Thursday, 5 December 2013

UK energy policy – Why a price freeze won’t save consumers money in the long run

Listening to politicians about energy policy you would think carbon reduction targets are low down the list of priorities as the debate about affordability rages on. One minister went as far as to change the energy trilemma to an energy dilemma, stating that UK energy priorities are affordability and security of supply, carbon reduction was noticeably absent from the list.

For the past fifteen years, we have had a renewable policy but no energy policy, which has helped lead to the current problems. Our current carbon reduction targets for 2030 require the UK to build 100GW of new renewable power generation capacity. This is an enormous task, particularly as the public and capital markets are being asked to fund it. It also looks implausible at this stage, given the recent backlash we have seen against rising energy bills. To put this target into context the dash for gas the UK entered into in the 1990s involved building only 19GW of new generation capacity!

Two options: change policy or hike prices
Our current renewable targets were drawn up with far too little thought or worse little understanding of the consequences for consumer bills. I believe at this point the Government has only two options, either change policy or convince the public that higher bills are worthwhile. Both require bold and radical action.

Which of course is possible - politicians can announce bold and radical policies – Ed Miliband announced a 20 month energy price freeze if Labour got into power at the next election. The problem with the policy is that it adds fuel to the fire rather than helping to solve the problem.  It has certainly helped ignite the debate about affordability and Mr Miliband personally gained a great deal of political capital but will it benefit consumers?

False hope
Sam Laidlaw, the CEO of Centrica, recently said that the price freeze creates false hope for consumers. We believe a price freeze would lead to higher prices in the long run for consumers for a number of reasons:

  • Global energy prices are not going to remain flat for 20 months simply because Mr Miliband wills it to be so, therefore energy companies will have to hedge forward power prices prior to the price freeze. If all the energy companies are trying to buy all their power needs in advance at the same time, for the same period, that will push up demand. Higher demand is likely to lead to higher power prices. 
  • Mr Miliband's comments mean it is less likely that energy companies will invest in new generation capacity in the UK. Given that 25% of the UK’s generation capacity is expected to shut in the next decade, new generation is needed and a slowdown in new build will lead to power shortages, which will likely lead to higher power prices.
  • Increased political risk increases the cost of capital, which means companies require a higher return on investment to offset higher risks. Which will likely lead to higher bills in the long term. 
  • Finally, if prices are frozen, what happens if global gas prices and therefore electricity generation prices fall during the freeze period - how is this passed onto consumers? 

If required, the energy companies will freeze prices for 20 months, but consumers should be under no illusion that this will mean lower bills beyond this.

On Monday, the coalition tried to draw a line under the affordability debate by announcing reductions to bills which will total £50 for the average dual fuel customer next year. This will be done by putting off some electricity distribution costs for one year, saving £5, moving the cost of the Warm Homes Discount scheme into general taxation, saving £12, and extending the deadline for energy efficiency measures to be installed by the energy companies, saving £35 on the average bill.

Little comfort for investors
The energy supply companies share prices have rallied marginally recently but that is little comfort for investors, who have seen the share prices of Centrica and SSE fall 15% and 16% respectively, since Ed Miliband first suggested a price freeze.

You therefore might be forgiven for being surprised that given this backdrop, the UK government announced changes to its Electricity Market Reform yesterday which focused entirely on support for new renewable generation. One of the biggest beneficiaries of these changes will be Drax, which has rallied strongly in the past 24 hours.

Ironically, it has historically been the UK’s largest carbon emitter, as it is the largest coal plant Europe. However, it is planning to convert half its plant to run on biomass rather than coal and is therefore eligible for government renewable support. Once all three units are converted, Drax will be one of the largest renewable generator in the UK. Drax, as purely an energy generator, is fortunate to have no residential energy customers, so currently sits on the right side of the energy debate.

Elaine Coverley
Head of Equity Research

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