Increasing subsidies don't always mean higher bills.

Many of our government's U-turns on energy policy have been triggered, we are told, by a predicted overspend on the Levy Control Framework - the mechanism that limits the maximum cost of renewable energy subsidies we pay through our energy bills. In October 2014 the government estimated the energy subsidy cost in 2020/2021 would be £6.25 billion. Nine months later their prediction had mysteriously increased to £9.8 billion. One of the reasons given for this was that wholesale energy prices have decreased - but under the mysterious workings behind energy subsidies, decreasing wholesale prices brings total bills down even though the subsidy part of our bill increases. The purpose of the Levy Control Framework is supposedly to keep consumer bills down, so why limit the subsidy if bills come down anyway?



The Energy and Climate Change Committee's report 'Investor confidence in the UK energy sector inquiry' [1] was published yesterday and it is grim reading. The renewable energy sector currently looks good as investors rush to get projects through before policy changes come into effect in the summer - but after that there is going to be a serious hiatus unless policies are changed. Carol Gould from the Bank of Tokyo/Mitsubish told the committee that conversations with developers for new offshore wind projects were down 95% because investors lack confidence in government policy. There seems to be no policy at all beyond 2020. For example there is no indication of what the budget for the Levy Control Framework will be after that.

However, whatever budget it gets the Levy Control Framework doesn't achieve its purpose very well. Increasing proportions of renewables have a disproportionate effect on subsidies compared to bills, and reducing wholesale costs increases the subsidy part but not the total bill.

To illustrate these unintuitive results, here are some simple examples. To start with, assume that fossil fuel costs 4p/unit and renewables cost 0p on the wholesale market (because the marginal cost of wind and solar is zero) but they get subsidised through the new Contract for Difference scheme with a strike price of 6p/unit. That means the renewable energy providers get paid the difference between the 6p and the average wholesale price.

Increasing renewables has a disproportionate effect on subsidies compared to bills.
First an extreme case - increasing the proportion of renewable energy from 50% to 100% increases bills by 50% but the subsidy is up 200%

50% renewables		100% renewables
Fossil fuel (1 unit) Renewables (1 unit) Mean wholesale price (0+4)/2 CfD subsidy/unit (6-2) Total cost to consumer (4+4) Total subsidy	4p 0p 2p 4p 8p 4p	Fossil fuel (0 units) Renewables (2 units) Mean wholesale price CfD subsidy/unit (6-0) Total cost to consumer (6*2) Total subsidy	0p 0p 0p 6p 12p 12p

As the proportion of renewables goes up from 50% to 100% consumer bills increase from 8p to 12p (50%) but the cost of the subsidy goes up from 4p to 12p (200%). From the Levy Control Framework point of view this is a disastrous increase in cost but the impact on bills is much less.

Decreasing fossil fuel costs increases the subsidy but the total bill goes down
In this example the first case is the same as above - the second case is the same 50% split but this time the fossil fuel price is cheaper.  Overall the bill comes down even though the subsidy is up.

50% renewables 4p/unit wholesale		50% renewables, 3p/unit wholesale
fossil fuel (1 unit) renewables (1 unit) Mean wholesale price (0+4)/2 CfD subsidy/unit (6-2) Total cost to consumer (4+4) Total subsidy	4p 0p 2p 4p 8p 4p	Fossil fuel (1 units) Renewables (1unit) Mean wholesale price CfD subsidy/unit (6-1.5) Total cost to consumer (3+4.5) Total subsidy	3.0p 0.0p 1.5p 4.5p 7.5p 4.5p

As fossil fuel wholesale costs decrease by 1p, the cost of the subsidy goes up from 4p to 4.5p but the consumer bill has gone down from 8p to 7.5p.

In general the effect of the CfD subsidy is to keep energy prices more stable. When international gas prices go down consumer bills go down too, but not as much. On the other hand when international gas prices go up consumer bills go up too, but not as much. Incorporating more renewables reduces the risk we take by relying on global markets.

The committee's report has a lot of other criticisms of the Levy Control Framework and the budget predictions that have driven policy changes. For example the government has promised but failed to deliver an explanation of the assumptions behind their predictions.

Taking a wider view they list factors contributing to the demise in investor confidence including:

• Sudden and numerous policy announcements have marred the UK’s reputation for stable and predictable policy development.
• Policy inconsistency and contradictory approaches have sent mixed messages to the investment community about the direction of travel. Examples of this include:
• claiming to want to decarbonise at lowest cost while simultaneously halting onshore wind;
• giving local people a say in wind consents but not shale gas; and
• emphasising the important role of gas while scrapping support for carbon capture and storage.

The worst of it is that dents in investor confidence increase prices in the long term, because we must have investment in new power infrastructure of one sort or another, and when investors lack confidence they demand higher returns to allow for the extra risk.

This government needs to sort out a policy that actually delivers on its stated intentions and sticks to it - fast.


[1] Investor confidence in the UK energy sector inquiry (www.parliament.gov.uk) 3 March 2016