Ending reliance on the market alone to deliver for the power sector

11 Mar 2021

In recent years we have witnessed the central role, everywhere, of governments dealing with massive market failures, or potential failures, in critical parts of the economy and society. The most obvious crises and interventions have been in the financial sector, and in public health. But attention is also now turning to the biggest crisis of all, the looming threat of climate change. As with the pandemic and with finance, this makes the risk of systemic failure in the energy sector something that governments, of whatever ideological complexion, can no longer ignore. This may be the end for the road for market fundamentalism in the energy sector.

National Grid faces being stripped of its role … after the energy regulator concluded an independent body would better oversee the changes required to meet the UK’s 2050 net zero emissions target. It would also avoid potential conflicts of interest and allow for the “greater strategic planning and management” of the electricity system. (FT, January 2021)

The wheel turns full circle. We are now a million miles from the “liberalised” structure of markets and governance, with all investment choice driven by market signals, and celebrated as such an achievement after the complex and innovative restructuring of the UK power sector in 1990.  The government has already resumed its role as the prime decision maker on new generation investment, and nothing substantial is built without a long-term contractual commitment on off-take that only government or a regulated monopoly can provide. Government has become the de facto “central buyer”. The new proposal simply follows the logic of a return to a more planned and coordinated power sector by explicitly extending this role to transmission. Since transmission investment is frequently an alternative to additional generation capacity (most obviously with international interconnection), this seems entirely logical.

While it is still not clear what changes will result from the OFGEM proposal, one obvious deduction is that we are moving towards the creation of a new body with strategic responsibility for planning and coordinating all significant future investment in the power sector. It would be hard to avoid linking this with the existing functions of government in securing new capacity, through auctions or other means. In its fundamentals, this represents the re-establishment of the planning functions of the old Central Electricity Generating Board (CEGB), but without the CEGB’s functions of ownership and operation of generation and transmission. If this interpretation is correct, and the proposals are implemented, then this represents an essential development for which I have been arguing in several outlets for many years.

To understand how and why, even with successive governments as the most enthusiastic promoters of theoretical “free market” philosophies, we have got to this position, we need to look at some of the basics of power sector and infrastructure economics, and also at the climate policy imperatives.

The infrastructure investment problem

Investors in high capital cost and immobile assets typically require long term contractual or similar assurance. Their assets are almost always specific to one purpose, and depend on a secure long term revenue stream. Reliance on a spot market or short term contracts, the core components of electricity market structures and both dominated by short term factors, are just not good enough to satisfy private investors. This is particularly so for key investors like pension or sovereign wealth funds who are seeking secure but modest returns. And the low cost of capital these investors can provide is exactly what is necessary to keep electricity prices affordable.

Along with construction risks, the biggest risk to infrastructure investors is that, having sunk the costs of their capital investment, future revenues are exposed to opportunistic actions by other parties. These include government, regulators and customer utilities, all with political or economic incentives to attack their future revenue stream. The owner cannot transfer the asset to an alternative use or jurisdiction, and faces expropriation of expected revenues in the interest of lower prices to consumers.

The two main options are inclusion in a regulated utility framework (traditionally vertically integrated monopoly) in which reasonably incurred costs are passed to consumers, or long term contracts with or commitment from a reliable counterparty, usually the only plausible party being the government.   In the UK, network investments have in recent decades typically depended on the former, and generation on the latter (via CfDs, feed in tariffs etc).

Either remedy can work but both draw a monopoly utility, or government, into strategic investment choices. Both are a long way from the paradigm of the fully liberalised market.

The coordination problem

Recent complaints have focused on failure to coordinate offshore wind development with the transmission investment necessary to bring it ashore. But there are plenty of other examples of the need for coordination with low carbon systems, mostly reflecting the fact that these sources are less controllable than conventional thermal fossil plant.  Factors include the advantages of planning for diversity in the siting of wind facilities, the need to get the right seasonal balance of solar and wind, issues around storage and whether to treat it as supply or demand. It looks improbable that any of these issues can be resolved either through short term price signals from power markets, or by “technology neutral” invitations to bid new capacity.

The remedies are either informal coordination within the sector, which risks running foul of competition law or anti-cartel legislation, or a central direction of what types of generation are required.

I have previously argued that the National Grid already plays such a central role that one solution might have been an extension to include a more formal planning or even a central buyer role. But this may well not have been acceptable to a private sector management, and the OFGEM proposals may lead us to an equally satisfactory outcome.

The carbon emissions externality

Climate change is the “biggest economic externality of all time”, to date addressed only to a very limited degree by carbon taxes or emissions pricing.  Low carbon prices, only partial in coverage, may be due to insufficient ambition or vested interest capture, but are grossly inadequate to match any serious estimate of the cost of the externality.

So failure to price emissions adequately means that market solutions cannot work on their own. Moreover the “Theory of the Second Best” implies that once we have one major failure in the market, like the failure to price carbon, we cannot assume that other policies, eg competition policy or a merit order, normally thought of as good, will actually improve welfare rather than reduce it. In our context even the best designed markets will produce the wrong seriously sub-optimal outcomes, for both operations and investment, if the damages of unconstrained emissions are not included in economic calculations.

Recent examples include the huge coal for gas substitution in 2013/14, driven by a temporary change in fuel price relativities, Dutch competition authorities prohibition of collusion between utilities to reduce coal use, and the UK exclusion of domestic gas, but not the power sector, from emissions trading.

But difficulty in allowing the market to “price” emissions is another prime reason why governments cannot and will not “leave it to the market” to meet its climate objectives. Societies can no more afford systemic failure in relation to energy and climate issues than in health or the financial sector.

Dr John Rhys was prior to 1990 Chief Economist at the Electricity Council, and later joining NERA Economic Consulting. He played a large part in UK market and regulatory design, and subsequently in World Bank energy sector reform programmes. He is a past chair of the British Institute for Energy Economics (BIEE) seminar programme on energy policy and climate policy, and currently a Senior Visiting Research Associate at the Environmental Change Institute of the University of Oxford. John is also engaged as a lead researcher with the Oxford Martin School programme on the integration of renewable energy resources. 

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