Energy bills: getting the balance right

By Jess Ralston, Analyst @jessralston2

Published:10 February 2021

Measures to move levies from electricity to gas bills are surely imminent.

The disparity between fuel costs is one of the biggest barriers to the Government’s aim of cleaning up domestic heat, with the recent noise around carbon pricing an indicator that the status quo will not be around much longer.

As it stands, each kilowatt hour (kWh) of electricity we use at home costs around 16p, for gas it’s around 4p. Despite the superior efficiency of electric heat, producing around three times as much heat per kWh consumed, this disparity has an effect on running costs of gas boilers relative to heat pumps and remains a major barrier to the wider use of clean heat.

But what could rebalancing these costs look like, and what might it mean for domestic energy bills?

Levies

As it stands, around 23% of electricity bills (£140/year per home) are made up of ‘environmental and social levies’, compared to just 2% of gas bills (£11/year per home).

Composition of electricity and gas bills
Figure 1. Currently, Ofgem report that around 23% of an electricity bill is due to environmental and social levies. In 2019, a typical electricity bill was £612, with the total of all levies therefore accounting for £140. To compare, the typical gas bill was £572 and just £11 (2%) was due to environmental and social levies. Source: Ofgem (2019 data).

These levies pay for various policies that either support clean energy (Renewables Obligation, Feed-in-Tariffs, Contracts for Difference) or help with social issues such as fuel poverty (Warm Homes Discount and Energy Company Obligation, which offer direct payments to help with bills or support to cut energy waste, respectively). A very small amount goes to support high network costs in remote regions such as the Scottish Highlands.

Around 70% of these costs fund clean energy, with 30% earmarked for social policies.

At the time, placing these costs solely on electricity bills was justified as a means of avoiding free-riders. 99.7% of homes in the UK are on the power network compared with 86% on the gas grid.

However, the rapid decarbonisation of the power sector – carbon intensity is down by over half from 535g/kWh in 2008 to 181g/kWh in 2019 – means this set up is increasingly hard to justify. Shifting some or all of these levies from a cleaner fuel to a dirtier one represents a carbon price by proxy, ensuring that the more polluting fuel carries a higher cost.

Where next?

There are a number of options facing policy makers. First up is directly moving some of the levies onto gas bills instead of electricity, crucially leaving overall dual fuel bills unchanged.

Distribution of costs (Regen)
Figure 2. It is estimated that less than £0.5bn of the £3.8bn cost of environmental levies is paid for through gas bills or taxation. Regen suggest that reconfiguring the current system via a carbon levy of £36 per tonne of CO2 emitted would rebalance costs but leave total household bills unchanged. Source: Regen: the Decarbonisation of Heat.

A good starting point here is likely to be social policy costs: Warm Homes Discount and Energy Company Obligation. In a typical electricity bill of £612/year, these social levies account for around £42.[1]

To cover the cost of moving these costs – taking £42 from electricity and adding £42 to gas bills – gas prices would rise by just 0.4p per kWh (c.10%), whereas the price of electricity would fall by 1-1.4p per kWh (c.6-8%).[2] Overall bills would remain unchanged.

Cheaper electricity means lower running costs for families that have switched to electric heat, and unchanged bills for those still on gas.

The next step may involve repeating this process with environmental costs. This would not only further bring together fuel prices but would significantly equalise effective carbon prices borne by domestic energy and gas.

The three main policies to support early renewable projects (when costs were higher than they are now) add just under £100 to annual electricity bills. Were all these to be bumped over to gas, the unit cost of electricity would fall by 2-3p per kWh, with gas rising 0.8p per kWh.

Care is likely to be needed should these levies be moved, ensuring they are done gradually as clean heat becomes more prevalent to ensure some families, those more dependent on gas for example, do not face higher bills than expected.

Table 1. Various environmental and social levies add almost £140 to an electricity bill.
LevyCost on typical electricity bill (£612)Proportion of total environmental and social levies
Renewables Obligation£5942%
Feed-in Tariff£1410%
Contracts for Difference£2417%
Energy Company Obligation and Warm Homes Discount£4230%
TOTAL£13999% (not 100% due to rounding)

For another route, the Government may look to Professor Sir Dieter Helm and his 2017 Cost of Energy Review. Instead of a swapping onto gas bills, Prof. Helm suggests that some levies could be shifted into a ring-fenced ‘legacy cost’ bank and paid for through general taxation.

These legacy costs typically include the renewable projects supported en-route to the precipitous fall in costs seen in recent years, supporting the industry when costs were higher. They could also be extended to cover the cost of Hinkley Point C.

The effect on electricity bills would be largely the same as that detailed above, falling by £97 as environmental tariffs were borne elsewhere. However, with these costs shifted to general taxation, their bill would be footed in a more progressive manner, with higher earners contributing more.

A third, and much less likely option, is adding a carbon price to gas bills and leaving levies on electricity unchanged. While this would go some way to reducing the differential in carbon pricing across fuels, it would see gas bills rise without a compensatory fall in electricity bills. At a time when energy use is high and domestic finances are stretched, this highly regressive option would be hard to justify.

Stepping stone

Rebalancing these costs is seen as essential but is not a total solution in the move to clean heat.

Running costs for electric vehicles have for years been lower than for petrol and diesel models, with high purchase costs dissuading many from making the switch earlier. A similar situation is brewing for clean heat.

Fortunately, though, Government seems aware of this, and is set to introduce policies to help with up-front costs a clean switch.

The slow-starting Green Homes Grant and the coming-in-2022 Clean Heat Grant schemes both offer help with upfront costs for clean heating systems. By correcting one of the major flaws in the Renewable Heat Incentive – that capital costs were repaid over several years – these schemes are instantly more accessible.

However, as ever, there are problems of ambition. Only a small proportion of the c.600,000 homes expected to be upgraded through the Green Homes Grant are likely to opt for Heat Pumps – roof and underfloor insulation are the most popular measures – and the Clean Heat Grant is only funded to support 25,000 heat pump installations over two years. Both targets are of a different magnitude to the Government’s aim of installing 600,000 heat pumps per year by 2028, so detail on more support could be expected soon in the Government’s heat and buildings strategy.

Tackling both upfront and running costs are vital to ramping up heat decarbonisation, with most of the solutions in plain sight. For now though, we continue to wait for the Government’s grand plan to decarbonise heat, within which answers to these points we will surely find.


Footnotes:

[1]The environmental and social levies placed on bills total £12.2bn in 2020/21. Of these, around 70% are the Renewables Obligation, Feed-in Tariff and Contracts for Difference (£8.4bn). Therefore the social levies, including the WHD and ECO, account for around 30% of the total cost of levies (£3.8bn).

In 2019, a typical electricity bill cost £612, with 23% (£140) being due to all environmental and social levies. So at 30% of the total levies (£140), the social levies (WHD and ECO) account for a substantial £42.

[2] Based on typical gas use in the home being 12,000kWh per year and typical electricity use between 2,900kWh (for unrestricted customers) and 4,200kWh (for Economy 7 customers) per year.

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