The Cost Reflective Pricing project investigated whether or not the fixed charges on energy bills – for network, environmental and social costs – are efficiently distributed between the standing charge and unit (per kWh) price of electricity and gas tariffs.

Working with the Oxford Martin School of Oxford University, Energy Systems Catapult found the arrangement of fixed and volumetric charges within electricity and gas tariffs, may inadvertently distort market behaviour towards favouring investment in decentralised generation technologies, like solar PV and diesel, over demand technologies like heat pumps.

The Cost Reflective Pricing Challenge

An energy system with a significant increase in heat pumps and electric vehicles could add to the capacity requirements of both the generation fleet and electricity networks, particularly at peak load times and if energy prices faced by consumers remained constant throughout the day and between seasons. Conversely, if consumers were incentivised to spread their demand throughout the day, as happens with railway pricing, the same energy could be supplied with fewer power stations and network upgrades.

How costs are allocated through energy bills contributes to the following market decisions:

• Choices by all sources of power generators (including on-site or decentralised energy), the type of fuel they use and how to connect to the power system: transmission, distribution or within a consumer’s premises;
• Choice by consumers regarding fuel type, typically between gas/electricity for heat and petroleum/electricity for transport;
• Choices about time of consumption.

If energy pricing is not cost reflective, there is a risk of distorting decisions by both producers and consumers, leading to inefficient decisions and higher overall costs to the energy system.

The Solution

Energy bills are comprised of a combination of market and fixed costs. There is a wholesale market for the cost of the actual gas and electricity, while administrative arrangements recover the fixed costs of transmission, distribution, environmental and social policy.

The Cost Reflective Pricing study looked at the administered components of pricing for electricity and gas. It examined how these largely fixed costs are distributed across the standing charge and unit (per kWh) price of tariffs, and whether they reflect and recover their true underlying costs for supplying each consumer.

The Outcomes

Under current tariff pricing, different consumers pay different contributions for the same fixed costs of making energy supply available. This is because costs are recovered as a % of the unit price. This approach means:

• Consumers installing generation assets on their own premises, such as solar PV or diesel generation, under-paid their correct share of fixed costs (including ‘feed-in-tariffs’ through which they benefit). This is because they avoid many of the costs recovered in unit pricing by generating their own electricity;
• An artificial incentive has been created to build small ‘on-site’ generation vs large generation;
• Consumers installing low-carbon demand technologies, such as heat pumps, over-paid their correct share of fixed costs recovered in the unit price because they used more electricity. As a result, an artificial barrier has been created to the deployment of incremental demand including low carbon technologies such as heat pumps and electric vehicles (although this disadvantage is small compared to the advantages EVs enjoy through tax treatment and current subsidy).

This meant that overall consumers are:

• Under-charged for the fixed costs of making energy supply available;
• Over-charged for the units of energy they consume; and
• The fixed costs avoided by those with generation on their own premises have to be recovered in the bills of other consumers, including those in fuel poverty, increasing their energy bills.

The Cost Reflective Pricing study also found that rebalancing fixed and volumetric charges into the standing and unit prices respectively would more recover fixed costs more efficiently. In addition, if environmental and social costs were moved away from energy bills to general taxation, this effect would be greater. As a result, the marginal cost of operating a heat pump would be lower than a gas boiler because gas bills did not contain these environmental and social policy charges. If it was not possible to move environmental and social costs to general taxation, spreading them more evenly between gas and electricity bills would improve the efficiency of the system.

The Impact

UPDATE: March 2019

The following actions recently taken by Ofgem are consistent with the argument that network charges should have a larger fixed component and a smaller per kWh charge:

• Decision on the recovery of residual charges (which recover the networks’ historic expenditure) on a per customer basis rather than per kWh.
• Decision to review the forward-looking distribution charges to get the correct balance between per kW and per kWh.
• Decision to review transmission charges in relation to distributed generation, demand side response and Triad charges.

Next Steps

Decisions about which fuel to use and what electricity generating plant to build/run would be improved by cost reflective pricing. This may support the adoption of low carbon technologies, such as heat pumps and electric vehicles, although there are many other factors at play in their uptake.

Behind the meter generation technologies, such as solar PV and diesel generators, may be over-incentivised in the current arrangements. While not within the remit of this report, the findings underline the potential of time of use pricing to realise a more efficient power system.