Everybody now knows that their gas and electricity bills will be much higher this year than ever before. But why? Why are energy prices so much higher? Is it just because Russia has invaded Ukraine?
There’s no doubt that the war in Ukraine, the West’s sanctions on Russia, and Russia’s retaliation by weaponinsing its gas supply to Europe, is a big part of the story. But it’s not the whole story. Supply and demand were already badly out of balance last year – before the war began.
Who decides how energy prices are set?
The system for energy price-setting is different for gas and for electricity. The systems in the UK were set up in the 1980s and 1990s and there’s a good case to be made that what worked 30 or 40 years ago doesn’t work now. What’s more, it will be absolutely hopeless for a future where we will have lots more wind and solar power making the electricity.
The 1980s system replaced the nationalised gas and electricity industries that were themselves set up in the 1920s (for electricity) and the 1940s (for gas). In the 1980s, the government decided that a 40-year-old system was not fit for purpose. We’re now learning that our own 40-year-old system is not fit for today’s – or tomorrow’s – purpose either.
Gas and pipes
Let’s start with why gas costs what it does today.
When you pay your bill, you pay for two separate things. First for the gas itself (this is called the ‘commodity’) that comes to you through pipes. And second for using the space and the compression to drive the gas through the pipes (the ‘capacity’). By law, a company that owns pipes isn’t allowed to own gas; and the gas that you burn is sold to you by companies that aren’t allowed to own pipes. This legal splitting up of the gas and the pipes is called ‘unbundling’.
The companies that you buy gas from have to pay a fee to the company that owns the pipes. This is the National Grid (it’s a private, profit-making company, despite the name). But your bill comes from whoever you choose to buy from – Shell, Octopus, Ovo, SSE, or whoever, and yes British Gas … which is now just one among many suppliers, despite having the same brand name as the old, nationalised company.
These guys all pay fees to the pipeline owner for the right to use the capacity in the pipe. All this is very complicated, and there has to be a rulebook, called the Network Code, that tells everyone how to behave in relation to everyone else. This is to make sure that the gas they put in at one end of the pipe, and sell to customers at the other end, balances out, and that no one’s cheating. Imagine how complicated that is when you decide to change your supplier!
There’s been a lot of talk recently about the energy regulator, Ofgem. The regulator was set up to manage the Network Code rule book, and to decide what fees the supplier companies should pay for using the pipeline. Otherwise the pipeline company, which is a monopoly, would have been able to charge whatever it liked.
Note that the regulator was set up to manage the cost of using the pipeline. It was not set up to fix the price of the gas itself. Nobody in the UK has the power to do that – not the regulator, not the government, and not the companies. When Theresa May introduced the price cap for consumers, and asked Ofgem to ‘fix’ it, she was just pretending that she did have the power.
Pricing gas
The price of the gas that goes into the pipes is set by two familiar worldwide characters – supply and demand. When gas supply around the world is greater than world demand, the price drops a bit, to the point that some suppliers (the most expensive ones) stop producing and selling, because they lose money when they do. Then supply and demand get back into balance.
The problems start when demand is greater than supply. What happens then? If you can use another fuel, then you do (if you’re allowed to). Say you’re an electricity-generating company and you have idle coal-fired power stations – if need be, you turn them on instead of the gas-fired ones down the road. But if you live in a gas-heated home – and about 45 million Brits and about 230 million Europeans do – then you don’t have that choice.
You can choose to be cold of course. I’m one of the 45 million Brits, and on a cool September evening I’m typing this wearing fingerless gloves, two shirts and a sweater. Because I know we have to reduce demand in order to get back to any kind of normality. When it gets to December … and February … what will I do then? And what will the neighbours in my terrace do? All but two of my 12 neighbours are pensioners, living on benefits, or on minimum wage.
Some people can stop using gas for their ordinary jobs – read entry 734 on the Davis Downside Dossier to see how Britain’s cucumber growers are reacting. Hit by labour shortages after Brexit, about half the country’s cucumber growers have simply shut up shop now that they can’t hire workers and can’t afford the gas for the greenhouses. Don’t be surprised when cucumbers get much more expensive. Supply and demand will strike again. Blame Brexit; and blame the gas crisis.
So, what is the price that will cause enough reduction in use of gas to bring supply and demand into balance again? Is it twice as high as it was before? Five times higher? Ten, 20 times higher? The truth is that nobody really knows. This winter maybe we would have found out, but the government seems ready to borrow as much as it can to help us out.
We’ll see whether the government really can do this, or whether the people who lend money to governments (the bond market) think they can’t trust the government to pay them back one day. Last week, the cost of taking out insurance against the UK defaulting on its debts went up – so people are getting nervous, and don’t be surprised if as a result the pound soon drops to below one-to-one with the dollar (you heard it here first).
Electricity and wires
What about electricity? Why are electricity prices going up?
Only a bit of our electricity is made in gas-fired power stations. Some comes from nuclear power; about as much comes from offshore windfarms; a little from onshore windmills; a little from solar power, and some (about as much as solar) from a single power station in Yorkshire (Drax) that burns waste wood products, olive oil waste and various other stuff. This is all cheaper than gas, so why is the price of electricity going up so much?
The explanation is once again back in the 1980s. Just like for gas, the rules that were set up in the 1980s said that no one who owns power stations can also own the transmission wires that bring electricity to your home, office, school or factory. ‘Unbundling’ again. National Grid owns the wires. And different companies own the power stations. They compete with each other to access the wires and to sell to you – but again, it’s complicated and there’s a Network Code for electricity too.
Some bright spark looked at the economics textbooks and figured out that the efficient way to price the electricity that the power stations make was to have the cost of the ‘marginal’ generating station (it’s a gas-fired one) determine the electricity price for everybody. They were right, and it’s worked well for quite a long time, making electricity a pretty good deal for everybody.
But what is efficient is not necessarily robust. Think belt and braces. It is efficient to hold your trousers up with a belt. Or with braces. It is not efficient to buy both. But it is robust, and if one of them goes wrong, you’re still OK.
The gas market has gone wild – because no one knows how high the price has to go to bring supply and demand into balance. And because of the design of the electricity market, the electricity price has gone wild too. It’s been efficient, but it’s not robust! We need to disconnect the price of electricity from the price of gas. It makes no sense today, and it will make less sense in a wind and solar-dominated electricity system tomorrow.
Solutions to energy prices and the political response
I’ve been nerdily following the European Union’s energy ministers’ meetings. There was a meeting a week last Friday, and the next (an emergency meeting) will be on 30 September. The other 27 countries in Europe look ready to decide two things:
- That the cost of electricity from anything that’s cheaper than gas will no longer be set by the gas price
- That the benchmark gas price is only part of the story about what gas really costs, and that an alternative is needed, which they will make sure gets established.
If the 27 European countries carry this through, these are sensible responses. The British government will probably find itself following suit. Our problems are structural, and our government, like the 27 in the EU, also needs to come up with a response to fix the problems of the 1980s energy market designs. It’s a response that needs to be more carefully considered than just ‘we’ll borrow more money to tide people over for the next two winters’.
The borrowing to help us out will calm the worries that I and my neighbours have about our heating bills this winter, and it might work. But it might not – you heard it here first.
