Why Are Energy Prices So High?

While Liz Truss has promised to soften the blow of skyrocketing energy prices for households with the Energy Price Guarantee, businesses and commercial venues have yet to receive the same comforting news.

In fact, there’s currently no price cap for energy bills on businesses, which may drive companies with even the most favourable profit margins into an untenable position.

Although industry leaders in business may be looking to large-scale renewable energy projects as a long-term solution to the energy crisis, Liz Truss’s movements toward fracking and her disdain for onshore wind farms are unlikely to make this a venture worth investing in.

So, what are businesses to do when faced with potential closures and a looming recession?

It’s no secret that renewable energy is cheaper to produce and sell than natural gas and oil. But with the structure of the UK market forcing all energy to be sold for a single price, something needs to be done by industry leaders like OFGEM to manage extortionate business tariffs before companies are pushed past the point of no return.

In this comprehensive deep dive, I’ll uncover the reasons for Britain’s extortionate energy prices, how they’re impacted by national demand and how the country can resolve the issue for good.

3 Major Reasons for High Energy Prices

1. Great Britain has one national price for electricity

Since 2005, Great Britain has used a national pricing model, which means there is one price for electricity at any point in time. This system is also in place in France, Germany, Greece and Poland.

The UK government operates Britain as one big energy market covering England, Wales and Scotland. Electricity prices are set by the normal market forces of supply and demand across this combined geographical area. So National Grid has to match everyone who needs electricity to everyone selling electricity across an extremely large geographical area.

National Grid does this until there is a perfect balance and a single market price emerges at which everyone has received the amount of electricity required.

Two benefits of this approach are:

• Great Britain’s electricity market can be overseen by a single national operator (the National Grid)
• Electricity prices do not differ from city to city.

How other countries tackle it

This is in contrast to other countries such as Australia, Denmark, Italy, New Zealand, Norway, Singapore, Sweden and parts of the USA who have split their electricity market into smaller geographical areas called zones or nodes. In this scenario, each zone has its own separate energy price.

A key benefit of this approach is that electricity prices remain low in areas that produce enough energy to meet their local needs. As a result, these spots remain unaffected by higher prices experienced in other regions that import foreign energy to meet their energy needs.

Ultimately, the price of electricity is determined by how much we need and where this electricity comes from.

2. It’s all about where our energy comes from

As we use a large amount of electricity in Great Britain, we need to generate it from a variety of local and foreign sources.

Our breakdown of current sources includes:

• Renewables (43 per cent)
• Gas (36 per cent) 
• Nuclear (16 per cent)
• Oil (3 per cent)
• Coal (2 per cent)

Over the past 30 years, as illustrated in the diagram below, our reliance on coal and oil has fallen by 97 per cent and 52 per cent, respectively. These sources have been replaced by renewable energy and gas.

In general, renewable energy provides enough electricity to cover the UK’s needs for five months of the year. Gas supplies our electricity to make up for the rest of the UK’s needs.

Although there’s still a long way for the UK to go on the renewable energy front, this is undeniably impressive.

But we’re still unable to meet all our internal energy requirements with onshore sources.

And therein lies the problem.

3. Our electricity needs and the cost of supply varies from month to month

As Great Britain has a single price for electricity, its price is determined by how much electricity we need and whichever energy source has the highest cost.

Sometimes we need less electricity. This is usually the case  during warm summer months when central heating isn’t required or during lockdown when many energy-intensive businesses were closed.

During periods like these, most of our energy needs can be met by a few sources. Typically, we’ll rely on renewables and nuclear, which cost £10 and £20 per unit of energy, respectively.

The actual price of electricity will be determined by whichever of the two sources has the higher cost of supply – in this case, it’s £20 per unit.

So, although we could have received some of our electricity from renewables at the cheaper price of £10 per unit, there simply wasn’t enough electricity available from it to meet 100 per cent of our needs. 

And because Britain operates as one market with a single price for electricity, the company supplying electricity from renewable sources will receive £20 per unit (instead of its original cost of £10 per unit).

That’s just the way the cookie crumbles in the British energy market.

In the graph above, Great Britain requires 20 million units of electricity, half of which (i.e. 10 million units) was sourced from the country’s limited number of renewable energy projects at a price of £10 per unit.

Unfortunately, this would’ve been insufficient to meet Britain’s total energy needs for the period. So, suppliers needed to source a further 10 million units of electricity from nuclear projects. This energy source had a higher supply price of £20 per unit.

So, the final market price at which all 20 million customers could receive electricity was £20 per unit.

In short, it’s all about demand.

If we can’t meet demand through a single source, the price of all energy supplied will naturally rise to match the single price of electricity as defined by the market.

And if Great Britain’s customers only required 10 million units of electricity? Well, this lower demand could be met by the country’s renewable energy projects at a final market price of £10 per unit.

Now, imagine that Great Britain has just experienced its coldest and most prolonged winter on record. Our demand for electricity would be extremely high thanks to the increased reliance on central heating and lights. During this period, we would likely need all five sources of electricity ‘to keep the lights on’ as it were.

The individual cost of supply are as follows:

1. Renewables – £10
2. Nuclear – £20
3. Gas – £40
4. Oil – £50
5. Coal – £60

NB: fictitious numbers used for illustrative purpose only

In this scenario, the price of electricity would be £60 across Great Britain, because coal had the highest cost of supply at £60.

If we removed coal from the mix, the price of electricity would come down to £50. In this case, the next highest source of supply would be oil.

But without coal there wouldn’t be enough electricity available to meet the total demand of 60 million units. As a result, the National Grid would become imbalanced and the lights would go off for everyone in Great Britain.

Alternatively, you could think of it as a Lego bridge made from different colours, with each colour representing a different source of electricity. Let’s say we have the following layout for our energy sources:

• Renewables (purple)
• Nuclear (blue)
• Gas (yellow)
• Oil (orange)
• Coal (red)

Although each block might have a slightly different cost of production depending on its colour, all blocks are essential to make the bridge work.

Consequently, each block is able to command the same final selling price as the most expensive individual block, because they are all essential for completing the finished bridge.

It’s not about teamwork per se, but each source is crucial if we want to adequately meet Great Britain’s intense energy requirements.

So under the current electricity system, the only way to reduce the price of electricity to a manageable level is to dramatically reduce our consumption of electricity.

In other words, shorten the length of the Lego bridge, making sure we can support it with our present capacity of renewable energy and nuclear power stations.

Alternatively, we will need to build more power stations to supply more electricity whilst keeping the cost of supply low.

Why Have Energy Prices Increased?

There are a few reasons for the recent increase in energy prices.

Usage levels

The main reason for the increase in energy prices is down to usage levels.

Great Britain currently uses more electricity than is available from renewables, nuclear, oil and coal. In fact, we import foreign gas to cover 36 per cent of our energy needs from regions such as the North Sea, Norway, Russia, Qatar and the US.

The war in Ukraine

Unfortunately, the cost of gas has also skyrocketed in recent months due to the ongoing conflict between Russia and Ukraine.

This has dramatically reduced the supply of natural gas, as Russia is the world’s largest supplier of this commodity. As we know from economics, when supply reduces, prices will rise – sometimes exponentially. Since we can’t live without electricity, the balance tips in favour of energy suppliers.

As for the Brits? Well, we simply have to pay the price.

So what does this mean?

Going back to our earlier example, the global shortage of natural gas has also increased the cost of supplying gas in Great Britain’s energy mix.

The current prices are as follows:

• Renewables – £10
• Nuclear – £20
• Gas – £200
• Oil – £50
• Coal – £60

Now, the price of electricity has increased to a whopping £200 per unit across Great Britain, as gas now has the highest cost of supply.

If we remove gas from the mix, we could bring the price of electricity down to £60 per unit. The next highest source of supply is coal, which would then influence gas prices.

But there simply wouldn’t be enough electricity for the whole of Great Britain if we did this.

And because Great Britain has one price for electricity, all the other companies that supplied electricity from other sources (i.e. renewables, nuclear, oil and coal) also receive £200 per unit.

Why Can’t We Just Fix Our Broken Electricity Market?

Well, the UK government is currently considering various ways to fix the electricity market to keep prices low. It frequently describes this as ‘decoupling’ the cost of electricity from high fossil fuel prices.

In reality, Great Britain’s electricity market is working perfectly well. We just don’t like the results of the normal market forces which are not currently working in our favour.

The existing system is making things incredibly expensive for the average British household, which is causing widespread frustration, hardship and increased distrust in market forces.

Ultimately, the UK government has failed to invest in enough power stations to meet the energy needs of Great Britain. Instead, it has relied on importing cheap foreign energy (namely gas) to meet its shortfall of energy.

Unfortunately, the government was not adequately prepared to deal with the repercussions of imposing sanctions on Russia. As the UK is reliant on foreign gas, this was extremely problematic.

It’s extremely tricky to resolve this issue without significant government intervention that would cushion the blow for the average Briton.

So, How Do We Fix It?

To bring energy prices back to reasonable levels, we need to:

1. Have amenable negotiations with Russia to end the current conflict
2. Significantly reduce our consumption of electricity
3. Force low-cost energy producers to sell their electricity at pre-2022 prices
4. Implement a new concept that would innovatively divide the UK into smaller electricity markets with lower regional prices
5. Build more power plants to make the UK fully energy independent

A Final Thought

Now, each of these actions would take significant time, effort and money to implement. But it’s become glaringly obvious that serious investment is needed to fix the problems at hand.

The British population can do their part by reducing their consumption levels. But realistically, the government needs to formulate a meaningful plan that will set the country up for decades to come.