In the midst of current debates about energy costs it is important to retain a sense of perspective both about what has happened and future prospects.

While this will not console those struggling to pay their bills today, energy bills rose by much less than general inflation from 1990 to 2004. The reasons for this extended pause shed light on more recent developments. There were three key factors: international prices for, in particular, gas were relatively stable, new technology for gas-fired plants reduced the costs of electricity generation, and there were significant improvement in the operating efficiency of networks and generation following the breakup of energy monopolies.

This conjunction of circumstances encouraged the belief that the UK could set ambitious targets to reduce CO2 emissions and switch to renewable energy without incurring large costs as a consequence. Unfortunately, policymakers neglected the reality that international energy prices follow a strongly cyclical pattern while the other factors represented one-off gains that would not be repeated. Energy prices were already increasing before the Climate Change Act of 2008 was passed but policy choices made at that time have had a major influence on trends in energy costs since then.

One key factor is that the UK became a large net importer of gas in 2005. As a consequence, gas prices in the UK market are now determined by import costs rather than by demand and supply within the UK. This transition coincided with a sharp increase in international oil and gas prices from 2004 to 2008. Gas prices in the UK reached a peak in 2008 but fell in 2009 due to the financial crises and have remained below the 2008 level since then. However, the UK has not benefited from the huge expansion in shale gas production in the US, partly because import and storage capacity for liquefied natural gas (LNG) is limited and partly because of high demand for LNG in Japan and East Asia following the closure of nuclear plants.

Improvements in operating efficiency were partly achieved by deferring investment in the replacement and expansion of networks. As the UK relies more on imports and renewable energy, the level of investment in storage, pipelines and electricity networks has to increase. The regulated costs of greater investment are passed on to customers through charges for network use. This will continue for the rest of this decade. Indeed, some believe that the UK needs more investment than is currently planned to expand gas storage and provide greater security of supply in future.

The third factor driving up energy prices for households and some businesses is the increasing cost of programmes to reduce emissions of CO2 and to promote the use of renewable energy. These goals overlap but they are not identical. The expansion of renewable energy is an expensive method of reducing CO2 emissions and would not be the first choice if this were the sole objective of policy. Both goals are supported by a plethora of incentives whose details are often obscure and whose net impacts are hard to assess. In addition, some costs of relying upon renewable energy, such as backup to offset intermittent production and extensions to the transmission system, are incorporated in charges borne by all network users.

Stripping away the complexity, the net effect of subsidies for renewables and taxes on CO2 emissions is to offer an average price for electricity generated from the main sources of renewable energy - wind and wood chips - that is at least double the equivalent pool price of electricity which is determined by the cost of running gas-fired generating plants. The incentive is somewhat lower for new plants but the margin is sufficient to sustain long term costs of wind and wood generation that are 60-80% higher than for the most efficient gas plants. The cost differentials are much greater for offshore wind (at least 150%) and solar photovoltaic panels.

To meet 2020 targets for renewable energy, the share of renewables in total electricity production will increase to three times its level in 2012-13 and the share of renewables in electricity, heat and transport will increase to nearly four times its level in 2012-13. Since this growth can only be achieved by relying upon increasingly expensive sources, the targets mean energy costs will increase by at least 3% per year on top of inflation. In practice, the effective increase may be significantly higher than this estimate.

As the costs of meeting the targets set when energy prices were much lower has escalated, the justification for the shift towards renewable energy has shifted. The current argument is that a huge investment in capital-intensive generation is required as insurance against volatility in international gas prices. As a corollary, this might imply a strong commitment to developing the UK's resources of shale gas but this logic has not proved attractive. In any case, the level of future gas prices required to justify investment in renewables is much higher than the planning assumptions used by investors. Hence, there is little prospect that subsidies for renewables - and nuclear power - can be scaled down before 2020.

Natural gas is the key benchmark for energy prices in the UK because of its role in domestic heating and electricity generation. Sharp increases in international prices in 2008 (due to demand from China) and again in 2011 (due to the Fukushima earthquake) have been passed through to UK consumers. In the longer term it is policy decisions that are the major source of increases in the prices paid by households in the UK. Better insulation and other investments in energy efficiency can achieve one-off reductions in energy use, but above-inflation increases in energy prices are an unavoidable consequence of current commitments to expand the share of renewables in energy production and reduce CO2 emissions.

 

Gordon Hughes has been a Professor of Economics at the University of Edinburgh since 1985. He spent 10 years as Senior Adviser on energy and environmental policy at the World Bank in Washington, DC. Since returning to the UK, he has advised a range of public and private organisations on regulatory, economic and environmental policies in the energy sector.