Electricity Market Reform - Energy and Climate Change Contents


Examination of Witnesses (Questions 62-91)

PROFESSOR DIETER HELM CBE

25 JANUARY 2011

  Q62  Chair: Dieter, good morning, and thank you very much for coming. I think that this is the first time you have been to this Committee in this Parliament, so you are welcome. Most, but not all, of us are new to the Committee—I certainly am.

  You will know that we are engaged on an extremely topical exercise, which is quite wide-ranging and, in some aspects, quite complex. Would you like to say, in general terms to begin with, whether you think that Electricity Market Reform is actually needed if we are going to have secure and lower-carbon electricity supplies in the UK?

  Professor Helm: Thank you for inviting me, Chairman.

  Reform is needed, regardless of whether one wants to pursue the particular objectives that the Government have in mind. The market is not designed to produce investment in an orderly and cost-effective way, and therefore intervention is required. What really sets the context for this form of intervention is just how extraordinarily demanding the targets are. In legislative terms, we are driven to try to achieve the 15% renewable energy target within nine years, and effectively to decarbonise the entirety of the electricity system within 19 years. Even on a fair wind with these reforms, they are not going to be in place until 2014-15. We are on a five-year track to finish off an enormous build for what is extremely expensive offshore wind, and then for a huge charge to achieve full decarbonisation.

  The only example that I can think of for a large economy that will have made anything like that kind of transition is the French programme to build 59 nuclear reactors—state-driven, state-financed and planned. I am not recommending any of those things, by the way, but that is the only example that I can think of, certainly since the second world war, on this kind of scale. It is an enormous ask, and the idea that existing arrangements could achieve that is quite close to absurd.

  Q63  Chair: That's a clear view. I wish all our witnesses were so concise and emphatic.

  Now that we have started the consultation, do you think that the balance of the objectives which have been put out—on the security of supply, sustainability and affordability—is right in this process?

  Professor Helm: Achieving security of supply, and achieving that by having a view about what mix of low-carbon as opposed to high-carbon technologies one would want, can be done perfectly consistently. The difficult bit is the affordability bit. In my view, what is extremely implausible in both the last Government's and particularly this Government's views of prices under this regime is the idea that all the transition can be done and that customers' bills will only go up by about 2% by 2020. You have to stand back to see the sheer scale of what is being asked, and then think about the plausibility of saying, "And by the way, it won't cost you very much."

  The arithmetic behind that is the green deal arithmetic. The green deal in itself is a good idea. But the idea that that will actually achieve sufficient demand reductions—this is not about energy efficiency; it is about energy conservation—to such a level that that will offset the unit costs of offshore wind by 2020 and to the extent that the effect on consumers' bills will only be 2%, is again really stretching one's imagination.

  My personal view is that, if one wants to decarbonise and to achieve the climate change policy objectives, it behoves, if I may say with respect, politicians to explain to the public: "This isn't a free lunch. It is going to cost. Bills will go up." However much energy efficiency we pursue, people are going to be paying a lot more for their energy. My fear is that, by about 2015-16, the costs of wind will start to feed through to bills on a quite substantial scale. The public, having been led to believe that this is essentially a free lunch, will, by the middle of this decade or slightly later, face sharply rising bills. The danger then is that they will lose faith in the climate change objectives. The affordability bit is not plausible next to the targets of 15% renewables by 2020 and complete decarbonisation of electricity by 2030.

  Q64  Chair: I entirely share your view that achieving the first two objectives cannot be done without the strong probability of much bigger price increases for consumers. Assuming we accept the risk that prices may go up much more than is anticipated, do you think that in other respects the proposed reforms are sufficient to achieve the other two objectives?

  Professor Helm: In principle, the answer is yes. If we look at the components, we have the EPS, which is essentially a closure programme for the coal industry as we know it. Secondly, we have the carbon floor price—it depends what the price is, but anyone who thinks that we can rely on the EU ETS to deliver a carbon price that reflects a level necessary to carry through decarbonisation is sadly misled. The EU ETS produces a low, volatile and short-term price, and we want a rising price that is stable and long term; that is that component. The final bit, which is the crunch bit, is the reform of the market itself, particularly the proposals on FITs.

  At one level, it is absolutely right to say that we need long-term contracts. In my view, that is essential to drive this programme through, and it is one of the big flaws of the old market system that we have at the moment, regardless of the climate change objectives. But to say that we need contracts—I mean this in a non-controversial way, but the Government's proposals are extremely ambiguous as to how that is going to be achieved.

  There are potentially two routes. One is to go down the route of using markets and auctions of those contracts, so that we use the market to test out the cheapest routes, and award the contracts on the basis of open, competitive tendering. The other is to have a much more interventionist planning system, which looks much more like the band of ROCs that we have at the moment. If the latter, I question whether the Government would have the capability to do it, and whether it will work very well in practice. If the former, and provided people are prepared to pay the prices that emerge from the auctions—that is one of the reasons why people are reluctant to use the market; they might actually see what the true prices are—and customers are prepared to pay what the market reveals are the prices, of course the objectives can be tailored to the capacity that is developed over time.

  Q65  Sir Robert Smith: On affordability, the 2% is unrealistic. What is a more likely range of figures that the consumer will have to confront?

  Professor Helm: The first thing to say is that the price is an outcome rather than an ex-ante imposition upon the system, so there will be considerable uncertainty. We know quite a lot about the costs of offshore wind. We know that costs have not been falling for offshore wind and that, because of the way in which the networks, and so on, have been developed, it is pretty badly co-ordinated. Therefore, looking at that programme, it is possible to imagine quite substantial cost increases coming from that direction.

  The question of the ultimate bills depends on what else is going in. One good piece of news for consumers is that we are now in a world—radically different from five or six years ago—in which we have abundant gas. Indeed, we have so much gas that, from a policy point of view, it is probably best to assume that it is an infinite supply. The resources are now doubled at world level. Shale gas is competitive, and the US is now beginning to export gas. This is a transformational event in energy markets. If those gas prices were to see their way through into the British market, and if quite a lot of the wind-generation capacity is not built but quite a lot of gas generation is built, the price profile looks gentler. If we really build all the wind generation that is required to meet the objective—if we build the whole lot and we do it by 2020—there will be very substantial bill increases, because of course the gas is being choked off this system.

  Q66  Laura Sandys: I am interested in your focus on the market at auctions. Affordability is certainly a Government objective, but predictability is more important for both consumers and industry. Is there a market structure that could help with predictability? If we actually achieved the renewable generation, would there ever be a decoupling from the gas price for electricity that would be able to give a little less international volatility to the market?

  Professor Helm: If I can unpack that, the first point is that, other things being equal, people like stability in prices. But if they have stable, very high prices, they prefer volatile, low ones. That is very important, because the gas and oil price bring a degree of volatility into this—mainly the gas price—but it may turn out to be volatility on the downside rather the upside. There is a question about that. But let us say that they want stability. In a market like this, one would look for long-term contracts, which, in my view, are natural to its economics. There is nothing that says the long-term contract should just be about wind farms. My view is that there should be long-term contracts for gas, nuclear and lots of other component parts within the system.

  It is rather disingenuous to think that renewables somehow bring stability to prices, and that therefore that is a good thing, whereas other technologies do not bring stability to prices and that is therefore a bad thing. There are two points to make there. Long-term contracts can be applied to lots of things. It is the long-term contract that gives stability. There is a perfectly plausible scenario, contrary to the Secretary of State's view, that we may see very low fossil fuel prices in respect of the fossil fuels that matter for electricity, which is gas.

  Chair: I apologise. I should have drawn attention to my entry in the Register of Members' Financial Interests at the start of the session. I am a director, option holder and shareholder in several companies involved in renewable energy.

  Sir Robert Smith: I should also draw attention to my interests in the oil and gas industry. I am a shareholder in Shell.

  Q67  Albert Owen: I have great interest, but not financial. On the carbon price support that you touched on, do you think that carbon price support will make investment in low-carbon technologies, research and development much easier?

  Professor Helm: Let us suppose we do things in the right way in my view and auction these things, and decide that we need slots of capacity brought on to the system. We might want to say that the next lot of slots have to be low carbon, and people can bid those in and get long-term contracts. That in itself reduces the risk of the fixed cost of the investment. It makes a great deal of difference to the investments, but does it drive R and D? I think that was the question. The answer is that it helps a bit, knowing that the market will be stable, but it will not solve the R and D problem.

  The R and D problem is that the investments that companies make are long-term and speculative, many of which might not turn out to work. We know across a whole chunk of industry that R and D support policies are very important. That helps, but it is not sufficient. We still need to think very hard on the R and D front. On that scale, it makes a world of difference whether you think that every company should be doing its own R and D as well as every university and so on, or whether you think that it is the sort of thing with which Europe should co-operate and bring big budgets together. That is a bits-and-pieces approach to such matters, but we need those policies in addition.

  Q68  Albert Owen: Do you think that that will crowd out new entries or will the carbon floor pricing make it easier for new entries, as we move on? I am worried not only about new companies, but new technologies and the ones that have been advanced will take the advantage.

  Professor Helm: I may have mistaken your question, because the force of that is about the carbon floor price rather than about the market mechanism.

  As for the market mechanism and the auction capacity, the brilliant thing about having an auction rather than a planning system is that anyone can bid. Once you have a contract, you are in. To go down the auction route is one of the best ways in which to promote competition in the industry. It is a really major advantage. The auction could have demand-side bids, so you can bid in to reduce capacity of demand by so much in so many years' time, and that brings a long-term contract into the energy efficiency side of the market, which has been sadly lacking to date.

  On the carbon support price, it is neutral between technologies. That is the nice thing about it. It is just the price of carbon. But what really matters is not what the price of carbon will be this year because that is basically just a tax. No one will do anything very different in the next two to three years on the basis of that tax. You will want to know what the price of carbon will be in 2020 or 2025, and the further out you are on R and D, the further you need to know into the future. It is very important to give serious policy consideration to how you can develop a robust, credible, political framework within which there is a clear understanding about the direction of travel and the rules by which that carbon price will be adjusted.

  We had cross-party support on the Climate Change Act. There has been cross-party support for the Climate Change Committee. From the perspective of someone who is neutral to this game, that is extremely encouraging. To me, the most important question about the carbon floor price is whether we can have a degree of consensus that, whatever the swings and roundabouts between political parties, an investor knows in 10, 15 or 20 years' time what the direction of travel will be. That is missing at the moment, but it augers rather well from the experience so far of climate change policy that that might be achieved.

  Q69  Albert Owen: If we achieve that consensus and some sort of stability, will it really make a difference if that the volatility is still with the gas prices?

  Professor Helm: Yes, although if you are really worried about volatility on the gas price and think that the gas price or the oil price has a degree of market power in the price, you might want to make the carbon price inverse to the gas or electricity price, or some index of that. Much like the discussions at the moment about petrol pricing, for several years I have advocated indexing. If the oil price—I suspect it is high level—goes to $200 a barrel, there will be a fat chance of a carbon tax making much difference in that context. You do not need it. You have a very high carbon price implicit.

  If the oil and gas prices fall very sharply, which in the gas case—if not the oil case—is a possibility, you would really worry about prices falling very quickly and then consumers getting used to lower prices. You then have the whole problem of bringing them back up again rather than locking in the consumer expectation, which is roughly about where we are at the moment. Indexation would be a great idea. You might not be able to do that immediately, but, in the rules about how to change the carbon price through time, you might be able to indicate that one of the factors taken into account will be what the profile of oil and gas prices turns out to be.

  Q70  Albert Owen: On an international comparator, what difference will the carbon price make to the distortions in the trading of electricity to the continent and to the Republic of Ireland?

  Professor Helm: There are a couple of things to say. The first is that almost every country in Europe is toying with the idea of the carbon tax. Everybody understands—privately, at least—that the EU ETS is not producing the stable, long term, and rising carbon price. It is not the basis, and when you talk about research and development, you are a long way adrift from that framework.

  Everybody is toying with carbon taxes; the problem in Europe is that people are toying with different kinds of taxes. So, the Irish now have a tax that concerns everything that is not in the EU ETS, to give it a wider coverage. Our carbon tax is almost entirely concentrated on electricity and nothing else. So, there is mix and match across Europe, and the effect in particular countries will depend on precisely how the tax is designed, its domain and its level.

  Q71  Albert Owen: Are you comfortable with what you have seen in the consultation documents?

  Professor Helm: I have advocated, for at least five or six years, a floor price for carbon, so I am delighted that that recognition is there. I am in favour of a carbon tax that looks roughly like the current one, which is applied to the whole economy.

  I am very worried that in the decarbonisation strategy we have said, "Transport is too hard and lots of other areas are too difficult, so we will do it all on the power stations." It seems that the great merit of a carbon price is that you do not know what the alternatives will be in future. The price gives everybody an incentive to respond, and you will be surprised as technologies and other things come along.

  The one thing I would like in the framework of the proposed carbon floor price, in addition to the rules for revising it through time, is a recognition of the scope to expand its domain. So, even if we start with only electricity, we could widen that, and transport is the obvious area in which to do so. But there are lots of adjustments to be made, given the taxation we already have in transport.

  Q72  Albert Owen: You said that you were delighted with the carbon floor price. Do you think that the nuclear industry will be delighted with it? Is it, in itself, sufficient?

  Professor Helm: I regard myself as technologically neutral. By that I mean that we do not know what the technology change will be.

  Q73  Albert Owen: I will add to nuclear, long-term contracts and the long-term investment that is necessary.

  Professor Helm: Yes, but nuclear power shares a feature that is common to wind power, in particular, and to a number of other technologies, in that it has long-term sunk cost—the marginal costs are way below the average cost. The investment problem is therefore how to ensure that you are going to get back all the capital that you have sunk. So the long-term contract bit is essential to a range of technologies.

  In addition, pricing carbon helps—it starts to create a level playing field between the technologies.

  Q74  Albert Owen: Is it a big help?

  Professor Helm: It depends how high the tax is: if the tax is £200, and it is credibly going to stay at that, that will have a big effect; if it is £10, it will not make much difference.

  Q75  John Robertson: I was interested in how you—promoted is not the right word—saw gas within the energy market. Correct me if I am wrong, but it appears that you think that gas will probably be, if not the cheapest option, an option that we will take, at least in the short term. It seems that you think that wind power is too expensive and, therefore, the research and development in that area will be curtailed. Do you think that we should go down that road or that when we set the price barriers, we should include a portion for the research and development of those industries that we might not want to pursue?

  Professor Helm: Let me unpack the bits of that question. First, any energy—climate change—policy misses something if it fails to take account of the phenomenal change in what we know about fundamental fossil fuel markets, compared with what we knew only five years ago. Five years ago we were worried about the Russians, Ukrainian supplies, and being at considerable risk from a security supply perspective in terms of gas. That has fundamentally changed, on an enormous scale.

  The second thing to say is that gas has about half the emissions of coal. If you are interested in global warming, and if what we are doing in this country is supposed to address global warming—not Britain's national emissions but global emissions—this is potentially, in the short to medium term, fantastically good news, because the driving force of global warming is the increasing burn of coal internationally, in particular by China, India and, to an extent, the US. The extent to which these countries can now, at extremely low cost relative to where they were before, build for gas rather than coal is already shown through an IEA forecast—you see a tailing off of the increase in the coal burn, through time being replaced by gas. This buys us time in the global warming context, in which there is no international agreement.

  So, gas for coal is a quick, temporary, short to medium-term way of getting on top of some of the aspects of climate change quickly. In the UK context, let us for the moment set aside the renewables directive—a legally binding constraint, and I have been trying to think of how to achieve a legally binding constraint—and get the arithmetic into proportion.

  We are projected to spend—I don't know—£100 billion on the offshore wind programme, which is over nine or 10 years, so £10 billion a year. The total infrastructure capex in the British economy is about £20 billion historically, so that is a huge ask. Ask yourself the following question, or do the following thought experiment: if you close some coal stations quickly today and replace them with gas CCGTs quickly today, how much would you have to close, and bring on those CCGTs in two to three years' time, to achieve the same reductions as the £100 billion being spent on wind? And how much would it cost? To get a grip on this problem, you only have to have a ballpark number in mind, but it would probably cost less than £10 billion.

  We are, therefore, paying for a hell-for-leather, nine-year charge to build extremely expensive offshore wind farms at a cost 10 times more expensive cost for the same emissions reductions. It is fair to say that, at the end of that period in 2020, you would have the gas stations and not the wind farms, and you would have to think what you did then. But even if you scrap the gas stations quickly at that date, you would still be quids in against this enormous capital expenditure. What makes it even more ironic is that very few people think there is much chance of achieving that offshore wind build to the scale required.

  We live in this game in which we design policies to achieve an objective that most people think we are not going to achieve. That is a recipe for a very expensive energy policy.

  Q76  Chair: You just characterised the central approach of the Government's energy policy as the emperor's new clothes. What would happen if we went down the route you suggested, which is extremely interesting to this Committee? I think you have already acknowledged that we would be left with a lot of stranded gas assets which, by 2030, would not by themselves be anywhere near delivering the nearly total decarbonisation of electricity generation, which is an explicit goal of the Climate Change Committee. What will we then do? Say we have £90 billion in hand—which, admittedly, is quite attractive, and even the Treasury might think that's a good idea—what would we then do to achieve the objective?

  John Robertson: What happens to R and D? How do we stimulate research?

  Professor Helm: I once wrote a piece in The Times, probably three years ago, suggesting that if you really cared about climate change at the global level—this is not a British problem but a global one—and spent the £100 billion on R and D rather than on a single wind farm, you would make a much greater contribution.

  I am not against building some wind farms, and I want to answer the Chairman's question, but you have to look at the credibility of the targets. In the period up to the 2020 target, there is only really one generation technology that you can build to achieve the target in nine years. R and D will have no effect and nuclear power is right at the end of that period, with a lot of nuclear coming off. So, in that short-term period, if you wish to achieve that objective, which we are bound to do by directive, you have to go down that route, and you have to accept that that is the cost consequence of what you are doing. That follows.

  If you then want to say that by 2030 we will decarbonise the electricity system, that is at least as demanding as building all that wind within the next nine years. If you really want to do that, you do have a bit more technological freedom, because there are things you can bring on to the system between 2020 and 2030, which you cannot do in time. Let us think what those are. First, there is the revolutionising of the grid itself. There are smart meters, smart technologies and electric cars. Those have really radical effects on how the electricity system works. Looking at the French programme, if you wanted to—I am not recommending it—you could build 10 nuclear power stations in that time. You could build even more, if you wanted to do so. You could build some more wind farms, or a number of other technologies. There are more degrees of freedom, provided that you really mean that you will achieve that 2030 objective. If you asked me whether I would bet on you achieving either the 2020 target or the 2030 target, I would not put much money on the table. That matters, because if you want to achieve the objective, you have to create a framework where investors credibly believe that you really will do it. That requires all sorts of consequences that follow through. As I have said, we are not really there at the moment.

  Does it matter that we will have too much gas brought on to the system? That was the Committee on Climate Change's concern, if we push the gas forward in the next 10 years—which, by the way, we will do anyway, and I might come back to that later, if I have an opportunity. This gas will be there. All I am saying is that if you really wanted to achieve your objective by 2030 and you just told it to close—you used command and control—it would still be a lot cheaper than what we are currently embarked upon. In fact, having the option of some gas stations on the system—and perhaps gas CCS as well later down the road—might be a good thing. Even if you didn't want it, you could still squeeze them off and save a substantial cost.

  Q77  Barry Gardiner: Professor Helm, it has been fabulous—we love this. You have given us Scylla and Charybdis, but we have to steer a course between the two. You have said that, on the one hand, we have this immutable directive that we have to achieve and, on the other, you have given us the problems of stranded gas assets. In closing your remarks, you said that we will build some of these gas stations anyway. Will you map out for us a reality, rather than a fiction on either side? If we can all see what the case is and follow your numbers, we can do the arithmetic with you and say, "Yes, that's ridiculous." Let us now chart what the reality will be over the next 15 years, with perhaps too much gas coming on to the system to provide that long, stable, incentive price to invest in low carbon and onshore and offshore wind. What will actually happen? The Committee has an interest in knowing what the two extremes are, but we need to chart a proper course for the Government, or to help them chart that course.

  Professor Helm: The first thing to say—it is really important to make this point—is that if you are designing an energy and a climate change policy, you should do so while recognising the degree of ignorance you have. We do not know what will happen to a whole range of prices. It is private sector firms that will make investments, and we do not know whether and to what extent the enormous effort that is now going into R and D will deliver new technologies. We do not know how smart meters will come out, in what form and so on.

  I have always been interested in designing robust energy policies. I always ask the question: "You have this energy policy and take your expectation of how the world will be. Supposing it turns out the opposite way, what will happen?" We designed an energy policy in 1979 assuming that the oil price was going to go through the roof, but within five years it had collapsed. Our current Secretary of State talks about a doubling of oil prices, but my reaction to that is sceptical—what would happen if they halved? I want to stress that energy policy must be robust against a lot of different outcomes. That said, in the short run—the period through to 2020—the technology is basically given. We will not have a smart grid in that time and we will not have much smart metering. That is pretty well defined.

  So, what do I think will happen? We won't build all the windmills; we'll build some of them. You can write on a piece of paper how many gigawatts you think will be constructed by 2020, and it will be interesting privately to see whether people come to a roughly similar number—my guess is about half of them. We will squeeze down coal, because of the EU directive on other emissions, which will hit quite hard in 2015-16 and beyond. In the meantime, some of the nukes will have their lives extended; they will have a bit more of a run. On the gas side, we will build lots of gas stations.

  If the concern is that we ought to choke off the building of gas, because you are worried that those gas stations will be in the system after 2020, which will make the 2030 decarbonisation target too hard, the irony is that the Government's set of proposals—if you came down from Mars and didn't read the rhetoric—is incredibly pro-gas. EPS squeeze the coal off, so if you are building a gas station, you know that coal, which is your main rival, will be squeezed off the system. The wind is probably not going to be built to the time scale, so you know that the amount of wind will be limited compared with what it otherwise would have been. Instead of designing a long-term capacity market, which I am in favour of, we have a short-term capacity market, the main beneficiary of which will be gas.

  Adding those things together, if I was interested in building gas power stations, the world would suddenly have got quite a bit better. The carbon price is likely to be relatively low, which disadvantages coal vis-à-vis gas. Of course, in the climate change levy, coal does not pay its full carbon burden, so in fact you have also improved the relative price between coal and gas in favour of gas. The reality is that we are going to build a lot of gas.

  The question is whether we are going to build enough gas for the security-supply objective, given that we're not sure when the nuclear power stations are coming off, that we don't know how fast the coal stations are going to fall off the system, that we're not sure how much wind is going to be built and that we're not sure when the first new nuclear power stations are eventually going to come on to the system. That is the question.

  Is this good news? It turns out that from a climate change point of view, between now and 2020, more gas and less coal is actually a very good and cheap thing to do. But that does not address the longer-term agenda to decarbonise the entire sector, and therefore to close down the gas industry by 2020 in respect of electricity. That is in a context where you expect electricity demand to have gone up a lot, because you want gas to be the fuel used for electricity for cars so as to displace oil. Actually, you do not want gas; you want wind farms for energy for driving cars, which is again part of the framework of forcing gas off the system.

  I am sorry that that was a long answer, but you asked a complicated question.

  Q78  Barry Gardiner: No, it was an illuminating answer.

  Can I then ask for your response to the Minister's statement to the Committee that he anticipated 16 GW of nuclear being supplied, which means one new nuclear station being built every nine months from 2017 to 2028? Do you think that that scenario fits in with what you have said, or do you regard it with the same sort of scepticism that I do?

  Professor Helm: On nuclear power, there is a very important sense in which a nuclear programme is different from building gas, coal or conventional technologies. My attitude to this has always been that if that's what you want to do, let's do it properly. If you think about the example of a large-scale nuclear programme being driven through on that timetable, that is what the French did. They produced 59 nuclear reactors in their programme.

  What do you have to do to achieve that? First, somebody has to be capable of making the things. We have only one AREVA plant in Europe. It could perhaps make two of them a year, but I don't know. So you need a whole scaling-up process. The Dutch are now switching away from offshore wind to nuclear, and everybody else is going in that direction. Adding up all the nuclear orders, if you think about the capacity needed to build them and that you need that capacity in place within eight or nine years—in fact sooner, if you are going to have a nuclear power station on by 2017—it is a big ask. There is a skill chain to think about and there is a whole series of manufacturing suppliers. As with the French, and as with the Germans actually on their wind developments, you decide to have the programme—not the individual station but the programme. How many stations could you then build? As many as you like, but take the consequence of doing it.

  What are we doing? Well, here we are in 2011. We still really have not sorted out the contracts. The new regime will not be in place until 2014 or 2015, so we do not know what the contract is. We are not yet clear what the carbon floor price will look like and how it will go. On planning and a whole host of things, we are still trying to sort them out. Progress is being made, and if you want to achieve your 2030 target, in my view it is almost inconceivable that you could do it without a big nuclear programme, regardless of what you are doing on renewables and other areas. I am not in favour of or against nuclear power; I am simply putting it in that context. The answer is that it could be, but we are not there yet, and you really have to get your industrial and energy policies into a much more—dare I say it?—command and control-driven system, if that is what you want to do. It is yours to do.

  The one thing that you would not do is build nuclear power stations like we built them in Britain. The AGR programme was the worst example. It probably turned out to be the worst investment decision since the second world war—compared with Concorde. Every one was first of a kind. They had to be made in Britain. If you think of the industrial mistakes that were made in our programme, it is a template of how not to do it going forward. We at least have that experience to draw upon. Remember that Dungeness B in that programme took 22 years to produce a spark. If you contrast that with the success of the French programme, you have an example of how to do it and an example of how not to do it.

  Q79  Sir Robert Smith: Let us go back to the carbon floor price and the different European approaches. If every country in Europe is taking a different approach and you have an emissions trading scheme on top of that, do you end up with whichever country is actually driving most efficiently a low carbon price subsidising the rest of Europe?

  Professor Helm: There is a real danger of having strong discontinuities between both the coverage—because that affects industries and where they want to locate—and the levels. That said, all countries have had differential energy taxes for a long time. Energy taxes have within them implicit bits of carbon tax, so it is not as if we have suddenly come on the territory. There is a sense in which everyone has some sort of tax already.

  Sir Robert Smith: We started the ETS only recently.

  Professor Helm: Yes. The EU ETS is added to the process. The ETS is probably not going to go away. There are so many vested interests and so much money made by traders, and so many incumbents benefit from the system. The lobbying of political power is so great that we are not going to get rid of it. My personal view is that, if you put a floor price on carbon—a critically good thing about the Government's document—independent of the level of the EU ETS price, over time my hope is that the carbon price can start to take up the strain. We have a world in which unfortunately we have to have both, but over time, since we really need to know that the carbon price will be at a sufficiently high level, we can allow the carbon floor price to pick up. If the EU ETS does not then deliver what we want, we can take over some—in my ideal world all, eventually—of the strain setting the carbon price.

  Q80  Sir Robert Smith: If we, uniquely in the UK, drive ahead with a carbon floor price, our emissions will be reduced and we shall therefore reduce the value of the ETS system and allow those in the rest of Europe to freeload on the back of us.

  Professor Helm: There are two things to be said about that. First, we have already decided unilaterally to put much higher costs here than elsewhere by virtue of how we are driving the offshore wind programme. The cost of our decarbonisation is very high. That leads to another point: one of the great illusions about the EU ETS is that, because it is tied up with the Kyoto targets, it is a good way of addressing climate change. Remember that, since Kyoto and measuring the production of carbon in this country, we have done very well—15% reduction in emissions from 1990 to 2005. If you look at our carbon footprint and add back in all those energy intensive industries that are now in China instead of here, the irony of the Kyoto processes, because they encourage offshoring energy intensive industries, is that our carbon consumption from 1990 to 2005 went up 19%. These numbers are starting to be reproduced across Europe, so let's not delude ourselves that the Kyoto framework and the EU ETS are doing much about global climate change. As I said earlier, global climate change is overwhelmingly about that wall of increased coal burn and the coal power stations that go with that. That is the story of the increase in global emissions since Kyoto came on the scene.

  I would argue that Kyoto has made virtually no difference to global warming. Indeed, if the Europeans ramp up their costs by opting, as in the case of the UK, for things such as offshore wind, the policy might meet certain lobby interests—certain companies might do extremely well—but as a policy for dealing with this enormous challenge that we face called global warming, it won't get us very far. That is very important to bear in mind.

  Are you interested, in the end, in unilateral domestic targets, such as the 2030 target, or in global warming? Those are not the same things—they are easily equated in the political debate, but they are not the same thing, and we ought to put our mind to that.

  Chair: There are some interesting points there, which we might want to pursue on another occasion, in the context of another inquiry—you have suggested some things that we could indeed pursue. However, we have got to be focused: we have very limited time this morning, and we are trying to get evidence on electricity market reform. Could we perhaps move on to the capacity mechanism, which is one of the aspects of the Government's proposals?

  Q81  Barry Gardiner: Of course, Chair, I will respect your ruling, immediately after I have said that we must remember that the difference between Annex I countries, which have legally binding commitments, and the others. Kyoto was a start, not a finish. Therefore, the remarks you have just made about Kyoto are somewhat unfair. Anyway, respecting your ruling, Chair, I will move on to capacity mechanisms.

  Respondents to this inquiry have shown a certain uncertainty about the purpose of the capacity mechanism. Is it to show that there is a certain total level of capacity of a particular type in the system? Is it trying to encourage a certain level of low-carbon capacity or is it aimed at dealing with increasing intermittency and inflexibility? In your view, what is the primary purpose of capacity mechanisms?

  Professor Helm: I will say one sentence on your first remark. The implication of what I said is that we should measure carbon consumption, not production, for setting our targets in Europe, so that we Europeans pay the true cost and take the true steps to address our impact on global warming. That is not against the treaty framework, but simply says that if you measure the wrong thing and use market reforms to drive that, you might just end up with energy-intensive industries somewhere else. That is my point.

  Now to the capacity market. The way to think about this is to ask what the question is to which it is supposed to be an answer. If the question is, in the very short term, how to make sure that there is enough peaking capacity in the system, particularly with greater wind penetration of the system, you could use a variety of mechanisms. The national grid has to have a mind to this anyway—you could let it do a bit of contracting to do this, or you could have a short-term capacity market. The problem has been with electricity systems for 100 years—there are some pretty straightforward ways of handling it, and this might be one of them.

  Is that, however, the question that you should be asking here? It seems to me that we should be more concerned about there being sufficient capacity in the system, including peaking capacity, rather than just being worried about whether there is enough short-term peaking plant and that's it.

  In my world, I want to auction capacity contracts. However, my world is one in which we auction long-term capacity contracts. In that world, the national grid or whoever is in charge of balancing the system in the short run would have incentives—of course, prices would reflect the scarcity value of that plant in the short run.

  Q82  Barry Gardiner: How confident are you that it would be possible to specify the required level and functionality of the capacity?

  Professor Helm: You will not get it perfectly right. It depends on how risk averse you are. You might specify a bit too much, so we might have a bit more insurance than we want. If you specify too little, you will have to do very short-term purchasing to balance the system, as you do at the moment. You would need to be pragmatic and balance out the asymmetric risk. If you have too little capacity on a system at peak, the costs are enormous to everybody. If you have too much, they are a bit higher than they otherwise would have been, but not very much. It is asymmetric.

  Supply always equals demand in electricity. The lights can always be kept on in the sense that there is always a price that will clear the market. When you think about the security of supply, you have to bear in mind that we are interested in security of supply at reasonable prices. When people say that we have one of the most secure electricity supply systems in Europe, it does not tell you anything. What you want to know is, have you got a reasonable security of supply at a comparable cost with other people? We saw in California that that market would have cleared itself. The price could have gone to whatever level necessary to ration enough people off to make it hit, but it would not be a good market. NETA is designed to reinforce the attractiveness of those spot prices at pinches.

  In the broader sense of security of supply, why are gas prices going up at the moment in the UK? Why are we having this big price effect in winter? Partly it is because we do not have the infrastructure to back up the system to provide the security that would provide the capacity to smooth out those peaks, and that is the sort of question you need to focus on. The capacity market is narrowly conceived. The short to medium-term issue of capacity has a lot to do with infrastructure.

  Q83  Barry Gardiner: Introducing capacity mechanisms will clearly have an effect on the demand side and on interconnectors. Are you equivocal in any way about the effect that introducing capacity might have on security of supply in the other context in terms of getting investment for the interconnectors with the rest of Europe?

  Professor Helm: Security of supply is a public good. You do not get security of supply by the actions of any individuals. It is a system property. That is why the market will never provide optimal security of supply. It is something that you have to decide about the system. What is more, the players in any market have an incentive for the market to be tight, particularly under a NETA regime. The most profitable way of looking at this market would be for the lights not quite to go out but for the market to be tight. So you have to decide what security of supply you want for the system, and that is a part of policy, which is underplayed in the Government papers that have come out. You are putting excess supply in the market—remember that security of supply and electricity means not that you predict to meet the mean demand, but that you build in an extra cushion, so that you have a capacity overhang on the market, which of course the incumbents will not like, because it depresses their prices, therefore you must pay for it.

  In any sensible electricity market, you have an energy market, but also a capacity market, which is the insurance so that when you turn the switch, the light goes on. The energy market is the energy that goes through the light bulb. The other bit is the insurance when you press that switch, and you must pay for it. That is why electricity is priced—until we have storage, electric cars, smart meters and all that stuff—as energy plus capacity. If we are going to introduce a capacity market, you must have a proper way of rewarding that capacity in order not to deter the incentives to build the capacity that we need for the system. In my world, that is what the long-term contracts are about. You need to specify what those frameworks are.

  There is an important consequence. It is a general comment on where the Government's documents go. The institutional demands on Government include the skill set required, the expertise to decide what contracts to sell—you are fixing price rather than quantity—and the contracting process itself. Those are demands that I think would be readily acceptable—this is not a controversial comment—which DECC or Ofgem do not possess. It is no good going down this route of doing the capacity markets, the FITs and the long-term contracts, unless one wills the means to the end. The means to the end are very substantial changes in the institutional apparatus, whether that is an energy agency, whether it is the Department doing things, the people that we need or the framework of that. That is mentioned in the documents, but if we want this whole thing to be rolling by 2014, all the institutional stuff to do these things has to be rolling by 2014 as well. Remember that I said there are only nine years to go until 2020, and only 19 years to go until 2030. We are a long way back down the curve to deliver that.

  Q84  Laura Sandys: To be really clear, you are saying that we do not have the institutional capacity to deliver a reform—one can argue whether your model will be right or wrong. You are saying that we do not even have the options on the table to look at different reform mechanisms, because we do not have the institutional capacity, skills and, possibly, attitude.

  Professor Helm: We can think about the reform mechanisms, but I am saying that what comes with these reform mechanisms is a demanding job. If you want to decarbonise the entire electricity system in 19 years, the skill set that you need to decide what the investment programme will be is substantial, because you are deciding, not the market. You are imposing this constraint upon the market.

  The skill set to design and impose the capacity market, to have the framework within this, to have enough flexibility to adjust through time as the world changes—as it most certainly will in ways we will not anticipate—to understand the impact of the demand side on the framework, and to understand the impact of smart meters, smart grids and the integration of those systems, de minimis you need an energy agency and a substantial skills capacity to do that. That is not a job for the regulator. It is not an Ofgem job. NETA probably isn't an Ofgem job either, but this certainly isn't. Ofgem's job is a narrow regulation of networks. It is not, in my view, the job of DECC; DECC's job is to design policy. It is a job of implementing policy. In this architecture, you can call it what you like, but it is a job for something like an agency, which is given a very clear remit by DECC as to what the targets are that it has to achieve, and a legal framework to the reforms—I suspect that that will be one of the many annual energy Acts that we will have going forward. It needs that framework and it needs a skilled set of people who will not be rotated around. This needs expertise and we have none of that within our existing framework.

  To be fair, the Department and others seem very aware of it and it is mentioned in the document, but there is no detail of how we will achieve that. If you think back to my timetable, we get to a White Paper in the summer, we get to some kind of outline legislation in the autumn, which gives secondary powers to sort these things out, but where is the institution? We are looking at 2012, 2013, 2014, 2015. With the best will in the world, we are pushing that quite a long way out. That is a sensible thing to do, because you want to do this properly, you want this to last, you want this to be robust, you want this to do us through 20 years. You do not want to hurry it. On the other hand, the targets are so pressing. We are in 1936, and we need some Spitfires by 1940. You cannot hang around, thinking it would be nice to design a proper aviation market in which people might have the right incentives to do those things. It is really pressing. Abandon the targets and life is a lot easier, but that is not where we are. These are legal requirements.

  Q85  Sir Robert Smith: Another intervention in the market is feed-in tariffs. I was wondering how you felt the FIT with the contract for difference will affect the cost of capital for low carbon?

  Professor Helm: There are two bits to the feed-in tariffs. The main bit is essentially about long-term contracts. That they are called FITs does not tell you anything interesting at all. These are long-term contracts granted to low-carbon technologies going forward, such as nuclear power stations and wind farms. In principle that is sensible, provided, in my world, that those are done through long-term auctions of those contracts.

  The other part of the feed-in tariff is related to the reform of the renewables obligation. In that world there is both an optimistic and a pessimistic thing to say. The optimistic thing to say is that since the existing system is about the most expensive support system for renewables known to the developed world apart from Italy, and so far has produced very little wind—so little, in fact, that only Cyprus and Malta had less wind than us when we came to adjust the targets—almost anything you do to it pushes you in the right direction. That is the good thing.

  The bad thing is that if it means, effectively, that we have a glorified banded ROCs system, it will probably not be much better, because the Government will pick the technology and put weights on each one. It will be wide open and vulnerable to picking winners, picking technologies, political lobbying, rent capture, and what I call—to try to be non-controversial—the climate change pork barrel.

  In a banded ROCs system, every technology hires lobbyists to explain to the Government, "This is the technology of the future and you really must give us two ROCs, three ROCs"—or whatever number of ROCs it is. Of course, in any political system, the idea that lobbying will have zero effect is naive. So, on the ROCs side, we should go all the way and bring the renewables into the broader framework of the market reforms, which should be able to cover the low carbon programme. In the FITs for that regime, we want long-term auctions. The danger is that the whole system will become like a glorified banded ROCs system, which would be cause for considerable concern.

  There is a fork in the road: the Government can decide how much low carbon they want and auction it, using the market, or they can decide how much low carbon they want and, essentially, plan it. That fork is unclear in the document, and there are major consequences of going down one route rather than the other in that framework.

  Q86  Sir Robert Smith: Would you go down the auction route?

  Professor Helm: That comes back to my point about the Government's capacity. If you say that the Government's job in, say, an energy agency is to decide sequentially to auction certain amounts of capacity, that requires quite a lot. But if you say, "This agency not only needs to auction to see what the market prices are, but needs to decide what the answers are without the market," the demands on that agency as a planning body are vastly greater—it becomes a bit like the CGB.

  There is one final point, which is not brought out in the document. If you auction a contract to a nuclear power station, wind farm or whatever, who is the counter party? Who signs the contract? The answer must be that suppliers are obliged to take those contracts. In other words, the counter party, which is taking the liability of the contract, is not the Government—it might be, because it might be a central buyer, although it probably will not—it is the supplier.

  It comes back to the notion that this is not so radically different from a low carbon obligation. Essentially, the suppliers are required to buy this stuff, it is just that you are saying, "We will organise the market, which will decide what you will buy, rather than you doing it for yourself." That is the distinction—it is a difference of degree, not kind. The RO, the low carbon obligation and the FITs in this framework are part of a family, but they are not strongly distinguished ways of doing things.  

  Q87  Sir Robert Smith: Is there an argument for doing without FITs?

  Professor Helm: My argument is that you need long-term contracts. There are deep reasons for needing those, regardless of whether you are worried about climate change. You need them to underpin the sunk cost, and to get the cost of capital down, which you rightly identify as a core issue, and which is mentioned only about once in the whole document. You need those contracts. If you want to call the FITs a long-term capacity auction, great, I'll call it FITs, but that is not the same as the Government's setting interventions such as banded ROCs.

  Let's think about the cost to capital. If, as I suggested in a different context, the total capex for our infrastructure by 2020 in this economy is £500 billion, which is more than twice the usual spend—it is a huge ask—1% on the cost to capital would be £5 billion per annum. That swamps any other cost consideration you could think of. The NETA market, particularly for entrants and for some of the technologies produces very high costs of capital.

Once the things are complete, we want to refinance them at relatively low cost if people are obliged to buy the off-take. I have suggested separately that, at that point, particularly for wind, one way of cascading down the capital costs would be to have the equivalent of a utility-style regulatory asset base. I propose that that could be run through the green infrastructure bank. It is essentially the refinancing of completed projects, and if they are backed by the contracts that come out of the energy market reform, we have a way of really making an inroad into the cost of offshore wind. The point is not just whether it is very expensive to do offshore wind—yes, it is—but that we are doing it in a very expensive way. So, on the cost of capital, we can use the green infrastructure bank at the refinancing point, building on the concept of the regulatory asset base, to bring a really substantial change to that £100 billion cost number.

  That is an expansion of the subject, but it is important that we see the market reforms, the green investment bank, the carbon price, the EU ETS, the overall targets and the global-warming problem as part of a whole, and not design the right answer for each bit and hope that they add up at the end. That is the classic example of where the green investment bank will come to bear.

  Q88  Dan Byles: I am conscious that we are short of time, so I'll be brief. Given the current requirement for any new coal-fired power station to demonstrate CCS on 300 MW of production, is there any point behind the emissions performance standards on either of the two options? Will they change anything?

  Professor Helm: There are two or three points. One is how much of the coal is just going to close, anyway. The other directives bearing on this close a lot of it off, before you get anywhere near CCS and all the other component parts. So, you might say, "It's going to happen, anyway." The second side is to ask, "How far, as part of the energy policy mix, do you see CCS as being crucial to the frame?" You can think about that in two ways: either we are going to say, "We're not having any fossil fuel unless we have CCS, and if it's too expensive to have CCS we just won't have any fossil fuels"; or you say, "We want to use this as a programme towards really driving the technology forward." With the best will in the world, CCS has become pretty marooned. After four or five years, we have one competitor left in the competition, and the station to which it is being applied is one of the oldest coal stations in Britain—it is hard to make it up.

  If you think that carbon fuels are going to go on beyond 2030, and therefore you think that CCS is an important component, whether EPS rations out the fossil fuels depends on the long-term FITs contracts that you are prepared to give to these technologies. I am not advocating this, but if your energy agency, the Government or whatever, wanted to reserve a chunk of the market for CCS coal gas, there will be a long-term contract. Therefore, the EPS is essentially redundant, except that you must have one to carry on down the road. That is a bit belt and braces, and I suspect, given that the binding constraint is below the existing EU directives and that there is the question of what you can do with the FITs, it is sort of superfluous, but probably not doing any harm.

  Q89  Dan Byles: But surely it creates an additional policy risk. As long as it is there, there's a fear—we have talked about the need for long-term investment confidence—that it might be ratcheted down over time.

  Professor Helm: Yes.

  Dan Byles: So it represents a policy risk, because there could be a disincentive to investment.

  Professor Helm: You're absolutely right. The important point is not the effect on coal, but the effect on gas. The ambiguity here—one is aware of the discussion before the Government's documents appeared—is that CCS might be applied to gas. That would raise the cost of capital for a gas station. On the other hand, the gas stations being built now are so competitive with everything else on the system, that if CCS was not to be applied until 2025—given that you want to get nearly all the fossil fuel out by 2030, so there would only be about four years left—it is probably still worth building the gas station.

  In a sense, on the one hand there is a lack of clarity. Anyone who is interested in markets delivering at low cost wants clarity. On the other hand, there is a fundamental reason for that lack of clarity, which is that we do not actually know a lot about whether CCS is going to work, but in 2020 we might well do so. If we discover in 2020 that CCS is really what we have to do, and that emissions are at a level where we really have to act fast, it would not be unreasonable to use that instrument in 2025 to ratchet it up. I am therefore more relaxed about that bit than I am about the contract. The driving force is the FIT long-term contracts. They are what drive the market. The carbon price and the EPS are additional bits, but the meat is in the contracts and that is what investors will be interested in, and what drives the costs of capital.

  Q90  Barry Gardiner: How successful do you think that Ofgem has been in introducing real liquidity into the market?

  Professor Helm: Not very, but then Ofgem was the key trumpet blower for NETA. The problem is NETA. It is part of the folklore that we had an old market with the pool. Because its capacity market did not work and people were using market power in that market, which the pool revealed beautifully, all that system was considered bad and NETA was perceived to be good. Ofgem pushed NETA very hard. NETA replaced a compulsory energy market—you had to sell into it, and you had to buy out of it, therefore, by definition, it was liquid and transparent—with the opposite. You could vertically integrate; you could bilaterally contract; you could pluralise the contracts, and that has the inevitable consequence that entry is virtually impossible. You cannot get liquidity and transparency through those fiddly little mechanisms back to the degree necessary for a functioning market.

  It also leaves us in the current position. Under NETA, how can the generators prove that they are not abusing market power, and how can anyone prove that they are? They all have different contracts. They are all pluralised. The problem for Ofgem is that, having finally admitted in Project Discovery that security of supply would not be achieved by the market—it claimed for a long time that it would be—it now has to go one stage further and admit that liquidity and transparency, and NETA, do not mix. But since it advocated both—they are part of its institutional history—the opportunity we now have to reform Ofgem is as much about reforming the culture and defining the constraints of that, as opposed to just fiddling at the margins.

  An important characteristic is that what happens to NETA in the FITs long-term contract world and the capacity market is not discussed in the document. If you have a proper capacity market and your carbon price, NETA effectively collapses into an energy-only market. That looks more like the pool. If I had my way, I would push it just a bit further and go back to where we started, but that might not be possible. We spent £500 million designing NETA and its net effects have not been successful. That is an important component.

  Q91  Barry Gardiner: What reforms to the retail market would be required to introduce more liquidity and to get new entrants, who are currently finding it difficult, into the market?

  Professor Helm: Trying to separate the retail market from the wholesale market is not productive. In other words, if the wholesale market is not working in a transparent, liquid way with plenty of entry, you do not really have a wholesale benchmark from which to work out what is going on in the retail prices.

  There were many flaws in the pool. The capacity market was awful but, just because that capacity was awful, it does not mean that all capacity markets are awful. Since everyone could buy and sell in the pool, you could see what was going on. Actually, abusing market power was pretty difficult. Indeed, we discovered that market power was being abused, and we could see what they were doing. I am not saying that abuse is happening at the moment. We do not know. Getting the wholesale market right is part of the package.

  On the retail end, I am pretty pragmatic. You want people to have the right to swap and switch supplier, but how many people switch is not a measure of competition. Actually, most people don't want to switch. We have seen this in the banking case recently, too—people suggesting that it is the fault of the customers, because they don't switch. Most of us don't really care who supplies our electricity, we just want to know that it is being supplied in a reasonable way. The inertia in the market is quite natural, because it is costly to switch.

  There will always be an element of market power and supply. It is going to be there for a long time. So, the real issue is whether you want to carry on the current position, which is what I call the "threat of regulation retail market"—everyone is being watched all the time and there is an inquiry every year into what is going on. Do you want to go the whole hog and regulate these things—I think that is a step too far—or is there some intermediary bit?

  If one really worries about that retail market, people should be honest that one of their concerns is fuel poverty. Historically, in all utility infrastructure industries, there has always been some cross-subsidy. In the fuel poverty case, with poorer customers or those who have difficulty paying their bills and so on—remember that, in my world, this green energy would increase the problem substantially—if you want to do cross-subsidies, you can't do that and have competition. You have to have levies and be explicit about what you are doing. There is an honesty in that domain.

  Going back to the discussion we started about prices, if I am right about the cost of the green energy from offshore wind flowing through to bills, we are not talking about 4.5 million people living in fuel poverty, but about 6 million or 7 million. Once you start talking about such numbers, in a decent society in which fuel, energy and heating are part of the basic social primary goods for ordinary people, it is very hard to live with that level of people in such an exposed position. Historically, we always did a bit of cross-subsidy, just as we do with water, broadband, housing, health or education—it is part of our extended welfare state.

  That issue should be honestly approached in retail regulation, rather than pretending we're not really doing that, and thinking that competition will solve all our problems—it won't—or that you can proclaim it's competitive because 15% or 20% of people switch. Who cares? That's all a cost—it costs those 15% of people to do something. That is a loss to the system, which must be made up by additional benefits in bills lower than would otherwise have been the case. That has never been demonstrated.

  Chair: We're out of time, I'm afraid, but thank you very much indeed—a very stimulating and provocative session. I am sure that we will want to talk to you again, when we have completed this inquiry, about some of the other issues that you've touched on. Thank you.

  Professor Helm: Thank you for your questions.


 
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