Q2 2022: The cost of energy crisis

Professor Matt Hannon – University of Strathclyde.  Dr Malte Jansen, Dr Iain Staffell – Imperial College Londonn 

A cost-of-living crisis is consuming the UK, Europe and much of the world alike.  A major component of this has been the dramatic increase in the price of electricity and gas.  As this filters through into consumer bills it has become a major driver of inflation, which has risen above 10% for the first time in decades.  Average household bills had been forecast to rise more than five-fold to over £500 per month.  This led to fears of civil unrest, and dire warnings of thousands of businesses forced to fold and ‘a catastrophic loss of life’ due to fuel poverty this winter.

The incoming Truss government announced a new Energy Price Guarantee that will freeze the bill for a typical household at £2,500 per year from October, with support also going to small businesses.  This will soften the immediate financial impacts to consumers, but in the long-term, high energy costs will weigh heavily on the economy.

Without this intervention, the retail price of electricity to households would have hit 52 pence per kWh at the start of October.  Britons would have been paying more for electricity than at any point since 1923, when there were just 1 million consumers of ‘light and power’ and “keeping just five bulbs going for a day would cost a week’s wages”.  Households will now instead pay 34 p/kWh for electricity and 10.3 p/kWh for gas, still more than at any point since 1935.

What is driving up energy prices?

Coal and gas prices started rising in the summer of 2020, initially rebounding from the historic lows during the first COVID lockdown.  Prices continued rising through 2021 as global supply chains struggled to adjust to the repeated closing and reopening of economies.  A year of reduced coal and gas production resulted in low stock levels going into the harsh winter of 2020-21 and then an extremely hot summer in 2021 across China, Europe and the Americas.  The extreme weather pushed energy demand higher at a time when supplies were constrained.

The retail price of electricity in Britain in real terms (2020 p/kWh), averaged across all consumers (residential, commercial and industrial).

By the start of 2022, British wholesale electricity prices had already risen to £200/MWh, quadruple the average during the 2010s.  As winter eased and demand for heating fell, prices would normally have eased back.  However, on February the 24^th, Russia’s invasion of Ukraine had dire consequences for energy geopolitics and security.

Europe’s reliance on Russia for 40% its natural gas has proven its Achilles Heel.  Germany has become a flashpoint as the sanctions imposed on Russia have meant NordStream 2, a major gas pipeline that took ten years to build, will no longer go into operation.  Russia’s Gazprom has then turned the screws on NordStream 1, posing a severe threat to Germany’s energy security coming into winter.  

The UK does not directly import gas from Russia, although around 4% of our gas does come indirectly through the interconnected European markets.  However, as gas is traded widely on the global market, shortages abroad will lead to price rises at home.  Analysts from Cornwall Insight and the World Bank expect gas prices to remain high for next 18 months at least.

Household bills at their highest ever

Ofgem sets an energy price cap on the maximum price (per kWh of gas and electricity) that suppliers can charge their consumers on standard variable tariffs. The cap was intended to protect consumers that did not switch regularly between fixed tariffs from ‘price gouging’ by the big energy companies. With fixed tariffs now largely unavailable or unattractive, most consumers are now likely to be on variable standard tariffs, and so pay these capped prices.

The bill for gas and electricity in an average household has varied between £70 and £100 per month over the 2010s.  In the space of just a year, these bills have more than doubled.  In April of this year, the cap for an average dual-fuel household increased to £164/month, and then in October it was scheduled to increase by another 80% to £295/month. 

The government’s Energy Price Guarantee now limits the amount that households will pay directly (shown by the blue area in the chart below) to £208/month on average.  This does not make the underlying energy sources any cheaper though, so retailers (the companies that sell gas and electricity to consumers) will still need to receive the original (higher) price cap set by Ofgem to stay afloat. 

So long as the wholesale cost of gas and electricity remains high, the taxpayer will be picking up the additional bill (shown by the red area).  Over the next two years this is expected to add £150 billion to the national debt (around £6,000 per household), which will have to be recovered by future taxation or reduced public services.

The wholesale cost of electricity has risen to five times the levels during the 2010s.  The retail bill for an average British household has followed, and for winter 2022/23 the cost of a typical household’s energy is projected to hit over £500 per month.

The price caps set by Ofgem limit how much firms can charge for the things they can control, such as network and operating costs, and profits.  Other expenses – most notably wholesale energy prices – are beyond the control of any one company (or country), as gas prices depend on international circumstances, and electricity prices are driven by gas prices.  Ofgem allows suppliers to pass these changes onto consumers, hence the cap increases when wholesale prices go up, and decreases when they go down (as was seen briefly in the Summer of 2020).  There is a lag between the two, hence the first big rise in the cap came in April 2022, more than a year after wholesale prices started to rise.

It is important to note that the increase in gas prices is responsible for 96% of this bill rise.  Green levies have not changed over the past year, but these have now been waived to fund part of the Energy Price Guarantee (reducing tax take for the Exchequer).  Ofgem has shown that UK CfDs (mainly for offshore wind) are now reducing energy bills.

The speed and size of the recent price changes caught many smaller suppliers off guard, leading to the collapse of 29 companies as their costs overtook their revenues.  This has added £85 to the average annual electricity bill.  The bankruptcy of ‘Bulb’, which supplied 1.4 million homes, is expected to add another £150 onto the average energy bill.

Low building efficiency spells a looming catastrophe

The tripling of household energy bills since 2021 is made worse by the low energy efficiency standards of British housing stock. The UK has some of the oldest and least efficient housing stock in Europe, which lose warmth much faster than in neighbouring countries.  Three in five homes are rated EPC D or worse, meaning they use more than 100 kWh per m² per year, and cost upwards of £30 per m² per year to heat.

Improving energy efficiency is a key route out of this crisis, but one we have failed to capitalise on as a country.  The uptake of home energy efficiency measures is at a 10-year low, which can be largely attributed to the Cameron government “cutting the green crap”.  This resulted in a major redesign and shrinkage of energy efficiency supplier obligations. The consequences of low efficiency housing stock are now magnified, adding an estimated £2.5 billion onto UK energy bills.

Even with the government’s Energy Price Guarantee, many households will be plunged into energy poverty this year, spending more than a tenth of disposable household income on energy bills.  Around 13% of English and Welsh homes are already energy-poor, along with a quarter in Scotland.  Fuel poverty in Wales tripled with the April 2022 price cap rise, and this will only worsen with the October rise.

Many households now face the agonising choice over whether to heat or eat.  This will have catastrophic health impacts for the country.  Excess winter deaths are almost three times higher in the coldest 25% of housing than in the warmest 25%.  Cold weather directly increases the rates of heart attacks, strokes, flu, falls and injuries and hypothermia.  Before COVID, there were 32,000 excess deaths each winter, over and above the mortality rates across the rest of the year.  Of these, nearly 10,000 deaths were avoidable, caused  by under-heated homes – equal to the number of people who die from breast or prostate cancer each year.

The Bank of England is expecting a recession in 2022, as energy prices impact on inflation and growth, with most businesses having to pass on energy costs to consumers. Small businesses are most at risk and may have to down-size. More than half expect to stagnate or shrink due to escalating costs, with fuel costs mentioned by two-thirds of businesses.

Getting away from gas

This crisis has stemmed from high gas prices which are affecting the whole of Europe, but the UK has been worst hit out of all countries.  Gas prices are particularly affecting British consumers in three ways:
(1) increasing the cost of heating our homes,
(2) increasing the cost of electricity from gas-fired power stations, and
(3) increasing the price of goods and services, as the cost of heating, lighting, cooking and industrial production soars.

The UK is addicted to gas for heating our homes, as 88% of English homes use gas boilers for central heating. At the same time, the share of heat from low-carbon sources has been broadly flat since 2017, even in new-builds. The installation of heat pumps has doubled in 2021, but remains very low at 70,000 per year, again trailing the developments in Europe.  In comparison, Germany has installed more than twice as many heat pumps in 2021, with half of new-build home opting for heat pumps. The Netherlands have made heat pumps mandatory from 2026 onwards for all new-builds.  The UK has an ambitious target of 600,000 new heat pumps per year within just six years, but shows little signs of progress towards meeting this.

Britain’s electricity market is also more heavily exposed to gas prices than any major European country.  Around 40% of Britain’s electricity comes from gas, yet it sets the electricity price 80% of the time.  Progress moving away from gas was slowed down with curbs on the development of onshore wind and ground-mounted solar PV.  A new generation of nuclear power (starting with Hinkley Point C) is also running into severe delays, and is not expected to be delivering power before 2027.

So what can be done?

The policy options for mitigating the impact of gas price rises fall into two categories.  Initial action has been taken to reduce the short-term financial impacts on households and businesses, and now longer-term measures are needed to reduce our exposure to fossil-fuel prices.

Measures to reduce power and gas consumption are paramount. For example, explaining to consumers how to lower the flow temperature of their gas boiler so it can go into condensing mode could save 6-8% of gas consumption, or £180 per year, with no change in comfort levels.  Collectively, even small reduction in energy consumption can reduce the pressure on gas prices, further reducing the bills.

In the medium and long term, re-energising efforts to retrofit home insulation, while building more renewable and nuclear generation and storage are all vital.  As the country transitions towards net-zero, the energy system will become more independent and lower cost, shielding us from future fossil-fuel price shocks. For this purpose, the government is currently performing a Review of Electricity Market Arrangements (REMA) to explore future arrangements in a low-carbon, low-generation-cost markets, to prevent minority shares of fossil fuels setting the marginal price.

Conclusion

The UK is facing its worst energy crisis in fifty years.  A combination of high reliance on gas for both heating and electricity and inefficient buildings makes the UK the worst-hit country in Europe.  Addressing this must be the highest priority for any new government, or the consequences for households and businesses will be severe.  Quick action can mitigate the worst effects, but there is no quick fix for the underlying causes, which will require a sustained move away from fossil fuels in our energy system.