October 30, 2013

The great energy debate, and Hinkley C

Unless you are living on Mars, you will have noticed a great deal of news coverage and political froth on energy supply recently. I thought I would set out the lay of the land as I see it in an attempt to try and cut through some of what has been reported.

Energy prices have increased significantly above inflation since 2007, when we all started to become poorer as a result of the credit crunch and hence have been sensitive to cost of living increases. Those cost increases are down to a number of pressures:

  1. The cost of fuel is increasing. This is in turn driven by a number of factors which include increased demand from emerging economies, finite reserves depleting making extraction more expensive, and fuel being traded internationally when the pound has significantly weakened. Roughly speaking, the wholesale cost of energy makes up around 45% of a domestic bill, and has been responsible for about 60% of the cost increases to the consumer.
  2. The transmission costs for the UK networks are increasing above the rate of inflation. This is because of the need to create a lot of new infrastructure for gas storage and connection of renewables to the grid. Transmission costs make up about 20% of a domestic bill, and are responsible for around 15% of the cost increases.
  3. There are a range of environmental subsidies which are all paid for through levies on domestic bills. You have probably noticed the large numbers of solar panels springing up on rooftops and in fields, or the construction of lots of new wind turbines. All of these are subsidised through feed-in tariffs, which come out of bills. Then there are smart meters and energy efficiency measures like “free” loft insulation. This is “free” at the point of use, but your energy supplier does this at zero cost to themselves – it’s all paid for through these levies. Additionally, a carbon price has come into force. This makes up around 5% of the gas pricel and 30% of the electricity price, and starting from a zero base a few years ago this is entirely a cost inflationary aspect.
  4. Following privatisation and subsequent botched market reforms, the price of energy collapsed around the turn of the millennium. We were therefore starting from a very low base, where energy was cheaper than it sustainably could have been. The energy companies were essentially all broke (sob sob I hear you cry…) and as a result of this and a lack of a clear long term direction for the sector set by policy there has been no driver to invest in new plant. We are now at the point where old stations that were build during the state industry days need replacing or are being forced to close due to new regulations. In order to invest in plant, energy companies need to raise the cash and demonstrate a reasonable rate of return to investors.

You will notice that none of these drivers are “trying to make a quick buck”. The headlines you read about profit margins are often misleading, to say the least. The energy market is volatile so it is only to be expected that year on year sometimes profits will jump up and sometimes they will fall back. In 2012, the company I work for (EDF Energy) saw profits fall by about 6%. A lot of our profits are also going into building new stations, covering investment in our existing plant (for example, post-Fukushima upgrades to our nuclear fleet) and covering other costs such as pension deficit repairs. The actual bottom line figure is much lower than the headlines suggest. Companies have to make a reasonable profit in order to be sustainable for the long term, otherwise you get market instability and a lack of investment. Healthy companies mean stable employment for a large sector of the UK workforce, and good returns for investors. A large chunk of institutional investors are actually pension funds of the UK workforce, so I suspect it’s in many of our interests that a reasonable return is given to them otherwise our retirement suffers.

To be fair, the coverage I have read on the BBC is largely quite balanced and communicates the above information in a balanced way, if you care to look for it. Newspapers have their own agendas and will tend to follow the direction of the political parties they support, and in any case love to stir up a story of public outrage. Whilst this is disappointing, there’s not much that can be done about it. What irks me though is that politicians who must surely be in the know about all these facts have decided to play political football with energy prices as we all seem to have moved on from blaming banks for our present troubles. A great example of this is Ed Miliband’s price freeze policy.

Whilst the price freeze may gain a lot of popular support from hard-up voters who aren’t all that well informed or interested in the nuances of the energy markets and only see rising bills and the finger being pointed at “the big six”, it presents a completely false picture of what is happening in the market. We are at a crunch point where we need to spend well over £100bn in the coming years on new energy infrastructure, and the government is looking to the private sector to fund this. The bill is much larger due to the environmental pressures being exerted on the industry – by the politicians. And into this delicate climate where we are being asked to spend vast sums on new plant (with a rather unstable outlook), in wade the politicians with all guns blazing for a few cheap headlines. You couldn’t make it up. If you want to freeze your energy prices for 20 months, you can already do so anyway without the need to go to the ballot box – just switch to a long term price fix contract, which are available for up to 3.5 years in length. John Major with his support for a windfall tax is no better – what sort of message is that sending? Please invest all these billions of pounds in projects that take decades to pay back, but don’t you dare make any money out of it or we’ll just shift the goal-posts and tax you at a moment’s notice. Or maybe all these environmental obligations we’ve been working on for years, perhaps we’ll just scrap them and upset the apple cart on all your investment planning.

With this kind of unstable climate, all that you will do is scare off investors and we won’t have any new infrastructure. As a result, we will see long term prices continue to rise whilst becoming increasingly unstable and the threat of a capacity shortfall will increase. That’s good for no-one. What is needed is a sensible and grown up approach, the outlook for which until the 2015 election does not look hopeful.

This brings me neatly on to the new nuclear deal at Hinkley C. The coverage centred on the strike price, and rightly so. The price agreed is lower than existing costs for all other low carbon technologies, so it should be a good deal for consumers. As I understand it, the price is also what will be paid when the plants come on line – i.e. you need to view the figure in the context of the value of money in 2023, not 2013. Add 10 years of inflation to the current wholesale price and £92.50/MWh looks a lot more palatable. Also, unlike feed-in tariffs, if the wholesale cost is above this level then the government gets the difference back. With all the inflationary pressures on wholesale prices, there is therefore a good chance that the consumer will effectively make money out of the plant. All good stuff.

What I am most pleased about however is that in all the coverage, despite the incident in Fukushima in 2011, the focus has been entirely on the price agreed. That no-one has (to my knowledge) questioned the safety and integrity of UK operators and regulators when new nuclear power plants are in the news is both right and something that makes me proud to be in that industry.


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