The Big Squeeze | Energy Costs and a Way Forward

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January 23, 2023 | Nicole Anderson

Energy costs are the biggest contributor to the cost of living crisis – In this two part series we explore why.

Part 1: we examine the reasons for the escalating energy costs crisis and how this has led many western countries to the verge of energy poverty.

Part 2: we then build the case for resolution in this complex, evolving mix of circumstances. 

The Power Play in Energy Provision

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Renewable energy infrastructure remains challenged despite decades of investment.

Political pressures, government policies, corporate influence, age-old infrastructure, lack of proper energy storage systems, and now-increasing political geo-political tensions have led to many parts of the western world locked in an energy costs crisis. This situation creates even more pressure on renewable energy to deliver. But it is still missing the mark. 

Despite the dominance of wind and solar power generators in the EU and the UK, regional electricity prices touched record highs in 2022. We can see this in the case of Germany, where renewables contributed to 46% of 2022 power consumption. Similarly, in the UK, wind energy contributed to more than 60% of the total requirement on some days. 

At the same time, higher oil and gas prices have led incumbent fossil fuel companies to increase activity and report record profits.

Despite a large portion of the energy market (offshore wind and solar) not being impacted by the war in Ukraine, energy suppliers enjoyed high demand while the pressure fell on consumers to deal with the brunt of the price increase for fuel and electricity energy costs. 

We pose these questions:

Why are consumers facing high electricity prices if the renewable energy electricity supply price hasn’t changed? Is the investment in renewable energy subsidised initially by public funding not worth it?

The High Cost of Installation

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Of all the energy sources, solar and wind are the cheapest sources in the current market.

However, there is a vast difference in the upfront installation cost of a renewable project and a fossil fuel plant. This high upfront installation cost makes investors and lenders consider renewables a high risk, whereas they find fossil fuel plants more acceptable due to their low installation costs. But fossil fuel plants come with the disadvantage of higher pollution and environmental damage that renewables do not have. 

Wind and solar energy can be better investments when considering lifespan costs.

Legacy Infrastructure

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Lack of infrastructure is a barrier to renewable energy development. The present infrastructure is mainly built for fossil fuel plants and nuclear plants and lacks sufficient grid capacity to transport electricity from renewable energy generators to consumers. 

The existing energy infrastructure needs urgent reform as it cannot handle large amounts of renewable energy and most importantly, some of its best sources are left with no infrastructure at all.

Renewable energy suppliers are also highly centralised and concentrated in certain regions with less demand but abundant supply. For example, offshore wind projects in the UK are focused on the North Sea, whereas the electricity demand is from the Southern region. 

Lack of Storage

Most importantly, the lack of large-scale energy storage at an affordable cost is another drawback.

Renewable energy sources generate most of their energy at certain times of the day. But this output does not match the peak demand hours of the electricity consumption. The intermittency of sunshine and wind cannot provide an on-demand power source 24 hours a day. Solar energy and wind are unpredictable. Generation and volatility are volatile in loads. At the same time, energy generation by burning fossil fuels is more consistent. 

On the other hand, intermittent power generation by renewable energy sources requires an efficient storage system. An energy storage system such as a battery helps to store the surplus energy for later use. It can also help with grid instability, thereby preventing blackouts. Technological advancement has improved the longevity and capacity of batteries, but high upfront costs stand in the way of being widely used installation. Battery prices must come down to make storing energy more cost-effective. Other emerging technologies and traditional pumped hydro storage can provide a solution, but they require a more studied approach. 

Fossil Fuel Monopoly, Policy and Subsidies

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Solar, wind, and other renewable energy sources must rival the well-established fossil fuel industry in both installations and usage. Even though the government is providing rebates and additional support for renewable energy, the fossil fuel industry continues to enjoy massive support from the government.

Fossil fuels have been part of human life for a long time. Subsequently, it has its roots deep in the economy of most countries. They are also some of the highest-taxed companies governments use to fund social spending. So, it’s challenging to displace them as the primary energy source. 

The lack of policies, subsidies, incentives, and regulations that favour renewable energy technologies hinders its wide acceptance in many regions. The renewable energy market needs clear policies and legal procedures to attract investors. In other words, the government must introduce and implement support policies to strengthen the renewable energy market.

Corporate lobbying, political pressure, and inherent dependence on fossil fuels remain challenges in shifting from the age-old fossil fuel industry to the renewable energy industry.

Lack of Knowledge, Awareness and Industry ‘Motivation’

Lack of knowledge and awareness of renewable energy technology has contributed to reluctancy in adoption. Fossil fuel plants are usually located in populated areas and are also a source of employment for the local population. Operationally renewable energy is far more human resource efficient too. The huge property tax from fossil fuel plants also supports the local community.

The Current Energy Costs crisis – Market Pricing Mechanism and the Changing Energy Mix

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Most electricity markets work through a wholesale market, the primary regulated market where all the electricity trading takes place before the supply. The electricity pricing depends on the marginal price model used across these wholesale markets. This model sets the electricity prices by the variable cost of the most expensive plant to meet demand. Each supplier submits the rate and capacity they can supply to the regulator or the appointed agency. Based on the forecast demand for the immediate period, the electricity is sold and purchased at this marginal price. This uniform price is then paid by all the consumers and received by all the generators 

As we can see, over the last two decades, the grid’s energy mix has changed from coal, nuclear and gas to a blend of renewable (wind and solar) and natural gas. Gas continues to be an essential source of electricity. 

Source: https://www.ofgem.gov.uk/energy-data-and-research/data-portal

The seasonal nature of both solar and wind energy output means they cannot be relied upon to meet the electricity demand all year round perfectly. This phenomenon can result in too much renewable generation in the summer and insufficient generation in the winter when energy demand is at its highest. Also, wind energy depends on the weather, and in periods where wind speed is low, the turbines do not perform at high efficiency leading to a fall in energy output. 

Due to this intermittent and unpredictable nature, grid operators use flexible, sometimes more expensive sources like gas and more polluting sources like coal to cater to keep the demand-supply constant. This constant ratio is also essential to avoid grid failure and maintain the frequency constant within the required range.

Gas Prices: Source: Yahoo finance – https://yhoo.it/3X95vh9

 

Source: https://www.ofgem.gov.uk/energy-data-and-research/data-portal

But as the war in Ukraine broke out and spread, the price of Natural gas tripled, as we can see from the chart above. With increased volatility and price surge in natural gas, the cost of electricity rose from around £90 / MWh to nearly £360 / MWh in 2022. 

This steep increase led to high electricity prices for consumers as the natural gas-powered projects primarily drove the cost of electricity. As the global price of natural gas continued to be volatile, electricity prices followed a similar trend from the graph below. Most of the energy suppliers benefited from the automatic price fixation due to the marginal price mechanism with different margins, depending on their variable cost of production.

But this benefit did not accrue to most renewable energy suppliers because of how their fixed-price contracts are structured. In developed markets like the UK, renewable energy projects sell their output based on a secured power purchase arrangement which helps them access project finance/bank debt at low rates.

In the UK, the government uses the Contract for Difference (CfD) mechanism, which allows renewable energy projects (post-2015) to curb any volatility in the end supply price of electricity. Under the CfD mechanism, renewable energy projects contract with a government-owned company (LCCC) and receive revenues based on an indexed rate for the electricity they supply, known as the strike price.

If the supply price is lower than the strike price, projects get compensated with top-up payments by the LCCC. If the supply price is above the strike price, they must pay the gains above it to the LCCC. So, despite the high electricity prices, most renewable energy projects did not make windfall profits. 

In closing off Part 1 of this blog series, the reasons are broad and diverse as to how we find ourselves at the tipping point where many western nations and their citizens are being forced into energy poverty. 

In Part 2, we will expand on the solution – which while multi-faceted, is at the core, propelled by innovative and patient capital.

Authors:

Nicole Anderson, Managing Partner Redsand Ventures

Sandeep Dama, Partner Redsand Ventures

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