THE ENERGY PRICE CHALLENGE A report into energy price inflation for business

Transcription

1 A Power Efficiency White Paper THE ENERGY PRICE CHALLENGE A report into energy price inflation for business THE PROBLEM Why does a business need an energy management strategy? This paper looks at what will be happening to energy prices over the next decade and predicts a period of sustained energy inflation which will push the issue of energy management out of the plant room and into the boardroom.

2 THE ENERGY PRICE CHALLENGE Many of the UK s leading businesses rely on Power Efficiency to control their energy costs. Managing these costs has proved a major challenge since oil prices started to escalate in 200. Official figures show that electricity and gas prices have risen by 70% and 6% respectively above the consumer price index (CPI) between 200 and As well as rising international energy prices, the costs connected with green-motivated Government policies have contributed significantly to these increases. The two factors combined will see energy prices leap by at least the same amount again in the coming decade. We call this prospect The Energy Price Challenge and believe it underlines how urgent it is for businesses and the public sector to move energy management from the plant room to the boardroom if they want to protect profitability and defend budgets. In this paper we quantify The Energy Price Challenge. Future papers will describe how to meet it. We have supplemented WWA s analysis with scenarios and analysis of our own as well as explaining the market and policy framework that is causing The Energy Price Challenge. We conclude that international energy prices will be testing for all consumers, but the policy framework being put in place by our Government to cut emissions and improve energy supply security, although driven by the best of motives, will pose particular challenges for UK businesses. Power Efficiency, a Balfour Beatty company, is an energy procurement and carbon reduction consultancy that advises many leading corporate and public sector clients on how to reduce their energy costs and comply with regulations. Mark Callaway Energy Markets Director Power Efficiency Approach As our concerns about the extent of The Energy Price Challenge have increased, we asked respected independent market analysts, Waters Wye Associates (WWA), to project business energy costs in 2021 based on known and expected measures. Taking as their baseline official cost data, they have taken a bottom-up approach to forecasting a Central Case for electricity and gas bills for typical commercial premises. About the author Mark Callaway leads wholesale energy procurement, price and credit risk management strategies for Power Efficiency s largest commercial and industrial clients. His areas of expertise include trading and risk management, green electricity, pricing to industrial and commercial customers, sensitivity of demand to price and power price forecasting. 2

3 Executive summary Business costs for gas and electricity have increased by 77% since 200. Together, we expect that they will increase by another 81% in the coming decade. Energy Cost Increases 2010 to Change (%) Electricity p/kwh % Gas p/kwh % Electricity * 78,000 17,000 88% Gas * 30,000 8,000 59% Total 108, ,000 81% * Energy price forecast for a typical large office building This would indicate that by 2021 energy inflation will have added 8. billion per annum to the fuel bill of UK commerce and the public sector combined, raising energy bills from 10.3 billion to 18.7 billion per annum. There are two key two drivers of these increases: rising prices for fossil fuels from international markets combined with higher costs for implementing policies designed to reduce UK carbon emissions and improve the security of energy supplies. International energy prices have been volatile, but on a generally rising trend since 200. The UK is becoming increasingly exposed to international energy markets as we now import nearly half our gas, and use that fuel to generate half our power. The Government recognises this increasing cost volatility from international markets and, alongside the need to decarbonise our generation sector, has made it a major motive for its Electricity Market Reform (EMR) White Paper. EMR will reinforce the trend for the Government to tax energy use and make customers pay for an increasing number of subsidies offered to investors in low carbon energy sources. This package needs to be implemented with care to avoid damaging UK competitiveness. We also fear a new driver: imported inflation acting to increase wholesale fuel costs directly and increase other elements of the bill through regulated indexation formulas. We doubt the ability of UK business to pass through these higher costs to its customers. Our projections are based on a fundamental bottom-up view of business energy costs that we have developed with independent experts Waters Wye Associates. We believe our projections are prudent; we project an annual rate of price increase that is actually lower than the recent trend of costs from 200 to 2010 and our projections are much lower than the future price assessments used by the Government to evaluate energy policy choices. 3

4 Key findings In recent years UK plc has had to face up to significant increases in energy costs. Official figures show that spend on electricity and gas for commerce and the public sector in the UK rose from 5.8 billion in 200 to 10.3 billion. Senior management in UK businesses have to face up to a new reality what we are calling the Energy Price Challenge. Since 200 we have been emerging from a long period of deceptively low energy costs stimulated by competitive markets and plentiful supplies. We expect no let-up in the decade ahead. We expect upwards pressure on bills from volatile international energy markets. But we also fear substantial extra energy costs for UK plc from national policies including: the mandated closure of ageing nuclear and fossilfuel power stations and their replacement by capacity including more expensive and intermittent renewables generators; the burden of paying for these renewable generators and new transmission lines to export their power; and the burden of energy taxes being retained by the Exchequer specifically the Climate Change Levy and the Carbon Reduction Commitment. We have calculated a realistic price forecast for the next decade. We fear that in reality international energy prices could turn out to be even higher than we predict if there is a strong impact of any of the following: demand for fossil fuel in the developing world is rising, so any shortage of supply could obviously put further pressure on prices; fuel supply will continue to be affected by global instability in key areas like the Middle East; and post the Japanese earthquake, new nuclear energy plants worldwide will take longer to come online and in the UK they may not be commissioned before the current nuclear fleet is retired. Based on the energy consumption of a typical commercial customer, we predict that customers will see an 88% electricity price increase and a 59% gas price increase compared with a starting year of These price increases will drive the costs paid by a typical large commercial building up by 81% unless operators take remedial action.

5 The rise of energy prices Official statistics on prices of electricity and gas purchased by business consumers in the United Kingdom show that since 200 electricity prices have risen, on average, by 0.75p per kwh every year and gas prices have risen by 0.25p per kwh every year. In six years electricity and gas prices rose by 70% and 6% respectively more than the consumer price index (CPI). In absolute terms, this means that the energy expenditure for commerce and the public sector in the UK has increased from 5.8 billion in 200 to 10.3 billion in The chart below shows a dip in costs for 2010 offering some temporary respite, but we expect the upward trend to be resumed in 2011/2012. The chart also shows how far electricity and gas prices have increased in real terms compared to rising only by CPI. There have been two factors behind these cost increases: volatile and generally rising international fossil fuel prices; and Delivered Energy Prices (nominal pence/kwh) 10 9 Electricity Gas 8 Electricity+CPI 7 Gas+CPI 6 5 an increasing burden of levies and obligations to fund the transition to a low carbon economy here in the United Kingdom. Now that we are import dependent for nearly half our gas and we are also gas dependent for half our power, we are directly exposed to international oil markets for our wholesale gas and power prices. This is because world crude oil prices reached nearly $150/barrel in 2008, taking wholesale gas and power prices in Great Britain to record highs. With the credit crunch and recession, they then slumped back to lows near $0/barrel before rebounding to today s levels near $100/barrel. Delivered gas and power prices to UK business responded directly to these pressures and also the recent deterioration of sterling, which means world oil prices in pounds are now the most expensive they have ever been. In addition to rising wholesale prices, business customers have had to pay for above-inflation increases in the costs of environmentally related charges. For example, the cost of subsidising renewable energy reached circa 5% of business electricity bills in Recently customers have had to pay for higher transmission and distribution charges too as OFGEM allows the network companies more revenue to spend on upgrading their infrastructure. Furthermore, many commercial and public sector organisations are having to come to terms with the CRC Energy Efficiency Scheme. 1 DUKES Source DECC statistics, Table 3..2 Prices of fuels purchased by non-domestic consumers in the United Kingdom (including the Climate Change Levy) 5

6 Projected energy prices for the next decade We are extremely concerned at the path energy prices for UK business have taken in recent years and fear that this upward trend will accelerate in the future. We do not believe senior management in many organisations are as switched on as they should be to this Energy Price Challenge. To help increase understanding of the Energy Price Challenge, we worked with Waters Wye Associates (WWA) to forecast potential changes to electricity and gas costs to the commercial sector over the coming decade. The result is the Central Case view in the tables below and based on the energy consumption of a typical commercial customer Delivered Commercial Electricity Prices (nominal p/kwh) WW/PE Electricity PE High Electricity IAG Electricity According to our Central Case, which we believe to be based on prudent assumptions, we estimate that customers will see an 88% electricity price increase and a 59% gas price increase compared with our starting year of The reason for the differential between the two fuels is that we expect to see significantly more change and investment in the power sector than the gas sector. We have derived a High Case by extrapolating the price trend shown above for the period We have also reviewed official figures used by the Government to assess energy and carbon policies. They contain even higher prices as the tables below show. There is plenty to concern UK businesses from the projections in the tables. But the main point to note is that three independently derived projections show a consensus that prices paid by business customers are set for very substantial increases in the coming years. Projected Electricity Price Increase: 2021 versus 2010 and Price Forecasts Source 2 % Increase Price p/kwh 2021 Waters Wye/Power Efficiency 88% 1.7 Power Efficiency High Case 113% 17.1 Source: 2 Projected Gas Price Increase: 2021 versus 2010 and Price Forecasts Source 2 % Increase Price p/kwh 2021 Waters Wye/Power Efficiency 59% 5. Power Efficiency High Case Inter-departmental Analysts Group (IAG) Source: 2 131% 116% Delivered Commercial Gas Prices (nominal p/kwh) WW/PE Gas PE High Gas IAG Gas Government Inter-departmental Analysts Group (IAG) 167% Sources: 1) Waters Wye Associates projections for Power Efficiency, 2) Power Efficiency, 3) Inter-departmental Analysts Group (IAG) en/content/cms/about/ec_social_res/iag_guidance/iag_guidance.aspx Retail Commercial (Central Case), inflated at 3% pa.

7 Drivers of cost increases We expect that the two drivers of recent bill increases will continue to exert upwards pressure on business energy costs in the coming decade, namely volatile international fossil fuel prices and increasing national policy levies and obligations. The chart below breaks down the causes of the cost increases into individual components of bills. 90% 80% 70% 60% 50% 0% 30% 20% 10% 0% Breakdown of Price Increases(%) Electricity 2% 8% 11% 2% 9% 56% Source: Waters Wye Associates projections for Power Efficiency. Inflation will become a very important factor in energy bills. It will affect them in two ways: through escalating international fossil fuel prices and also because many national regulated charges and taxes have annual inflation escalators. In the past, managers in UK business wouldn t have lost sleep over inflation. They would have simply argued: I face inflation and so do my competitors and customers. In recent years however, inflation is actually being driven by global factors such as the oil price, but the weakness of the UK economy means that many companies are simply not in a position to pass on cost increases through to their customers. Gas 6% 9% 2% 6% 38% Wholesale Price Transportation Climate Change Levy Carbon Reduction Commitment Renewables Obligation Other We are predicting that: the Climate Change Levy will continue to rise with inflation. the cost of the Carbon Reduction Commitment will rise with expected increases in the EU Carbon Price. the cost of the Renewables Obligation will increase with the expected increase in the amount of plant collecting the subsidy. Low carbon measures will also act to increase network costs. Electricity will require significant changes to the National Grid which was built to move power from the coalfields to the cities and needs to be rebuilt to move power from the coastal and rural areas where new nuclear stations and wind farms will be constructed. Most of the Low Carbon energy policies discussed above will directly result in higher energy bills for consumers. In short, the infrastructure of the power generators needs to be replaced by low carbon technology. Most of this technology is more expensive than the technology it replaces. The Government recognises the scale of this investment and Energy Price Challenge and affordability for all consumers is one of the major drivers behind its Electricity Market Reform White Paper /emr_wp_2011.aspx 7

8 Power Efficiency White Papers The Energy Price Challenge is the first in a series of White Papers Power Efficiency will be publishing in the coming months aimed at helping key decision makers understand the need for developing an energy management strategy. The papers will look at: THE PROBLEM - Why do we need an energy management strategy? Addressed in this paper The Energy Price Challenge, it is clear that rising energy prices will rapidly move the issue of energy management from the plant room to the boardroom as businesses try to protect profitability and public sector bodies seek to defend budgets through a period of rising energy inflation. THE SOLUTION - What is an energy management strategy? How does a business go about finding the solution to the problem? This paper will set out to explain how a business or a public sector body should develop an energy management strategy and will look at the issues they will need to address in order for it to be successful. THE DELIVERY - How do I implement an energy management strategy? Our third paper will look at how an energy strategy can be implemented. It will provide an insight into the practical steps any organisation can take to mitigate energy prices rises through a four-tier action plan which includes avoidance, reduction, substitution and compensation. In practical terms, this will involve businesses radically changing the way they use energy. Other actions Power Efficiency suggests businesses should take will involve monitoring and targeting energy use, undertaking regular energy reviews, initiating creative and imaginative energy reduction projects, looking at carbon offsetting, developing an energy efficiency policy and looking at corporate governance. If you would like to receive any of these White Papers, info@powerefficiency.co.uk 8

9 Appendix 1: Methodology 1) Waters Wye/Power Efficiency Calculations Waters Wye Associates (WWA) and Power Efficiency have developed a methodology that projects a representative view of future delivered electricity and gas prices for businesses. WWA s model is based on the wholesale price projections from the Redpoint Energy modelling undertaken for DECC s Electricity Market Reform (EMR) consultation. Their base case assumes the thrust of existing energy policies is continued and that EMR is implemented. This will encourage renewables and other low carbon generation rather than fossil fuel. Redpoint s projections embody two fundamental assumptions: generation costs will rise as the oldest coal and nuclear stations retire and fossil fuel stations have to be paid to run intermittently on days when there is no wind; and 1 2 on the other hand, renewables generators will sell their energy whenever they can, regardless of market prices because they are receiving a significant subsidy on top of wholesale prices. This means that wholesale prices will be very low in windy and wet conditions. Redpoint allows the wholesale price to reflect the impact of climate change policies on the wholesale prices where the policies are levied on the energy providers rather than the customers bills directly. For example, the EU ETS applies to the emissions from the generators and is therefore picked up in the wholesale prices projections. We also assumed the cost of the Emissions Performance Standards and Contracts for Differences elements of the EMR package for nuclear power stations are recovered in the Redpoint projections. The WWA model lowered Redpoint s results to reflect the lower carbon price support for 2020 announced in the 2011 Budget. We have deliberately chosen not to over-egg our assumptions and our results. For example: we could have argued that Redpoint is seeing a possible shortage of power generation, particularly on days with no wind, when we approach Historical experience, from the California power crisis of , says that prices can rise exponentially in these circumstances; we have also used a $80/barrel 5 oil price forecast even though prices are currently over $100/barrel; we capped our Renewable Obligation assumption at a 20% target on suppliers even though the latest figure from DECC is already 15.8% for ; and we could have argued that Redpoint s assumptions about the cost of nuclear are now looking optimistic given the Fukushima disaster and also the continuing lack of progress in starting to build any new nuclear stations in the UK. For gas prices, WWA used the same gas price that Redpoint Energy used in its modelling. The other assumptions are summarised in the following tables. Policy Name Climate Change Levy Renewables Obligation, subsequently FITs Transmission and Distribution Costs Capacity Payments Policies Impacting Electricity Bills Assumptions 3% increase per annum to reflect inflation 3% increase per annum to reflect inflation and by 2021 the proportion of ROCs for every unit supplied to customers reaches 20% 50% of Ofgem s 30bn forecast cost increases are recouped via customers bills and generators recover the other 50% of the costs from their income Conservative starting point inflating power prices from 2/MWh starting in 2013 Policies Impacting Gas Bills Policy Name Assumptions Climate Change Levy 3% increase per annum to reflect inflation Transmission and Distribution charges 3% increase per annum to reflect inflation Policies Impacting Customers Directly Policy Name Assumptions Carbon Reduction Commitment Model assumes a policy start date of 2011 with the price rising with inflation We made some assumptions about the size of the customer and aimed to represent a large office building consuming around 2.5m kwh per annum of electricity and slightly below 1m kwh of gas. Our projections of prices are not particularly sensitive to these assumptions. 2) Power Efficiency High Case We chose the most appropriate customers 6 from the industrial prices section of DECC statistics website, 7 Table 3..2 to represent the same typical office building used in the section above. We used linear regression and established that the electricity price rose by 0.75p per kwh every year since 200 and gas prices have risen by 0.25p per kwh every year. We extrapolated these trends out to ) Inter-departmental Analysts Group (IAG) The Government s Inter-departmental Analysts Group publish their price projections and their assumptions on their website. They comment: these estimates of the long-run variable supply costs for different fossil fuel prices should not be considered forecasts, but as estimates to assist in policy appraisal. See Appendix 2 for more detail on EMR ) the average of the Small/Medium and Medium electricity price series and 2) the average of the Very Small and Small gas price series

10 Appendix 2: Government Low Carbon Policy for Energy 10 A number of Low Carbon energy policies have been implemented and a further suite has been set out in the July 2011 Electricity Market Reform White Paper. Some of the policies are complex and difficult to understand while others such as the 15% renewable energy target at 2020 are easy to understand but difficult to pay for. Below we summarise their main points. Policy Acronym CCL CCA RO EU ETS CRC FiT CPS CfD EPS Key policy terms and their acronyms Stands for Part of Electricity Market Reform (Yes/No) Climate Change Levy Climate Change Agreement Renewables Obligation European Union Emissions Trading Scheme Carbon Reduction Commitment Feed-in tariff for micro-generators Carbon Price Support Contracts for Difference Capacity Payments Emissions Performance Standard No No No No No No Yes Yes Yes Yes Climate Change Levy In 2001, the Government introduced the Climate Change Levy (CCL) to encourage energy efficiency by non-domestic customers. The CCL is a tax on fuels including electricity and gas consumed by business set at a fixed rate for specific forms of energy and normally inflated by RPI each year. It is supported by a complex range of mechanisms and exemptions including Climate Change Agreements (see below) and Levy Exemption Certificates (LECs). Climate Change Agreements Intensive energy users can qualify for up to a 65% reduction in the CCL by signing a Climate Change Agreement (CCA). CCAs are negotiated for each qualifying industry sector in return for a commitment by companies in each sector to improve energy efficiency. The 65% abatement is to increase to 80% from April Renewables Obligation The Renewables Obligation (RO) requires electricity suppliers to buy a proportion of their electricity from renewable sources. In 2009, the UK Government signed up to a more demanding EU-driven target that 15% of energy should be generated from renewable sources. It acts as a levy on electricity consumption which is collected each year by suppliers from all consumers and distributed to the renewable generators. The cost increases materially each year as production targets rise. It is expected to be superseded as the means of supporting new renewables projects from 201 according to the EMR by contract for difference feed-in tariffs (CfD FiTs see below), but will remain in place for existing capacity. EU Emissions Trading System The EU Emissions Trading Scheme (EU ETS) is the largest such scheme in the world. It works by giving or selling permits to release CO2 emissions to the largest CO2 emitters. It relies on the principle that these emitters will find cheap ways to introduce their own carbon-reduction programmes and sell spare permits under the scheme. The EU ETS applies only to the most energyintensive users such as power generators, steel, ceramic and cement producers. Power generators pass on the price of EU emissions credits in their wholesale power prices. Carbon Reduction Commitment Industrial, commercial and public sector organisations not covered by Climate Change Agreements or the EU Emissions Trading System are caught by this scheme if they consume more than 6,000MWh of half-hourly electricity a year. Participants buy allowances from the Government to cover their direct and indirect carbon emissions from use of fuels including electricity, gas and heating oil effective with the year April 2011 to March The scheme was radically altered in the autumn of 2010 when emission charges were converted into a non-refundable tax to be administered by The Treasury. Feed-in Tariffs The Government in April 2010 introduced a series of new feed-in tariffs (FiTs) for small-scale renewables generation of up to 5MW capacity. The mechanism is intended to encourage the take-up of renewables technologies, often for on-site use. It is intended to be simpler to understand for generators than the RO and offer more predictable revenue streams. Carbon Price Support Carbon Price Support (CPS) is an element of the Government s Electricity Market Reform (EMR) package. CPS is being introduced to encourage investment in low carbon generation by increasing the costs to generators of burning fossil fuels. From 2013, fossil fuel generation will be taxed at rates intended to top-up the costs it faces from the EU ETS to a target level of 16 per tonne in 2009 prices. The carbon price is scheduled to rise each year to 30 per tonne by 2020 and progressively thereafter until 2030 to 70 per tonne, again in 2009 prices. Contracts for Difference Contract for difference feed-in tariffs (CfD) are also an element of EMR. They are proposed to be introduced from 201 and replace the Renewables Obligation (RO) entirely from The preferred model is assumed to control costs for consumers, provide stable returns for investors and maintain the market incentives to generate when electricity demand is high. A CfD would be a long-term, fixed-level contract where variable payments are made to ensure the generator receives an agreed tariff (assuming electricity is sold at market price). Capacity Payments A capacity payment mechanism rewards generators for being able to produce power even when they are not ultimately required to do so. With increasing quantities of unpredictable wind generation expected in the coming years, a capacity payment mechanism may be implemented to ensure power demand can be met during times when wind is unavailable. Emissions Performance Standard The Emissions Performance Standard (EPS) would complement the three other elements of EMR by ensuring that, alongside incentives to build low-carbon plant, the market is prevented from building unabated fossil-fuel power stations. A standard would be likely to be applied to individual power stations and be set as an annual limit on the total amount of carbon dioxide permitted per unit of installed capacity. It would be applied to new power stations only, and the level of EPS at the date of consent would apply for the economic life of the installation.

11 ABOUT POWER EFFICIENCY Power Efficiency is a leading UK energy procurement and carbon reduction consultancy with a proven track record in helping clients improve their energy efficiency, cut costs and shrink their carbon footprint. Part of multinational infrastructure group, Balfour Beatty, both companies have considerable collective experience in this field, delivering unique insights and bespoke, end-to-end solutions to corporate clients, SMEs, government agencies and the voluntary sector. Using a suite of integrated services spanning procurement, compliance, strategy, implementation, operations and maintenance, the firm s mission is to deliver added value to its clients by helping them use energy more effectively, sustainably and profitably. THE NEXT STEP For more information on our procurement services and wider energy solutions, contact: or visit: The content of this White Paper is based on information available from a range of sources at the time of publication. The interpretation of it is not, however, an exact science and the factors which impact on the wholesale price of oil, natural gas and electricity change in relative importance at short notice. The content should, therefore, be regarded as informed opinion, provided for general purposes and not as professional advice. Readers should be wary of using it for commercial decision making or other purposes. Copyright. Power Efficiency November

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