The eminent economist John Maynard Keynes is often attributed with an acerbic response to criticism about his consistency: ‘When the facts change, I change my mind. What do you do, sir?’
Whilst there is little evidence that he said this, the sentiment holds valuable lessons for us all. We tend to have beliefs about the world based on assumptions that seem so obvious they are rarely, if ever, challenged. This enables us to efficiently navigate the complexities of everyday life. And there are few issues more complex than energy market and regulatory design.
It therefore comes as little surprise that the current policy conversation is dominated by incremental changes to the same basic structure. How do we make transmission charging more cost reflective? Can we reduce the time it takes for customers to switch supplier? What fiscal incentives might encourage people to install low carbon heating? Why isn’t there a ‘Pot 1’ feed-in-tariff for onshore wind? Etc. Etc.
Unfortunately, these discussions fail to recognise that the world has changed. Delivering a net zero emissions target takes us into new territory – not just in terms of the extent of the changes required, but in the timescales over which they must be achieved. The current framework has failed to keep us on track with the previous carbon budgets designed to meet a far less challenging target. There is little evidence that any of the measures currently being discussed have the potential to create the step change that is needed.
This should come as little surprise. The basic market and regulatory structures were designed to optimise the operation of an existing set of infrastructures and not to rapidly transform the asset base. I would highlight three key limitations of the current model:
- Lack of outcome focus: The key design objectives of the current model are to promote competition amongst producers, choice for consumers and short-run prices that reflect the costs of producing the products consumers require. In other words, the focus is on achieving the right inputs whilst outcomes, including investments, fuel mix and emissions, emerge as a result of market processes. However, Governments are generally more interested in achieving specific outcomes and a wide range of measures have been adopted to achieve these goals: feed-in-tariffs to drive investment in renewables, cap and trade mechanisms to limit emissions, regulated tariffs to control prices, etc. Decarbonisation of the energy system is, by definition, about achieving a desired outcome – eliminating carbon emissions by a certain date whilst maintaining the required level of system security and doing so at least cost to consumers. The current model is not well-designed to achieve a prescribed set of outcomes and a complex tapestry of interacting mechanisms has become a feature of the market as policy makers attempt to constrain underlying market mechanisms.
- Cross system planning: Currently, regulators attempt to define arrangements to charge generators and consumers for connecting to and using energy networks. The network operators are required to plan investments that will deliver the necessary quality of system services in line with the connection and use of system agreements that have been implemented. Persuading regulators of the need to make these investments is the core business objective of regulated network companies. This process is inadequate to cost-effectively integrate large volumes of variable renewable generation. Firstly, it is much more costly to incrementally develop the network as new renewables are built than to establish new network capacity that can be shared by many system users in the future (so-called ‘anticipatory investment’). Secondly, networks are just one component of flexible energy systems and investing to create the necessary flexibility involves evaluating investment options all along the value chain, including storage and flexible demand, on an equivalent basis. The ability to make the necessary ‘whole system’ planning decisions does not exist with investments in generation and consumption being driven by market prices rather than regulatory agreements.
- Efficient finance: One of the core objectives of liberalisation was to transfer the risk of investments from energy consumers onto the financial markets. It was envisaged that investors would be able to accept these risks since they would be comfortable in forecasting future demands and prices or even directly manage these risks through trading in long term forwards markets. Focus was placed on designing short term markets which accurately reflected marginal resource costs. Whilst there have been some examples of so-called ‘merchant’ generation investment in power markets, investors are now generally wary of such investments. The difficulty in obtaining long term contracts has led to several high-profile company failures and the ability to confidently forecast the market is particularly challenging at a time of potentially radical change. This has been an important issue for investment in renewable projects given their capital intensity since high costs of capital can have a significant impact on overall project costs. It is even more relevant for investors seeking to finance building refurbishment by sharing the benefits of reduced energy costs with consumers over the years ahead given the focus placed on encouraging supplier switching.
Net zero delivery requires a learning governance system that combines deployment and innovation processes. We have moved on from the decade of creating options to one where choices must be made. Whilst Government can own some big, high profile issues such as nuclear power, a series of decisions need to be made across the whole energy system at both national and local level and this means taking big risks on behalf of consumers. Which decisions need to be made now and which can be kept open for a later date? How do we ensure these are based on consistent and up-to-date knowledge, informed by the latest learning from deployment activities? Are we sure innovation spend is focused on solving the most important challenges and will it yield results in time for us to make key choices in the future? Are market and regulatory mechanisms focused on achieving the outcomes necessary, efficiently and in the best interests of consumers? Are we minimising the investment and operational costs of the transition?
The election of a new Government, committed to the net zero target and with a strong parliamentary majority, provides the political opportunity for these important questions to be addressed. However, the window for radical thinking will not remain open for long. Now is the time to open our minds to new ideas about how we run our energy system.
The world has changed. What do you do, sir?
Simon will be discussing these issues with Nigel Cornwall, Laura Sandys, Catherine Mitchell, and a host of key industry figures on 27 February, 11 - 16.30, at Squire Patton Boggs, 7 Devonshire Square, London