13 October 2022

The latest energy windfall tax is the latest in a spiral of misguided policies


The best way of managing an energy supply crisis is to find new sources of energy supply. If you can’t do that quickly you need energy use to fall until such a time as supply catches up. In a market-based energy system this is relatively simple, albeit politically painful. As demand exceeds supply prices rise. High prices than drive both increased investment in new supply and reduce use.

The politics however are hard and we see it in today’s cost of living crisis. If high prices mean the less well off have to choose between heating and eating, the Government must intervene. If businesses cannot pass on higher input charges to their customers, then they will need support and many will still fail. Both sides of Parliament have decided this cannot stand and supported policies that amount to one of the largest one-off peacetime interventions in our history.

The first move, after pressure from Labour, was to introduce a third North Sea windfall tax, raising the headline rate of the fossil fuels profits tax from 40 to 65% versus 19% in normal markets. Justified or not, this created an anomaly with renewables generation. Projects deployed between 2002 and 2017 under the Renewables Obligation (RO) receive the wholesale price of power plus a subsidy. That price in turn is driven by gas power prices, which have rocketed. What were already generous profit margins for green generators at 50% have more than quadrupled.

These are windfall gains. It makes no sense to argue one is dirty and justified while the other is clean and green when the two are linked by the  same commodity. First Labour and now the Government have u-turned on this exclusion and there will now be an Energy Price Bill to redress the balance.

This isn’t just about fairness between energy suppliers. It’s also about the uncertain cost of price controls, at £100-200bn a year. This is massive unfunded spending, dwarfing the unfunded £45bn of tax cuts, to which the markets have already given an early verdict, heralding higher borrowing costs. The Government then is very keen to get the underlying cost of energy down, to reduce the stability risk from the package.

One way is intervening directly in wholesale markets as the buyer of first resort for most gas. Then selling that gas to industry, the grid, and generators at a loss, such that wholesale prices are lower, no price caps are required, and unjustified windfalls do not then accrue to generators. But having already imposed a cap and a windfall tax on others, the chosen path instead is another complex intervention to suppress the RO and encourage voluntary transfer to the cheaper contracts for difference used by new sites. That is when they’re not cheating the system by delaying their uptake.

We call this ‘ratchet intervention’, and it’s the sad history of UK energy policy for the last 20 years.

In order to achieve climate targets, incentives were introduced to accelerate renewables. But these favoured cheaper renewables first, so we decided to skew the market to increase diversity of supply. But these changes caused offshoring of energy-intensive manufacturing, so we decided to exempt some industries. But these created complexity so we decided to ‘ditch the green crap’. But we didn’t actually and kept loading the grid with more supply. But without making it accountable for the high cost of connection and back-up on windless dark days, while discouraging new investment in the gas that actually does that job and when drilled here helps fund the renewables. So, we’re now trying to redress both problems while imposing windfall taxes on all of them, increasing the problem.

We’re getting initiatives, not a coherent energy strategy, while drifting towards state ownership as each incremental bad idea undermines the UK’s reputation as an attractive place to invest. We saw the first wave of that in the retail energy sector, culminating in the nationalisation of Bulb and deeper price controls. The second in Labour’s proposal for a French-style state energy corporation that will evolve from investor to owner as its sovereign wealth fund-subsidised presence undermines rivals. The third in this spiral of subsidies and taxes that make all further interventions look cheap by comparison.

Which to be clear will be no solution, it will just reduce competition, innovation, and transparency. Making us more reliant on politicians second guessing the next crisis, or more likely causing it.

So here we are again. What looks like a reasonable if regrettable energy policy in isolation, but one that moves us further down the path to an expensive, insecure energy system, run by politicians, making us all poorer for longer. Last year the then Business Secretary Kwasi Kwarteng said he would ‘put a free market approach at the heart of the post-Covid recovery’. Still waiting.

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Andy Mayer is Chief Operations Officer at the Institute of Economic Affairs.

Columns are the author's own opinion and do not necessarily reflect the views of CapX