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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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Why Are The British Paying So Much For Energy?

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Early this year, British politicians upset by the UK's high electricity prices, commissioned a study, the Cost of Electricity Review. There is an irony here. High electricity prices are in large measure the direct result of government energy policy.

But instead of empaneling a politically "safe" and well-vetted committee of regulators and senior civil servants, they handed the task to one of the UK’s preeminent energy economists, Dieter Helm. In reporting back he minced no words. His report’s analyses and recommendations have implications beyond British electricity markets. Here are some takeaways:

Consumers pay too much for electricity. The British, in the process of decarbonizing their economy, started out by picking the most expensive and needlessly complicated ways of doing the job.

The government should have started with a uniform price on carbon throughout the economy. That would have triggered the most economic energy savings and decarbonization moves, the low hanging fruit so to speak. It didn’t and now consumers are stuck paying for expensive, early stage renewables investments. The government should have realized that closing down coal-fired power plants was the cheapest, most effective way to reduce carbon emissions. But it didn’t.

You can find Leonard Hyman's lastest book ‘Electricity Acts’ on Amazon

Don’t depend on long term forecasts. Of course, neither the government nor the regulators can be faulted simply for their poor track record of long term forecasting. Last time we checked a crystal ball wasn't required for these jobs. But they can be faulted for thinking that they had a handle on costs and technological choices over the medium term to near to distant future. Technologies and markets can change fast. Planners should take that uncertainty into account.

The UK's electricity consumers, then, are overpaying for energy plans based on grossly erroneous assumptions for developments as far as 40 years away. They seem to be overpaying as well for assumptions made by regulators about expenses during the eight year price setting that will benefit electricity suppliers for years to come. With power producing technology and software changing so rapidly and the cost of renew-ables declining, long term projections and financial commitments make little sense and represent a burden on future customers.

The market does not assure resiliency. Prof. Helm characterized resiliency of the system as a “common property." That is, we all benefit from it but, it's not clear who and how we should pay for it. Too much resiliency might be better than too little at some price. But getting the right amount of resiliency cannot be solved by profit maximizing power markets.

Power prices in the wholesale power market do not and increasingly will not generate revenues adequate to support new and replacement power generating facilities, that is, the assets needed to make sure that the system can meet demand. Imagine being in a business so competitive that you were unable to fully recover capital as well as operating costs. Why invest? That’s why nuclear power plant builders require enormous government subsidies and guarantees. Related: New U.S. Sanctions Threaten Russian Oil Projects

Renewables with their declining cost structures, and "smart" software are the culprits. Increasingly, either government or its regulator faces a decision. What to do when the system can't support itself via its present market based fee structure? Do we turn back the clock and return to government ownership?

Reintegrate industry sectors and regulate supply (retail) prices. Prof. Helm argues that it's time to functionally reintegrate the electric utility industry’s generation, supply (retail sales) and distribution businesses into one entity at the local level. The UK pioneered separate functions in the mistaken belief that free market forces would get the efficient pricing of these separate services it right and the total price of the separate services would come in lower than that of the integrated utility. Probably a mistake, but that is for another discussion.

At present the electricity supply function is supposed to be deregulated. This has meant various suppliers, all buying from the same wholesale market, offer an often confusing array of price schedules to customers. Intentionally or not, this often results in consumers paying too much and their bills failing to do reflect changes in wholesale price fast enough. One temporary solution would be to establish a default tariff with a fixed margin to help consumers. (But that’s regulation, isn’t it?)

The existing wholesale power market, with prices set by the marginal cost of fossil-fueled generators, will not work in the future. We might argue that it barely functions right now. Power is clearly exchanged for money. But prices paid are inadequate to compensate for high fixed costs of many power pants. That is not a sustainable business.

The electric utility industry is heading toward a new structure. Renewables will provide an ever larger proportion of energy. Consumers and producers will increasingly have the ability to store electricity and to a degree control their electricity usage via smart devices. This increase in usage flexibility away from high peak rates will further undermine traditional utility economics. Related: Trump’s China Trip To Reap Billions In Energy Deals

Renewables have high fixed costs and no fuel costs. Prices in the wholesale power market are set by the marginal costs of production of that last unit required to meet demand, basically those of a gas-fired power station. (Close to three quarters of its total cost of production including cost of capital is accounted for by variable costs, largely fuel.) Renewables require a different structure of pricing, because they have zero marginal costs but, someone has to pay the fixed costs of power plant investment, regardless of variable costs or nobody puts up the renewable resource. Electricity could end up priced like cell phone service. You pay a monthly bill for a plan that allows you up to a given kWh usage level. In other words, once you pay the monthly bill the electricity is free so to speak. That kind of retail market probably requires a new kind of wholesale market.

It sounds harsh but in reading Prof. Helm’s report, one can't avoid the conclusion that the past quarter century of electricity restructuring, particularly in the UK, wasted our tine and diverted policy makers from the vital issues of energy and the environment, misdirected by unrealistic, ideological, often academic-driven assumptions about the efficacy of the market to dramatically drive down costs. Dieter Helm, for all his insight and candor does not come right out and say that. But that may be his most important takeaway, at least for us.

How do we as societies adjust electricity production systems to the challenges of climate change in an efficient and timely manner? That — not how to fiddle with the market to marginally improve results— is the real question.

You can find Leonard Hyman's lastest book ‘Electricity Acts’ on Amazon

By Leonard Hyman and Bill Tilles

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