Cutting the cord

This post was originally published on our Substack.

The news that the Government is planning to ‘de-link’ gas and electricity prices has been leading discussions on energy policy this week. But for those who, understandably, spend less time keeping up with the ins and outs of energy bills and the Government’s drive to net zero it might not have caused quite as much excitement. Here we dive into the details and explain what the Government’s proposals mean, what still needs to be tweaked, and what savings this might deliver to billpayers.

What’s been announced?

The Government’s plan to ‘de-link’ gas and electricity prices, faces up to one of the most-discussed issues in UK energy policy. The fact that the most expensive successful electricity generator (typically a gas power station) sets the price for all of the wholesale electricity market means that British households and firms are overpaying for electricity, and have been for some time.

So, what is the suggested fix? The Government is proposing fixed price deals that older renewable and nuclear projects can sign up to, with the idea that this de-risks both us and – in theory – them from gas-driven price volatility.

But this carrot for generators comes with a big stick as the Government has also announced an increase in the Electricity Generator Levy (EGL) rate from 45 per cent to 55 per cent and made it indefinite – effectively a threat to tax away profits created by high gas prices if generators don’t get on board with the new scheme.

Add on Corporation Tax (from which EGL payments are not deductible) and we’re looking at a headline tax rate of 80 per cent on revenues deemed to be exceptional (assuming receipts pass through to taxable profits with no further deductible costs): a pretty spicy incentive to shift.

A high tax rate, but will it bite?

While the headline tax rate is set to increase, affected generators have benefitted from high inflation pushing up the threshold at which the EGL bites – from £75/MWh when first introduced in 2023 to close to £83/MWh today.

But day-ahead wholesale electricity prices have been above this level for 70 per cent of days since the start of March (and 63 per cent since the start of the year). Further, they have only been above £90/MWh for 43 per cent of this period. It is likely then that the threshold at which the EGL is activated is too high and will not capture much of the excess profits made by generators.

Further, as the threshold continues to increase by inflation each year, and if prices fall from current elevated levels (futures prices for this winter are around £75/MWh, at the time of writing) it risks being even further above the level needed to chivvy firms into doing what the Government wants of them.

The high EGL threshold could reduce the impact of a higher tax rate

The Government has also not closed exemptions that could limit the efficacy of a higher headline rate: small (<50 MW) generators remain exempt, and the £10m revenue threshold survives. This means that smaller projects (or smaller companies) will not be affected and will continue to pocket windfall revenues from higher gas prices.

Combined, these factors mean that the tax change risks being underpowered. But it also shows where Government should be thinking about acting – reducing thresholds and broadening the tax base – if firms drag their heels on agreeing to ‘voluntary’ deals.

Ministers need firms to respond to the threat of higher taxes

The value of these voluntary CfDs will be determined by an auction in 2027, representing another step towards electricity prices being a function of government decisions instead of a result of market forces. So, ministers will need to take care when setting auction parameters to ensure that resulting prices are as low as possible.

Fundamentally, for the Government’s ‘de-linking’ to work, and for customers to benefit, it is vital that interest in the new CfDs is high. Shifting around 30 per cent of Britain’s power supply onto fixed price contracts is a big deal – far bigger than individual CfD auctions to held to-date.

As such, ministers need competition to be as high as possible for prices to stay low. A well-designed allocation round that sees competition cut £20/MWh from clearing prices, for example, would be worth around £1.7 billion, or £16 per year to the typical household (on top of savings resulting from less exposure to the wholesale market when gas prices are high). A small upside but one that could prove important if other forms of downward price pressure don’t materialise.

As well as enabling competition, the Government should avoid repeating recent mistakes that have increased CfD clearing prices for new capacity. For example, the Clean Industry Bonus allows renewable developers to claim a higher CfD price for delivering particular labour market outcomes; while these are certainly worthy, they would be better funded in a way that doesn’t push up electricity prices. Ministers instead should be laser-focused on low prices.

A good step forward