Energy price risk – perception and reality
As our energy systems developed, electricity prices did not start out as an economically derived supply/demand price. Supply dominated pricing as owners of generation assets made calculations based on capital costs depreciated over a significant number of years, operating costs including the commodity cost of fossil fuel and then added a desired return on capital to arrive at a wholesale market price. This set up was made possible through a combination of vertically integrated utilities, a generation mix consisting of variable margin cost generation units due to the commodity cost of the fuel they were burning and a demand side that was price inelastic. These conditions no longer hold true and this change has caused a seismic shift in electricity market economics which is only just beginning to filter through to price.
The first solar panel that was installed on a roof, the first wind turbine blades that started spinning commenced the inextricable march away from pricing that was divorced from supply/demand economics. The growth of zero marginal cost renewable generation has created conditions of over supply and will eventually create undersupply when enough loss making fossil fuel generation is retired. This over and under supply creates the pricing dynamic that enable innovation to flourish. Energy only markets, where they exist in the world, are able to function because high prices have created the investment case for fast response gas fired generation. Price risk during high demand/low supply events is mitigated by making the electrons in fast response gas fired generation. The same market conditions will create the investment case for a flexible demand-side and battery storage.
The licensing framework for electricity suppliers/retailers is premised on the need to hold a party responsible for price risk. Individual customers, even large customers are reluctant to take on this price risk as the inability to perfectly hedge unknown future demand means there is always a level of residual unhedged price risk, even where the party diligently attempts to reduce risk through hedging. A stagnation has occurred in electricity retailing (supply) as smaller, more innovative new retailers lack the balance sheet strength to sustain risk positions.
The most cost effective way of managing price risk is through developing a customer base capable of being flexible with the time of electricity consumption. However, this requires courage to manage price risk though innovation. The Tempus Energy UK supply business was the first electricity supplier in the world to follow this model. When this model is widely deployed, renewable generation will outcompete fossil fuel completely and it will be the end of fossil fuel burning to generate electricity.
In response to the worrying risk of undersupply, governments around the world yield to lobbying based on fear tactics. The UK government is particularly susceptible to this lobbying due to the historical memory of the 1970’s three day week caused by oil price spikes. In 2014 it launched a capacity mechanism to build the investment case for gas fired generation outside energy markets. This thinking was flawed for several reasons. The UK has long been characterised by a lack of price transparency and liquidity in the electricity wholesale market due to bilateral trading within corporate groups. E.ON sells to E.ON, Centrica sells to British Gas, EDF to EDF etc. This bilateral trading reduces the liquid market for independent supply companies making it harder for them to access generation and compete effectively. Evidence of this is plentiful in the market share held by the Big 6 energy companies.
Layering a capacity market on top of an inefficient market can only add to the inefficiencies, precisely at the time when innovation offers the opportunity to create a truly efficient market as technology can facilitate new business models that disaggregate the old. The UK Capacity Market has failed completely in driving the investment case for new gas fired generation and early auctions provided a windfall profit to existing nuclear plant, forced customers to pay the tax bills of coal fired generators that had been taxed out of the market and incentivised diesel generation both through capacity market obligations and through the payment methodology. The World Health Organisation has declared that particulate emissions from diesel generation are carcinogenic and shorten lives. In London air quality has significantly deteriorated and there is growing evidence of increases in early deaths from breathing diesel particulate emissions.
This has meant a growing distrust in the motivations and actions of the Big 6 by customers who feel they are being cheated but don’t have the data to verify if this is the case or not. This is coupled by a reluctance for change on behalf of the Big 6 and the strength in lobbying terms of industry organisations like Energy UK that are perceived as working for industry participants, not customers. It is inevitable that this approach will eventually fail as anyone serving customers who fails to act in their best interests eventually fails. The urgent need to resolve climate change means there is a pressing need to ensure this fails quickly and the best ways to ensure this is for innovative companies to serve the interests of their customers by enabling demand flexibility.