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Mind the cap: rewriting the energy market rulebook

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Driven by the rapid increase in energy costs,  Prime Minister Liz Truss has been forced to step in, announcing a £2,500 a year cap on bills for the next two years. But why has the UK suffered particularly from record-breaking gas and electricity prices?  Professor Paul de Leeuw, director of RGU’s Energy Transition Institute discusses how such record prices have prompted calls for fundamental market reform across Europe.

The European Union (EU) announced in September 2022 that it is looking to impose historic interventions in the energy market to rein in soaring commodity prices, including considering a levy on excess profits and potential gas price caps.

  • UK electricity prices are determined – every 30 minutes – by the cost of the last unit of energy acquired to meet the UK’s electricity demand and the electricity required to balance the grid.
  • Most of the time, the marginal electricity required is generated by using gas-fired power stations. This means lower-cost renewable energy is sold at the same price as more expensive fossil fuel-generated electricity.
  • This directly links the cost of electricity in the UK to the rocketing and often highly volatile spot market for gas, which has a disproportionate impact on UK electricity prices.”

And the EU isn’t alone in looking at radical options to re-write the energy market rulebook. With the cost-of-living crisis threatening living standards for millions across the UK, the government announced an unprecedented – potentially £130 billion-plus – support package for UK consumers and business on September 8th.

Although this will go a long way towards solving an immediate problem of dealing with rising bills, it doesn’t solve the fundamental issue as to why electricity prices are so high, when the overall cost of generation in the UK has only seen modest changes in recent years and in some areas is actually falling.

To address the problem, rather than the symptoms, will require more than money; it will require fundamental market reform. Although the UK government is reacting to the current crisis, UK electricity prices have been consistently higher than the EU average for many years. Indeed the gap between UK and EU electricity prices started to widen significantly from mid-2021 onwards as the global economy recovered from COVID-19 and the impact of the war in Ukraine began to be reflected in utility bills.

Notwithstanding the announcement in September 2022 that UK household bills will be protected by a government-backed ‘energy price guarantee’ mechanism, UK families are still facing some of the highest electricity prices in Europe. On a like-for-like basis, UK electricity prices in mid-2022 were around 40% higher than in Germany and more than double those in France.

So why are UK consumers paying more than our closest neighbours in Europe when the electricity systems are connected?

History is a good guide for the future here. Over the last few decades, the UK has been relying more heavily on natural gas for heating and electricity generation than its European neighbours. Currently over 44% of all the electricity in the UK is generated by gas-fired power stations. This compares to around 22% across the EU, where nuclear and renewables play a bigger part in the generation mix.

UK electricity prices are determined – every 30 minutes – by the cost of the last unit of energy acquired to meet the UK’s electricity demand and the electricity required to balance the grid. Most of the time, the marginal electricity required is generated by using gas-fired power stations. This means lower-cost renewable energy is sold at the same price as more expensive fossil fuel-generated electricity. It also directly links the cost of electricity in the UK to the rocketing and often highly volatile spot market for gas, which has a disproportionate impact on UK electricity prices.

In addition, the sky-high gas prices are also impacting our heating bills. With around 1 in 5 homes across the UK built before 1920 and the majority of homes constructed before 1980, the UK has some of the oldest, least insulated and energy-hungry housing stock in Europe. To keep warm, over 8 out of 10 UK households rely on natural gas for domestic heating, which compares to less than 1 in 2 on average across the EU.

With natural gas continuing to be such a critical part of the UK energy mix, getting access to gas – especially over the winter months – will be crucial. Around 80% of the UK’s gas is currently coming from a combination of domestic production and Norwegian imports, with imported liquified natural gas (LNG) and gas storage making up the remainder. Compared to our European neighbours, the UK has very limited gas storage capacity (up to 5 days versus up to 90 days in Germany). This makes the UK more dependent on accessing gas in the short-term markets and therefore more exposed to price volatility.

With a large amount of new renewables capacity coming online in the coming years, the volume of gas the UK needs for future electricity generation is likely to decline rapidly. This will then provide a real catalyst to change how electricity prices are determined and to ensure that customers benefit from cheaper forms of electricity generation.

To address the cost-of-living crisis all options should be on the table to alleviate the immediate pressures on vulnerable customers, households and businesses across the UK, including capping the unit cost of gas and electricity, reducing VAT and temporarily reducing other levies included in utility bills. In parallel, the UK will need to look at reforming the energy market and at mechanisms to decouple the electricity and gas markets.

By decoupling electricity prices from gas prices, the UK will be able to price electricity closer to the actual costs of electricity generation. Inevitably this will be a complex and time-consuming process, but the prize for the consumer will be lower and more predictable utility bills. This will be a smarter, cheaper and greener way to manage the cap in the long term and should be a ‘win-win’ for all.


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