Global economy supplement: energy bills will rise

One of the many challenges for energy investors and planners concerns timescales. Energy investments involve huge amounts of capital with long payback periods, and operating lifetimes generally counted in decades. Yet market sentiment, and energy prices, change rapidly. A glance at the oil price over the last 50 years illustrates the point.

As had been the case in the 1970s, the five-fold increase in the price of oil through the 2010s was a major factor in the revival of interest in both coal and nuclear power, as well as driving a huge rise in energy costs generally. The oil price crossed the $100 a barrel level in 2010 and has remained there ever since (except for a short period in 2011). The gas price, of much more importance to electricity generation and heating in most areas of the world, tends to shadow the oil price to a considerable degree. Until recently, that is. Having stood at $115 per barrel in June, by October the price had slipped to around $85, despite conflict in the Iraq region.

A variety of factors have contributed to this. Hydraulic fracturing (fracking), not just of gas but also of oil, in the United States has had a major effect. In 2005 the US imported 60 per cent of its oil; by 2014 that was down to 30 per cent, with every prospect that the US will become an oil exporter. The end of the US embargo on Iranian oil and the restitution of Libya’s oil infrastructure, damaged during the overthrow of Muammar Gaddafi, have boosted global supplies. The risk of a global recession and the slowdown in China in particular have reduced demand forecasts, as has the prospect of Japan reopening some nuclear plants. In addition, vast new reserves have recently been discovered in the eastern Mediterranean, Brazil and the South China Sea.

Of course, as the situation in the United Kingdom (not atypical of many developed countries) illustrates, falling wholesale prices are not the end of the story. Household power bills can be divided into five components. In the UK the wholesale price of power in the marketplace, a bit less than half of the total, depends heavily on the price of gas. Getting the power from the power station to our homes accounts for roughly another sixth. Operating costs (running an office, meter reading) make up a tenth, plus a profit margin of around 7 per cent. The other quarter, government costs, includes the costs of environmental and social schemes.

The availability of generating capacity is important for wholesale prices. If a few plants break down or have to be taken off line for safety checks, this tends to raise wholesale prices. It forces the use of more expensive, often dirtier, alternatives while the fear of shortages increases the price people are willing to pay for secure supplies. Unplanned power outages are extremely expensive for consumers. The wire network, by which electricity is delivered, is a regulated monopoly. A new grid capable of connecting to current levels of reliable power stations when the wind isn’t blowing, and windfarms and other variable renewables when it is, will cost tens of billions. The costs of social and environmental schemes similarly are likely to continue to rise.

Social measures to help the fuel poor are of course highly worthwhile. Renewables have many attractions—a very efficient way of transferring money from hard-pressed bill-payers to rich landowners, manufacturers of equipment and an army of lobbyists and researchers. What they are not so good at is providing electricity when we need it and not when we don’t. This imposes huge costs on the system, requiring for example the reintroduction of capacity payments to incentivise reliable generators to keep their plant available even when it is not earning money because, say, the wind happens to be blowing. Direct green taxes have largely been moved onto the backs of taxpayers but wider system costs will show up in bills, even ignoring the near-doubling of offshore wind costs during the last decade.

The power cuts and astronomical prices in California in 2000-01 show the acute dangers of price caps—a capping regime has at least three potential negative effects on fuel bills. First, companies will buy more gas further in advance to hedge against price rises which could not be passed on to consumers. This would lead to higher prices than a mix containing a higher proportion of short-term contracts. Second, companies are nervous of passing on falls in wholesale prices to customers in case they get stuck with rising wholesale prices. And third, with rates of return already as low as 7 per cent an impression that even these levels are under threat will drive out necessary investment. In the very short term this may reduce bills, but at an enormous cost in the medium to longer term.

So next year’s bills probably won’t change much whoever wins the general election. Decisions we take will cast long shadows on future costs and reliability. But if wholesale fossil prices continue to fall we may see a slowing of price rises, maybe reductions—until the screw turns again.