Cost of Energy Review Dieter Helm 25th October 2017 Copyright © 2017 Dieter Helm | Cost of Energy Review | Contents Preface and Acknowledgements ........................................................................................... i Terms of Reference ........................................................................................................... iv Abbreviations .................................................................................................................... vi Key Findings and Recommendations ................................................................................. viii Executive Summary ........................................................................................................... xi 1. Introduction ................................................................................................................ 1 PART I: THE BUILDING BLOCKS 2. The Objectives ............................................................................................................. 8 Objective (i): Decarbonisation, climate change and the Climate Change Act ................................. 9 Objective (ii): Energy security ........................................................................................................ 18 The other objectives ...................................................................................................................... 20 3. Constraints: Household and Industry Bills, the USO and the Ability to Pay ....................... 23 Price is only one dimension: the USO ............................................................................................ 26 Current household and industry costs ........................................................................................... 28 Alternative ways of allocating the fixed system costs across retail and wholesale customers..... 32 4. Current Policy Interventions and Forecasting ............................................................... 35 Forecasting and modelling to support the interventions .............................................................. 41 5. The Legacy Costs ....................................................................................................... 50 The pre-2000 legacy assets ............................................................................................................ 50 The post-2000 renewables and their legacy costs ......................................................................... 54 6. Technical Change ....................................................................................................... 60 Why the current structures emerged and why they are increasingly badly designed .................. 60 The generic technological seismic shifts ........................................................................................ 61 | Cost of Energy Review | PART II: THE ELECTRICITY COST CHAIN 7. Electricity Generation ................................................................................................. 80 The wholesale market .................................................................................................................... 81 Capacity markets ........................................................................................................................... 90 FiTs and low-carbon CfDs ............................................................................................................... 97 How to reduce the costs of renewables ...................................................................................... 110 Second-best solutions and a continuation of direct contracts for renewables ........................... 117 8. Networks ................................................................................................................ 122 What to do about the current periodic regulation ...................................................................... 124 Options now ................................................................................................................................. 134 Why the periodic reviews should be abandoned in the long run................................................ 135 The role of the NSO and RSOs ..................................................................................................... 137 Regulation and ownership in the NSO and RSO model ............................................................... 139 Transitional arrangements ........................................................................................................... 140 9. Electricity Supply ..................................................................................................... 143 The CMA approach ...................................................................................................................... 146 Recalculating the supply margins ................................................................................................ 156 A fair margin ................................................................................................................................ 157 10. Energy Taxes, Carbon Prices, Levies, and Regulations .................................................. 166 The case for tax simplification and harmonisation ...................................................................... 179 Direct regulation of emissions ..................................................................................................... 181 Other levies and costs: energy efficiency measures .................................................................... 182 Taxation and the industrial sector ............................................................................................... 186 PART III: THE WAY FORWARD 11. A Long-term Framework ........................................................................................... 190 Decarbonisation and the carbon price ........................................................................................ 190 The pricing of networks ............................................................................................................... 195 The institutional structures: the role of the NSO and RSOs ........................................................ 196 The role of Ofgem and government ............................................................................................ 198 Summarising the new model ....................................................................................................... 200 12. A Road Map: What to Do Now .................................................................................. 201 13. Conclusions and Summary of Recommendations ........................................................ 210 | Cost of Energy Review | Tables Table 1: Current policies and interventions .......................................................................................... 36 Table 2: Policy development ................................................................................................................. 38 Table 3: Energy efficiency schemes ...................................................................................................... 41 Table 4: Historical plant capacity (GW) ................................................................................................. 51 Table 5: Existing coal plants .................................................................................................................. 52 Table 6: Nuclear plants due to retire by 2035 ...................................................................................... 53 Table 7: The CCC’s estimates of LCF costs ............................................................................................ 56 Table 8: Capacity auction summary ...................................................................................................... 93 Table 9: The costs of capacity and auction results ............................................................................... 94 Table 10: Renewables support scheme timeline .................................................................................. 98 Table 11: CfD allocations ..................................................................................................................... 103 Table 12: Summary of auction results: allocation round 1 ................................................................. 104 Table 13: Summary of auction results: allocation round 2 ................................................................. 105 Table 14: Carbon values and sensitivities 2010–2100, 2016 £/tCO2e ................................................ 112 Table 15: Carbon costs – Canada ........................................................................................................ 112 Table 16: Ofgem’s calculation of the return on regulatory equity (RIIO eight-year) .......................... 129 Table 17: Post-privatisation mergers and acquisitions in transmission and distribution ................... 131 Table 18: Domestic supply market shares in Great Britain (%) .......................................................... 155 Table 19: Domestic supply EBIT margins in Great Britain ................................................................... 155 Table 20: Percentage supplier operating profit margin on the revenues that would have been generated if the value of network and environmental/social costs is stripped out (%) ...................