The UK’s Energy Price Cap – friend or foe

Amidst the events surrounding the loss of Her Majesty, it is easy to forget that Liz Truss made her first move as Prime Minister last week by implementing an energy pricing cap for UK consumers. An average UK household will pay no more than ￡2,500 a year and a ￡400 rebate will be issued in six, monthly instalments. What will this do to solve the underlying problem?

Many UK households were facing severe energy poverty, so an emergency measure is understandable and welcome. But while it mitigates the immediate problem of the end consumer facing impossibly high energy bills this winter it does not address the root causes of the problem. A price cap does not allow the market to respond efficiently either through increased supply (the cap is driven by wholesale prices and supplier losses will be reimbursed) or reduced demand. The merit order, a market clearing price mechanism, has become the villain in this scenario. While the price levels are self-evidently unwelcome for consumers, the price signal is doing its job - accurately reflecting the current supply and demand fundamentals in the UK market. Simply put the country, and indeed Europe, is short power.

Prices are high because of a mismatch between supply and demand which needs to be addressed over an investment horizon. Without a long-term view, the risk remains of ongoing shortages combined with an escalating cost to the nation’s finances in future years because of the high cost of retaining a price cap. Taking it away is likely to be much more challenging politically than its introduction.

The aggressive push to renewables, supporting electrification, as the key means of achieving the legally prescribed 2050 net zero target, has resulted in a market where investment in weather dependent generation has surged compared to carbon-free baseload nuclear and reliably dispatchable fossil fuel generation. Government figures show that renewable generation capacity increased by 6.5 per cent in Q1 2022 on the same period last year. While overall capacity has been nominally increased, reliability has been reduced.

The UK has a problem of both the market price level and the underlying market volatility. Both effects are based on this surge in wind and solar investment at the expense of taking a broader systems view. UK market design aimed to produce a marginal price signal which would signal tightness of supply and underpin investment. The effect of renewables is that this tightness is signalled on an extremely volatile and concentrated basis. The supply response has been nullified both by government and central bank policy and the negative effect of ESG considerations on fossil fuel investments. High prices are not visibly curing the underlying reasons for high prices.

To ameliorate the immediate negative political effects of these policy decisions, the UK government is taking on vast amounts of debt over the next two winters, with some analysts estimating a total cost of up to ￡150bn. This spending will reduce the pain on consumers but will have minimal effect on the wholesale price of power. The demand response will be, if not negated, then at least reduced. To put this current spending into perspective, Sizewell C., the newly approved 3.2GW Nuclear power plant, is estimated to cost ￡30bn which will account for 10% of UK power demand.

The UK’s problem is both a security and reliability of supply problem. Transmission constraints are being increasingly felt and balancing costs are rising year on year. Despite this situation the government is forecasting an increase in electricity demand by 2030 of 50%. Reducing unnecessary demand would help, but it is the supply response which is truly broken. It can only be fixed by thinking of UK power as an interconnected and interdependent system and nurturing it as a system rather than emphasising one part (zero carbon during generation) to the exclusion of the others. A weather dependent power generation stack is extremely complex, and that complexity can no longer be reliably simplified into one useful price signal as it was once understood.

The solution is easy to state but incredibly challenging politically to implement: solve for the long-term beyond the life of a parliament by creating a stable investment environment; balance diverse sources of renewables and fossil-fuels to create a robust generation mix; invest in reducing transmission constraints; find practical means of reducing the burden of high-power prices to those most affected. Any temporary price cap may or may not be temporary, but it will certainly not fix the underlying problems.