Peak Prices: What’s up with the energy prices?

As energy companies continue to increase gas and electricity prices, you’ll not be alone in feeling the squeeze to your bank account. In a seemingly ever upward trend, it is difficult to see where the prices will peak. Or is it? Insight Quarterly takes a look into the murky world of predicting the price of energy.

In recent years, wholesale gas prices have more than quadrupled. This has been quietly blamed on rapidly depleting North Sea reserves, low capacity for new supplies from the continent due to infrastructure bottlenecks, and a cold winter. Once again there are calls to investigate, with insinuations of market rigging and profiteering.

Gas provides the fuel for 40% of our electricity needs, as well as the majority of our heating needs. In the post-liberalised early 1990s, when there were many players in the energy market, recent years have seen a consolidation within the industry as the larger players gobbled up the smaller ones unable to compete in a market with low prices. Most people now enjoy the services of around six major vertically-integrated energy companies. They own and manage the gas fields, the pipes that pipe it to the power stations for conversion into electricity, and supply it via infrastructures such as the National Grid and the gas network to our homes and offices.

The price that people pay when they turn on the kettle or their boiler fires up is a difficult beast to break down. It is made up of the following components:

• price of generation, including fuels – coal, gas, nuclear – and the cost of plant,
• the cost of transmission and distribution, 
• the strategic planning, implementation and glossy materials that go with marketing, 
• amounts paying the price for various government policies such as the Energy Efficiency Commitment and the Renewable Obligation Certificates,
• a mark-up or -down for uncertainty – commonly referred to as a ‘security premium’.

While some of these costs are fixed, others are variable.

The costs of building new plants are relatively fixed. They are factored into the price of energy at a known rate. The component with the highest variable cost is that of the fuel.

Figure 1: Gas and power prices (Source: DTI, 2005)

Much of the UK’s electricity (40%) is provided by the burning of natural gas in combined cycle gas turbines. Unlike oil, there is no unified market for gas, although uncertainty and speculation in the oil markets often ripple through to deals struck over the price of gas. Contracts are therefore often bilateral agreements between the companies that pipe it from the North Sea gas fields or via international pipelines and the people who use it to create heat and/ or power. It has been calculated by consultants McKinsey that these wholesale prices make up around 30-50% of retail prices. As can be seen from Figure 1, both wholesale and retail prices have seen substantial increases following marked declines in through the 1990s.

When looked at in real terms, i.e. those adjusted for inflation, despite recent rises, average prices in the UK are still well below 1985 levels. The real cause for concern is whether these upward trends can be expected to continue. To answer that, it is necessary to look at the underlying factors concerning price.

Fuel supply
Gas
As the North Sea gas fields mature, the UK is moving from a position of net exporter of gas to that of an importer. Much of this comes from Norway, where more restrictive government policy has preserved more of the field. The UK was world-class in allowing the private sector to develop its reserves, and so has provided a double edged sword case study into the effectiveness of the private sector for exploiting natural resources. Costs came down, but so did the reserves. It was so effective that companies have exhausted reserves at a faster rate than expected. It now could be argued that the country enjoyed a ‘windfall’ increase in welfare. Some economists have argued that we have squandered this. Others point to Japan which is the world’s second largest economy, despite scarce national energy resources. Admittedly the higher prices means that smaller companies are moving into develop fields that were considered uneconomic by larger companies, but overall the rate of depletion has taken most by surprise. Therefore the UK will have to rely on imported gas.

New pipelines are under construction, with the Langeled Pipeline scheduled for completion this year (2006), as well as expansions to the existing infrastructure from Belgium providing an increased flow. This is expected to bring down the wholesale price of gas within the next several years, although after 2010 further supplies are expected to be required.

Figure 2: Existing and proposed gas pipelines (Source: Oxford Institute for Energy Studies, 2005)

However, with as yet no freely functioning liberalised market on the continent, access to the piping and pumping infrastructure is largely restricted to those who own it. Therefore even with high spot prices for gas due to the cold winter, it has not been possible for adequate supply to be brought in on demand. Some have hinted at ‘gaming’ tactics being employed, to drive up UK prices even higher.

Coal & nuclear
Old King Coal was replaced during the 1990s ‘dash for gas’ as the dominant fuel for the Dirty Man of Europe’s power stations. While much has been done to clean up the sulphur, particulates and NOx emissions, the carbon content of coal is far higher than gas. Therefore until the widespread economic capture and storage of CO2 becomes a technical reality rather than a policy aspiration, coal-fired power stations will continue to bear the brunt of carbon emissions reduction schemes. These regulations will effectively continue to drive up the operating costs of these plants, which will in turn be passed on to the consumer.

Nuclear power has yet to prove its economic case. There are many that argue if renewables had been subsidised as much as nuclear over the years, we would probably be living on a green planet now. Newer nuclear technologies, such as pebble bed reactors, are said to provide better inherent safety and value for money, and nuclear doesn’t attract a direct carbon penalty for generation under the EU ETS. However, there is still much public mistrust of nuclear regardless of the whiff of hypocrisy noticeable around international finger wagging at other countries’ nuclear programmes.

Marketing
The dark arts of marketing are difficult to put a price on. Depending upon whether a company wants to capture a larger slice of the market by offering lower prices than competitors, or that they need to increase their profit margins and have done the maths based on customers lost if the price goes up, the pricing strategy adopted by a company can push the price up or down.

Indeed, British Gas claims that it is only now passing on some of the increased wholesale costs to their customers and that its domestic service has been operating at loss over the last half-year. This indicates a pricing strategy that seeks to keep its customers at a certain level, although they have lost more to its rival suppliers than any other. They also introduce ‘value added’ services such as the long-term fixed price guarantee that is designed to retain those loyal customers who fear the effects of a ‘free’ market. In effect, they are introducing a futures market to the domestic consumer. However, they have also always been the first to raise their costs. This could well be due to the fact that they are the largest energy supplier, and feel they can lose some market share and still make considerable money.

However, a counter movement has been instigated by Ofgem whose mission is to ensure that an oligopoly – where a couple of large companies act in concert to collectively and ‘artificially’ raise the price – is not achieved. Therefore the ability of consumers to switch supplier is a key weapon in ensuring competition and not collaboration between suppliers is the rule. Ofgem, politicians and consumer groups are on the constant watch for oligopolistic behaviour by the energy suppliers, hence recent calls for enquiries post-price hike. There are a number of organisations whose role is to allow consumers to easily compare prices and switch.

Transmission and distribution costs
The wires and transformers, pipes and storage centres that make up the transmission and distribution networks for electricity and gas are massively expensive bits of infrastructural kit. And the UK’s needs significant investment in its slightly creaking energy skeleton.

According to the government, transmission and distribution costs add around 20% to the average energy bill. This price is capped by the regulator Ofgem. Its four power transmission networks are not currently well set up to deal with adding lots of new distributed generation centres, such as wind farms. Transmission companies claim that they will need some £3 billion worth of investment between 2007-12, which is nearly twice as much spent from 2000-06.The larger distribution network will also require an estimated £5.7 billion worth of improvement. Whether this increase is being priced into current bills is not clear.

As discussed above, the new gas pipelines being run into the country from the continent should bring more supply into the country. But that supposes that the continental suppliers are acting in a free market, and seek out the highest return for their commodity. And that means that prices need to be high enough here to avoid the gas being piped to other spot markets.

There is also significant investment in Liquefied Natural Gas (LNG) terminals, with the largest being at Milford Haven where two are under construction. Another is also being developed at Canvey Island. These will bring ships in with LNG for gasification, which will then be pumped into the gas network.

Energy policy
Don’t mention the word ‘tax’, but most people are paying a certain amount through their energy bills for the government’s aspirational targets of destroying fuel poverty, increasing energy efficiency and promoting renewable energy production. With the introduction of the EU Emissions Trading Scheme, the price of CO2 will increasingly get factored into people’s energy bills.

It was estimated that the Energy Efficiency Commitment (EEC) in its first period cost the average household an additional £15 per year. Looking forward to the third EEC period, rumour has it that targets will be set at three times the EEC 1 limit, which should add more. However, Ofgem have set price caps on the amount that energy suppliers can pass on.
 
The Renewable Obligation designed to promote investment in renewable energy production will, according to a DTI report, cost the consumer an additional £600 million. While sounding a lot, this boils down to around £10 per year.

The price of the carbon is increasingly a traded commodity, and therefore the price fluctuates according to demand. In recent cold winter months, the price for a tonne of CO2 has climbed around 30% to €27 tCO2e according to market analyst Point Carbon. It is unclear at this point whether it is being passed onto the customer as yet. However, as the market matures and should carbon certificates become scare, you can be sure that producers will only bear so much pain before seeking to share the burden.

All these effects must be put into perspective. With the average household fuel bill reaching around the £1000 mark, these costs are marginal. They also provide significant benefits, such as reducing the amount of energy needed through energy efficiency gains and reducing carbon levels.

However, again, these prices only seem set to rise.

Security premium
As the source of fuel moves further from our shores and in the absence of a fully liberalised market, there are increasing concerns over the geopolitics of gas. Russia holds some of the largest reserves of the substance and is set to become the largest supplier to Europe. When Russia decided to turn off the taps to Ukraine, a chill wind blew down the necks of most policy makers. One of the trickiest components to price in is that of a security premium.

Even in an open market, where traders are constantly assessing the future and bringing aspects such as security questions into the price, the figure is unknown. Where contracts are bilateral agreements, and spot prices are highly temperamental, the tasks become impossibility. One way to look at the question is who holds the reserves, and for gas the answer is in huge state-owned energy companies such as Gasport in Russia and the Iranian National Oil Company.

While revenues from the export of gas provide massive percentages of national incomes, the use of energy exports as a weapon should not be ruled out. The effects of this will be felt particularly in the spot market, and users who rely on ready access to meet spikes in demand would suffer as a consequence. Witness the recent concerns due to the dispute over gas between Russia and the Ukraine.

All this indicates the need for more liberalisation and increased independence through provision of home-grown sources to provide the biggest base load possible.

Conclusion
While it is a fact that new infrastructure is being built, which should bring in more gas thus lowering the price, it is estimated that price will remain relatively high. In many models developed over the past year, it appears that the price is tracking the ‘high’ scenarios. This is due to the slowness of liberalisation of the European market, declining reserves of North Sea gas, and ever increasing demands for power.

Figure 3: Spot-market gas forecasts (Source: ILEX, 2005)

Due to slack in the system, as wholesale prices take time to filter through into retail prices, further price rises in the near term should not be met with surprise. However, it appears to many that we are nearing a peak. The prices we are now paying for gas should, in theory, decline slightly in the medium term. It looks likely that increasing environmental regulation will keep the prices for power at high levels, making efficiency logical and allowing new renewable technologies to come on stream.

A recent report by consultants IPA Energy for the Energy Savings Trust on the ‘spark spread’ – the difference between the cost of gas and electricity – indicated that while the cost of gas should in the medium term come down, the spark spread will continue to rise; for reasons discussed above.

And yet very few predicted the circumstances that we now find ourselves in. The art of crystal ball gazing is fraught with danger. Up or down, it seems clear that the low energy prices we enjoyed during the end of the 1990s and early 2000s are gone. Unless there is radical technical innovation, or a world-wide depression that reduces demand, it is time to prepare for a future that costs more than the past.
 

Disclaimer: The views expressed represent those of the author alone and are not reflective of Sustains corporate position.