Time for a radical rethink

While there is near universal support for the move to net zero emissions, the elephant in the room remains the question of how this should be paid for.  The Committee on Climate Change (CCC) asked HM Treasury to undertake a review of how the transition will be funded and where the costs will fall, noting that a key policy challenge is to ensure that costs are (and are seen to be) spread fairly and do not disadvantage UK industry.  The Treasury report is due out shortly.  To help inform this debate we have produced a discussion paper that builds on some of our earlier input to individual Ofgem consultations as well as our broader thinking on Fair for the Future.

The reason this is a knotty problem is firstly the magnitude of the costs involved – around 1-2% of GDP according to the CCC – and secondly the fact that as the energy system undergoes fundamental changes, what drives costs changes and the basis of charging needs to change to reflect that.  Inevitably that creates winners and losers and we welcome Ofgem's commitment in response to previous comments we've made, to do more to look at the distributional impacts of changes they make.

There aren't easy answers and we don't attempt to present a blue print for charging going forward but we do look at the principles, highlight some more obvious shifts and raise a number of questions that need wider debate and consideration on a more joined up basis, with much stronger consumer and citizen input.  These are too important to be treated as technical regulatory issues and there is a clear role here for government to provide political direction.

The policy debates that are running at the minute are around network charging (two separate reviews), settlement reform (which affects charges for energy used) and how best to recover the policy costs of government social and environmental schemes (building on the "no free riders" principle).  These projects are currently running largely separately.  They are also focussed on the charges that are faced by suppliers, with an open question about how far suppliers will reflect any changes to the structure of industry charges in the tariffs they charge end consumers.  There are good and bad reasons why suppliers might not do so and the Ofgem / BEIS consultation on Flexible and Responsive Energy Retail Markets gives a nod to the issue, saying (rightly) that it is something that will be kept under review.

The principles that underpin charging have traditionally been that they should be cost reflective but with thought also given to practicality and fairness.  To these principles we would also add sustainability and in particular the impacts on carbon emissions. In an ideal world, and pushing current boundaries, externalities would be built into the cost of energy (through for example a carbon tax).  In the absence of such measures there is room for the way that fixed costs in the system are recovered to act as a proxy.  Driving demand reduction and energy efficiency remains an obvious step towards de-carbonisation and consumers need an incentive to get them to do more in this space (albeit that changes in government policy in terms of building and appliance standards etc. will also be needed in the energy efficiency space).

Beyond this, what the shifts in the structure of the energy system point to is a much greater emphasis on capacity rather than energy as a driver of costs.  Given it is also seen as a fairer basis for charging than a simple fixed charge, we should expect to see more use of it as a basis for charging going forwards.  Our paper discusses some of the practical issues and variants of how capacity charging might be tackled.

There is still also a role for charging for energy usage but on a time of use basis, reflecting the fact that in the future when you use energy will be as important a determinant of costs as how much you use.

Our paper suggests that long run costs might be recovered through capacity charges and short run costs through time of use (TOU) charges.  From a consumer perspective, the capacity charge would impact your decision on whether to get an EV, for example, while the TOU charge would determine when you charge it.  Thinking about the different timescales for consumer decisions in this way can be helpful in developing charging signals that are more likely to drive a meaningful response.

Thinking more radically, putting a capacity charge together with an allowance for an essential level of low cost energy would create a form of rising block tariff that would be both fairer and help drive demand reduction and energy efficiency.

While most of the focus of current debate is on electricity charges, it is clear that – to avoid significant distortions in decisions around heat decarbonisation – there is a need to look across gas and electricity charges.  Currently policy costs account for 20.4% of the domestic electricity bill and only 1.6% of the average gas bill.  This makes electric heat solutions look relatively more expensive than they really are – and also unfairly penalises those currently using electric storage heating who are predominantly on low incomes.

Looking more broadly, it is essential that there is protection for those on low incomes or those in vulnerable situations who risk losing out through an inability to engage in the markets of the future.  Again bold thinking is needed around how to mitigate the impacts on these customers, through exemptions from underlying charges, a new role for universal service providers, or extensions to the Warm Homes Discount for example.  Clarity is needed on where responsibility for this sits between Ofgem and BEIS.

Beyond these obvious directions of travel there are a lot of questions that need to be worked through, including the intergenerational equity issues, whether charges that vary at a very local level would be seen as fair, and at what point it becomes untenable to recover ever higher costs through energy bills rather than taxation.

To reach fair and sustainable answers we need a wider debate on these issues – and, given the scale of the challenge, now is the time to explore more radical options.  Rather than tinkering with existing cost allocation models we should try to think at a high level about what would be a fair and sustainable way to pay for the costs of the transition.  We hope our paper will provide a useful contribution to that debate.