The debate about domestic energy prices needs more light and less heat

The subject of domestic energy prices creates more heat than light when “debated” on social and other media. It’s almost as if nobody has taken the trouble to find out about it (quite likely) or that it is too complex to understand (it isn’t). This is an attempt to explain.

Let’s look at some first principles about Energy. First There is a need to understand what Primary Energy is, where it comes from and how we use it.

Primary Energy is the high level presence of useful energy sources. These are:

Crude Oil

Natural Gas

Coal

Nuclear Power

Water (Hydroelectric schemes)

Renewables (Sun, Wind, Tidal etc.)

U.K. Primary Energy supply (Hydro shown under “Renewables”)

Crude Oil is useful only when converted to something else – usually in an oil refinery. These are oil products and also feedstocks used in plastics manufacturing. Among the products are a number of Secondary Energy manufactured fuels – the most familiar are petrol and diesel for road vehicles (motor fuel) and various fuels for other transport – aircraft, ships etc.

The price of oil products is determined by (1) The dollar cost of the Crude Oil input. (2) The exchange rate between the Pound and the dollar (3) Refining costs. (4) Transportation costs – both for the Crude Oil to the Refinery and for the refined product to the customer. (5) The producer and refiners margin and (6) Taxes and duties.

If we take the principal domestic use of oil products, motor fuel, the price build up can be seen in this graphic:

This is illustrative and not directly based on current pump prices. What it shows is that at a price of 132p a litre tax (Duty and VAT) is some 60% of the consumer’s cost. The raw material (crude oil) cost is less important than the tax.

Other uses of oil products (e.g. for Aviation or Marine applications) are not generally taxed.

Gas

Now let’s look at Gas. Natural Gas, like Crude Oil, is a hydrocarbon and is the Primary Energy source of choice in the U.K. for home heating (and cooking for some). For U.K. demand Gas is produced offshore the British Isles as well as in Europe especially in Norway and The Netherlands. Traditionally the only means of transportation was by pipeline but in the last 20/30 years Liquidied Natural Gas has been transported to Britain in special ships. UK has three operational LNG import terminals — two in Wales (Dragon and South Hook) and one in southeast England (Isle of Grain).

Gas, unlike Crude Oil, requires little processing to enter the gas grid. Just some adjustments to bring it to specification. It is a commodity and there is no product differentiation. The grid is owned and operated by National Grid plc a privately owned monopoly. National Grid’s role is entirely operational – it neither buys nor sells gas but solely provides the infrastructure for others to do so.

Domestic gas “suppliers “

The commercial element in domestic gas supply comes from dozens of so-called “Energy” companies (see above) who offer price deals to consumers. There is no product and little service differentiation between them. They are traders who buy and sell gas which National Grid transports to the consumers. The suppliers make a margin to cover their costs and profits and none of them has any strategic advantage (except that the larger companies like British Gas will have some economies of scale and may have some procurement cost advantage as well.)

As we have seen with Crude Oil, Natural Gas sourced either by pipeline or by LNG tanker starts with a cost of acquisition to which must be added transportation costs and other costs of the “Energy” companies – including their margin/profit. SSE, one of these suppliers, have showed their cost build up as follows:

SSE gas cost build up

The above graphic is worth studying. It is noteworthy that the actual acquisition cost for Gas to SSE is, according to them, only just over a third (36%) of their total cost. 46% are their operational costs and profits. “Delivery” is mainly the fees paid to National Grid for moving the gas through pipelines to the customer. SSE’s costs include marketing (not made specific) where the level of competition from over thirty other “suppliers” means they have strongly to advertise their price offers. Other than price there is no other significant benefit they can offer prospective customers.

As with Crude Oil the acquisition cost for gas is determined by international dollar denominated prices and the £/$ exchange rate. Purchasers can negotiate deals for term supply but ultimately there is not a lot of flexibility – gas is a publicly traded commodity.

Electricity

Power generation is the activity of converting primary energy (mainly hydrocarbons, nuclear and renewables) into electricity which can then be transported by the electricity grid cable system to customers. As with Gas the distribution system is owned and operated by National Grid plc. Power Stations mainly using hydrocarbons (Gas) as fuel convert the fuel to electricity. Everything described above for Gas, downstream of the power stations, is the same for electricity. Indeed the same companies are involved and it common to bundle Gas and Electricity together in consumer offers.

Coal and Nuclear

Power generation using Coal is a minor contributor – there are one or two specialist industrial processes requiring coal but in overall terms coal is no longer a significant part of Britain’s Primary Energy mix.

In 2019, Nuclear energy supplied 17% of the country’s electricity. This energy comes from 13 nuclear reactors at six plants. Although one new nuclear plants is planned and others proposed it is unlikely that production significantly above current levels will happen.

Conclusion

The U.K. has a reasonably diverse Energy supply situation and this will improve further as Renewables (mainly Wind power) expand further for power generation. As electric vehicles increase their share of the private vehicle sector then oil consumption will fall percentage wise. (For this to be environmentally positive the electricity used will need to be from renewables of course otherwise al that happens is that the location of the pollution moves !)

The key area for reform is domestic gas and electricity supply. The current situation is sub optimum with suppliers incurring largely unnecessary marketing and other costs which are passed on to consumers. The case for having unitary gas and electricity supply to create scale efficiencies and eliminate artificial competition is strong. As is the case for far greater transparency in cost and pricing.

The debate as to whether a unitary operation should be publicly or privately owned (and regulated) is secondary to the need to get our collective act together. The debate should include the role of National Grid as a monopoly transporter to the energy suppliers. But private sector monopolies are often defective (see also domestic water supply) !

The planned rises in gas and electricity prices need to be seen in the context of all of the above – especially the apparent comparatively low percentage (36%) that gas and electricity acquisition costs are of suppliers’ total costs.

One thought on “The debate about domestic energy prices needs more light and less heat

  1. Very interesting Paddy. Given the enormous profits announced by Shell, paradoxically yesterday on the same day as Sunak announced his hopeless ‘help’ initiative for struggling families, I would have thought a windfall tax was necessary. The French have announced such a tax on EDF.
    A windfall tax on oil and gas companies was featured in the Labour manifesto in the 2019 general election. Labour said the proposed tax would raise £11bn. Sadly Labour lost and utility bills inexorably rise and rise. Even John Major called for such a tax in 2013.
    If this continues it will reach a point where people will simply find other methods of staying warm in their houses. My wife and I sit in the evening in our sleeping bags or go to bed early with a good book. Spain is very cold in winter and our fuel allowance was removed by IDS some time ago.

    Like

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