Letter to David Cameron from advisers Ben Moxham and Gila Sacks on the impact of energy and climate policies on consumer energy bills.
11:55AM BST 05 Sep 2011
Your seminar on Green Deal implementation raised a number of wider questions about the impact of energy and climate change policies on energy prices, the impact of our renewables target in particular, how well the electricity market is operating, and what can be done to minimise consumer bill increases in the short and medium term.
Work is underway on all these issues and we will offer you advice over the summer. But for now, as context to the wider debate, a note on consumer energy prices – following on from last week’s note on energy prices faced by energy intensive industries.
Current household energy bills
At present the average household energy bill is £1,059, made up of £591 spent on gas and £468 spent on electricity.
Wholesale energy costs make up around half of household energy bills today. Both wholesale gas and electricity costs are largely driven by gas prices set in international markets (since gas-fired generation determines wholesale electricity prices most of the time.)
The second largest component of the average household energy bill is transmission and distribution charges, making up around 20% of the total cost
Supplier costs and margins (ie profit) makes up around 15%
Policy costs currently make up around 10% of the average household energy bill
The balance (around 5%) is the cost of VAT
Energy company profits
Analysis by DECC suggests that retail margins in the energy supply business are not out of line with other large businesses. In 2009, average global operating profits for the big energy suppliers were between 8% and 19%. This compares to average operating profits in FTSE 100 of 25%. Looking specifically at suppliers’ retail operations, profit margins have averaged 12% for sales of electricity and 6% for sales of gas over recent years.
However there are two caveats. First, its possible that higher margins are hidden through transfer pricing, for example opaque contracts between suppliers’ generation and retail arms. EON, RWE and EDF reported negative margins in their domestic supply business in 2009 but they did not make a loss across the whole value chain. Ofgem’s accountants are investigating.
Second, a profit analysis alone does not uncover the extent to which companies are efficient. Oligopolistic markets tend to breed bloated and inefficient companies, given there is typically less pressure to cut costs and innovate than in more competitive markets.
Future impact of energy and climate policies
It is important to emphasise that the precise future impact of energy and climate policies on household energy bills is difficult to calculate, and depends on taking a view on what the world would look like in the absence of those policies. A particularly important factor is the price of gas, however there are other unpredictable factors such as the costs of different low-carbon technologies over time and the future direction of currency exchange rates.
Turning specifically to gas, if one were to assume low gas prices in 2020, the cost of policies to encourage more nuclear and renewables would be high – since it would turn out cheaper not to pursue these policies and to instead to be more reliant on gas. On the other hand, if one were to assume very high gas prices in 2020, being more reliant on nuclear and renewables could conceivably make consumers better off compared to the alternative of greater reliance on gas.
There are a large number of different views about the future direction of gas prices. Our own view is that the only thing that can be said for certain about gas prices, as with all fossil fuel prices, is that it will vary. The high variability in historic gas prices is shown strikingly in the chart Appendix A. The chart also shows recent wholesale gas price increases, a significant factor behind the household energy price hikes announced in recent weeks by Scottish Power, British Gas and SSE.
DECC’s analysis is based on a mid-case gas price counterfactual, assuming a gas price broadly consistent with today’s forward prices (around 70p/therm). Against this backdrop DECC examines the costs of our energy and climate policies in the round including: the EU emissions trading scheme and carbon price floor, the Renewables Obligation and other renewables support schemes, the Electricity Market Reform package and energy efficiency policies (though not the Green Deal).
DECC’s analysis finds:
Our policies would have a relatively small impact on household gas prices
Our policies would increase household electricity prices by 25% in 2015 and 30% in 2020 compared to what they would have been in the absence of policies
The contribution of individual policies to the 30% policy-driven price increase estimated for 2020 is as follows: i) A third of the total cost comes from carbon pricing policies – both HMT’s carbon price floor and the carbon price derived from the EU emissions trading scheme. ii) A third comes from the Energy Company Obligation – the successor policy to CERT, to be implemented from late 2012 alongside the Green Deal, mandating energy companies to install hard-to treat energy efficiency measures and make fuel poor households more energy efficient. iii) A fifth of the total policy cost comes from Electricity Market Reform’s new long-term contracts. iv) A fifth comes from price support for renewables under the Renewables Obligation. v) Around 5% of the total policy costs comes from small-scale feed-in tariffs.
The impact of our policies on household electricity bills (as opposed to prices) would be lower due to the effect of other policies, notably energy efficiency measures, in lowering electricity consumption: i) According to DECC, the effect of this lowered consumption on household electricity bills would outweigh the impact of policies in raising prices, leading to electricity bills that are, net, 1% lower in 2015 and 4% lower in 2020 than they would be in the absence of policies. ii) While the rest of the analysis seems broadly plausible, we find the scale of household energy consumption savings calculated by DECC to be unconvincing. Their analysis may be based on the assumption that many energy efficiency measures will be taken up without subsidy, whereas we believe a large number of measures will need to be subsidised given, the hassle factor and other barriers to consumer uptake identified at the Green Deal implementation meeting. We are interrogating DECC’s assumptions further.
At present the price of wholesale energy is the most significant cost in consumer energy bills (around half of the total cost). It is notable that supplier company costs and profits are a material, but not hugely significant, factor (around 15% of the average bill) and that policy costs also make a relatively minor contribution (around 10% at present).
Over time it is clear that the impact of our policies on consumer bills will become significantly greater. How significant depends on what we assume the world would look like in the absence of policies, with the future gas price a particularly important unknown factor. DECC’s mid-case gas price scenario sees policies adding 30% to consumer energy bills by 2020 compared to a world without policies.
Four policies stand out as having the most significant impact on household energy bills: carbon pricing (both out own carbon price floor and the EU emissions trading scheme), the new Energy Company Obligation, our Electricity Market Reform package and the Renewables Obligation.
There are a number of questions that stem from this work:
Can we be more confident in the future price of gas, or do we have to live with uncertainty and unpredictability, and therefore the challenge of designing policy against future unknowns?
How do we balance the difficult tradeoffs we are faced with: between short-term and long-term consumer costs/benefits, and between cost, security and decarbonisation objectives?
Can we open some of our policies, particularly support for relatively high-cost technologies such as offshore wind, in a way that minimises cost and disruption to investment?
Can we go further on consumer energy efficiency to offset energy price rises, and if so how?
We will return to these questions with further advice.