Free electricity - sort of

At some stage in the future, electricity will be free. Of course nothing is truly costless and what I actually mean is that instead of paying for each unit of power we will buy a package of a certain number of kilowatt hours a month. Included in the bundle will be a payment for having a grid connection, and perhaps a restriction or a higher charge on the flow of electricity at points of peak demand.

Here’s what the advertisement for this service might look like. (Although they’ll probably phrase it a little more snappily).

£50 a month buys you our mega-bundle.

Up to 500 kilowatt hours outside our peak charge period

Charges inside the peak hours of 4pm to 7pm – only 20 pence per kilowatt hour

Maximum draw of 5 kilowatts at any time – enough for the tumble dryer and kettle (just)

What do we need from you? You let us switch your appliances off for half an hour or stop your EV charging when electricity is in short supply

Why will the future look like this? Because electricity is going to get cheaper and cheaper to generate while other costs will rise. More specifically, each extra unit of power coming from PV or wind costs absolutely nothing to make. The corollary is that suppliers will be prepared to supply the power at a very low price, pushing power costs down. But, on the other hand, paying for the distribution of electricity won't get any less expensive.

Although the ‘marginal’ cost of an extra unit of electricity is close to zero, the owners of solar and wind farms still need to be paid. What they want is a guaranteed payment for each month of operation. That will enable the owners to recoup the capital they invested in the initial construction of the farm. 

If I commit to buy the mega-bundle advertised above for twelve months, my retailer can make a secure payment to an electricity generator to cover my maximum use over each period. (As with mobile phone bundles, if I use more than I have paid for, I’ll get a large extra bill). The retailer will also get enough to pay its own business costs.

Peak times are excluded from the bundle. That is when the wind farm operators (or battery farms working with PV) will be able to get the highest prices for any power they haven’t sold because demand is high. So bundles will be constructed to severely discourage electricity use in peak periods. (If this policy is successful, of course, then peak time demand will probably fall sharply and it may no longer be the maximum).

The retailer that supplies me will also need to transport the electricity to me. Much of this cost is fixed. The pylons and the distribution cables don’t cost more when they are humming at times of peak use. Nor do they cost less when barely used in the dead of night. Logically, we should be paying for the connection to our homes, not necessarily the amount of electricity we use. This is essentially analogous to mobile phones; the base station’s costs are not related to the amount of data flowing through it.

You may think this all very bizarre and a very long way from what is happening now. That would be a mistake, I suggest. In fact, the obvious creakings of the UK retail electricity business today are a symptom of the market trying to move in this direction, obstructed by outdated regulation and entrenched pricing patterns.


Part of the problem is that the UK pricing system is tending to subsidise smaller electricity consumers to the detriment of those using large amounts. We cannot change this overnight, and nor should we, because consumers of small amounts of electricity tend to be households that are less well off. Rebalancing pricing to introduce lower charges for each unit of electricity and introducing a monthly fixed price will hurt poorer households.

Nevertheless, the long-run pressure is clear. The variable element of our electricity bill – essentially a payment for kilowatt hours – will fall sharply and the fixed portion – an amount we pay however much power we use within limits – will rise. This force is already at work.

Let me go into a little more detail.[1]

1)    In the six years to 2016 the percentage of household electricity charges going to pay for the power purchased by the retailer has fallen from about 55% of the bill to around 38%. 2017 will probably see a continuation of the decline. This means that only just over a third of your bill is being spent on buying the electricity to supply you.

 Source: Consolidated Segment Statements for Big Six electricity retailers

Source: Consolidated Segment Statements for Big Six electricity retailers

2)    The portion of your bill going on charges for transporting your electricity and covering the subsidies for energy efficiency and paying for renewables has risen from about 30% in 2010 to over 46% in 2016. In the final year, these charges totalled more than the direct cost of electricity purchases for the first time.

 Source: Consolidated Segment Statements for Big Six electricity retailers

Source: Consolidated Segment Statements for Big Six electricity retailers

3)    A split between transport costs (‘distribution’) and subsidy costs has only been available for the last year four years. Analysis shows that the costs of power distribution, paid to the National Grid and, more importantly, to the local network operators or ‘DNOs’ rose by over 4% to 29% of the electricity bill while subsidy costs increased by over 2% to almost 16% of the average domestic payment, or about £80 per household. Distribution costs are therefore now almost one third of the bill and the percentage is likely to rise further. Much of the distribution costs of the electricity system is not directly related to the amount of power carried over the wires. Some subsidies that are paid for by electricity customers, such as the ECO obligation to fund energy efficiency, are also not tied in any way to the amount of power consumed by a household. However, most subsidies - such as the cost of paying Feed In Tariffs - are directly tied to the amount of electricity produced.

 Source: Consolidated Segment Statements for Big Six electricity retailers

Source: Consolidated Segment Statements for Big Six electricity retailers

4)    The last category of covers the cost of running the business. This fell from about 15% in 2010 to around 13% three years later but has since risen sharply to almost 17%. This is probably a function of two things: rising expenditure on the smart meter programme and a fall in the total amount of electricity supplied. The second reason may need some additional explanation; if the amount of electricity bought by customers falls, but head office expenditure stays constant, then the percentage of the bill represented by overheads will rise. This appears to have happened recently. Very little of the costs of running the electricity retailing business will directly depend on how much individual consumers buy. If I double my purchases because I have installed air conditioning, the number of staff in the head office will not change.

 Source: Consolidated Segment Statements for Big Six electricity retailers

Source: Consolidated Segment Statements for Big Six electricity retailers

Across these four principal categories (power purchases, distribution, subsidies and business costs) the clear trend is for the cost of electricity itself to form a much smaller element. But fixed costs that are unrelated, either partly or completely, to the volume of electricity that a customer buys, are tending to rise.

Increasingly what the customer is buying is therefore not electricity itself but rather a package of services that is more and more dominated by distribution costs and other indirect items. In an entirely free and unregulated market, this package would probably be charged for by a fixed monthly fee.

At the moment, most domestic customers pay a daily standing charge of around 25 pence, or around £90 a year. In 2016, the average domestic customer (including those who use electricity for heating, which pushes up the figure) spent around £1.43 a day in total, almost six times as much. The daily standing charge does not even cover the cost of running the office activities of the Big Six retailers and their smart meter programmes. Whether or not the UK does eventually move to selling monthly electricity in packages like mobile phones, the daily fixed charge will have to rise.

The increase will pay for the business operations of the retailers and, more importantly, for the cost of distributing electricity to the point of use. At the moment, the local distribution companies charge a fee for each kilowatt hour they supply to domestic consumers. But as households decrease their consumption, now an established trend in the UK and elsewhere, the largely fixed costs of moving electricity round are spread across smaller and smaller volumes of power. The per kilowatt hour charges may rise.

Or, and I think this is more likely in the long run, the distribution operators will move to charging per connection, rather than per kilowatt hour supplied to a house. Consider, for example, a house with a 4 kilowatts of PV on the roof. Its draw from the distribution system is quite small, and its use is focused on evenings. Not only is the household not paying a fair share of distribution costs, but is also benefiting from being able to import power at precisely the times when the local network is most overloaded and so it should be paying a higher price per kilowatt. (Much of the cost of running a distribution company arises from having to upgrade or reinforce power lines to meet maximum demands). The UK and other countries could discourage domestic PV to avoid this problem or it could simply oblige all customers to pay a fixed monthly fee for distribution costs.

The increase in the proportion of power costs that are fixed, combined with decreasing costs to generate electricity, will have inevitable effects. It will take a long time, but electricity will eventually be sold as monthly contract that combines a bundle of kilowatt hours, higher costs for peak demand periods and, probably, fees for exceeding a maximum draw on the distribution system. And, as a corollary, the householder will get paid for handing control of the charging of the domestic EV to the electricity company so that it can manage supply and demand better.

Does this still sound like fiction? It shouldn’t do. All the individual elements are already in place around the globe. Sonnen, the battery company, runs a scheme in Australia and Germany that gives households a fixed allowance of kilowatt hours per month if they install a battery and allow Sonnen to charge and discharge remotely. Many places, including Hawai’i and other US states, use time of tariffs to hold down peak demand. Other countries, such as Italy, impose maximum usage limits in kilowatts. Some areas, including parts of California, incentivise EV owners to allow the electricity network to manage the charging of the battery. Other places have raised fixed charges sharply in relation to per kilowatt hour costs.

The move to pricing electricity similarly to mobile phones has social consequences. It may have severe impacts on less prosperous households and, in time, also on those that are unable to install batteries for electricity storage. (Such households will be less able to adjust their draw from the grid to minimise their use of electricity at peak times). The issues will need to be discussed and regulation needs to be thoughtful.

But the need to move to lower charges per unit of electricity sold combined with higher charges for the privilege of being connected to the grid and freely drawing power is clear and should not be ignored. The current review of the UK domestic electricity market by Professor Dieter Helm is a good place to start discussing how we manage to create a transition to fair pricing that also encourages low-carbon sources. It’s in no-one’s long term interests that pricing patterns that diverge strongly from the underlying economic reality remain unquestioned.

 

[1] The numbers in this article are largely derived from data submitted to the UK regulator, Ofgem, by the largest six electricity and gas retailers in the annual Consolidated Segmental Statements. These can be found here. https://www.ofgem.gov.uk/system/files/docs/2017/06/links_to_consolidated_segmental_statements_0.pdf . The figures for 2016 exclude Scottish and Southern because it has not yet filed its segment accounts with Ofgem because its financial year ends later than other companies.