The UK intends to reform the way the electricity market operates in order to encourage the growth of low-carbon power production at the expense of fossil fuel generation. The Department of Energy and Climate Change said in December that it would both increase the levy on CO2 from power stations, making coal and gas electricity more expensive and also reward low-carbon electricity by guaranteeing high prices for nuclear and wind power. Both these changes will tend to increase power prices to businesses and households. Nevertheless, the Department claimed that its proposal would not effect customers significantly, noting ‘small impacts on bills in the near term, but in the longer term bills are expected to fall by 2030’ (1). Can bills really be lower as a result of changes designed to increase wholesale prices? Let’s get one thing clear to start with. Despite any impression given to the contrary, electricity bills are going to rise sharply under the government’s proposals. Wholesale power changes hands today at around 5-6p a kilowatt hour. Charges for transmission, distribution, customer service and VAT, as well as retailer profit, add another 7p to this total, meaning a retail price to household customers of about 12-13p. The government’s December consultation documents make clear that its purpose is to double the wholesale price of electricity to around 11-12p by 2030. If the increase in wholesale charges is simply passed on by the retailers, the cost to householders will rise to 18-19p, an increase of about 50% on today’s prices. Although the government may wish to disguise this fact, the future increase in prices is a fundamental part of its policy. The average householder is going to be paying about £200-£25o more per year for electricity.

Why does it need to increase prices in this way? The simple fact is that gas-fired power stations are producing power at a full (‘levelised’) long-term cost of around 5p per kilowatt hour. No low-carbon technology is currently remotely competitive with this figure. Research commissioned by the Department suggests a figure of 7-8p for nuclear power and perhaps 9p for onshore wind. (And regular readers of Carbon Commentary will know that 8p for nuclear seems a suspiciously low figure). Unless the cost of gas-fired generation rises by at least 4p, the generators will simply continue to pile their capital into this form of power station and the UK will end the next decade with relatively little offshore wind and few nuclear power stations under construction.

Current estimated costs of generating one kilowatt hour at a modern CCGT (gas) power station

Fuel	3.4p
Carbon price in ETS	0.4p
Operating costs	0.4p
Contribution towards capital costs	0.7p

Total	4.9p

The National Grid’s seven year forecast from spring of last year suggested that generators are planning to build about 17 gigawatts of CCGT power stations – about one quarter of current UK generating capacity - before mid 2017, compared to only about 12 gigawatts of new wind. And because well-sited wind will typically produce only 35% of its rated capacity over the year, this 12 gigawatts is only equivalent to about 4 gigawatts of actual generation, a quarter of the new gas power station output.

The government, and its adviser The Committee on Climate Change, want to largely decarbonise the UK’s electricity production by 2030. The precise target is to reduce average emissions to less than 100 grammes of CO2 per kilowatt hour, 20% of today’s level. The aim will not be achieved if gas (producing about 350 grammes of CO2 per kWh) forms the backbone of UK electricity generation. The implication for policy-makers is obvious: gas needs to be made more expensive to price it out of the market.

The December proposals seek to achieve this objective by increasing the price of carbon dioxide from about £12 a tonne now to £70 in 2030. In addition, the government’s forecasts see the price of gas rising to about 74p per therm, compared to about 55p in winter 2010/2011. These two forces will increase the cost of gas-generated power. A countervailing reduction will arise because a) there will be small efficiency improvements in CCGT, with about 60% of the energy value of gas being turned into power, up from about 57% today, and b) power station construction costs are likely to slip slightly from their recent and unusual figures of over £1,000 a kilowatt.

My approximate assessment of the net impact is as follows.

Cost of producing electricity from gas in 2030

Current cost per kWh	4.9p
Impact of increasing CO2 tax to £70 per tonne	+2.0p
Increasing fuel price	+1.3p
Efficiency gains	-0.3p

Net cost in 2030	7.9p

The government’s proposal to raise the carbon dioxide price to £135 a tonne by 2040 will add a further 2.3p per kilowatt hour, taking the cost of generating electricity to over 10p. If it does this, nuclear and onshore wind will almost certainly be cost-competitive, particularly if the government guarantees the prices that these technologies obtain in the electricity market. Generating companies looking at whether to invest in CCGT plants may have second thoughts.

All this is fairly straightforward, and probably sensible if you think fossil fuels need to be driven out of electricity production. But the question remains, why does the government say there will no impact on prices from its twin promises to sharply raise the carbon price and to guarantee returns to low-carbon generators? The unfortunate truth is that the Department has employed a trick to disguise what it is doing, hoping commentators wouldn’t notice.

The carbon pricing proposals it has put forward for consultation see the CO2 costs rising quite gently to 2020, followed by sharp rises to 2030 and beyond. These will be written into law. The trick is that in its December documents it assumes that the free market price of CO2 within the European trading system, currently languishing at about £12 a tonne, will anyway rise almost as fast as the UK’s new mandatory carbon price in the next decade. Since power stations are all already within the ETS, gas generators would pay much higher carbon costs anyway. By 2030, the European market price and the UK’s legally enforced level would be identical. The counter-factual against which the UK is presenting the impact of its mandatory minimum carbon price is a guess about the future evolution of the market price for CO2, not today’s levels or even future markets indications. And if government thinks the European price will reach £70 by 2030, the carbon price legislation it proposes for the UK will have no effect.

This linguistic trick seems to me to be verging on the dishonest. People deserve the truth: under the Department’s assumptions about fuel and carbon prices, electricity prices for householders will rise by about 50% by 2030 if we are to largely decarbonise generation by the date.

There is another problem not squarely faced by the Department. Participants in the market for gas see a real possibility that prices may fall, not rise, over the next decade or so. The shale gas revolution is really changing the gas market. If prices fall from today’s levels, the attempt to use the carbon price alone to drive the cost of gas generation above alternative low-carbon technologies will fail. Even the Climate Change Committee acknowledged the possibility in its recent 4^th Carbon Budget. Here’s what they said:

‘The International Energy Agency has estimated the scale of unconventional gas resources and the range of costs of production. These suggest that the gas price of 76p per therm in 2030 under the central fossil price scenario is towards the high end of the range of supply costs (actually, it is above all but the prospective costs of some Artic gas sources) while the DECC’s lowest price of 35p/therm and the current price of 40-50p per therm are closer to the middle of the range’ (p265).

The unfortunate truth is that if the generating companies really think that gas is going to cost 35p a therm in 2030, they will still want to invest in CCGT and not wind or even nuclear. No-one is very comfortable with this fact but the decarbonisation of electricity generation will not easily take place while generating assets remain privately held and utilities are completely free to continue to invest in fossil fuel power stations.

5^th January 2010