House of Lords - The Economic Impact on UK Energy Policy of Shale Gas and Oil

The Economic Impact on UK Energy Policy of Shale Gas and Oil - Economic Affairs Committee Contents

Chapter 2: The UK's energy market

The UK energy mix

5. The energy market in the UK is being reshaped by three distinct factors. First, on the supply side, North Sea oil and gas output is declining. Production of oil and natural gas liquids fell by 9 per cent in 2013, and gas by 6 per cent. Total output has fallen by almost 40 per cent since 2010.[5] The Government are seeking to revive output and have adopted the proposals of the Wood report for simpler regulation.[6] The industry response, however, remains uncertain. Figure 1 shows the range of DECC's production forecasts over the next five years.

FIGURE 1

North Sea Production

Source: Oil and Gas UK, DECC

Imports of both oil and gas have grown over the last decade as North Sea output has declined. Even if North Sea oil and gas production can be stabilised for a period, import requirements are likely to grow further over the next two decades.

6. The second factor shaping the market is a long term shift in the UK's energy mix. The share of total energy demand provided by electricity and gas has grown as the role of manufacturing in the economy has declined. Since 1970 gas consumption has grown from 14.4 million tonnes of oil equivalent (mtoe) to 47.1 mtoe in 2012. Figure 2 shows trends in fuel consumption over the last four decades.

FIGURE 2

Final energy consumption by fuel, UK (1970 to 2012)

Source: DECC, ECUK Table 1.06

7. Figure 3 below illustrates the sources and uses of energy within the UK economy.

FIGURE 3

Energy Flow Chart 2012

Source: DECC, National Statistics

The impact of policy commitments to renewable and low-carbon energy

8. The third factor shaping the UK's energy mix is Government policy, including the Climate Change Act 2008 and the Energy Act 2013. This legislation reflects the UK's commitment to a long term reduction in carbon emissions by 2050 with intermediate targets for 2020, to be achieved by reduced use of coal and gas in power generation (except if carbon capture and storage technology can be used) and by supporting development of low carbon sources of supply including onshore and offshore wind power, solar, biofuels, and new nuclear.[7]

9. The development of alternative sources of energy will displace some gas. But, according to the most recent estimates from National Grid, substantial volumes of gas will still be needed over several decades for home heating and as back up supply in the power sector, where supplies from renewable sources such as wind and solar are inevitably intermittent.[8] Even if gas fired power generation is replaced over time by renewables and new nuclear, gas is likely to remain the main source of heat in the UK's economy. Mr Ken Cronin of the UK Onshore Operators' Group (UKOOG) reminded us that "Some 80% of our heat comes from gas."[9]

10. Renewables are therefore likely to complement rather than completely displace gas in the UK energy market. Natural gas remains an attractive and flexible fuel, capable of providing heat and power at a relatively low cost, thanks to advances in generation technology over the last twenty years and to the UK's established gas infrastructure including a comprehensive transmission grid with links to Europe. Gas also produces 28 per cent fewer emissions per unit of electricity produced than oil, and 45 per cent less than coal.[10] Regardless of whether the UK develops indigenous shale gas reserves, the UK is likely to be a substantial consumer of global shale gas as new supplies encourage gas-to-gas competition.

Gas prices

11. Gas prices have historically been set by long term contracts with producers—in the North Sea and elsewhere—with prices traditionally linked to movements in the international oil price. In recent years, however, this link has begun to break down and more gas is bought and sold at spot prices as the international trade in liquefied natural gas (LNG) has grown. In the short term prices have been falling, first in the US as shale gas development provided new and low cost sources of supply and more recently in Europe where gas to gas competition is undermining contracts which traditionally linked gas and oil prices. In a complex market, however, no particular trend can be guaranteed to persist.

Future price trends

12. There are widely divergent views on the future of global gas prices. A DECC report of July 2013 "Fossil Fuel Projections" argued that gas prices are expected to settle at 73.8 pence per therm[11] in the 2020s, compared to 63.6 pence per therm now.[12] A second DECC report, commissioned from consultancy Navigant in 2012, estimated that 2030 prices would be in the range 50 to 80 pence per therm.[13] By contrast Professor Dieter Helm of Oxford University saw "no particular reason for believing that the gas price is going to go up in the medium term. There are quite good reasons for thinking that it is going to go down. It is abundant in supply".[14]

Costs of renewables

13. The change of the energy mix in favour of low carbon supplies as laid down by Government policy is not cost free. Hopes that the costs of renewables would fall materially as a result of large scale application have so far been disappointed, and the costs of new nuclear have risen dramatically to the point where the proposed new nuclear station at Hinkley Point will require a support price of £92.50 per megawatt hour, double the current wholesale price. The support price will be guaranteed and index-linked for 35 years after the station comes on stream. Critics of Government policy foresee a UK and European energy market locked into high cost renewables while global energy prices fall due to abundant new supplies of shale gas. Mr Peter Atherton of Liberum Capital said

"If … in 2020 … the world is enjoying abundant and relatively cheap fossil fuels and very few of our major competitors have followed us on the decarbonisation strategy, so all the public is seeing is the costs and none of those benefits, it will be extraordinarily hard for policymakers to hold the current line on European energy policy."[15]

Electricity generation: the investment gap

14. The economics of power generation are heavily dependent on high load factors. The shift to renewable sources is not only expensive for consumers but also imposes a burden on other generators. Wind and solar power are by their nature intermittent. Constant supply of current requires back up generating capacity from conventional sources. Its limited usage can make it an unattractive investment. Professor Helm told us that once intermittent generation from sources such as solar and wind provides a substantial proportion of electricity, everything else on the system becomes intermittent as well. Gas fired capacity is used for only part of the time, undermining the economics and discouraging investment.[16]

15. Uncertainty over the economics of new conventional generating capacity and more generally about future public energy policy is discouraging investment at a time when older stations are reaching the end of their working lives or, in the case of coal fired stations, being decommissioned under environmental regulations. Viscount (Matt) Ridley, a science journalist, said, "Our policy is that, when somebody wants to make electricity, they will take the wind power first and the gas second. They will only take the gas if the wind is not blowing. As a result, they are not going to build the gas plant because they cannot run it all the time."[17] OFGEM reported in 2009 that £200 billion would be needed by 2020 to ensure that capacity could meet demand.[18] More recently, the Government have estimated the electricity sector's investment needs at £110 billion over the next decade.[19] The slow pace at which that investment is proceeding is arousing serious concerns about the ability of generators to maintain sufficient supply to meet demand, particularly during periods of high use.

16. According to OFGEM's most recent Electricity Capacity Assessment report, the probability of a large shortfall requiring the controlled disconnection of customers, involving industrial and commercial sites before households, will increase from around 1 in 47 years in the last winter to 1 in 12 in 2015/16.[20] This will increase to 1 in 4 if anticipated demand reductions resulting from increased efficiency do not materialise.[21] There is a concern that inadequate capacity could lead to cuts in supply to business and industry which would have serious economic consequences.

17. Professor Helm described the situation as a "very slow-motion car crash"[22] and warned that

"by 2015 or 2016, the capacity margin in this country will be very close to zero; in fact, I have done some numbers which suggests that it might be below zero. What is going to fill the gap in 2017, 2018, 2019 and 2020? We will be lucky if Hinkley is on the system by 2022 or 2023. More nuclear power stations are coming off between now and then. Most of the coal, through emissions control, thankfully, is being closed. There are not enough wind farms and solar panels to fill that gap in a credible way … it is inescapable that gas is a transitionary fuel and can actually make a big impact quickly."[23]

18. There is a growing risk of power cuts in the UK as the margin of electricity generating capacity over peak demand shrinks. It reflects a lack of clarity and consistency in energy policy over many years. UK-produced shale gas could not, of course, contribute to a short term solution. Its development is a separate issue. Indigenous shale gas could, however, provide in the medium term an additional source of supply which, combined with policy changes to encourage investment in generating capacity, could help ensure that competitively priced electricity supplies are maintained at an adequate level for many years to come.

Security of supply

19. In the absence of shale gas development, imports will rise. By 2030, DECC has forecast that the UK could be importing three quarters of its gas.[24] The Institute of Directors estimates the costs of such imports at £15 billion per annum.[25] The IoD report's central scenario for UK shale gas production suggests that gas imported could be reduced to 37 per cent of consumption in 2030, with the cost of imports falling to £7.5 billion which "would assist with the UK's balance of payments and support energy security".[26]

20. Some witnesses believed that even without domestic shale gas, the UK was well placed to withstand any disruption in supply. E.ON wrote that the UK is part of a "well connected and liquid market [therefore] relatively insulated from supply-side shocks."[27] Mr Richard Sarsfield-Hall said that Poyry International Consulting Engineers "did some work for the Government a couple of years ago that looked at the security of gas supply. We identified that broadly because of its diversity, it looked very secure."[28] Policy Exchange thought that arguments about energy security have "tended to be overplayed in the UK policy context."[29]

21. DECC wrote that increasing reliance on imported gas "can expose the UK to new gas supply risks, whether from geopolitical events … or from diversions of gas supplies driven by higher prices in other markets … Onshore unconventional production could mitigate these risks."[30] The Chemicals Industries Association (CIA) expressed the view that development of the UK's indigenous shale gas would "certainly" have a positive impact on security of supply, not least because, when supplies are tight, LNG shipments are always liable to be diverted from the UK to markets willing to pay a higher price.[31]

22. INEOS highlighted the strategic risks associated with import dependence on supplies from the Middle East and Russia.[32] Recent events in Ukraine and the resulting tensions between Europe and Russia demonstrate how real these risks are. Europe imports over 25 per cent of its total energy needs and over 30 per cent of its gas supplies from Russia.[33] The UK is not directly dependent on Russian supplies but in an integrated market we would not be immune from shortages or price increases across the European Union. After the US and European Union imposed sanctions on Moscow, the Minister for Energy reportedly described the situation in Ukraine as "a wake-up call to Europe of the need to develop more energy sources of all kinds. We can't be more and more dependent on imports from unstable regions … We have to develop more home grown energy like shale."[34]

Compatibility with development of low carbon forms of energy

23. Concerns have been expressed by NGOs that development of the UK's indigenous shale gas resource could lead to higher carbon emissions and lock the UK into a gas based economy for longer than compatible with the Government's targets for emissions reductions. Mr Nick Molho of WWF-UK said "Our organisations are opposed to the development of shale gas in the UK mainly on grounds relating to climate change".[35] He added:

"To the extent that those [UK] reserves are brought out of the ground and encouraged to be used in our gas power stations and gas infrastructure, the most likely scenario is that this will displace low-carbon generation … [It would be] … a very dangerous mistake to associate exaggerated hopes on the future of UK shale gas exploitation with a policy that will encourage the construction of excessive amounts of new gas infrastructure, because the most likely outcome will be a continued high dependency on imports".[36]

We address the topic of shale gas and carbon emissions more fully in Chapter 6.

24. Some witnesses took the view that exploitation of the UK's own shale gas resource would displace imported gas rather than renewable energy. Mr Dan Lewis, CEO of Future Energy Strategies, said his company's economic modelling indicated that shale gas imports would be displaced by indigenous shale gas production, while renewables and nuclear would not be displaced because of the levels of subsidy for those forms of electricity generation through the Electricity Market Reform (EMR).[37] Mr Ken Cronin of the UK Onshore Operators' Association (UKOOG) said that the renewables industry should not have any fear of shale gas development: "Shale gas will give the opportunity for a transition to enable renewable energy to become cost-competitive."[38]

25. Dr Figueira of the Office of Unconventional Oil and Gas (OUOG) explained that "in terms of decarbonising the electricity system … there will be a continued need for gas in the decarbonisation efforts".[39] Mr Cronin told us that "the facts are that we will need low-carbon forms of energy for the future … They are quite expensive at the moment, and we need to have a transition. The transition has to be gas, and it will have to be shale gas."[40]

Gas prices and energy intensive industries

26. Substitution of locally produced gas for imports could also have some effect on prices due to the added costs of processing and transporting imported LNG. Mr Dorner of the International Energy Association told us that "the cost of transporting gas is about seven times that of transporting oil on an energy-equivalent basis" and that the costs involved in transport would continue to be the main factor causing final gas prices to diverge between one region and another.[41] Gas prices and the wider economic impact are discussed more fully in Chapter 5.

27. Rising energy costs pose a particular challenge for energy intensive sectors such as metals and for the petrochemicals industry, where gas is a feedstock. The International Energy Agency published a study in 2013 that showed how far European costs have risen and diverged from those in other parts of the world and warned of the risk that industries could move to areas where energy costs are lower.[42] Mr Tom Crotty of INEOS said "we have to sell our products globally. Today, the cost of energy in the UK is three times that in the US and three times that in the Middle East. They are our two major competitors for the manufacture of petrochemicals."[43]

28. Development of shale gas in the UK on a significant scale could provide substantial benefits:

· enhancement of energy security through a decreased reliance on imports;

· an affordable bridge fuel towards renewables-based electricity generation;

· enable decommissioning of high-emission coal fired generating capacity;

· reduce the risk of gas price increases or even lead to falls in prices;

· reduced costs for energy intensive businesses and the petrochemicals sector that also use gas as a feedstock.

5 Sir Ian Wood (2014) UKCS Maximising Recovery Review: Final Report. Back

6 Ibid. Back

7 The UK's climate change objectives are discussed further at paragraph 118. Back

8 National Grid (2013) UK Future Energy Scenarios. Back

9 Q 58. Back

10 DEFRA (2012) Greenhouse house gas factors for corporate reporting. Back