Why has the price of green tariffs increased in line with the wider market? Andy Regan explains the reasons behind the rise and what Welsh Government can do.
This month, the energy price cap increases to almost £2,000 per year for an average household. A terrifying prospect for struggling households, to which the UK Government response has been over complicated and underwhelming.
The biggest driver of this increase is wholesale gas prices, pushed up by a couple of cold winters which depleted gas reserves, low wind generation output, nuclear outages, and wider geopolitical uncertainty.
You might be forgiven for thinking that having a ‘100% Renewable Energy’ tariff, would protect you from all this, but sadly this isn’t the case. Why not? [Caveat: this is an explanation, not an endorsement.]
The short answer is the price of gas sets the marginal price for the whole electricity generation system. What does this mean?
Firstly, we need to understand our electricity generation mix. Obviously this varies day to day, but we get roughly 25% from nuclear and biomass, 25% from renewables, 40% from gas, and another 10% is imported via large interconnector cables.
Of these sources, nuclear provides the baseload because you can’t easily flip it off and on. Renewables are the next ‘go to’ source. They are the cheapest, but also the most variable. Any imbalance between supply and demand then mostly comes from gas – it fills the gaps where demand is high, and / or where output from renewables is low.
Gas is really good at providing this flexibility, because it can be stored easily and cheaply, and gas fired power stations can be switched on and off at an hour’s notice.
So when we need to urgently meet some extra demand, it will be gas that the system operator turns on. This flexibility comes at a premium, which we either pay or the lights go off. That urgency premium is compounded when the underlying price of gas as a commodity is higher.
So many suppliers – particularly smaller, newer ones – don’t have huge cash reserves to buy high volumes of power years in advance.
Other generators see power being sold at that price, and sell their power at the same price. Gas becomes the ‘marginal unit’ and sets the price for the whole ‘pool’ which electricity is bought from.
Of course, the sensible thing to do is buy the energy you need in advance – and to hedge against changes in price. When energy suppliers do it well, they can offer fixed rate tariffs which can be much cheaper than the market price. Some buy energy months or even years in advance.
The trouble is, energy suppliers actually operate on relatively thin profit margins. The price cap allows for an EBIT (earnings before interest and taxation) figure of 1.9% – which is actually pretty low, albeit on huge volumes of product sold.
So many suppliers – particularly smaller, newer ones – don’t have huge cash reserves to buy high volumes of power years in advance. Many are constantly months away from insolvency, (as we saw in the high number of market exits last year), so their ability to hedge is somewhat limited.
Even suppliers with deep pockets can only hedge so far in advance, and in a volatile market they face a strong incentive to sell spare power now when prices are high, hoping that pays off long term if prices go down.
I can see you all getting your tiny violins out for the poor old energy companies. So I repeat: explanation, not endorsement!
You may still be wondering what on earth this has to do with your 100% renewable energy tariff. If suppliers can buy energy in advance, and renewables are the cheapest, why not buy 100% renewables in advance?
The answer lies in the mysterious world of REGOs or ‘Renewable Energy Guarantees of Origin’ certificates. Suppliers have obligations to meet a percentage of their customers’ demand from renewables, but once electricity is in the grid, it is all the same – there are no ‘green’ electrons.
So REGOs exist to help account for the fuel mix used to generate the energy. When a supplier buys renewable energy, they also receive REGOs. To advertise tariff as ‘100% renewable’, they have to show the regulator that they have REGOs for 100% of what their customers use.
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The issue is suppliers can also sell REGOs to each other in a secondary market, for pennies. This is controversial. Some argue that buying REGOs to cover demand is greenwashing, and that ‘100% renewable’ suppliers should either own their own generation or have direct power purchase agreements (PPAs) with individual renewable generators.
I personally think this argument is a bit of a red herring. If demand for 100% renewables tariffs ever outstripped supply of REGOs, you would expect a few things to happen; the value of REGOs would go up, this would push up the price renewable generators could charge, thereby increasing the incentive to invest in them.
The thing is that hasn’t happened, because consumer demand for green tariffs simply isn’t outstripping supply of REGOs – so they are still only worth pennies.
How might we solve this ‘greenwash’ problem? We could change the rules so ‘100% renewable’ meant ‘meeting 100% of demand from PPAs’. However, suppliers won’t ever have perfect knowledge of their customers’ future demand. So no supplier would be able to claim ‘100% renewables’, because they would inevitably end up purchasing some wholesale energy at the marginal price.
What is that marginal unit most likely to be? Gas.
So what’s the solution? Use less gas.
At Nesta, our Sustainable Future mission is focused on designing, testing, and scaling innovations to speed up the decarbonisation of household emissions. In Wales, almost two thirds of our gas is used for domestic space heating and hot water, around a third is for generating electricity. So the gas we burn in our homes is another area where we’re hit hard by increasing prices.
Getting a heat pump might not be the best option for households struggling with fuel poverty in 2022, but every boiler we replace reduces our exposure to future gas prices across the system.
We believe heat pumps are the best replacement for methane gas boilers. They heat your home by extracting heat from an outside source, using electricity rather than fossil fuels. By speeding up their adoption, we can significantly reduce our carbon emissions, and decisively reduce our exposure to global gas prices across the whole system. We know this will be a challenge, which is why one of our areas of focus is bringing down the cost and hassle of getting a heat pump.
What could the Welsh Government do?
Firstly, it should continue to invest in insulation, whole house retrofit, and demand reduction, particularly for the fuel poor. Free gas boiler replacements are cheap and welcome, but they lock in exposure to gas prices – and they’re just not compatible with net zero goals.
Secondly, it should make switching to heat pumps an urgent priority for its forthcoming heat strategy. We’ll be saying a lot more about this soon, but a recent YouGov poll for Nesta Cymru showed 55% of respondents would support a scheme to roll out heat pumps to all homes in Wales.
Finally, it should help Welsh households benefit from the newly available subsidies for heat pumps. Why not set an ambition to see Welsh households receiving more per capita from this funding pot than England?
Getting a heat pump might not be the best option for households struggling with fuel poverty in 2022, but every boiler we replace reduces our exposure to future gas prices across the system. Many more homes in Wales could make the switch with the right package of advice, support and finance – all things the Welsh Government can act on today.
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