Energy and Climate Change Committee - Draft Energy Bill: Pre-legislitive ScrutinyWritten evidence submitted by Alex Henney

“Most schemes of political improvement are laughable”

Dr. Johnson

Summary

1. The purpose of this paper is to show that over the last quarter of a century or so the government and regulator have made a series of major policy errors regarding the electric industry. The examples are:

A privatisation flawed by nuclear unreality.

The government and Ofgem mess up of the wholesale electricity market.

The waste and failure of mass market retailing.

Smart metering provided unsmartly.

The flawed renewables obligation system.

2. The purpose in citing my own views is most definitely not to say “told you so”. Rather it is to show that if one assembled the relevant information the mistakes were avoidable if decision making had been both knowledgeable and evidence based rather than ill informed and politically driven. Also I propose that we should learn the lessons of the past to apply to the present. My book “The British Electric Industry 1990–10: the rise and demise of competition” provides the detailed evidence for the contentions made here. It also concluded that “Perhaps fundamentally a competitive electric industry is just too complicated for political and bureaucratic processes.” The conclusion I now draw is that the Electric Market Reform is too complex and DECC is out of its depth. We have messed up the market, and should now abandon the pretence of a market. We should move to regulated generation which will be much simpler and also more appropriate to energy policy objectives.

A Privatisation Flawed by Nuclear Unreality

3. In March 1987 the Centre for Policy Studies published “Privatise Power” in which (with help from an American, Miles Bidwell) I advocated a competitive restructuring of the electric industry in England & Wales including a pool to which in June 1987 we added a LOLP*VOLL capacity payment; and retail competition for medium to large customers. After the election of June 1987 this approach found favour with Cecil Parkinson and civil servants, and in October I wrote a paper titled “The Operation of a power market” which showed that a competitive market would not (as claimed by the Central Electricity Generating Board, CEGB) lose the merit order, and helped to encourage the break-up of the CEGB. I thus hope my market credentials are beyond challenge.

4. The eventual restructuring and privatisation of the electricity industry in England & Wales was a tour de force, and shows what the government can do. But it operated under special circumstances—it was forced to face reality by the combination of a tight timescale and the requirement to produce a flotation prospectus that was a legal document for which it could be sued if it indulged in the economizing with the truth that is unfortunately too typical of its pronouncements. Also a large squad of very bright people were involved from bankers, City lawyers, consultants, accountants and the electric industry.

5. The Sizewell B inquiry was flawed from start to finish. At the beginning the inspector was told the answer that was required; a civil servant was secretary; the chief economist did not take the trouble to go to Washington DC to check out data about the costs of pressurised water reactors. Following the decision to go ahead with it, on 23 February 1987 I published “Sizewell B losing investment” in The Times which was based on representations which had been made to the Sizewell Inquiry by the Electricity Consumers’ Council and others, and on reports produced by the US Department of Energy. On 7 July 1987 I advised the Chairman and Chief Executive of the Central Electricity Generating Board that the Magnox reactors were not saleable, and subsequently concluded that none of the nuclear plant could be sold in the way the government hoped (I proposed a leasing solution). And so it came to pass, but the failed attempt to privatise nuclear power resulted in creating a duopoly of price setting generators (National Power and PowerGen) that disfigured the market for a decade.

The Government and Ofgem Mess Up the Wholesale Electricity Market

6. The consequences of the high prices set by the duopoly led Labour politicians to wrongly believe that the design of the Pool was biased against coal and facilitated the exercise of market power.1 Then a group of regulatory officials and civil servants, who had strong simplistic convictions about auction designs that were based neither on theoretical analysis nor empirical evidence and who were ignorant of foreign electric market experience, got to work and came up with the New Electricity Trading Arrangements (NETA). This (for a cost of about £1 billion) it was claimed would reduce wholesale prices by 13%.

7. Professor David Newbery of Cambridge University, Professor Derek Bunn and John Bowers of the London Business School who had undertaken an elaborate simulation of NETA, and I argued that NETA would not reduce prices. And so it proved; indeed NETA achieved few of its stated objectives.2 But ironically it went live just after the Pool price collapsed due to the fragmentation of the generation industry following forced divestment of the duopoly together with various companies building surplus merchant generation in the belief that the duopoly would always be there and would keep prices high. Subsequently, following a flimsy and flawed Impact Assessment, NETA was extended to Scotland for more cost but no perceptible benefit. NETA was a factor inducing both vertical integration and consolidation; reducing liquidity in the contract market; virtually eliminating small suppliers and generators; and adversely affecting combined heat and power schemes and windmills. So we end up now with an oligopoly and a few large generators.

8. Over a decade Ofgem has fiddled and fiddled with the cash-out prices to little avail,3 and is going to have another go. And it has fiddled with requiring the Big 6 to auction off some of their power.

The Waste and Failure of Mass Market Retailing

9. In December 1995 I published “The proposals for liberalizing the electricity market in England and Wales in 1998—A poll tax on wires” which argued that retail competition would be a wasteful endeavour because residential consumption in Britain (at less than a quarter of the consumption in Norway) is so low as not to make it worthwhile. The regulator, Professor Stephen Littlechild, made no attempt to analyse the implementation costs (which tripled) or the benefits. He created an ersatz form of “competition” by setting high regulated prices to provide “headroom” to give “competing” suppliers scope to undercut the prices of the incumbent suppliers. A detailed study by Dominic Maclaine, editor of New Power, showed that customers in general would have been better off with effectively regulated prices.4

10. Subsequently there has been a succession of problems of mis-billing and mis-selling and fines; the exercise of market power over incumbent customers; and the gross margin of retailing has doubled in real terms.5 For years Ofgem sat on its hands playing Pooh sticks, and on 16 January 2008, following a meeting with Alistair Darling, Messrs. Mogg and Buchanan published a press release “The market is sound—Ofgem Assures Chancellor”. Then the Select Committee on Business and Enterprise got on the case, which stimulated Ofgem to begin its so-called Market Probe. It discovered the reality of the market and this has resulted in the application of elastoplast after elastoplast until eventually supply has been virtually re-regulated with a requirement on supliers to advise customers annually of the lowest tariff available.

Smart Metering Provided Unsmartly

11. The government has made a pig’s ear of residential smart metering. First it dilly dallied; eventually it sponsored some relatively ill designed trials. Then, before it got the results from the trials (2011), it announced in October 2009 that it would mandate a roll-out. Although all other jurisdictions in Europe and North America that have mandated a roll-out have looked to the DNOs to install the meters and backhaul the data,6 the government went into an elaborate and complex procedure of “market model” options to develop the most complex way of proceeding, including looking to suppliers to roll-out the meters and devising a centralised Data Communications Company (DCC) which it would design—this is another government IT disaster in the making. Based on a study of 11 jurisdictions Britain has taken longer and produced more paperwork to devise a more complex system than anywhere else.7

12. The Impact Assessment for a roll-out was politicised by green dreamers. The 2007 analysis by Mott MacDonald came to a net disbenefit of £4½ billion; by August 2011 it was a positive net benefit of £4.9 billion,8 which stretches credibility. The Impact Assessment had basic information missing,9 the risks were not realistically appraised, particular for IT; comms are not mentioned, nor the logistics of installation. And there were various methodological flaws.10 (Also there are many examples of unclear drafting which make the document very difficult to understand.) The result of these fudges is that the British assessment of the benefits is by far the most optimistic of the 10 other cost-benefit analyses analysed. I do not believe the British figures because they are not believable.

13. The roll-out for the electric only part of the project appears very expensive (2009 prices):

Part of the high cost is the proposal to provide in-house display units at some £20 each—at least half (perhaps more) will not be used but thrown away. No other jurisdiction is giving any out.

14. In 2000 ENEL prepared a business case for smart meters and then designed and tested a prototype. Between 2002 and 2008 it rolled out 31 million, an overall period of nine years. In 2008 the British government initiated the Energy Demand Research Project and in 2009 announced a roll-out; the earliest beginning of a roll-out (to be spread, in theory, over five years) is 2014, a period of six years involving a great deal of faffing around to start.

15. Following a paper that Professor Ross Anderson of Cambridge University and I prepared. the Cabinet Office is now trying to at least stop the DCC become another public sector IT disaster like the NHS database. Also hopefully it will try to cut the costs of this mismanaged project.

The Flawed Renewables Obligation System

16. To promote the development of renewable sources of energy—especially wind—the government introduced the Renewables Obligation scheme for subsidising renewables. The scheme required licensed suppliers to procure an annually increasing proportion of their electricity supplies from certificated renewable energy sources. The Renewables Obligation Certificates (ROCs) could be purchased separately or the obligation could be bought out at a fixed price. The buy-out fund was returned to the renewable generators pro-rata to their output.

17. This was an ill-conceived scheme based on a naïve belief in markets. For no useful economic purpose it required renewables generators to sell their power and implicitly assume the risks of the Balancing Mechanism for which they had to pay 10% or so of their electricity price income in order to sell their power to a party that would assume the risk.11 It also exposed renewables developers to the risks of gas driven prices in the wholesale electricity market; to the politically driven price risk of the EU Emissions Trading Scheme; and finally to the future indeterminate value of the buy-out fund for ROCs. Risk was piled on risk was piled on risk, and consequently the cost of capital—and hence the cost of renewable energy—was unnecessarily high. And if all that were not enough, as the Pöyry analysis for banding12 pointed out in its sensitivity analyses, the amount of renewables built depends in part on the price of electricity.

18. The British scheme was about a fifth more expensive than the simple German feed-in tariffs (FIT)13 and failed to deliver much because there was a perverse incentive to under-deliver in order to push up the value of the buy-out fund. Initially the scheme was technology neutral, but in order to make offshore wind development (and some other technologies) attractive, “banding” was introduced that varied the number of ROCs associated with the output from different renewable technologies, thus introducing further regulatory risk. Over the years the government fiddled and then fiddled again with the scheme, making it very complex and effectively turning it into a premium FIT.

The Pretence of Market Reform

19. Following reports by Ofgem and then the New Labour government, the Coalition government announced that it was going to undertake the “Electricity Market Reform” (EMR). The intention was to replace the ROCs for windmills with a feed-in tariff; to develop contracts for nuclear power plants; to support carbon capture and storage with contracts; and to devise a capacity payment mechanism to financially support the gas plant necessary to back up the windmills and to ensure security of supply because about a fifth of the existing portfolio of plant may be retired by 2020. The project is misnamed—it is not about reforming a market but about replacing the investment function of a market with central planning (indeed in the case of renewables, micro central planning)14 and with what are in effect regulated price contracts designed to de-risk investment. The conventional investment role of a normal market has been eliminated and the “spot” market price will be depressed and distorted by the must-run subsidised renewables.

20. Two years later all we have is Bill of framework legislation which provides the government with great latitude to devise secondary legislation and regulations but does not tell us about money. No indicative prices have been tabled for nuclear, nor outline proposals for risk sharing and incentives. The only clue to cost has been that DECC estimates the minimum return of investment to be 11.2%.15 DECC has seemingly rejected the financing approach adopted for the only nuclear power plant being developed in the US of building against the regulated asset base (which has a post-tax cost of capital of 7.8%) because it clings to naïve delusions that this development is in unexplained ways “market” related. The difference in the cost of capital between 11.2% and 7.8% results in a production cost of about £80/MWh versus £56/MWh, and represents a saving of £billions for customers.16 DECC appears to be proposing to repeat the mistake of the Renewables Obligation Scheme at the expense of customers.

21. At least up to the end of 2011 the development of a capacity market has been a naïve mess. First, DECC proposed an approach adopted in Sweden of a so called “strategic reserve”. While this was appropriate for the potential problem the Swedes wished to address of having a few thousand MW available to meet a possible water shortage, it was not appropriate for providing and keeping on-line the many thousands of MW required to back-up windmills. Next, although I advised DECC in September 2010 that reliability options (ROs) had been implemented in the New England market following advocacy and work by Miles Bidwell,17 DECC’s EMR green paper of December 2010 referred to ROs as “academically interesting but not applied in practice”. In early January 2011 I corrected this misapprehension and provided an article by Bidwell describing the New England ROs. In its next consultation paper of July 2011 DECC had many pages on the RO concept but got its nature wrong, describing it as a financial option when in fact it is an option on electricity production. Eventually a Spaniard put DECC officials to rights both on the Swedish issue and the RO, but not before DECC had wasted more than a year and the time of people in electric companies.

22. Further shortcomings of the EMR are:

The lack of provision of information to industry participants. As Nigel Cornwall observed18 “The proposals as they stand do not give sufficient clarity and confidence for investors to proceed”.

There has been no indication as to where DECC has got with trying to resolve the very difficult issue of striking a balance between 1) revenues and profits to investors and 2) the interests of customers (which it failed to do with the ROCs).

The seeming failure to look at the impact of the CFDs on the rest of the market, notably the impact on small generators and suppliers.

Stating the capacity market will not be introduced until it is shown there is a need for it will encourage developers to delay investment until it becomes necessary to implement it.

The failure to sort out NETA properly19 but merely have Ofgem undertake yet another cash-out review, and not to address the issues raised by the EU’s “target model” in market splitting between Scotland and England and the related issue of using locational incentives to minimise costs.

23. The legacy of the EMR may be that we mess up the market even more. We make changes on the assumption that there will be significant wind, but this may not be realised. Thus instead of improving the market to rectify the shortcomings of NETA, we create new problems and complexities.

The Patchy Experience of Bringing Officialdom to Account

24. Some of the failures of competence that I have identified have resulted in severe criticism by Select Committees:

In 1990 the House of Commons Energy Committee conducted an inquiry into “The Cost of Nuclear Power” (7) because “after years of official assurances that nuclear power was (or could be) the cheapest form of electricity generation, Parliament and the public are entitled to know why it was only when faced with the commercial discipline of life in the private sector that nuclear power (from both existing and proposed reactors) suddenly became an expensive form of generation.” The Committee observed that “on the basis of the evidence we have received, we are convinced that there has been a systematic bias in the CEGB costings in favour of nuclear power…we believe the Department of Energy, as the CEGB’s sponsoring department, must share the blame for this, since it apparently made no attempt to obtain realistic costings from the CEGB until it was seeking to privatise nuclear power.” The Committee concluded that “We believe that the determination of successive governments and Secretaries of State for Energy to expand nuclear power caused them to pay too little attention to discovering its full costs…The manner in which the Department has supervised the CEGB over the years can only be described as inadequate”.

The Trade and Industry Committee had several critical goes at the implementation of mass market retailing:

in July 1995 it observed “there has been remarkably little analysis of the potential benefits and the costs of liberalisation”;20

in February 1997 it observed “We are astonished to find that despite our previous recommendation, no detailed independent cost-benefit analysis…has been published”;21

in July 1998 it commented that “…the cost estimates presented to our predecessors by the DGES have proved to be woefully inadequate…We are appalled to find that the estimates of the costs of liberalisation presented to our predecessors by the regulator at the time of their last inquiry (early 1997) should have proven so inadequate…”22 (Emboldening in the original); and

In 2008 the Business and Enterprise Select Committee published “Energy Prices, Fuel Poverty, and Ofgem” which was very critical of Ofgem.23

25. But in general the authorities have got off lightly. The NAO produced an inept report on mass market retailing in 2001 intimating that customers were benefiting,24 and a facile report in 2008,25 in 2003 it produced a glib report on NETA, incorrectly concluding that “NETA has facilitated lower wholesale prices”, and made the entirely fallacious claims that “under NETA there has been active demand-side participation”, and “Since the inception of NETA two exchanges (UKPX and APX) have traded significant volumes of electricity”.26 Recently it has produced a limp wristed report on smart metering.27

26. A former civil servant commented on a draft of this paper that “I can’t disagree with your conclusions…Civil servants are skilled, but not at running things. Their skills are political and PR…the loyalty of civil servants is primarily to their Minister, thus time horizons are very short (what minister lasts more than 12–18 months) and joined-up Government is next to impossible. Direction is provided by the prejudice or whim of whichever Minister is currently in charge of a department, who won’t be around to pick up the consequences of his or her actions. With this muddle at the centre, it is hardly surprising that the parts of Government that are supposed to run things get no direction or holding to account. Civil servants are skilled at handling this muddle, but since Ministers have no interest in evidence-based decision-making it is hardly surprising that neither do civil servants”.

The Serial Incompetence of Government in Dealing with the Electric Industry

27. The EMR is a case example of how not to restructure an industry. While politicians have had some say over the general direction of policies and too often want to be seen to be doing something, there can be no doubt that the major failures of the last dozen or so years—the expensive and fruitless introduction of NETA (which is an intellectual abortion) and its flawed extension to BETTA; the expensive ROC system; the overly generous FITs for solar panels; the incompetent mess made of capacity payments; the nuclear misconception; the proposal to waste £bns on an ill-conceived and expensive implementation of smart meters, are due to the limitations of DECC officials. In part the shortcomings reflect their lack of technical and commercial professionalism resulting from civil service selection procedures and belief in generalists, and a shortcoming that is exacerbated by the continual job switching.28 In consequence there is very little corporate memory of why and how things were done and what worked and did not work, and little knowledge of foreign electric systems. Furthermore, there must be a suspicion that analyses are politicised. DECC appears to confuse “roadmaps” with action; to create complicated bureaucracy; to fudge numbers, some of which are frankly deceitful; and to throw customers’ money at vested interests who knock at its door.

28. Three conclusions I draw in my book are that many of the mistakes that have been made are due first to “naïve marketism”, an ideological wish to introduce so-called market solutions regardless of the complexity of the proposals; of transaction costs; of the prospects for the exercise of market power; and of the interest of customers in competitive choice. Second, to the propensity of the British civil service to seek “big bang” and complex solutions, which is in stark contrast to the Norwegians (who pioneered the Nordic market, the most successful in the world), whose approach has always been incremental and Keep It Simple Stupid. Finally I concluded that “Perhaps fundamentally a competitive electric industry is just too complicated for political and bureaucratic processes.” The experience of the EMR endorses this view. The conclusion I now draw is that the Electric Market Reform is too complex; we should abandon the pretence of a market and revert to regulated generation. Thus I recommend:

The EMR should be scrapped; the pretence of a market abandoned; and generation should be based on US style rate of return price regulation with central planning and central dispatch based on short-run marginal costs. The dispatch would provide a signal that would indicate short term surplus and scarcity.

June 2012