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The Energy Review

A Performance and Innovation Unit Report - February 2002

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EXECUTIVE SUMMARY

Key points

Trends in energy markets have been comparatively benign over the past 10–15 years: the UK has been self-sufficient in energy; commercial decisions have resulted in changes in the fuel mix that have reduced UK emissions of greenhouse gases; and trends in world markets and domestic liberalisation have reduced most fuel prices.

The future context for energy policy will be different. The UK will be increasingly dependent on imported oil and gas. The Californian crisis has highlighted the importance of putting in place the right incentives for investment in energy infrastructure. And the UK is likely to face increasingly demanding greenhouse gas reduction targets as a result of international action, which will not be achieved through commercial decisions alone.

The introduction of liberalised and competitive energy markets in the UK has been a success, and this should provide a cornerstone of future policy.

But new challenges require new policies. The policy framework should address all three objectives of sustainable development – economic, environmental and social – as well as energy security. Climate change objectives must largely be achieved through the energy system. Where energy policy decisions involve trade-offs between environmental and other objectives, then environmental objectives will tend to take preference.

Key policy principles should be: to create and to keep open options to meet future challenges; to avoid locking prematurely into options that may prove costly; and to maintain flexibility in the face of uncertainty. Increasingly policy towards energy security, technological innovation and climate change will be pursued in a global arena, as part of an international effort.

Within the UK, the overall aim should be the pursuit of secure and competitively priced means of meeting our energy needs, subject to the achievement of an environmentally sustainable energy system.

The UK's future energy strategy should have the following elements:

(i) energy security should be addressed by a variety of means, including enhanced international activity and continued monitoring. However, there appear to be no pressing problems connected with increased dependence on gas, including gas imported from overseas. The liberalisation of European gas markets will make an important contribution to security;

(ii) continued attention to long-term incentives is needed, though recent levels of investment in the energy industries have been healthy;

(iii) there is a strong likelihood that the UK will need to make very large carbon emission reductions over the next century. However, it would make no sense for the UK to incur large abatement costs, harming its international competitiveness, if other countries were not doing the same;

(iv) keeping options open will require support and encouragement for innovation in a broad range of energy technologies. The focus of UK policy should be to establish new sources of energy which are, or can be, low cost and low carbon;

(v) the immediate priorities of energy policy are likely to be most cost-effectively served by promoting energy efficiency and expanding the role of renewables. However, the options of new investment in nuclear power and in clean coal (through carbon sequestration) need to be kept open, and practical measures taken to do this;

(vi) the Government should use economic instruments to bring home the cost of carbon emissions to all energy users and enable UK firms to participate in international carbon trading. Achieving deep cuts in carbon would require action well beyond the electricity sector where cuts have been concentrated in recent years;

(vii) step changes in energy efficiency and vehicle efficiency are needed, with new targets for both. In the domestic sector, the Government should target a 20% improvement in energy efficiency by 2010 and a further 20% in the following decade;

(viii) the target for the proportion of electricity generated from renewable sources should be increased to 20% by 2020;

(ix) institutional barriers to renewable and combined heat and power investments should be addressed urgently; and

(x) the Government should create a new cross-cutting Sustainable Energy Policy Unit to draw together all dimensions of energy policy in the UK.

In the light of this review, the Government should initiate a national public debate about sustainable energy, including the roles of nuclear power and renewables.

Recent trends in energy markets have been benign for policy

In recent decades, the context for energy policy in the UK has been remarkably benign. The UK is currently one of just two G7 countries which is self-sufficient in energy. Energy prices have generally been falling in real terms, partly because world oil prices have fallen and partly because of the successful liberalisation of UK gas and electricity markets. UK industry and consumers, including the fuel poor, have gained. And the UK has found it easier than many other countries to achieve greenhouse gas reductions – the "dash for gas" in particular (which was driven by commercial decisions) reduced carbon emissions from electricity generation.

But the future context will be much more challenging

The future for energy policy seems likely to be much less benign for two reasons:

  • issues of energy security are likely to become more important. The UK will become increasingly dependent on imported oil and gas. And the Californian energy crisis has highlighted the importance of getting incentives for new investment in energy right;
  • the UK is likely to face increasingly demanding carbon reduction targets. A low carbon future, if it were to be adopted, could not be achieved on the basis of spontaneous changes within the energy system, especially when at present, one low carbon source, nuclear power, faces a progressive run-down as existing plant reach the end of their lives and are decommissioned.

In addition, although good progress is being made towards the elimination of fuel poverty, many people continue to spend a substantial proportion of their income on fuel, largely as a result of the age and energy inefficiency of the housing stock.

New challenges require new policies

The introduction of liberalised and competitive energy markets in the UK has been a success, and competitive markets should continue to form the cornerstone of energy policy. But new challenges require new approaches. The future framework for energy policy needs to address all three objectives of sustainable development – environmental, economic and social – as well as energy security. But climate change objectives must largely be achieved through the energy system.

Consistent with this, the future aim of energy policy should be the pursuit of secure and competitively priced means of meeting the UK's energy needs, subject to the achievement of an environmentally sustainable energy system.

The strategy articulated in this review thus has three main dimensions:

  • measures to address the security of the energy system;
  • measures to ensure the energy system is environmentally sustainable – these are intended in particular to create options to put the UK on a path to a low carbon economy; and
  • approaches which take full account of the potential costs of achieving the objectives of policy, in terms of higher energy bills.

Concerns about security need to be addressed

There are a number of reasons why security is on the agenda. These include:

  • the Californian experience of electricity blackouts;
  • concerns resulting from the terrorist attacks in the USA of September 11; and
  • the sensitivity to the UK's future need to import gas, possibly across long pipelines and from trading partners who seem to offer less security than we are used to.

There is general agreement that a diverse energy system – both in terms of types of energy and their sources – can benefit security. Some people argue that self-sufficiency is needed for security. But this is not necessarily so. As in other markets, imports can be a valuable means of increasing diversity and reducing risks – most other G7 countries already rely substantially on imported energy. Some submissions to the review have suggested that the Government should decide the fuel mix to be used for electricity generation. This review has rejected these proposals on the grounds that they would seriously distort the efficient functioning of energy markets.

Instead, the approach taken is to view issues of security in risk management terms. Some risks are essentially international, others domestic.

There are three main ways to safeguard security:

  • to make maximum use of competitive markets to meet customers' needs. A key conclusion of the review is that the liberalisation of EU gas and electricity markets is important for energy security. Liberalisation would add flexibility and depth to European energy markets, increasing substantially the resilience of the energy system;
  • to create a more resilient and flexible energy system. The review considers various options for enhancing the resilience of the UK energy system, including increased gas storage; greater use of liquid natural gas (LNG); and greater ability to use coal than would otherwise be the case. In the first instance, these are matters for market participants to address. The role of government should be to monitor the actions of market participants; to remove any barriers due to policies, such as the planning system; and to intervene directly, as a last resort, where there is clear evidence of market failure and where the benefits of intervention are likely to outweigh the costs; and
  • to use international action to address global threats to energy security. On just about any scenario the UK will become more dependent on imports both for both its gas and its oil. There is little risk of there being insufficient gas available internationally: there is plenty, and 70% of the world supplies can be accessed from Europe. But the UK cannot be sanguine about the path that the gas will take from its source to the European market and the risks it may encounter en route. Particular concerns are:
  • the level of investment in the exporting countries;
  • investment in the transit countries; and
  • facility failure overseas.

These risks need to be monitored. They are outside the direct control of UK purchasers or the UK Government. The key is to develop strong links with trading partners, so that the UK can ensure that the benefits associated with trade are mutually recognised and delivered.

Making sure suppliers face the right investment incentives is essential

The other main area of risk to energy security is the set of issues which arise as a result of the Californian experience. Supplies of electricity were interrupted because insufficient investment had been made both in the network and in electricity generation. The Californian problems were very specific to that state and were due in considerable measure to failures in regulation, which have no parallels in the UK.

Present levels of capacity in the UK in both electricity and gas networks and in electricity generation are healthy. The processes of privatisation and liberalisation seem to have succeeded well. Even so, the situation needs to be monitored since future investment might be constrained if the wrong signals and incentives come through the regulatory structures. But there is no reason for immediate concern. Care is also needed to ensure that the anticipation of public intervention does not lead the private sector to hold back its own investment plans.

Moving to a low carbon economy poses a major potential challenge

Looking to the longer-term, the central question for energy policy is the weight to be given to environmental and other objectives. The strong likelihood of a stringent greenhouse gas target being adopted in the future is sufficient to justify giving the environmental objective a strong priority within future energy policy – especially since the energy system is the source of 80% of UK greenhouse gases and 95% of CO2. Low carbon options also have the merit that, particularly where they are local and dispersed, they generally contribute to the security of the energy system.

This review has not considered the scientific case for carbon reductions – this was the task of the Royal Commission on Environmental Pollution (RCEP), and of bodies such as the Intergovernmental Panel on Climate Change (IPCC). Neither has the review conducted a cost-benefit analysis of the different ways of responding to the challenge: this is a matter for the international community as a whole. There is a lot of work on the possible overall costs to the economy of meeting a substantial carbon reduction target. Most estimates suggest that the impacts on GDP are likely to be small – though precise costs will depend on the methods chosen to reduce carbon, the rate of technical progress, and the scope for trading reductions elsewhere in the world.

Possible future energy worlds in 2020 and 2050 have been analysed using scenarios. Credible scenarios for 2050 can deliver a 60% cut in CO2 emissions, but large changes would be needed both in the energy system and in society. Two opportunities stand out. Substantial improvements in domestic and business energy efficiency could be made, and there are prospects for significant improvements in energy efficiency in the transport system. Yet even if these improvements can be achieved, and even if the electricity system was to produce no carbon whatsoever, a 60% cut in CO2 emissions could only be met if we were also to go on to make very large reductions in the use of fossil fuels as the main means of powering future vehicles. This shows the scale of the challenge.

The Government will need to make decisions about its longer-term approach to carbon reducing policies in the light of the UK's international commitments. The RCEP has proposed that the UK should adopt a strategy which puts the UK on a path to reducing CO2 emissions by 60% from current levels by 2050. This would be in line with a global agreement which set an upper limit for the CO2 concentration in the atmosphere of some 550 ppmv. It would be unwise for the UK now to take a unilateral decision to meet the RCEP target, in advance of international negotiations on longer term targets. Greenhouse gases are global pollutants, and it would make no sense to incur abatement costs in the UK and thereby harm our international competitiveness, if others were not contributing.

Given the strong chance that future, legally binding, international targets will become more stringent beyond 2012, a precautionary approach suggests that the UK should be setting about creating a range of future options by which low carbon futures could be delivered, as, and when, the time comes. The focus of this review is on ways of creating new options, and building upon the options we already have. Attention has been given to the cost-effectiveness of different options, both immediately and in the longer term.

There is a central role for market-based instruments and for support for innovation and R&D

A centrepiece of any long-term carbon-reducing policy should be the use of market-based instruments to put a price on carbon emissions and to help determine the most cost-effective opportunities. This need not happen immediately, but decisions about long-term approaches are needed soon, since early commitment will start to influence decisions in many markets. A central aim should be to enable the UK to participate in international carbon trading.

A vital means of increasing the range of options for the future is innovation. This is a theme that needs to pervade all areas of energy policy and a range of policies should be directed towards it. The encouragement of renewables is one means of increasing innovation and new technologies.

Central to that process will be a stronger research and development (R&D) base. A group convened by the Government's Chief Scientific Adviser (CSA) has undertaken a review of energy research to inform this review. The findings of this group suggest there is a need for much greater investment in R&D if the cutting-edge technologies for a low carbon future are to be developed. R&D will not only facilitate the achievement of environmental goals but should create valuable export opportunities for British industry. A healthy R&D base is also necessary to attract and foster the scientific expertise needed by the new industries which will arise from the innovation it stimulates. The CSA's group suggested that a national Energy Research Centre should be established to provide the focus for such scientific activity.

A step change in energy efficiency is needed

Increased energy efficiency is obviously worthwhile if it saves money. There is no point in wasting energy that can easily be saved. The scope for cost-effective energy efficiency improvement is large and new potential will continue to be created by innovation. Major energy users have the incentive to save energy, but where energy is a small part of an individual's or firm's budget the opportunities are often ignored, partly because there are risks and bother involved in making the necessary investments.

This review puts forward a programme to produce a step change in the nation's energy efficiency. At the centre would be a new
target – to ensure that domestic consumers' energy efficiency improves by 20% between now and 2010, and again by a further 20% between 2010 and 2020. This would approximately double the existing rate of improvement. It is a challenging proposition. The gains in terms of energy savings in a year could reach about 0.25% of GDP by 2020, over and above the cost of the investment needed to unlock these savings.

Combined Heat and Power (CHP) – which is sometimes viewed as a form of energy efficiency – is a low cost option for carbon abatement, but not zero carbon. In the long term, it will benefit from policies that put a price on carbon. Industrial CHP is a mature technology. It does not need support to encourage "learning by doing" cost reduction, in the same way as new renewable technologies do. Yet it is important that current market and institutional barriers to CHP are removed – many of these barriers are similar to the ones confronting renewable investments. The scope for CHP will be increased substantially by micro-CHP suitable for use in homes.

An expanded role for renewables should be a key plank of future strategy

Renewables are not just a single technology but a highly flexible set of options. Some of these options will be developed under the existing Renewables Obligation. At the moment, the use of renewables nearly always costs more than the use of fossil fuels. Government support is justified for two reasons:

  • use of renewables will help the UK to obtain carbon savings in the short term which helps in meeting international obligations; and
  • support for renewables will induce innovation and "learning", bringing down the longer-term unit costs of the various technologies as volumes increase and experience is gained. In this way, today's investment buys the option of a much cheaper technology tomorrow. Although learning will be international, some of the new technologies – notably the marine technologies – may have particularly British applications and require UK based technological development.

In order to bring down the cost of new renewables and to establish new options, an expanded renewables target of 20% of electricity supplied should be set for 2020. The review estimates that meeting the whole of this 20% target could produce domestic electricity prices in 2020 around 5-6% higher than otherwise. The longer-term assurance which an extended target would give to the industry could, however, help to bring down the costs of supporting renewables over the next decade. The review has not come to a conclusion about the means by which the 2020 target should be delivered. This should wait upon the review of the working of the Renewables Obligation in 2006/07.

Achieving the existing target that 10% of electricity should be supplied by renewable energy by 2010 is by no means guaranteed. The renewables industry faces three institutional barriers that must be removed if it is to succeed. These are:

  • the excessive discount which, following the introduction of the New Electricity Trading Arrangements, is currently imposed on the prices paid to small and intermittent generators;
  • the urgent need to change the way in which local distribution networks are organised and financed; and
  • the working of the planning system, which at present fails to place local concerns within a wider framework of national and regional need.

Recommendations are made to address all of these barriers.

Measures are needed to keep the nuclear option open . . .

Nuclear power offers a zero carbon source of electricity on a scale, which, for each plant, is larger than that of any other option. If existing approaches both to low carbon electricity generation and energy security prove difficult to pursue cheaply, then the case for using nuclear would be strengthened.

  Nuclear power seems likely to remain more expensive than fossil fuelled generation, though current development work could produce a new generation of reactors in 15–20 years that are more competitive than those available today. Because nuclear is a mature technology within a well established global industry, there is no current case for further government support.

The decision whether to bring forward proposals for new nuclear build is a matter for the private sector. Nowhere in the world have new nuclear stations yet been financed within a liberalised electricity market. But, given that the Government sets the framework within which commercial choices are made, it could, as with renewables, make it more likely that a private sector scheme would succeed.

The desire for flexibility points to a preference for supporting a range of possibilities, and not a large and relatively inflexible programme of investment such as would be implied by the 10GW programme currently proposed by the nuclear industry. If the UK does not support nuclear power today, the option will still be open in later years, since the nuclear industry is an international one, using designs that have been developed to meet circumstances in many countries. The desire for new options points to the need to develop new, low waste, modular designs of nuclear reactors, and the UK should continue to participate in international research aimed in this direction.

The nuclear skill base needs to be kept up-to-date. In particular the Government should ensure that the regulators are adequately staffed to assess any new investment proposals. Action is also required to allow a shorter lead-time to commissioning, should new nuclear power be chosen in future. Finally, within a new framework for encouraging a low carbon economy, the Government should ensure that, as methods to value carbon in the market are developed, additional nuclear output is able to benefit from them.

The main focus of public concern about nuclear power is on the unsolved problem of long-term nuclear waste disposal, coupled with perceptions about the vulnerability of nuclear power plants to accidents and attack. Any move by government to advance the use of nuclear power as a means of providing a low carbon and indigenous source of electricity would need to carry widespread public acceptance, which would be more likely if progress could be made in dealing with the problem of waste.

. . . and to create future options for coal by carbon sequestration

In the medium-term, coal has a continuing role to play in the energy mix. Its longer-term contribution depends on there being a practical way of handling the CO2 that it produces. CO2 capture and sequestration – whereby carbon is taken out of fossil fuels and stored:

  • could be a means to preserve diversity of fuel sources, while meeting the need for deep cuts in CO2 emissions;
  • has the potential to allow fossil fuels to be a source of hydrogen for transport and other applications without large-scale carbon release into the atmosphere; and
  • seems to be well suited to UK circumstances, since the UK has potential repositories in the Continental Shelf, and the carbon could possibly be used to get more oil from existing wells.

At the moment uncertainties surrounding costs, safety, environmental impacts and public and investor acceptability are large. Steps should be taken to reduce these uncertainties – as discussed more fully in the DTI Clean Coal Review. As part of this work, the legal status of disposing of CO2 in sub-sea strata needs to be clarified, in the light of possible conflicts with the London and OSPAR Conventions.

Increased vehicle efficiency and investment in new options for transport fuels is required in the longer-term

The transport sector is likely to remain primarily oil-based until at least 2020. Access to oil supplies is not a current concern. Nevertheless, the economy's dependence on transport, coupled with increased imports as UKCS production declines, reinforces the need to improve the energy efficiency of oil-driven vehicles. Prospective advances in vehicle technology hold out the possibility of significant reductions in fuel use.

The potential long-term requirement for significant CO2 emissions reductions from the transport sector combined with the possibility that oil will become scarcer, raise the need to develop alternative fuels. There is the long-term prospect that the technology for powering vehicles by fuel cells fed on hydrogen will fulfil its current promise, and so ultimately provide a substitute for oil. Other options, such as liquid biofuels may also have a role. International efforts are needed to develop these technologies.

Handling the projected growth in aviation energy use and CO2 emissions must become a priority. Taxation and other measures to manage aviation demand should be prioritised for discussion in EU and other international forums.

Institutional changes, including to the planning system, need to be made to deliver the strategy.

The approach adopted in this review suggests that in the long-term the Government should be aiming to bring together the three interlinked themes in this review – energy policy, climate change policy and transport policy – in one department of state. In the shorter-term, consideration should be given to locating responsibility for energy efficiency and CHP policy with other aspects of energy policy.

As an immediate response to the challenge, the Government should set up a Sustainable Energy Policy Unit. This would be a cross-cutting unit staffed by civil servants from all the departments with an interest in sustainable energy, as well as staff from the Devolved Administrations, external experts and people from the private sector. The Unit would focus on providing ministers with cross-cutting analytical capability to ensure that key developments in energy use and supply were monitored and assessed. It would lead on the development of strategic policy issues, adapting quickly to changing circumstances.

The different responsibilities of the DTI and the regulators, most notably Ofgem, should continue. The DTI and DEFRA should do more to set out their priorities in guidance to Ofgem, so that Ofgem can further consider the impacts of its proposals for non-economic objectives. But it is Ministers who should take responsibility for intervention in markets, if economic objectives conflict with environmental and social goals.

In many parts of the energy industries, investors have found that their projects have difficulty in gaining planning permission. The attitude of local communities to proposals for new energy developments is important. They must continue to have their say in the planning process, which is one reason why it is important to engage the public in the energy policy debate. But national planning guidance needs to make it clear where there is a national case for new investment in energy-related facilities by establishing the relevant national and regional context for each type of development.

Next steps: a national public debate is now needed

The review develops a radical agenda – to enable the UK to put itself on the path to a low carbon economy, while maintaining competitively priced and secure energy. Precautionary action is needed in advance of further international agreement. Tasks that should be undertaken within the next five years include:

  • Government should move towards a clear rationale for the balance of policy instruments – taxes, permits and regulation – to create powerful incentives for long-term carbon reduction; and
  • immediate action is needed to assist innovation and to create new options, and also to manage risk.

But these are not matters for the UK alone. Increasingly, policy towards energy security, technological innovation and climate change will be pursued in a global arena, as part of an international effort.

The implementation of an ambitious low carbon policy would be a demanding task. Change of this kind takes a long time. It would be wrong to imagine that everything can be "win-win": there will be some hard choices, and there will be losers as well as winners. For this reason the Government needs to take the issues to the public soon. During the review, proposals were made to the PIU for an extensive process of public involvement. There was insufficient time for this, but it should constitute a central part of the implementation of the findings of the review.

The nation must not be lulled into inaction by the focus of much of the expert debate on long timescales and on energy systems in a future which will belong mainly to our grandchildren: the time for action is now and all players in the energy system have a role to play. Given that there is considerable inertia in the system, and that the low carbon technologies are not part of the conventional energy system, a change of direction will be difficult to achieve. It will require clarity of purpose in all parts of Government.

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