What’s really driving the rocketing price of electricity?

Natural gas provides roughly under half of the total electricity in the UK. Yet the price of gas – which has been soaring over the last year or so and is the source of so much of our misery – is the benchmark used to set all electricity costs for 84% of the time. 

It is this rocketing price of gas in the UK – and across Europe – which is behind the extraordinary rise in all our electricity bills. Over the last year wholesale gas prices have risen by four times while retail prices – what you and I pay for our electricity at home – have gone up by over 80%, the main driver of the cost of living crisis and inflation.

Why is the energy price cap so high? And why is the price of gas setting the price of all other sources of energy such as coal, oil and renewables, particularly when the cost of non-fossil sources is now down to around a quarter of the other costs in the wholesale markets?  

Why, if renewable costs are coming down so sharply and on some days are providing half or over half of all electricity, aren’t we paying less now on average? (This is only a rough guide: according to the National Grid live data base today at 12.50 pm, gas actually provided more than half of the UK’s electricity needs at 53.4% while wind and solar sources gave us 32.4% of our energy.)

It’s a puzzle, and one that has been bugging me for days now and I suspect it’s been bugging you too. So I set out to find out why by talking to one of the country’s most brilliant regulatory and energy experts, Professor George Yarrow, emeritus fellow at Hertford College, Oxford to find out why.  

It’s a little complex but with his help, here’s a brief explanation of why this energy enigma exists and what lies behind this seeming paradox within the UK power market.  

First question, is it some perverse structure of that power market which explains why we are paying so much more not less? Yarrow says no, the structure is far from perverse: any competitive market in which a higher price is required to tease out more supply has the feature that prices will settle at or close to the cost of the marginal supplies. It’s normal, but we usually don’t notice the feature, because it is typically non-problematic.

Let’s start with the fossil-fuel prices. Oil and gas producers sell to the suppliers at the spot price ruling in the market or via longer-term contracts valued at around prevailing market levels. For contracts of any significant duration, Centrica, say, which is a major buyer of gas, will start by paying something like the current market price when it arranges its long-term contracts with wholesale producers such as Norway’s Equinox oil and gas giant and others such as Qatar. 

Importantly, these gas supply contracts typically contain indexation provisions that determine the later prices to be paid by the buyer. The index could be one or more of several candidates, for example some measure of general price inflation, or the international oil price, or international coal prices. Crucially, over the last twenty years, buyers and sellers alike have found it advantageous, each for their own different interests, to use the spot price of gas as the index. 

So if wholesale gas prices go up because of a shortage of supplies and higher prices triggered by Russia’s invasion of Ukraine, then Centrica has to pay the going spot market rate as do other European buyers with similar indexation provisions in their contracts. Traditionally, continental contracts have tended to rely much more on oil prices than in the UK. 

Whenever, therefore, additional electricity generation is required to meet demand that cannot be fulfilled by nuclear and renewables, gas-fired generation will be called upon, and the cost of the extra gas burn will have to be paid at something approximating the spot price of the day.  

There’s another wrinkle adding to the conundrum: setting the most expensive price by the gas producers also means that the renewable producers can match the prices for the most expensive producer and, therefore, achieve higher returns for their energy.  Wind farms that sell in the spot market, typically older facilities pre-dating the present procurement arrangements, make a bundle from this and the term “windfall profits” is nicely apt. 

Those wind farms which have a long-term contract for their output with the government at a fixed, inflation adjusted, “strike” price, pay revenues back to the government whenever the market price rises above the “strike” price. 

And it’s the government which receives revenues from the latter contracts when market prices are high, and the revenues are higher, the higher the market price goes. The good news, explains Yarrow, is that these revenues are recycled to electricity consumers via reductions in the levies to which electricity retailers are subject, which reduces retailers’ costs and then translates into lower retail prices via competition or the price cap.  So far, the amounts of money involved have been modest, but they are shooting up in the current period.

Thus, when the regulators, such as Ofgem, come to set the formula for retail costs and the “price cap”, they base the prices that retail suppliers can charge on a very complex formula based on the price of gas looking backwards and forwards. 

With great timing, Professor Michael Grubb of the UCL’s Institute for Sustainable Resources, has this week published two interim bits of research surrounding the electricity market with the aim of coming up with proposals for electricity market reform, power sector decarbonisation as well as measures to reduce electricity prices to facilitate the electrification of the UK economy. 

As Grubb says : “If we actually paid the average price of what our electricity now costs to produce, our bills would be substantially cheaper.”

Yet costs are so high because despite renewables providing more and more electricity, natural gas is still needed to meet extra demand. The most expensive natural gas producers are still needed to cope with fluctuations in renewable energy production, so they are setting what’s called the marginal cost, at the edge of what’s needed. 

And because natural gas generation is expensive, those producers charge the highest prices – which means that other producers are also able to charge similar prices.

Sounds mad? Well, yes it is but so long as gas is required to fulfil our needs – and wholesale prices stay high – our electricity prices will stay high.

This method of pricing is not confined to the UK. In the first of the research papers, Grubb compares electricity sources and costs across the European Union, the UK and Norway.

Once again, fossil fuel electricity generation has set the bar for electricity prices 66% of the time, despite only 37% of electricity being derived from fossil fuels. 

However this varies across Europe. In Germany, it’s a high of 91% dictated by fossil fuels in Germany (primarily coal), to a low of 7% in France, where electricity prices are primarily dictated by nuclear energy production. And the research shows in the UK, Italy and Spain, more than 80% of the time, electricity prices were following the supply bids of natural gas generators.

What’s interesting too is that the role of fossil fuels in setting electricity prices has increased from 2015 to 2019 – even though fossil fuels have produced a lower share of total electricity as coal production has declined. But Russia’s war on Ukraine, and the weaponisation of its gas exports, has caused prices to shoot up.

Now to the second question, the stickier part of the puzzle: How should the market be reformed to reflect the growing role of renewables, if at all? Or indeed, any other cheaper form of energy? Grubb is working on potential solutions now, and hopes to publish more of his proposals later this autumn and in the spring because he claims the current approach to pricing – which in the jargon is known as “short-run-marginal-cost-on-all pricing” – is inappropriate for driving investment in non-fossil fuel assets, and is obscuring the growing success of a transition to increasingly cheaper renewable energy. 

From the outside, Grubb says it is obvious what needs to be done: a solution needs to be found so that customers can benefit from lower cost renewables or other forms of energy generation, particularly as the amount provided by fossil fuels should contine to decline. 

However, Yarrow takes a different view. Work he has done in the past on an electricity wholesale market in Kazakhstan, which priced according to technology, suggests that it is only a partial solution, he says. Instead, it raised new sets of problems of its own. 

Indeed, he has little confidence that it is anywhere close to being a good option for the UK since the main cause of very high UK gas prices – and therefore electricity – is the substantial market power triggered by President Putin. “This is behaviour which, in ways explicable by a simple demand/supply diagram, led to very high, very inequitably distributed economic rents, which is what we are observing.”

Yarrow adds that the way forward is to mitigate the market power (which is happening but will likely take a year or two), recycle to consumers more of any accruing rents that the UK government can get hold of while also providing support for consumers. “The big problems are to do with income distribution – the transfer of income from households and businesses to the energy producers – and not market design. Focus on them and what needs to be done can be carried out more simply and more quickly.”

Finally, there is the question of the energy price cap which most observers now agree has to be abolished or at least reformed. When Theresa May decided to borrow Labour’s plan for an energy cap, she did so more out of exasperation over rising “rip-off prices” than smart thinking. 

Even then the Competition and Markets Authority – charged with looking at competition in the energy market – warned that such a cap brings “excessive risks of undermining the competitive process, likely resulting in worse outcomes for customers in the long run”. In fact, most economists reckon that bills would be about the same now even if we didn’t have a cap on prices.

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