Shifting policy costs off power bills would boost price signals

Shifting low-carbon levies off electricity bills would not only reduce the differential between the running costs for heat pumps and gas boilers, but also strengthen the price signals provided by locational and time-of-use charges, Cornwall Insight has argued.

In a new report, the consultancy has outlined a series of potential options for reallocating policy costs to help drive the uptake of low-carbon heating systems.

According to the report, around £12 billion of environmental and social policy costs are levied on electricity bills each year, comprising nearly 23 per cent of the typical household bill. The Renewables Obligation, Feed-in Tariff and Contracts for Difference schemes, the costs of which are currently recovered entirely from electricity, accounted for £10 billion in 2020/21.

For comparison, environmental and social policy costs comprise less than 2 per cent of the typical household gas bill. The report said this disparity means that the running costs for electric heat pumps are typically much greater than those of a gas boiler.

Cornwall Insight said one option to encourage their uptake would be to transfer some or all of these low-carbon levies onto gas bills.

The consultancy calculated the annual running costs of an air-source heat pump for a typical household at around £728 in 2019/2020 compared to almost £647 for a boiler. It said allocating 50 per cent of the costs of the Renewables Obligation, Feed-in Tariff and Contracts for Difference schemes to gas bills would reverse the situation, with the former falling to £651 and the later rising to £753.

Whilst acknowledging that these costs are generated in the power sector, the report said they can also be viewed as transitional costs for the energy system as a whole and their reallocation to gas justified under the “polluter pays” principle:  “In fact, a 50:50 burden of electricity and gas bills to recover these costs would more accurately reflect the carbon intensity of the relative fuels, with gas at 184gCO2e and electricity at 253gCO2e per kWh consumed”.

Reallocating these costs entirely onto gas would tip the balance even further in the favour of air-source heat pumps, with typical annual running costs dropping to £559 versus £967 for gas boilers.

Annual running costs for different heating systems

The report said this option would provide a strong incentive to customers to electrify their heating but would also increase gas bills, with potential impacts on fuel poverty. The greater variation in demand for gas in comparison to electricity could make it difficult to price the levies into tariffs and gas suppliers would face increase forecasting risks. The recovery of costs would also be reliant on the continued use of some form of gas.

Cornwall said another option would be to shift policy costs onto general taxation, thereby avoiding any increase in gas bills. Doing this for all £12 billion of the environmental and social policy costs levied on electricity bills would still make air-source heat pumps cheaper to run than gas boilers at £506 per year.

Nevertheless, the report said support schemes such as the Clean Homes Grant would still be required to cover the upfront costs of installation.

It said this option would have several ancillary benefits, including lower risk and forecasting requirements for energy suppliers and reduced industry exposure during supplier of last resort events, but would also put additional pressure on the public purse.

The report said a third option would be to convert the volumetric p/kWh levies into a fixed p/day charge on electricity bills, drawing a parallel with Ofgem’s decision as part of its Targeted Charging Review (TCR) to recover the “sunk” costs of the power grid through fixed residual charges.

“Many elements of policy costs could be considered as the sunk costs of decarbonising the electricity network,” it noted. “This is particularly relevant for those policy costs that have now closed, such as the Renewable Obligation and Feed-in Tariff schemes.”

Cornwall modelled two approaches – the first in which only legacy costs are applied as a fixed per day charge, and the second in which all volumetric charges are converted. It said although these approaches they would reduce the net cost of operating an air-source heat pump by up to £100 per year, they would still remain more expensive than gas boilers by around £60 per year. Ground-source heat pumps would become cheaper than gas boilers but only by around £4 per year.

The consultancy also said this would have significant distributive impacts across different types of users, favouring those who consume more electricity, and would “double down” on the effects of the TCR.

Regardless of the route taken, Cornwall said there would be multiple benefits of reform, beyond making electrified heating more financially attractive. It said all three options would strengthen the price signals provided by locational and time-of-use wholesale and network charges, which would become a larger component of variable electricity costs.

They would also simplify the “complex electricity retailing landscape”, allowing suppliers to focus more on their “core functions of customer service, proposition development and customer growth and retention and less on cost forecasting”.

Some would also reduce the incentive for “grid-defection” and lessen the impacts of supplier failures which have cost bill payers “millions of pounds in recent years” through the mutualisation of policy costs.

Dan Starman, lead consultant at Cornwall Insight, said: “Given the scale of the challenge that net zero presents, the speed of decarbonisation required to reach the target, and the fundamental shift needed in both the technologies consumers use and how they use them, policymakers will likely need to consider all available tools at their disposal to support the net zero transition.

“There are very good reasons that policy costs were initially applied to electricity bills. However, the underlying economics of powering heat with electricity vs the counterfactual fuel of gas means the government should consider reform in the area.”

He continued: “Current cost recovery mechanisms act as a significant disincentive to electrify and transition to newer low-carbon heating technologies. Driving the right financial incentives for consumers to choose low carbon options while managing the impact on the public purse will be key, and this is doubly important in a post-COVID-19 world.

“Inaction would result in a lost opportunity for the government to pull another policy lever to support the net zero transition. Hence, we believe policymakers should utilise an assessment-based framework to disentangle policy costs and the electricity bill.”