesale price and will shortly start returning hundreds of millions of pounds to the treasury. But 32GW of renewable capacity is remunerated by a combination of the old Renewable Obligation Certificates (ROCs) and power prices, set by gas. So we have the unseemly situation where the cost-efficiency of renewables is not being passed on to wholesale prices or consumers.

The solution - split the power markets

One obvious suggestion is to mandate a move of all renewables, including historic capacity onto a CfD. But it's a non-starter: you would be retroactively depriving the owners of revenue from the ROCs; they would sue, and you would lose at vast cost. There is also a problem with the 12 GW of power sold under Power Purchase Agreements (PPAs) - long-term private contracts between individual buyers and sellers - one or both sides of those contracts too would sue for expropriation of value.

There is a potentially much more elegant solution - split the power market in two. Let gas set the price only for that part of the market which is fulfilled by fossil fuels - gas, the remaining bit of coal, and oil. Trade all clean energy on the other market: renewables, nuclear and power storage, even fossil power generated with Carbon Capture and Storage (CCS) - if there ever is any.

To make this work, you would also need to place a price cap on the clean market. Think about it: clean power may now be cheaper to produce than fossil-fueled power and indeed most of it has no fuel cost at all, so you might think it would clear at a lower price, but it won't. If it did, since it provides essentially the same commodity, buyers would never buy fossil-based power, they would bid up the price for non-fossil until they were equal, and you have gained nothing. You need to put in place a price cap that is high enough for mature clean energy technologies to operate profitably, including the most expensive (most likely stored offshore wind), but no higher. When the market is tight, buyers will bid up the prices to the clean cap, but then have to turn to the fossil market, where prices will be set by gas-based power, which will be uncapped and likely to go much higher, as they do now. What this will do is ensure that the bulk of UK electricity trades at a price set by low-cost renewables, and not by high-cost gas.

Creating a liquid, transparent long-term clean futures market

While we are reforming the power markets, there is one more thing we should do: mandate that all PPAs be disclosed and tradeable . In other words, a power buyer, having secured a long-term contract on clean power, should be able to sell that contract on an open market. Similarly a supplier, having agreed to sell clean power at a certain price for a certain period, should be able to pay anyone else pre-qualified to fulfil that contract. What that does at a stroke is to create a liquid and transparent long-term futures market for clean energy.

There is a school of thought that assumes the government role in providing CfDs must constitute a form of subsidy, because the private sector hasn't provided the service. Now that CfD strike prices are below the wholesale prices and they are returning money to the treasury, it's obvious they are not subsidies at all. What they are, in fact, is a state-mediated swap contract: project developers are swapping volatile but perhaps higher short term revenues into lower but guaranteed long-term revenues.

The goal of making all PPAs disclosed and tradeable is to provide developers with a better way of securing long-term revenue for their projects than either selling to a state monopoly (CfDs) or to an illiquid market of just a few private, and secretive, buyers (PPAs). We will know when the Tradeable PPA market is really working when the government can exit the energy swaps market and withdraw CfDs. (Of course, the creditworthiness of the government is also of value in a CfD, but financial markets should be able to compete away that advantage too - they do not require the taxpayer to underwrite the debt swaps market).

So, let's recap

OK, enough technicality. Where does all this leave us? We've created a Clean Power Market (CPM) and a Fossil Power Market (FPM). The CPM is capped at a level that allows different forms of clean energy to compete, and we've engineered a transparent and liquid long-term futures market, the Tradeable PPA, to the point where the state is no longer the sole provider of term swaps for clean energy. The CPM, pegged to the real cost of producing clean electricity, covers 60% of current UK power demand, and does so at a considerable discount to the current price of gas-power, providing significant immediate relief to UK utility bills - commercial as well as domestic.

The FPM, is used to make up the difference between demand and the volume of power available via the CPM, and it clears at the price of the most expensive fossil-based power, generally gas. It is very expensive, providing two good incentives for users to dip into it as little as possible: it's not clean and it's not cheap.

The FPM is the power market equivalent of a bad bank - it serves a useful purpose as you run it down over time. As more clean energy and storage technologies are built, the CPM carries a higher and higher proportion of power trading. The FPM, needed to keep the lights on, carries a smaller and smaller proportion of power contracts, at a higher price, but without that price spilling over and driving up utility bills.

Clever, no? Well maybe. I am not a power trader. There will be a million details I have missed - in the way the market functions, in the legal nature of power contracts, in CfD and ROC regulations, in how the market deals with non-delivery, and so on.

I feel pretty sure, however, that splitting the power market into CPM and FPM and driving liquidity into long-term clean contracts, holds the key not just to controlling electricity bills this winter, but to attracting capital to finance the continuing clean electricity transition in the long term.

Disagree? Want to build on this idea? Let's be having you!

And, before I sign off, many thanks to @sicabc77 and my great friend Andrew Bissell (he of Sunamp fame) for the provocation and ideas behind this piece. And of course to Dr Simon Evans of Carbon Brief, for the scary analysis which kicked this all off. If my piece is bollox, blame me, if it's fabulous, please give them the credit.

Some quick updates after a day of responses:

No, the Greek proposal to split their power market is not the same as mine AT ALL. I must confess, hadn't read the Greek/EU proposal before writing my piece - been a bit busy and was only writing for the UK situation. Their proposal revolves around forcing all clean energy to bid for CfDs which, as we approach 100% clean power, will have the effect of entrenching a single government monopoly electricity buyer. Yuk! As I said in my piece, CfDs are really a combination of a term swap (short term volatility for long term lower returns) and a government guarantee. The goal should be to get the government out of the business of providing energy market products like term swaps and credit guarantees, and back in the business of designing markets that deliver social goods and economic efficiency.

No, if the CPM clears at lower prices than the FPM that does not mean that all capital will flow to new fossil generators. Fossil generators have fuel and carbon costs, so a higher price does not imply higher profitability, not by a long chalk.

Yes, while gas prices remain this high, oil and coal will make out like bandits on the FPM. But wait, they are doing exactly that right now, the split will not affect their economics at all. If you want to drive oil and coal out, there are other measures to do that, like limiting their ability to bid into even FPM or ancillary markets, negotiated accelerated retirements and so on. For the record, I don't think a bunch of fossil generators earning a few last billions en route to oblivion is the biggest problem the world faces. Your mileage may differ on this.

No, if the FPM clears at a lower price than the CPM (this current price spike will not last forever) this does not mean that it will suck up all the buyers in the market - it will only be able to meet a proportion of demand, shrinking over time, as more clean generating capacity and storage is built out. That build-out will continue to be be incentivized by CfDs, carbon pricing, hydrogen mandates, etc until the CPM is able to support it on its own.

Yes, I wish I had read Guy Newey's defence of wholesale power markets. I agree with it all, the only thing he's missing is The Split. The more I think about it, the more I think it's inevitable that the power markets will split into CPM and FPM. The end game is would be a bunch of fossil generators and the FPM dwindling to the point where they are only called on in emergency - a kind of ring-fenced strategic reserve for periods of exceptional energy stress, along with a mechanism to allocate demand, which can just sit there forever providing national security without messing up pricing during normal times. I guess I'll have to see if I can persuade Guy.

Yes, I like the idea of taking the costs of the old and expensive renewable contracts off people's power bills - as suggested by Sir Dieter Helm - even if they can't politically be loaded onto gas bills.

No, I have no time for Dieter Helm's idea that every generator should have to sell firm power. Demand for firming is an emergent property of a power system; to keep costs as low as possible you want as little of it as possible, not require that every generator has to procure their own plan B. Let me give an extreme example: every so often nuclear power stations shut down unexpectedly; should each one have to build an extra power station as back-up? Obviously not. Gas generators? Obviously not. Coal? Obviously not. So why should only renewables be targeted with a measure that makes them uncompetitive? What you want to do instead is make RETAILERS responsible for procuring power to meet demand from their customers. Only they know their customers - the exact shape of demand, how much of it can be shifted, how customers value it, etc. Just as Marks and Spencer has to procure products if it wants to run a promotion, power retailers have to take responsibility for procuring what they sell. The role of the regulator should be to stress test the retailers to ensure that any risk they are taking in the mismatch between what they are procuring can be covered by their balance sheet or insurance. If you buy short and sell long - like Bulb - that should have been nipped in the bud. Then, if a supplier falls over and can't supply, that's up to the National Grid to procure back-up (as it already does) and pass on the costs to the supplier in question, which again will have been stress tested to ensure they are insured or can cough up. I wrote this all up five years ago, sheesh, was no one listening or was I just too early?