8 April 2015

Britain’s energy market is back under state control


Energy policy exemplifies the contradictions of the new politics. The three main UK parties are in furious agreement about its essentials; yet Labour wants to make it a big dividing line in the election. Labour leader Ed Miliband says he wants more competition; as energy and climate secretary, the same Miliband’s 2010 Energy Act downgraded competition. To cap it all, in the election, the Labour leader is putting forward policies which would accelerate the collapse of the policy framework that he helped create and his party supports.

Paradoxes abound. The last Labour government examined but rejected a central buyer model for the electricity market as too statist. The most statist option considered by Labour in 2010 went on to become the centerpiece of the Coalition’s Electricity Market Reform (EMR). All three parties have the same aims – keep the lights on, keep electricity bills down and cut carbon dioxide emissions. All three back wind and solar power that does the opposite. Weather-dependent, intermittent renewables are inherently unreliable, extremely expensive and highly inefficient at reducing carbon dioxide emissions.  All three parties are against coal, yet coal has been a big winner: In the Coalition’s first three years, the amount of coal burned in Britain’s power stations increased by 20.6%.

These manifold contradictions – and more – were explored and ventilated at a pre-election event organised by Policy Exchange at which the current energy and climate secretary Ed Davey and his potential successor, Caroline Flint, spoke. The event’s theme was energy policy and the return of the state and began with a scathing appraisal of current policy by Britain’s leading energy economist, Oxford University’s Dieter Helm. It was ‘quite hard to make it worse than it currently is.’ It was so bad, Helm said, that surprising as it might seem, ‘the CEGB [the nationalised Central Electricity Generating Board, founded in 1957] would actually be better than what we’ve currently got.’

Make no mistake, the state has returned, but in a different guise. Whitehall now has more direct control over the electricity industry than it ever had in the days of the CEGB. Under Electricity Market Reform (EMR), the State:

  • Sets guaranteed prices for low carbon generation via Contracts for Differences (CfDs)
  • Awards CfDs which the government acknowledges is a form of state spending
  • Imposes levies on electricity suppliers to be passed on to consumers to fund the gap between the CfD strike price and the wholesale price which the government acknowledges is likely to be classified as a direct tax
  • Decides on the mix of generating capacity;
  • Makes predictions of supply and demand; and
  • Has created a capacity market designed to meet those predictions

But the mix of state control and high cost private sector finance is inherently unstable. As explained in my Centre for Policy Studies pamphlet, it results in higher bills for consumers and transfers political risk to investors. It is also reversing the efficiency gains from privatisation. Stephen Littlechild, the first electricity regulator, reckons there was a £23bn net benefit from privatisation. A large chunk of that came from avoided state capital misallocation, so consumers did not pay the extra costs of the CEGB’s planned investment in nuclear and coal-fired power stations.

Privatisation also resulted in a huge increase in labour productivity. Based on ONS sector data – which goes wider than the electricity industry – between 1994 and 2004, output per hour more than doubled. Since 2004, output per hour has fallen by 40%. By 2013, three quarters of the productivity gains recorded between 1994 and 2004 had been lost.

The toxic impact of subsidising zero-marginal cost wind and solar power is destroying the economics of gas and coal-fired power stations. If the industry were still nationalised, it would be impossible to privatise it. In Germany, which started down this path before Britain, electricity utilities are recording huge losses. Last year, e.on wrote off €4.5 billion from the value on its generating assets whilst RWE spoke of ‘the crisis in conventional electricity generation.’ According to the company, between 35% and 45% of its coal and gas-fired power plants aren’t commercially viable. ‘These power stations are costing us real money,’ RWE’s chief executive said last month.

In its investigation into electricity supply, the Competition and Markets Authority (CMA) has found a similar pattern in Britain. Looking at returns on capital over the period 2009 to 2013, the CMA found that by the end of the period, four of the Big Six electricity companies were making losses on their gas-fired power stations. Returns on coal-fired power stations had fluctuated, a combination of strong operating profits in the early years followed by significant write-downs in asset values.

The current and putative energy and climate secretaries avoided addressing this policy-induced crisis. Ed Davey described himself as a ‘liberal economist’ who disliked intervening before going on to justify every intervention he’d made and dismissing alternatives to his dirigiste approach.  There was, however, one ray of sunlight. ‘We didn’t make the mistake of the Germans by investing huge amounts in solar right at the top of the cost curve,’ Davey said. He’s right. Solar has turned out to be a disaster for Germany, costing around €23bn ($25bn) a year. ‘You could argue,’ Davey continued, ‘the Germans have given a present to humanity, as I like telling them.’ Unsurprisingly, Davey didn’t follow the logic of his own argument. There is no economic advantage to being an early adopter of renewables. The winners are those who learn from the mistakes of the first and second movers, the most important lesson being to avoid all forms of subsidy, whether overt or hidden.

By contrast with Ed Davey, his Labour shadow displayed the naïve confidence of the novice sailor with little idea of the storms lying ahead. The energy sector had lost its ‘social license,’ Caroline Flint boldly declared. Labour policy would be based on the oxymoron of a ‘managed market.’ If Labour wins the election, the regulator would be given powers to force energy companies to pass on reductions in wholesale costs. It would be a brave regulator indeed that decided against placating public anger at rising electricity bills and declined to use the new powers it had been given.

Linking retail prices to wholesale prices shows Labour’s lack of understanding of the energy market. It’s true that retail and wholesale costs have diverged. Gas, oil and coal prices have fallen sharply, yet over the last two years, retail electricity prices have risen 8.2% in real terms. As EMR bites, this divergence will widen: rising output of zero-marginal cost wind and solar power reduces wholesale prices whilst the retail price includes subsidies and price supports needed to induce private investors to stump up the capital to invest in uneconomic renewable capacity. Thus linking retail to wholesale prices would destroy the basis of current energy policy. Britain has a pressing investment requirement for gas-fired power stations. If Labour had set out deliberately to precipitate an investment strike, it could hardly have done a better job. Memo to Miliband: In a market economy, you can only expropriate assets once they’re built.

In his final pitch in last week’s leaders debate, Ed Miliband pledged to ‘take on those energy companies who are ripping you off.’ He is way off the mark. The electricity price rip-off is not the result of profiteering, but of policy. But, in the final paradox of Britain’s new politics, this is a fact that Nick Clegg and David Cameron can’t say out loud, because all three party leaders are signed up to the same policy. When it comes to energy policy, of the three, Labour is the party of creative destruction – at least, the destructive part.

Rupert Darwall is the author of The Age of Global Warming – A History (Quartet, 2013).