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Two hundred years ago, the Scottish economist and philosopher Adam Smith drew on a self-evident truth about energy prices to make a fundamental point about economics: ‘Coals are a less agreeable fuel than wood: they are said, too, to be less wholesome. The expense of coals, therefore, at the place where they are consumed, must generally be somewhat less than that of wood.’

But if Smith were to investigate the electricity industry for a 1993 edition of The Wealth of Nations, he would find his view rather off the mark. Power stations burn ‘less wholesome’ fuels even when alternatives are cheaper . Rather than recast his entire economic theory, he would undoubtedly look for evidence that the market was distorted.

He would very quickly find it because every country in the world, to a greater or lesser extent, rigs the market in energy. The motive for doing so may be to safeguard national security, to protect employment, to stop abuses of monopolies, to nurture high-technology industry or, although no government would admit it, to prevent revolution. And the energy market is particularly prone to manipulation.

‘Since the Second World War, the electricity industry, however organised in each European country, has shown all the characteristics of a monopoly supplier: subsidisation, protectionism and no differentiation of user needs,’ concludes an investment report on European power trends published in 1991 by Arthur Andersen, a firm of management consultants. In lay terms, this means that organisations which produce electricity decide how they will do it, who they will sell it to, and the price at which they will sell it. But without a truly free market, it is difficult to calculate the true costs of generating electricity, and thus to judge the effectiveness of different ways of doing it.

In 1988, however, the British government set in motion a bold programme to create a free market in energy. It broke up the Central Electricity Generating Board, the state authority that had until then generated and distributed power in England and Wales. Instead came a collection of companies that compete with each other in supplying electricity (via an independently owned national grid) to regional electricity companies, which in turn sell it to customers.

The new market came into effect in 1990. This meant, for the first time, that the marketplace, rather than government policy, would decide the mixture of technologies that would generate Britain’s electricity. The effects of this shift were more than the government had bargained for.

NUCLEAR EXPOSE

The first shock occurred even before the market took hold. The financial advisers handling the sale of generating companies to private industry found that potential investors were sceptical about nuclear power, which represents about 23 per cent of Britain’s generating capacity. The CEGB had claimed that its nuclear stations provided the cheapest source of electricity. Privatisation, however, changed the rules.

Nigel Lawson, who as energy secretary and later Chancellor of the Exchequer was closely involved in the break-up of the electricity industry, recalls in his memoirs: ‘It turned out that for years the CEGB, wittingly or unwittingly, had been making a deceptive case in favour of the economics of nuclear power (that) was not finally exposed until the government was in the final stages of the privatisation of the industry in 1989, and a detailed prospectus had to be drafted.’ This showed that ‘the CEGB had been underproviding for, and greatly underestimating the likely true cost of decommissioning a nuclear power station at the end of its life’. The CEGB had estimated its liability at £3.7 billion. The government decided that a more realistic figure would be £15 billion.

DASH FOR GAS

The second shock followed privatisation. Since the discovery of large resources of gas under the North Sea, Britain, like its continental neighbours, had considered the new fuel too precious to burn for electricity. Instead, the government decided, gas should be used only for direct heating and as a raw material in the production of chemicals. But since the free market was created in 1990, private companies have financed the construction of 16 large gas-fired power stations in Britain, encouraged by an offer from British Gas, a privately owned monopoly, to supply fuel at prices that undercut those of coal from Britain’s deep mines. This so-called ‘dash for gas’ was the immediate reason for the government’s decision last October to close 31 of Britain’s 50 coal mines.

British Coal, the public authority that runs almost all of Britain’s mines, blames distortions in the market for the lack of demand for coal. In fact, the only change is the arrival of the cost of capital as the main factor in energy economics. Under the old rules, the Treasury funded investments on power stations over 40 years, and required a return under normal public sector rules, which was usually about 5 per cent. It was, in effect, giving the money away.

CALCULATING REAL RETURNS

Private investors, usually consortia of banks, need to show real returns, which means that they must get their money back in roughly half the time, plus interest at perhaps two percentage points above base rates. Most private ventures to build power stations assume a financing cost of 12 per cent.

In Britain, over the past two years, these arrangements have favoured gas. First, gas-fired stations are cheaper to build than coal-fired ones, mainly because coal-fired plants need a separate steam-generating circuit while gas drives a turbine directly. The cost of a gas-fired station in Britain is less than half that of an equivalent coal-fired station, which, in turn, costs less than half that of a nuclear power plant. Secondly, the cost of capital represents less than a quarter of the cost of running a gas-powered generator over its useful life. Most of the rest is the cost of gas, paid for as the plant generates income.

With a coal-fired plant, however, the cost of capital is closer to half the plant’s total running costs. So, even if coal turns out to be cheaper per unit of energy produced than natural gas – as the British coal industry claims – it might still make business sense for a power company in an unrestricted market to choose the more expensive fuel.

The picture is even grimmer for non-fossil fuels. The cost of generating electricity from a nuclear plant, a wind farm or a tidal barrage is almost all in the capital cost, which is also greater than that of building a fossil fuel plant. The wind is free and the amount of uranium needed to supply a nuclear power station during its working life is less than 10 per cent of the overall cost of the station. The result is an unlikely alliance between supporters of nuclear and renewable energies, hitherto at opposite ends of the energy debate. ‘Since privatisation, the cost of finance has rigged the economics heavily in favour of gas at the expense of renewables,’ says Catherine Mitchell, a research student in the Science Policy Research Unit at the University of Sussex. Mitchell’s research into the costs of renewable energy has shown that power stations based on new technologies, such as wind, must endure a double blow: financing is usually available only over five years, largely because of investors’ suspicions about ‘new’ technology, as against a usual 18 years for gas-fired plants.

FORCED TO INTERVENE

The British government faces a dilemma. It has vowed repeatedly that it has no energy policy beyond allowing a free market. As Nigel Lawson put it: ‘I did not – and still do not – think that it makes sense to have an ‘Energy Policy’ over and above the government’s overall supply-side policy to the energy sector of the economy.’ Prime Minister John Major took this philosophy even further last year by abolishing the government’s Department of Energy.

In practice, however, the realities of politics have repeatedly forced the government to intervene. One example is the Non Fossil Fuel Obligation, a levy on the operators of fossil-fuelled power stations in the cause of ‘diversity of supply’. Income from the levy, which adds about 10 per cent to the average electricity bill, was designed to help fund the decommissioning of nuclear power stations and to encourage the exploitation of renewable energy, mainly in the form of wind farms.

Under pressure from the European Commission, which does not allow such subsidies to nuclear power, the levy is due to be phased out in 1998. British Coal complains that the levy has substantially reduced demand for its coal as electricity suppliers have compensated for shortfalls by making use of imported power from France rather than by drawing more power from local fossil-fuelled stations.

In the long run, the free market in electricity will work only if generating companies pay the real costs of the technology they use. This opens a new can of worms. There are the obvious costs of building and dismantling a power station, plus the costs of fuel, staff and insurance involved in running the plant, and the costs of financing the project. It is harder to put a figure on the environmental and sociopolitical costs. These fall into two categories. Internal costs fall on the producers and users of the electricity; external costs fall on everyone else – for example, farmers whose land is less productive because of pollution from power stations. These costs would tilt the equation against coal: equipping a large power station with equipment to remove sulphur from its flue gases costs around £250 million.

FAVOURING CONVENTIONAL GENERATION

Enthusiasts for renewable energy, on the other hand, say that their pet technologies would benefit. The European Wind Energy Association, in its report A Plan of Action, published last year, says: ‘The pricing policy which controls today’s power supply industry favours conventional means of electricity generation. It demands that electricity be provided at the lowest cash cost and not at the lowest total cost. The external, or environmental, costs of power production are not passed on to the end consumer, thus prices are being held down artificially. The economic disadvantage to renewable energy caused by the price distortion forms a major barrier to the development of a market for wind power.’

But calculating these external costs, and ensuring that they are paid, is likely to drag the government – whatever its ‘free market’ intentions – even further into the business of controlling the electricity market.

Michael Cross is a freelance journalist.

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Assessing the real price of power

The rules for assessing the cost of generating electricity vary widely between the different technologies used and between different countries. They even vary according to the time of year: at times of peak consumption, the more expensive power stations contribute more. Because building power stations involves strategic decisions over decades, cost estimates also depend on the accuracy of economic forecasting.

The prices quoted below, in pence per kilowatt per hour, apply to Britain. But they are also of international interest because they reflect the results of competition in a market which, by international standards, is relatively open.

The cost of COAL ranges from a theoretical minimum of 1.9p for the most efficient plants running continuously to more than 3p in practice. Last month, Britain’s Office of Electricity Regulation (OFFER) estimated a commercial price of 3p. Costs would rise if power generators had to pay the full external costs of generating from coal, such as compensation for the effects of acid rain. The European Commission’s proposed carbon tax would add 0.6p. Measures to reduce emissions of sulphur dioxide and nitrogen oxides would add more.

Costs would fall, however, if new technologies reduced the cost of mining coal and if coal from the cheapest mines was freely traded.

Making international comparisons, the cost of generating electricity from coal is almost identical in the US, though the fuel itself, from privately owned opencast mines, tends to be cheaper.

In Japan, with just five coal mines left, it is far more expensive. Coal-mining costs are also higher in continental Europe, though several countries subsidise mines.

But there are complications. The large numbers of people employed in coal mining make mining communities a powerful political force. The desire to reduce the power of miners has shaped the energy policy of governments in several countries, including Britain and Japan.

The cost of NUCLEAR power ranges from a minimum of 1.2p for old power stations that have covered their construction costs and whose decommissioning costs will be met by the Non Fossil Fuel Obligation, the levy on the operators of fossil-fuelled power stations. Modern plants operating under more realistic rules range from 3p to 4p.

Costs would rise if power generators had to pay a commercial rate of return on capital investment and for dismantling plants at the end of their lives. Tougher international controls on radioactive materials would also increase costs.

Costs would fall if interest rates fell and inflation soared. This would favour projects with a heavy capital cost. Capital costs themselves would fall if governments relaxed safety regulations. But both of these scenarios are unlikely.

In international terms, nuclear power is cheaper in countries that have good operating records combined with either state-controlled electricity industries, such as France, or those in which the government creates a favourable investment regime, such as Japan.

Of all energy sources, however, nuclear power is the most controversial and the most likely to arouse political opposition.

The cost of GAS ranges from 2.5p to 3p, a figure that OFFER says may underestimate the true commercial costs of operations.

Costs would rise if estimates of gas reserves were revised downwards and if gas generators paid the full external costs of pollution. The commission’s carbon tax would add 0.3p to 0.4p.

However, costs would fall if new technologies increased even further the efficiency of power stations.

The cost of gas depends also entirely on local availability, and much is still burnt off at oilfields. Costs are highest in Japan, which imports almost all its gas. Costs are lower in the US, though still more than they are in Britain. Historically, gas prices have been subject to many upsets.

The complications are that gas resources, like those of oil, tend to be in inconvenient places, geographically or politically. In most industrialised countries, dependence on gas raises issues of reliability of supply.

The cost of RENEWABLES ranges from virtually nothing in hydroelectric plants that have written off their capital costs to higher than fossil fuels in experimental biomass and wave-power plants. For wind energy, the technology with the most promising combination of technological maturity and unexploited potential, the range is roughly the same as for coal.

Costs would rise if an unfavourable economic climate increased the cost of capital. Renewables also occupy more land per kilowatt of capacity, so the costs depend on land prices (in the US, rents account for 10 per cent of the cost of hydroelectricity, and only 1 per cent of a coal-fired plant).

Costs would fall if new technologies and mass production were to cut capital costs, and if government energy policies reflected the external costs of electricity generation from fossil fuels.

Making international comparisons, the potential and cost of renewables depend on geography and political support. Denmark has Europe’s largest wind-power capacity, which is subsidised by an energy tax. In the US, wind power may be about to undercut the cost of generating electricity from gas.

However, renewables are vulnerable to changes in government policies.