Why Should a War Thousands of Miles Away Determine British Electricity Prices ?

Britain has some of Europe’s highest electricity prices. That is an increasingly strange distinction for a country surrounded by wind, connected to neighbouring electricity markets and generating most of its power without burning gas.

The comparison with much of Europe is stark.

For British industry the position is worse. Government comparisons have put UK industrial electricity prices at the top of the countries covered by International Energy Agency data, while prices for large industrial users have been more than twice the median across Britain and 14 comparable European countries.

Something about the British electricity system therefore requires explanation.

This week has provided another clue. Ofgem announced that its household energy price cap will rise again in October, following a sharp increase in July. The regulator attributes the renewed pressure principally to higher wholesale gas prices caused by the continuing conflict in the Middle East.

There is nothing mysterious about expensive gas making household gas more expensive. Britain imports gas and millions of homes burn it for heating.

Electricity presents the more interesting question.

A war in the Middle East does not make the wind blowing across the North Sea more expensive. It does not increase the price of sunlight or dramatically change the operating cost of an existing nuclear reactor.

Yet an international gas shock can still travel through Britain’s electricity market and affect the price of power generated from all of them.

Gas has an influence far beyond the electricity it generates

Britain no longer principally generates electricity from gas.

Wind has overtaken gas as the country’s largest individual source of electricity. Nuclear provides another substantial share, while renewables collectively produce more than half of domestic generation.

Coal has effectively disappeared.

Britain has transformed the physical electricity system.

The pricing system has not changed nearly as much.

Electricity demand has to be balanced continuously. Generators offer electricity into the wholesale market, with cheaper generation generally dispatched before more expensive generation until enough has been found to meet demand.

The final generator required is the marginal generator.

Frequently it burns gas.

Suppose Britain needs 100 units of electricity. Wind provides 40 units at an illustrative long term price of £40, nuclear provides 20 at £50, and solar and other sources provide another 20 at £50. The remaining 20 must come from gas at £100.

The weighted cost of those 100 units would be about £54.

But in a marginal pricing auction, the £100 gas station can establish the clearing price for that period.

Gas does not need to generate most of the electricity to have this effect. It merely needs to provide the final electricity required.

That distinction matters enormously.

The government says gas was setting Britain’s wholesale electricity price about 90 per cent of the time in the early 2020s. Its influence has declined as renewables have expanded, but gas still sets the price roughly 60 per cent of the time.

So gas can produce around three units out of every ten while determining the marginal wholesale price during approximately six periods out of ten.

Why design a market this way?

Marginal pricing is not irrational.

It was designed to encourage generators to reveal the price at which they are willing to produce another unit of electricity. The cheapest generators operate first. Increasingly expensive plants enter until demand is satisfied.

The last megawatt needed is valuable because without it supply and demand do not balance.

But the economics of electricity generation have changed.

Coal and gas stations continually buy fuel. Wind and solar do not. Their costs are concentrated overwhelmingly in construction, financing, maintenance and connection to the grid.

A market organised around marginal operating costs becomes increasingly peculiar when a growing proportion of generation has almost no fuel cost at all.

The problem is therefore not that Britain cannot distinguish wind electricity from gas electricity financially. Every major generator is metered. Britain knows how much electricity individual wind farms, nuclear stations and gas plants put into the system.

The difficulty is deciding what each should be paid.

Why not pay each source separately?

Britain could increasingly contract different forms of generation at different long term prices.

Wind farms could compete for contracts guaranteeing a price sufficient to build, finance and operate them. Nuclear could have contracts reflecting its very different economics. Solar could have another price. Gas generators could receive the high market price necessary when they are actually required.

Consumers would ultimately pay something closer to the weighted cost of the system.

If gas became more expensive, electricity prices would still rise. They should. Britain genuinely uses gas to generate electricity.

But the increase would fall principally upon the gas generated portion rather than necessarily transmitting the full force of the gas shock across much of the rest of the market.

In fact, Britain already does something remarkably similar.

Some wind farms already give the windfall back

Newer renewable projects commonly operate under Contracts for Difference.

A wind farm might, in simplified terms, have a strike price of £60 per megawatt hour. If the relevant wholesale reference price falls below that level, the contract tops up its revenues.

But the mechanism works in reverse.

If wholesale prices rise to £100, the generator generally returns the difference between the reference price and its contractual strike price through the CfD system.

The larger problem concerns older renewable and low carbon generators operating outside these arrangements.

When wholesale prices rise because gas becomes expensive, some of those generators can receive much higher revenues even though their own costs have barely changed.

The government estimates that renewable generation representing around 30 per cent of Britain’s total electricity supply remains exposed to wholesale prices influenced by gas.

It is now proposing long term fixed price arrangements for some existing generators precisely to weaken that connection.

The 2022 crisis shows how large the distortion can become

The gas crisis following Russia’s invasion of Ukraine provided an extreme test.

Britain generated about 325 TWh of electricity in 2022. Gas supplied approximately 125 TWh, while renewables generated about 135 TWh and nuclear almost 48 TWh.

The average wholesale electricity price reached roughly £202 per megawatt hour.

A simplified calculation illustrates the consequence.

Suppose low carbon generation had instead been remunerated at £75 per megawatt hour, while gas and other expensive generation continued receiving the crisis price.

The theoretical cost of generation falls by roughly £23 billion compared with valuing all domestic generation at the year’s average wholesale price.

At £60 for low carbon generation, the difference approaches £26 billion.

The distinction is essential.

Generators do not all receive the annual average spot price. Some electricity had already been sold forward. Some renewable generators were operating under CfDs and therefore returned excess revenues.

But the calculation demonstrates the scale of the amplification possible when extraordinarily expensive gas establishes the value of electricity whose underlying economics have scarcely changed.

For households, the theoretical exposure during that exceptional year was equivalent to several hundred pounds each before allowing for those contractual protections.

Marginal pricing was not a minor curiosity during the energy crisis. It materially transmitted the gas shock through the electricity economy.

But marginal pricing is not Britain’s only problem

Replacing it tomorrow would not suddenly give Britain Europe’s cheapest electricity.

Britain is simultaneously undertaking an enormous reconstruction of its electricity network.

The old grid connected relatively few enormous coal, gas and nuclear stations to consumers. The emerging system must carry electricity from offshore wind farms, Scottish wind generation, solar farms, batteries and interconnectors while preparing for millions of electric vehicles and heat pumps.

Consumers pay for that investment.

There are also constraint costs. Britain can sometimes produce abundant wind electricity in Scotland while lacking sufficient transmission capacity to move all of it south. Wind farms may be paid to reduce output while generators elsewhere are paid to increase production.

The consumer effectively finances both transactions.

Britain has also historically placed unusually large environmental and social policy costs onto electricity bills. The burden has been particularly severe for industry.

This produces another contradiction. Government policy encourages households and businesses to abandon fossil fuels and electrify transport, heating and industry while electricity itself carries costs associated with financing that transition.

Cheap wind does not mean cheap electricity

There is an equally important warning against the opposite argument.

The wind may be free, but reliable wind electricity is not.

A turbine must be manufactured, installed and financed. Offshore cables must connect it to land. Transmission lines must carry its electricity to consumers. When the wind stops, some combination of nuclear, gas, storage, interconnectors and demand reduction must keep the system operating.

Generation cost and system cost are therefore different things.

Britain’s electricity problem cannot simply be solved by announcing that wind costs £40 or £50 per megawatt hour and charging everybody accordingly.

The real question is whether Britain’s market is allowing consumers to receive enough of the economic benefit from increasingly cheap domestic low carbon generation.

The evidence suggests that it is not.

Britain changed the electricity but not the market

That is the anomaly at the centre of Britain’s electricity system.

The country has transformed what produces its electricity faster than it has transformed the mechanism that prices it.

The government itself is now trying to reduce gas’s influence through longer term contracts and changes to electricity market arrangements.

That is an implicit recognition that the existing system no longer fits comfortably with the electricity system Britain has built.

Networks cost money. Backup costs money. New generating capacity must earn sufficient returns to attract investment. Gas will remain important for some time.

But none of those facts answers the central question exposed once again by the Middle East crisis.

Britain possesses vast wind resources in the North Sea and increasingly generates electricity without fossil fuels.

Why, then, should a war that raises the international price of gas continue to determine the price of so much British electricity?

Until Britain answers that question, building more cheap electricity will not necessarily mean British consumers receive cheap electricity.