Taxing the lights on

Westminster is consumed by the Robbins-v-Starmer psychodrama, so a big new tax on electricity has slipped through almost unnoticed. It shouldn’t have. 

Today, Ed Miliband announced that he plans to raise the Electricity Generators’ Levy from 45% to 55% and introduce a new voluntary Contracts-for-Difference mechanism — all in the name of “delinking electricity prices from gas”. It will do nothing of the sort, and will only further damage the UK power market.

Under marginal cost pricing, every generator gets paid the price bid by the most-expensive dispatched generator. Normally, this is a gas power station. That may sound unfair, but it is perfectly natural. “Cheaper” generators typically have large capital costs, which they can use the gap between their short-run marginal cost and the final price to cover.

But most importantly, marginal cost pricing encourages firms to develop the right type of generation and run it efficiently. If every generator was just paid a fixed price, there would be no incentive to develop generation that displaces expensive gas. Moreover, there is no incentive to do maintenance in periods of low demand.

The EGL confiscates 45 per cent (soon 55 per cent) of any electricity revenue above £75/MWh earnt by nuclear and non-CfD wind and solar generators. This blunts these incentives — and undermines the business case for building unsubsidized renewables to replace gas when it is most expensive. 

Luckily, the direct effect on investment probably won’t be large, because the market is already broken

Luckily, the direct effect on investment probably won’t be large, because the market is already broken: unsubsidized generation investment that goes into the grid is very rare in Britain today. So many taxes and subsidies are layered atop each other that it rarely makes sense to develop a new power station (despite Britain’s world-leading prices) without government support, unless your new generation is underwritten by new load.

This means most of the revenue from the EGL will be extracted from existing suppliers. That may look like free money, but the long-run signal is highly damaging. It says to investors: come to Britain, build the electricity we desperately need, but if prices ever rise to a level where you can make a real profit, we will take it off you — randomly, and without warning.

Voluntary CfDs will be less damaging, but still unhelpful. CfDs effectively guarantee generators a constant price for their power, with the government taking the risk that prices are higher and enjoying the difference when prices are lower. Unless the Government signals some more drastic changes to the pricing mechanism, no sensible generator will sign up for a CfD at a price much below the expected value of future prices. This will mean revenue for the government when gas prices are high and big costs when they are low — all largely evening out in the long-run. It will make no difference to consumers and taxpayers, when considered together, except for replacing volatility in bills with volatility in taxes. Moreover, voluntary CfDs still blunt the incentive to time maintenance and other outages to align with market prices.

So, what should Miliband do instead? Rather than stacking intervention atop intervention to solve the problems created by previous interventions, he should go back to a clean sheet.

A pure wholesale market, with locational marginal pricing, should be the core of Britain’s future electricity system — not a hodgepodge of subsidies, taxes, and regulations. 

This is not theoretical. Both New Zealand and Texas run such systems, and the results speak for themselves. Both have added huge amounts of new renewables — and, in Texas, gas capacity — with few or no subsidies. When prices spike, investors earn real returns; when they don’t, inefficient projects fail. Market signals, not ministerial preferences, determine what gets built and where. It might work even better in Britain, which enjoys the insurance policy of interconnection with Europe, unlike the isolated grid of and New Zealand.

The transition won’t be easy. Decades of meddling will need to be reversed, contracts will need to be renegotiated, and some parts of the country (especially Scotland) will be made better off than others. But this is a price worth paying for an electricity system that doesn’t need to be redesigned every time an oil shock hits.