Mind the Price Freeze Gap

07 Sep 2022

Whoever won the race for Prime Minister would have had energy prices at the top of their agenda, and now the success of Liz Truss has been announced it should be no surprise that she has kicked off with an energy price freeze. The cost to do this appears huge – £100bn appearing in the news media (FT 5th September 2022). There are about 25 million households in the UK, so if domestic bills are held at £2000 against a projected rise to £4000, the cost would be about £50bn per year. It appears that government is earmarking a similar amount for commercial energy users. Even in a sector accustomed to large numbers this is a very, very large number.

The details of the price freeze have not yet been announced but the proposal appears to be that energy suppliers will be lent money by the government so they can hold prices below what it costs to buy energy on the wholesale market. This will be paid for either through government borrowing and ultimately through future taxation or energy bills.

The price of power

Can government do anything to reduce the total cost, for example by pushing down the price of gas or electricity on the wholesale market, rather than just subsidising prices to consumers? Back in April UKERC proposed a scheme that would reduce the prices paid to nuclear and renewable generators, who provide about 60% of our power and currently benefit from very high prices. Our idea was to put them all onto the long-run contracts called CfDs, currently only available to the latest renewable schemes and an as yet unfinished new nuclear station. Our idea is now endorsed by the industry and appears to be favoured by at least some in government. Our analysis showed we could save consumers up to around £20bn. This was based on last winter’s electricity prices. Prices have gone up, so the saving now is larger. Cornwall Insight estimate it at about £40bn.

UKERC’s scheme could reduce the cost of electricity from the fraction that is not gas-fired. What about the rest? Could government cap the price of all electricity? In theory yes, provided they are prepared to intervene in the market in more dramatic fashion. Spain and Portugal have capped the wholesale price of electricity and reimbursed gas-fired power stations for their losses. In effect, normal operation of the market has been abandoned and gas-power stations are now subsidised so that the wholesale price of all power generated comes down.

What about gas?

Electricity is about half of the combined bill for household energy. What about the other half – the gas we use directly, to heat our homes and businesses? If the government is minded to do so then it could also intervene in the price of gas. UK gas prices are set at what is called the National Balancing Point. This is a notional entry point for gas into the GB system, from our own North Sea, from Norway or the EU, and via tanker. The price is set by the ‘marginal unit’ needed to meet demand. There is little doubt that the NBP price is far above the cost of production from our own North Sea. One idea is that the government could cap the price paid to domestic gas producers. We would still need a globally competitive NBP price to attract LNG cargoes and pay Norway. Opponents also argue that a lower price would discourage investment. Primary legislation would be needed, and compensation to producers might be needed. But the potential saving to the Treasury could be huge, given that domestic production still provides about half our total gas supply.

None of these interventions is without complexity or potential unintended consequence. For example, price capped UK gas producers could export their production to neighbour countries where prices are higher, leaving an even more expensive shortfall. The same is true of electricity, which might flow through interconnectors to France and elsewhere if we subsidise it here (as the Spanish have found). This points to the importance of concerted action across Europe. The Commission and EU capitals are making very similar noises about price caps. Not surprising, since we all face much the same problem – which could be described as a common energy enemy. The importance of a collaborative approach, which could be described as a Western European energy alliance, is clear. Government would also need to reassure investors that it is not going to meddle in markets continuously (something the UKERC scheme helps guard against).

Thinking the unthinkable?

UKERC’s proposal was a voluntary scheme that required no primary legislation. Even so, when we introduced it less than 6 months ago it seemed quite radical. How things have changed. Liz Truss may have campaigned as a free-marketeer but the pressures to intervene dramatically in energy markets are now huge. Supporting hard pressed households and businesses is the political goal, but there are very significant macroeconomic drivers too. The price freeze could take 2 percentage points off headline inflation according to Bank of England analysis. It could also head off a recession, given the scale of the potential hit to spending. Even wealthier households will struggle with a £400 per month energy bill, and the economy would struggle with the impact on wider spending. This is why the price freeze was announced. The cost of the freeze is why interventions in the market that would have seemed implausible even a few months ago may now be on the agenda.

Commentators in the energy space might once have been rather overly-fond of the term ‘war footing’ when referring to action on climate change. We are now finding that an actual war in Europe transforms the context against which energy market interventions are assessed. Intervening in wholesale gas and power markets will have consequences and is not to be undertaken lightly but could dramatically reduce the fiscal cost of the price freeze. Pro-free market as they no doubt are, the choice facing incoming Prime Minister, Chancellor and Secretary of State appears to be to intervene in gas and power markets to an extent unprecedented since privatisation, or take an even bigger hit on the public finances.