We Could Massively Reduce the Price of Energy in the UK – By Changing the Way We Regulate Energy Prices

Yves here. I neglected to disentangle a key issue in yesterday’s downbeat discussion of Europe’s grim energy future. The bottom line was that without an increase in Russian gas, which seems very unlikely absent a regime change so that the EU and Russia repair their economic relations, the EU would have less energy than it needed to meet usual current demand levels. Yes, if the weather is mild and there is a lot of belt tightening, the EU might scrape through this winter, but the deficits will continue and become more constrictive. And the odds even in a favorable scenario for the winter favor “belt tightening” being involuntary, as in to some degree the result of business failures.

However, this real economy shortfall, which could be anywhere from manageably bad to terrible depending on weather and user action, is made much worse in pricing/market terms due to the UK and EU having adopted market-based spot pricing formulas. Due to having too many things to do and not enough time, I will confess to not having yet mastered this topic, but the Richard Murphy post below unpacks the UK scheme.

Now this ought to be good news, in that it means that regulatory reform could render a potentially disastrous situation down to being merely pretty bad, and importantly, prevent a lot of business failures.

However, I am not certain if action could be taken quickly enough to alleviate damage this winter. First, you’d need to have a worked-out replacement pricing scheme. Second, until things got impossibly bad, you would have “industry consultation,’ which takes time. Third, and this is a place where the expert commentariat could help, I am highly confident there are a lot of systems involved, both in the wholesale pricing/buying and then in generating consumer bills. We know from bank IT that implementing a new routine across the entire customer base is fraught and even on a crunch basis would take months….six? More?

As we stressed yesterday, merely imposing price caps does not solve the problem of likely and actual shortfalls. High prices, as terrible as they are, do serve as a rationing mechanism. Absent that, what will be the rationing mechanism? Blackouts?

Any input on the legal, regulatory and systems aspects of implementing a change in electricity pricing mechanisms would be very much appreciated. I suspect this is one of those Maine “You can’t get there from here” situations, at least in the time frame needed. But I would be delighted to be wrong.

By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK

I posted this thread to Twitter this morning:

There is much talk happening on how to solve the so-called cost-of-living crisis. Most of it fails to recognise that the problem is much bigger than that: the whole economy is in meltdown. None seems to address the cost of energy itself. A thread on the last point….

No one now doubts that the UK has an economic crisis on an unprecedented scale. My estimates suggest 60% of households are going to struggle to pay their energy and other bills this winter whilst public services and hundreds of thousands of companies might fail.

The focus of most comment so far has been in households. Don’t get me wrong. Their inability to pay matters, enormously. But hospitals, schools, care homes and businesses are also facing impossible bills.

I have set out a comprehensive plan to address this in a report called ‘Surviving 2023’. It might cost at least £144 billion to get through this winter, which only quantitative easing can provide. Let’s not pretend otherwise.

However, there is a dimension to this which is not discussed at all, which is changing the way in which domestic energy is priced in the UK. The rules are set by Ofgem, the government regulator. These prices are set to make matters as bad as possible for everyone but energy companies.

What follows is a little technical. I have checked the facts with energy expert Mike Parr, to whom I am grateful, whilst accepting that all remaining errors are mine alone, having said which I think all that follows is true.

It’s important to remember that the goal of energy regulation in the UK is to preserve the privatised energy ‘market’, whatever else is claimed. In essence, everything it does is meant to ensure that at least some of the companies engaged in this ‘market’ do not fail.

The way it sets energy prices reflects this. There are lots of ways to generate electricity in the UK. Renewables, nuclear, coal, hydro and gas all play a part. Most are used, except coal, which is now only in emergency use.

The cost of generating electricity using these various methods varies greatly. For example, using gas at current spot market prices costs about £611 per megawatt hour (MWh) right now. Other sources cost about £60/MWh for nuclear, £50/MWh hydro and in the range £50 to £140/MWh for on and offshore wind and PV. Those are big differences.

The electricity we actually get delivered to our houses is from a mix of all these sources. It is total nonsense, for example, that anyone supplies pure renewable electricity. All electricity from all generating sources is mixed together when it goes down the wires to our houses.

Bizarrely, however, that’s not how the price is set. The wholesale price of electricity in the UK is set on what is called a ‘marginal costing’ basis. This is much beloved of economists but is working against the interests of all consumers of fuel right now.

What it means is that the wholesale energy price is set so that the most expensive producer can make a profit from the sales they make into the wholesale energy market.

So, since gas-produced electricity is the most expensive to produce right now (and is likely to be so for a long time to come) its cost of manufacture plus a fair profit margin sets the wholesale price for all electricity right now, however it is generated.

What that means is that those producing electricity from gas can still make a profit and so stay in business at present. But what it also means is that the nuclear, hydro and renewables producers are being paid the price that the gas generators get.

This makes no sense at all. For example, there is no ‘marginal cost of production’ for wind and solar power: the wind and sun are free. In those cases a marginal costing is simply the wrong one to use.

That is also true of nuclear power, where the cost of production is based on the capital cost of the plant spread over its useful life. Again, a marginal costing basis for pricing makes no sense when the amount of variable input into the nuclear process is tiny.

The result is obvious: the profit in the nuclear and renewable producing companies, who usually make more than half of UK electricity, increase dramatically, and wholly unnecessarily when a marginal costing price setting model is sued to suit gas generators of electricity.

I should, however, add a twist. Many renewable energy producers are already subject to contracts that essentially fix their prices, with the government already taking the risk on price variation. See https://www.lowcarboncontracts.uk/.

Where these contracts exist, and where fixed price contracts guaranteed by the government exist with nuclear producers, the current excess electricity profits arising because prices are based on the cost of gas production already flow to the government, a little-known fact.

There is also a pricing problem in the gas market. The UK produces about half its gas needs, the rest it has to buy internationally. We can’t control that international price.

But the energy regulation system lets UK-produced gas be sold at the international price for onward supply to UK consumers, again massively increasing the profits of UK gas-producing companies wholly unnecessarily, and solely because of the pricing model used.

The talk is that a windfall tax could correct for this. That, however, is to ignore the fact that much of the problems that we face has been created by dire regulation, and changing that regulation is also within the scope of government.

Suppose that regulation was changed. Instead of all producers, whether of gas or electricity, being paid the price of the highest cost supplier in their market they were instead paid their own fair marginal cost of production, including a reasonable profit margin.

Then presume that the energy regulator priced the onward supply of wholesale gas and electricity to the energy distribution companies on the basis of the actual cost to produce (including fair profit) of the gas and electricity actually sold into the market each day.

I stress, that for much of the renewables sector and for nuclear this will not be hard to do because of the nature of the government price guarantees that are already in place.

For gas, simply mix internationally priced gas with UK-produced gas at its fair price of production. That’s all that is required.

This would, though, require a change in the law. There would be yelling, screaming and shouting from some energy companies despite what I have noted and legal threats galore. These will need to be ignored for one straightforward reason.

That’s because customers can no longer afford UK energy prices all UK focussed energy companies are technically bust. There is no market let for the energy they might produce, whether gas or electricity, at the prices currently being asked for it, at least without state aid.

In that case the state can intervene – to save these companies. I am sure a lawyer, somewhere, will see a chance to bring a legal action to dispute that, but the reality is that their chance of success might well be low.

If in doubt, the UK needs to declare this a national emergency with existing laws suspended since, as a matter of fact, it is a national emergency. And if we could do this sort of thing for Covid we could certainly do it now.

What would the impact be? Obviously, it’s not precisely possible to say, but broadly speaking the price of gas might reduce by 40% whilst the price of electricity could fall by maybe 65%.

I stress these are estimates and that this move would not solve all the energy problem overnight: the remaining prices are still problematic and massive reforms to the market would still be required. But we would win three things.

The first would be instant reductions in energy costs. Households and businesses, let alone many lives, might be saved as a result.

Second, inflation would be reduced, although not eliminated. Massive pressure would be taken out of the UK economy.

Third, the pressure for state interventions to save households, pubic services and businesses would reduce – although by no means entirely go away.

Those are three massive wins that almost no other reform that could so simply be put in place could deliver.

So why won’t this happen? First, because no one in politics seems to know about this. Second, because politics (of most sorts right now) is terrified of upsetting ‘the markets’, even if those markets crush consumers.

Third, as a result politicians who lack the courage to hold the positions to which they have been elected will not do what is required to protect us from harm.

A decade ago I wrote a book called ‘The Courageous State’. It was all about the need for politicians who believed in the power of the state to deliver good for the benefit of the people that they might govern.

The sad fact is that we don’t have such politicians right now. If we did they would be taking action to change energy price regulation right now to protect us all from the harm that those regulations are causing.

We need courageous politicians right now who might be willing to act in the public interest to change the rules of the energy price game to save us all from harm. I can live in hope that this might still happen. I am not holding my breath.

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  1. PlutoniumKun

    The awful way the UK energy market was organised was obvious going back to the 1990’s, when the so called ‘Dash to Gas’ was a sign that the market was attracting investors with more of an interest in manipulating the market than in supplying cheap energy. The number of CCGT stations built was far out of whack with actual energy needs, and led to the premature closure of a lot of thermal plants. It was a forerunner of what happened in the US with fracking except it was entirely driven by market structure, not the availability/price of natural gas.

    Another key sign is that the UK electricity price surge has been much higher than most other European countries, including those with a similar energy mix such as Ireland. The signs of stress go back a couple of years, when a series of providers went bust as they found that they’d contracted to supply electricity at prices they could not buy.

  2. Dave in Austin

    This seems to me to be a bit of magical thinking here. The issues he address are issues of equity and price.

    But the underlying issue is supply and demand; the supply is being reduced so demand must be reduced. The base units (nuclear, wind and North Sea gas) are capital intensive, the costs are already sunk and they have low operating costs. But if they supply only 60-70% of demand for example (a pure guess on my part), the “marginal cost” of the other 30-40% is very high.

    The choices are rationing by price or quantity. Unfortunately there is no way to ration gas and electricity by quantity at this time other than: “You get X number of KW/month and if you exceed that we cut you off”. That is a non-starter for practical reasons.

    If you use your ration in the first three weeks of the month do we shut you off and get the “How could that have done this to the poor widow Jones” articles in the tabloids? Do we take “Last year’s usage” as the basis and reward big homes? What about poor people with old, poorly insulated homes? Do we say “Here is your basic allotment” and tell people with big homes they have enough to heat for one week/month? What about stores, government buildings and cafes? And above all, what about industrial usage? The time to begin planning was in April. It is too late now.

    I don’t pretend to have a good answer. I’d probably launch a program to teach people how to shut off the heat in bedrooms and leave kitchens warm (look at the pictures of Ukrainian homes to see how that works there). Temporary industrial shutdowns during the worst weeks- with compensation- might help. Social pressure on people with large spaces are in order. When Great Britain was a homogeneous nation before the 1960s social cohesion helped, but that era is over.

    1. jsn

      As I understood it, Murphy described a market where the structure provided the same price per unit produced for the 60% of total supply that was unaffected by the gas shortage as was set in the 40% dependent on Russian gas.

      This means that the aggregate cost of energy paid for by the public is inflated for the 60% unaffected by gas supply. If those suppliers were held to a profitability that allowed for reasonable long term reinvestment rather than whatever the gas market demands, that portion of consumer costs could be eliminated.

      This doesn’t solve the rationing problem you define, with which I agree, but it does lower the overall cost of energy supply and end windfall profits. This is what utility regulation once did back when economic policy was set by Congress rather than Wall Street.

      1. Jason

        It is a no-go if the rationing problem isn’t solved. Who gets the cheap electricity, and who gets the expensive electricity? And as Grumpy Engineer noted, this price discrimination levelled on producers will disincentivize investment in renewables.

        A windfall profit tax that gets redistributed to households as electricity rebates seems much easier to implement (no need to tinker with billing systems), and doesn’t create the rationing problem. You don’t need to tinker with the electricity billing systems. You don’t create a rationing problem either.

  3. crandall

    I make no pretense of being an expert, and unfortunately don’t know much about the implementation side, but Murphy is 100% correct about the problem being entirely self made, and, if perhaps difficult to undo over the course of a few months, eminently solvable over the short-to-medium term, if the political will to do so is there. I think a lot of the problem is that it’s hard for people for people to wrap their head around the first time they hear about it.

    Across the developed world, during the wave of deregulation of the electric power sector in the 90s and 2000s, energy markets moved from an uncomplicated vertically integrated model, where utilities owned generation, transmission, and distribution assets, and supplied electricity to meet demand from their own facilities, with pricing set by regulators based on utilities overall cost structure (not just variable costs of generating, but also of fixed investment cost) to procuring power in markets structured as what is known as a “Dutch auction” format. Meaning the “grid operators” (utilities) are obligated to purchase at auction enough power supply to meet demand (nearly all of them no longer having enough generation assets to meet demand on their own) from a range of wholesale suppliers. Suppliers are not paid based on what they bid, but instead all receive the amount of the highest winning bidder at the auction for that block of time (most volume is transacted in hour-long blocks, but there are shorter intervals as well). Regulation allows utilities to set retail prices for you and me based on the wholesale prices paid in these auctions.

    The result being an entire industry that relies on getting paid not based on their own cost of doing business plus a markup, but on that of the most expensive guy operating at any given moment. That means that times like this, though nearly unbearable for the average ratepayer, are a windfall for electric generators. I’d suspect the challenges of clawing away the golden goose of marginal cost pricing from those who benefit most would be at least as difficult as the logistical ones of implementing any other given system would. Really I am not in the weeds of how these systems are set up from an IT perspective, but implementing one where generators are paid at the rate they bid for supply rather than the rate of the most expensive guy bidding seems pretty straightforward, it is the lobbying muscle of the industry trying to stop that from happening that is the bigger problem to tackle.

    1. Yves Smith Post author

      I am afraid you have not worked on IT systems. Billing for electricity is a lot like billing for banking services, albeit at a lower transaction volume. But they have similar requirements for exacting accuracy by being regulated businesses.

      The current complicated pricing model has to be deeply embedded in these businesses. Going to a different model is a major development project. That means well over a year. I will let IT types opine as to how much longer. IT systems introduce incredible rigidity into business processes and I have to think these are largely custom systems.

  4. Grumpy Engineer

    Hmmm… Moving to a “price based on marginal cost” scheme certainly sounds attractive at face value, but I can think of a couple of major downsides:

    First, paying different suppliers different prices for electricity encourages cheating. I can’t find a link, but I remember reading an article way back in 2007 (shortly before the financial crisis) where owners of solar farms in Spain were firing up diesel generators, rectifying the output, and feeding the resulting DC power into their solar inverters. Spanish subsidies for solar power were so high at the time that such cheating was profitable, despite diesel being an expensive way to generate power.

    And for today’s situation in the UK, I can think of a couple of ways to cheat just off the top of my head.
    Operators who have solar and gas facilities physically adjacent to each other (an arrangement I’ve seen in Florida) could easily run PV inverter output through a buried side cable into a step-up MV transformer that would feed into the generator bus that feeds the really big step-up HV transformer that feeds the grid. Low marginal-cost PV power would then be measured (and paid for) as high marginal-cost gas power.

    Or a tanker docking station could receive a shipment of high-price gas from the international market. And then the tanker could sit there “doing maintenance” while being secretly re-filled with low-price gas from the domestic market. The tanker would then head out, park in international waters for a couple of weeks, then come back in and sell the gas at full international market rates.

    When everybody gets paid the same in spot markets, the motivation for such shenanigans largely disappears, and the need to monitor for smuggling and artificial re-classifications is greatly reduced.

    Second, paying different suppliers different prices for electricity discourages investment. For example, building energy storage facilities right now would be enormously useful, as they can smooth out supply & demand (and spot market price) variations that happen over the course of a day. With the big spot price swings we’re seeing today, storage facilities would be very profitable to operate, and there’s definitely incentive to build more. But if the the spot market is eliminated and facility owners are only permitted minimal profits, there would be much less motivation. Even though they are genuinely useful from a technical grid-stability standpoint.

    And finally, would we trust the government to implement a “marginal cost” scheme correctly? Many Western governments seem to be struggling with basic competence at routine stuff these days, and I have great doubts about their ability to come up with an alternate scheme to regulate this technically-complex multi-party system that (1) accurately determined true marginal costs so that suppliers were never over- or under-paid; (2) diligently prevented cheating; and (3) handled things fairly when demand truly exceeded supply and some customers had to be cut off.

  5. Ignacio

    Let me explain a bit on how the wholesale market is organized in Spain and Portugal. The market place is managed by an independent operator, the OMIE and the market functions basically in a daily basis (with some intra-day operations every 3 hours for adjustments). Each day the price of the next 24 hours is negotiated between some large consumers and commercializing companies that sell to the general public in the buying side, plus the suppliers as sellers and the distributor setting distribution costs. It is negotiated hour by hour so that each hour will have different prices according to consumption estimates and supply offers by utility companies. It is organized as an auction starting with the least expensive suppliers (Nuclear, then renewables) to the most expensive (NG naturally these days). For each hour, the price will be determined depending of the most pricey supply that has to enter. In reality the final hourly price is calculated by an algorithm called EUPHEMIA (I haven’t studied it, I regret to say) which is used in all EU grids (though as Portugal and Spain have quite an independent grid with only small exchanges have independent negotiation). In any case this system is skewed when one of the suppliers provide at too high of a price in a way that ensure handsome revenues for suppliers other than NG during the hours when NG has to enter because demand is high. In Spain, due to de “solar effect” and demand structure the highest hourly prices in summer are set early in the morning (At 8:00-10:00) and late in the evening (22:00-24:00). The winter pattern is different.

    Because in Spain and Portugal wholesale prices are mostly transmitted directly to the final users each day the impact of high NG prices was felt very fast (In fact, since September 2021) both governments negotiated what was called the “Iberian exception” with the Commission, not without difficulties because the system involved a direct subsidy to the utilities using expensive fossil fuels; It functioned as a cap first settled at nearly 50€/MWh of NG supply, then increasing by 5€/MWh each month up to 2023.

    IMO, the subsidy doesn’t result in NG incentive, neither in consumption incentives, thought it results in lesser reduction of demand that would have “naturally” occurred with sky-high NG costs. In August, with hydropower plants barely operating and low speed winds, about 250-350 GWh are supplied from NG daily out of a total around 750-850 GWh. The Spanish distributor publishes an indicator for demand relative to the largest energy consumers (industries and others) in Spanish that uses 100 for constant demand, upper values for higher demand and below 100 for lowering demand. Current reads are about 90 indicating lowering demand since March.

    It is possible to speculate that a little change in the EUPHEMIA algorithm could do the trick to lower overall wholesale prices somehow and easily. Wouldn’t it?

  6. Susan the Other

    If we substitute the word food, or water, or air, or medical care (well not in this country) for energy and discuss the market pricing mechanisms involved, as if there were no crisis, as if this were just the rational market making its way through supply and demand, it would sound even more outrageous. There is no rational reason for civilized people to be held hostage to market rules and regulations in a crisis. Especially one predicted to last 10 years. The Saudis just said that if demand “softens” the price of gas and oil will go up to compensate. Do they actually think that this is market economics? And all the convoluted rationalizations for setting the price of a barrel of oil? That isn’t market economics either – it’s all monopoly economics. It’s not a question of demand; it’s a question of need without any other choices. Just nationalize it all and start over when this is under control. Start over and design something that actually makes sense. Which will not be what we have today.

  7. JW

    This is the re-invention of the Bulk Supply Tariff, the wholesale prices that were set centrally by the CEGB ( Central Electricity Generating Board) to the Regional Distibuting and retailing entities , called Area Boards.
    There were all in national ownership.
    No doubt it can be done by someone working out SRMC and LRMC for generation types and setting prices for the retailer ( supplier) to bill the end user.
    Given the amount of legal disputes that this would incur, it would require emergency primary legislation to drive this through.
    It took years to construct an imperfect market mechanism for privatisation. And then the industry and advisers pretty much knew what they were doing.
    Now I really doubt there are more than a handful of people equipped to work on this.
    It inevitably will be a complete ‘dogs breakfast’ of a mess.
    Surely better and easier to do what the Spanish are doing and subsidise the gas price to power stations. Even our politicians might be able to understand that sum, even if they might have a heart attack when they see the number.

  8. VietnamVet

    I must emphasize that privatized electrical power systems were set up to profit insiders. Enron was a pioneer is setting up energy markets. The current neoliberal capitalist system does not serve the public interest. It only increases private wealth which is proven not to trickle down. Either lots of people freeze and businesses go bankrupt this winter in Europe, or the electrical utilities are nationalized as a wartime measure.

    If they can’t do that, it means the EU has lost the Ukraine Russia proxy world war. The undemocratic corporate/state is incapable of fighting existential wars for the same reasons it cannot mitigate pandemics. It is incapable of mobilizing the people and industry to do the public good.

    1. JW

      Pleased to relate that Enron had nothing whatsoever to do with setting up the UK electricity market.

      1. Ludus57

        But we still end up with a basically incoherent, failed market, with regulation which serves the interests of producers/ providers rather than the public who employ the regulators.

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