UK electricity market needs reform, but changes must not deter investment

Electricity prices have risen dramatically in the UK and elsewhere in recent months, putting severe pressure on consumers and businesses. Recently announced UK government intervention will only provide relief in the short term - bolder structural reforms are needed in the UK electricity market to reflect the growing importance of low carbon electricity generation. It is imperative that these reforms don’t dent investor confidence in the UK as a leading market for the development of new electricity generation sources.

The Russian invasion of Ukraine and subsequent reduction in gas supplies from Russia to western Europe has has had a significant impact on energy markets across the continent. The UK does not rely on Russia for gas but is affected by price rises because gas is a globally traded commodity. Reduced supply from Russia has driven up gas prices in the UK and elsewhere. This in turn has had a significant impact on electricity prices in the UK, since we rely on gas to generate a sizeable proportion of our electricity requirements – it accounted for 35.7% of generation in 2020. High gas prices mean high electricity prices because the short run marginal cost of gas generation tends to set the electricity price in the UK for a large proportion of the year based on current market arrangements. 

The UK government has introduced an Energy Price Guarantee for households that limits the per unit cost to billpayers, meaning a typical household will pay around £2,500 a year for energy. A similar scheme, known as the Energy Bill Relief Scheme, was announced for business customers.

The government also said that it would impose a temporary cap on the revenue renewable energy generation projects which are not supported by contracts for difference can earn. This is known as the Cost-Plus Revenue Limit and it is not yet known what level it will be set at. The government said that it plans to consult on its precise mechanics shortly.

The introduction of a Cost-Plus Revenue Limit, exacerbated by the lack of detail on how the limit will be calculated, how long the measure will be imposed for and what proportion of revenue in excess of the limit a developer can retain, has introduced uncertainty and undermined investor confidence in developing certain forms of new renewable generation capacity in the UK. The lack of certainty regarding how much revenue a developer will be permitted to retain from a new project has made it challenging for investors to take key decisions on new renewables projects, such as entering into turbine supply agreements or long term power purchase arrangements, which in turn will likely result in project delays. Further uncertainty has been introduced by recent suggestions that the UK government might seek to impose a windfall tax on renewables developers, as an alternative to the introduction of Cost-Plus Revenue Limit.

The Department for Business, Energy and Industrial Strategy (BEIS)’s ‘higher demand’ scenario indicates the need for around 2.5 times more additional generation capacity by 2035 and over four times more by 2050 from 2020 levels, with significant additional electricity generation capacity required to decarbonise the heat and transport sectors and achieve the government’s aim of decarbonising the power sector by 2035. Consequently, we can ill afford market interventions by the government which stymie investment in new low carbon generation, if even for a short period.

While some short term market intervention by the UK government is understandable and reflects what has happened in other markets, more significant reform of the UK’s electricity market is likely required to better insulate UK electricity consumers from the impacts of spikes in global gas prices. The UK government recently consulted on an ambitous and wide ranging variety of potential reforms to the UK electricity market. The key purpose of the Review of Electricity Market Arrangements (REMA) was to consider whether current market arrangements were fit for purpose and adequate to achieve decarbonisation of the power sector by 2035.

One market reform considered as part of REMA would be the effective splitting in two of the current wholesale electricity market. This would involve moving from a single national wholesale price, to twin wholesale prices, splitting intermittent renewables from other generation types. This should have the effect of reducing the impact of high short run marginal cost based prices set by gas fuelled generation assets, meaning that the price paid by consumers for their electricity would reduce and more closely track the long run marginal cost of the renewable generation which is likely to form an increased proportion of our energy mix over the coming decades, thus creating a market which would not be exposed to gas price volatility ..

While the potential reforms to the electricity market contemplated by REMA, including splitting the wholesale electricity market into two, are abmitious, recent market events would suggest they may be necessary, particularly so if our electricity mix becomes dominated by renewables. It would be prudent, however, for government to ensure that lessons are learned from the negative impact recent market intervention is having on investment in some new renewables projects. In seeking to reform the electricity market to achieve decarbonisation by 2035, it will be critical that government listens to developers and collaborates on market reform, rather than imposes reform on the market.