Why has the government been criticised for paying too much for low carbon energy?
The government is paying over the odds for eight low carbon energy projects, according to spending watchdog the National Audit Office (NAO). It says the Department of Energy and Climate Change (DECC) has awarded unnecessarily generous subsidies in its haste to confirm the plans.
The NAO’s report led to a spate of headlines claiming renewable energy projects were receiving “too much” funding from the government. So what’s going on?
Early contracts
The government is introducing a new subsidy scheme for low carbon energy starting in April 2015, known as contracts for difference (CfDs). DECC decided to award early contracts to some projects to ensure there wasn’t a gap in investment during the transition between the old scheme and the start of the CfDs. It’s the early contracts that the NAO’s criticises.
In May 2014, the government signed early contracts for five new windfarms, one biomass plant and to convert part of Drax coal-fired power station to biomass. The projects could provide 4.5 gigawatts of capacity when completed, helping the UK hit its target to get 15 per cent of its energy from renewable sources.
But the way DECC handed out these contracts “may have increased costs to consumers“, the NAO says. Its main criticism is that the government awarded the contracts – worth up to £16.6 billion – without any competition.
The CfD scheme means the government agrees a guaranteed price for electricity with power companies, known as the strike price. If the wholesale price of electricity falls below the strike price, the government tops it up, with the cost passed on to consumers. If wholesale prices are above the strike price, companies pay back the difference.
The government will hand out some of the contracts at a fixed strike price on a first come first served basis. But companies may be forced to bid for contracts later if the scheme is oversubscribed. This could drive down the strike price.
The NAO argues that the government should have withheld more of its funds for when that happens. It identifies £325 million that could have been shaved off the bill if the government hadn’t been so hasty, for instance. This only amounts to two per cent of the total cost of the contracts, however.
Consumer group Which? has also called for earlier competition to ensure better value for money.
How will it affect bills?
CfDs, like other renewable energy subsidies, will be paid for through a levy on household electricity bills. The Telegraph reports that the £16.6 billion cost of these early projects will add £11 to annual household bills. The Times says it’s £16.
The reason for the difference comes back to the way CfDs work. The additional cost depends on the difference between the strike price and the wholesale cost of power.
The current wholesale price of electricity is around £45-50 per megawatt hour. It was closer to £30 per megawatt hour in 2007 but reached as high as £90 in 2008. In order to calculate the additional cost added to consumers’ bills you need to know what electricity will cost in future, but future prices are notoriously hard to predict.
DECC has estimated future prices under three scenarios. For instance in 2020 it thinks electricity will cost anywhere between £42 and £80 per megawatt hour, show on the chart below in shades of blue.
The cost added to bills depends on the difference between the strike price for offshore wind, shown in purple, and the future price of electricity. So the Times might be right. Or maybe the Telegraph. Only time will tell.
Image - Screen Shot 2014-06-27 At 11 (note)
Source: DECC projections
What happens next?
The NAO’s criticism is potentially politically damaging for the government, but has no legal weight.
Labour’s shadow energy minister, Tom Greatrex, told the Telegraph today that the episode “raises serious questions” about the government’s ability to lead the UK’s transition to a low carbon energy sector.
And the European Commision is also yet to confirm whether the contracts for difference system – and the early contracts – contravene ‘state aid’ regulations. If it finds against the UK, the system would have to be changed. That would create the very uncertainty for investors that the government’s early contracts were designed to avoid.