Climate & Energy

What Goes Up Must Come Down?

Commentary3rd March 2022

High and volatile gas prices could be here to stay – and governments need to plan accordingly

Energy prices, already a top political issue, have been brought even further into the spotlight by the potentially huge market impacts of the Russian invasion of Ukraine. The UK government has announced a set of measures intended to cushion the blow of higher household energy bills. But those temporary and relatively small-scale measures are based on the hope that the price will soon return to more “normal” levels.

But is that likely to happen – and what if it doesn’t? The UK needs to take action to ensure it is managing the risk of a higher and more volatile gas price from here on.

A “new normal” for gas prices?

Gas is the workhorse of our energy system. While the last 25 years has seen significant changes in our energy mix with the phase-out of coal and the rise of renewables, gas has been the pivot around which change has happened – never providing more than 43% of our energy use, and never less than 35%.

As well as providing the vast majority of our heating, gas almost always sets the price in our electricity market – meaning the UK, like other European markets, is hugely exposed to changes in the gas price. And recent price volatility has been remarkable.  This winter the price has spiked to an average of around 200p per therm – four times higher than the average of the past decade. That has fed through into a hit on both the economy and on consumers’ bills.

As recently as a few weeks ago, it seemed possible that the high prices were just a short-term blip as the global economy recovered from the Covid pandemic.  And that is the bet that the government has made: the centrepiece of its approach is a cost-neutral policy of cutting consumer bills by £200 to address the current price rise, and recouping that money over the next five years.  That approach only works if prices fall significantly.

But while recent months have shown that attempts to accurately predict the future gas price are a futile exercise, there are at least three reasons to think that we are entering a phase where the risks of higher and more volatile gas prices have significantly increased:

  • Uncertainty on existing supply. Russia’s invasion of Ukraine, and the European response, threaten to restrict supply into the European market.

  • Sustained increases in demand as economies – in particular China – both recover from Covid, and increasingly turn to gas as an alternative to coal.

  • A lack of incentives for new investment in gas production. Delays in delivering investment frameworks for low carbon energy production, and the time taken to build it, mean that new net zero sources of energy are not being put in place quickly enough to ensure they can take the place of gas in the short-term. At the same time, the drive to decarbonise is increasing the risks on investment in gas production and so hampering investments which will increase production.

Increasing UK-based supply will not address the problem

A range of commentators have argued that the solution to this problem is to increase supply and make the UK self-sufficient: “Drill, baby, drill!” is the cry. But the hope that UK production can have a material impact on prices in the international market is unrealistic.

UK production is around 1% of the global total, and around 5% of Russian production. Under these conditions there is no plausible way the UK could produce enough gas to make a dent in the international price.

Figure 1

Gas production

Aiming for self-supply and to decouple from the global price is similarly impractical. It would require a regulatory and investment framework which would double gas production, and impose export controls or price caps.  Neither of those is practically deliverable in isolation, and both together is a logical impossibility: which investor is going to pour billions of pounds into gas infrastructure if they are then going to face export bans and price controls?

Four steps to mitigate the risk of high gas prices

But while increasing supply is not a realistic solution, there are four key steps that the government can take to manage the risk of high and volatile future gas prices.

First, we need to reduce demand. Cutting the amount of energy we use was already a sensible, and radically underused, policy lever.  Doing so would reduce dependence on gas, cut costs, and lower emissions.  And the business case for energy efficiency measures would be strengthened by a higher long-term gas price as the payback periods for these investments is dramatically reduced.  The government should implement measures to rapidly accelerate energy efficiency deployment, particularly for those on low incomes who are most exposed to high prices.

Second, we should accelerate efforts to diversify away from gas by accelerating deployment of renewables, nuclear, hydrogen power generation, and electrified heating. But the policies which will drive investment don’t yet match the rhetoric; now is the right time to address that gap.

Third, the risk of a high and volatile gas price further strengthens the argument to reform the electricity market. Even if gas is providing a relatively small amount of electricity, its high marginal cost means it will continue to set the price in the electricity market for long periods.  The case for market reform was already overwhelming before the current crisis; government should start that process now, and as part of it consider market structures which can separate out despatchable plant such as gas from intermittent technologies with low marginal cost.

Finally, we need to review the UK’s hydrogen strategy, which placed heavy emphasis on blue hydrogen, produced from natural gas.  That was already a risky approach, given the significant cost reduction potential of renewable-derived green hydrogen. A higher gas prices would mean that major investments in blue hydrogen are at increased risk of becoming stranded assets, outcompeted by cheaper alternatives. The government’s strategy needs to be resilient to that risk.

None of these options are easy, and none will significantly cut costs in the short-term. But only by augmenting short-term support for consumers with a long-term perspective can we hope to reduce the risk of the UK economy being exposed to high and vol

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