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What Drives the Price of Electricity

Electricity can’t be extracted it needs to be generated

In its simplest form, electricity is made from turbines that are driven by steam. The commodities that are used to make this steam include gas, coal, oil and nuclear fuels.

As a result the cost of generating electricity is in a large part driven by the cost of the commodity used to power the generation.

The wider commodity market influences the price of these raw commodities, and a higher demand for limited supply will push the price of a certain commodity up, or divert investment to cheaper, alternative sources that in turn will place pressure on price.

However beyond the simple headline of  supply and demand there are a host of other drivers influencing the cost of electricity.

What drives the cost of electricity?

  • Commodity costs –  The commodity markets largely drive the cost of electricity. The fuel markets primarily being nuclear, gas, coal and oil (with oil driving a small element of the gas price and also being used for covering peak demand)
  • Carbon cost – Traditional generation methodologies such as fossil fuel gas, coal and oil or non renewable sources are required to buy a certificate for each tonne of CO2 created as a penalty for not utilising renewable sources. This effective tax on energy has a direct impact on the price of electricity.
  • Demand – Behaviour drives demand, and behavioural change in business is not only regular but also substantial. Ramping up the factory, opening up, shutting down, employing more people, laying them off, ramping down production, and closing plant. As demand grows, output needs to match and costs naturally grow as less economic plant is brought on line to meet the new level of demand
  • Weather – The weather impacts both demand and supply, for instance cloud cover drives the need for light, and low sun or wind levels impacts the generation capability of renewable sources like solar and wind. Convergence of these occurrences leads to a stark imbalance in the energy markets, pushing prices up.
  • Supply constraints – The availability of generation to match demand is not only impacted by the absolute level but also the available capacity. Plant outages, especially amongst inefficient, unreliable, old installations are commonplace. Sometimes this is seen as tactical by the generators to drive prices upwards, sometimes it is a genuine reliability issue. Overlaid on this is politics such as the phasing out of nuclear power, soon to affect the UK, and the replacement of that base load with the intermittent contribution of renewables.
  • Time to delivery – In classic economic terms, the greater the demand and the sooner that demand is needed to be met the more it will cost to secure it, the nature of the electricity market with no mass storage capabilities means that such a ‘just in time’ approach is commonplace.

Where does the UK’s supply of electricity come from?

In 2013/14 the UK fuel mix for electricity generation was:

  • Coal: 34.0%
  • Gas: 25.6%
  • Nuclear: 21.6%
  • Renewable: 16.7%
  • Other sources: 2.1%

Producing CO2 of 428g/kWh and High Level Radioactive Waste of 0.0017g/kWh

The traditional sources of electricity are Coal, Gas and Nuclear. In recent decades these have been supplemented by renewable generation sources such as:

  • Wind farms (on and offshore)
  • Hydro (water driven turbines)
  • Biomass
  • Municipal and industrial waste (recycling)
  • Landfill gas
  • Tidal (wave power)

The Global Complex (Or how the energy markets got a lot more complicated in the globalised economy)

We often hear the phrase ‘security of supply’ or ‘energy dependency’. Being blunt this is code for “not being held to ransom by a foreign power for the commodity we need in the absence of our own resources”.

Why has this become ever more important in recent years?

In the specific case of the UK we have been a net importer of our energy needs for over a decade and we are approaching all time high levels as our own generation capacity and reserves decrease.

More widely, a recently coined phrase, ‘The Global complex’, describes the chain reaction of events that affects world energy prices and how each country is to a large part dependent on another.

If as a nation you are fortunate enough to have a self-sufficient energy economy then you will be insulated from this global complex, sadly in the UK we are not.

The domestic energy market is largely insulated from the more direct impacts of the global complex as the number of households and their demand for energy remains broadly consistent and enables suppliers to hedge ahead for long periods with relative security. This doesn’t stop prices for domestic customers increasing, but it does help prevent price spikes.

The situation couldn’t be more different in the non-domestic market. Businesses are larger, less predictable and as a result the impact their variances have on overall energy demand are far greater.

To combat this energy suppliers buy energy much closer to the point of demand to cover the relevant needs of businesses.

Whilst there is usually a predictable ‘base load’ of power that can be confidently forecast regardless of the variability of individual businesses, it is the peaks of demand that produce the risk, and drive the unpredictability.

Suppliers must cover this demand and doing so requires a more ‘just in time’ approach than does base load, leading to the natural volatility in striking a price close to delivery and in unpredictable volumes.

This means that businesses are much more exposed to the prevailing market price than domestic customers.

As a result events affecting the world energy market will be felt in the boardrooms of UK business far quicker than the bedrooms of the UK’s housing stock.

As an example of how quickly events in one corner of the world can affect the price that UK businesses pay for their energy we can look at the occurrences of 2011.

The regional players in this story are Australasia, Asia, the Middle East, Eastern Europe, Western Europe and North America

Year: 2011, Location: Australia

Australia is a major provider of coal to Asia and in 2011 suffered significant flooding in its coal-mining district curtailing output.

Asian energy demand however continued at its normal level. The slack in supply caused by the Australian floods needed to be taken up and so China turned to alternative energy sources from other countries such as Eastern Europe.

In reaction, Eastern Europe’s energy giants, in the pursuit of maximum return on investment (selling to the highest bidder), diverted capacity away from their traditional home markets and their major Western European markets and diverted their supplies to Asia.

Year: 2011, Location: Japan

Japan was hit by the devastating earthquake and Tsunami that not only took many lives and decimated the regions but also rendered their nuclear power resources either inoperable or offline.

Again this slack needed to be taken up elsewhere, as Japan, who are a nation rich in natural resources and had been largely self sufficient until this point, suddenly needed to enter the global energy market.

This placed demands on the energy market that had not been foreseen. Japan, needing to gain this replacement energy focused their attention on LNG.

LNG or Liquid Natural Gas is largely generated in the Middle East and shipped to Western Europe. It’s natural mobility is a blessing but also a curse.

In the face of this sudden spike in demand from Japan and the backdrop of lessened supplier of Australian coal and Japanese nuclear, the LNG generators saw an opportunity to capitalise.

As a result, in choosing to sell to the highest bidder, the LNG ships literally turned around and made tracks to Japan. In turn Europe’s LNG resources were hit and prices rose.

Year: 2011, Location: Germany

On top of the perils of nature and the wants of commerce comes the danger of politics.

Facing doubts over her re-election, Angela Merkel the German Chancellor, under heavy challenge from the Green political parties, and with a backdrop of the Japan disaster, arbitrarily took Germany’s nuclear capacity offline.

She got back in, German nuclear generation didn’t.

And so Germany like Japan and China needed to enter the market to meet their needs.

With less and less generation to go round, compounded by more demand from countries previously insulated from the market, the inevitable increases in the price of commodities followed.

Year: 2011, Location: The energy trading desks of the World

Overlain on all of this is market sentiment, or how nervous energy traders are about their respective positions.

In times of uncertainty traders react to protect their position and by doing so amplify any directional move of the price.

The resulting Global Complex

Australia’s problems causing Asian demand to be diverted to Eastern Europe, impacting their traditional supply to Western Europe mixed with Japan’s thirst for LNG further limiting Western European supply and traders protecting positions is the perfect example of the global complex.

Only becoming self sufficient in energy resources will decouple a nation from it.

Given in 2012 the UK imported 43% of its energy needs we are a long way from achieving that.

You may have noticed one nation conspicuous by its absence. North America. America believes it has isolated itself from the global complex through drilling in the arctic and the discovery of shale gas.

Indeed these findings have been trumpeted as having the potential for a huge shift in the political and economic balance of the energy market.

But, both these activities are controversial.

We only need to look at the limited fracking activities in the UK and their fallout from the morecambe earthquake in 2011 to the imbroglio in Balcombe to realise that these potential solutions could be strangled at birth.

The truth is that the Global Complex, the upward pressure on prices and UK’s exposure will only continue grow until the ‘new’ North Sea Oil is found. And we’re no nearer to knowing what that genuinely is.

Given fossil fuels still made up the majority of our energy generation in 2012 it is shocking to see that 87% of our coal usage, 47% of gas and 37% of oil was imported.

A stark reminder of just how tangled in the Global Complex the UK remains and why the electricity price is impacted by issues well beyond our own borders.

To understand more about the market or to simply act to insulate your business from price shocks call us on 0800 051 5770, we’d love to hear from you.