Why electricity prices will keep rising

The cost stack

First consider where we are now, and also the history. Figure 1 shows the breakdown of an electricity bill according to the Ofgem Price Cap data. Note that:

• Ofgem’s figures are for a typical (2nd quartile) bill, not the average bill

• Two elements of Ofgem’s take on wholesale costs have been reallocated, so that the wholesale figure below is the pure market cost: CfD subsidies have been moved to Policy, and the Backwardation Allowance is now in Other.

Figure 1 Breakdown of electricity bill

Figure 2 shows how the breakdown has changed in real terms in the last 10 years.

Figure 2 Changes in electricity bill

Since Network and Balancing costs have mostly increased because of the addition of renewables to the grid, more than half of the increase can be shown to be due to decarbonisation policy. Only 25% is due to changes in wholesale prices, and this is a recent effect. In 2020, there would have been a reduction in wholesale cost relative to 2015.

Knowing all this, we would expect – other things being equal – a further increase in electricity prices as renewables capacity expands in the next few years. In the next section I will look at the individual elements of the stack to see what pressures there are on costs.

Pressures on the cost stack

1. Wholesale costs

Our old fleet of combined cycle gas turbines (CCGTs) will increasingly be replaced by open cycle units (OCGTs). These are better suited to the intermittent operations to which gas-fired power stations are reduced. However, they are less efficient, so wholesale markets will clear at higher prices.

OCGTs are also more carbon intensive, so demand for emissions permits will increase, driving up permit prices, pushing up wholesale markets still further.

However, futures markets see gas price reductions in 2026, which may bring some relief.

2. Policy costs

The underlying cost of wind is increasing because of

• Supply chain issues

• Higher Crown Estate costs

• Increasing curtailment, as periods when renewables output is greater than total GB grid demand become more frequent.

These increases in underlying costs are reflected in the higher CfD auction prices seen in AR6, and the introduction of a top-up subsidy, the Clean Industry Bonus, from AR7 onwards.

Policy costs will also be affected by changes in wholesale prices

• For extant CfD units, any increase in wholesale prices is cancelled by a decrease in subsidy payments.

• But for Renewables Obligation units (the largest part of the renewables fleet), the wholesale price increase passes through to consumers and there is no effect on the subsidy.

Capacity market payments – subsidies to firm capacity – will have to increase. Much of existing gas-fired fleet is very old and will close soon. Without these units, the lights go out when the wind doesn’t blow. Higher subsidies will be needed to keep them operational and to bring new units onto the market.

The OBR thinks policy costs will increase by £4bn to nearly £15bn by 2029.

3. Balancing costs

Note that balancing costs, although mostly caused by windfarms, are recovered as levies on consumer bills, so form part of the network and balancing segment of the cost stack.

The cost of balancing the grid is rising rapidly, and exceeds £2.5 billion per year, up from less than £0.5bn (in 2025 prices) ten years ago.

£1.5 bn of this is payments to windfarms (mostly in Scotland) to switch off (including secondary payments to gas turbines, which have to increase output to meet the windfarms' customers' demand). These payments will increase rapidly in coming years because there are many new windfarms coming on stream in Scotland, and this will outpace the new grid infrastructure being put in place.

And the increased network costs will also be recovered through levies on consumers and generators.

In combination, NESO thinks balancing and transmission will add £4bn to system costs by 2029.

Figure 3 Official estimates of increases in network and balancing costs

We believe these are highly optimistic figures. The cost of the balancing mechanism is increasing rapidly (Figure 4)

Figure 4 Cost of the Balancing mechanism versus renewables penetration.

Note: Excludes data for 2021 and 2022, affected by Ukraine war. Values uplifted by 25% to allow for ancillary services.

Figure 3 includes nothing for Distribution Network costs. In 2015–2023, these added £3.3 billion per year to system cost. For 2024–2028, they will add £4.4bn year. We might reasonably expect the cost to have risen to £5 or £6bn per year by start the next price control period (2029–2031). This would imply an extra £1 bn per year cost by the end of this Parliament.

Summary

In summary, there are major cost pressures on almost every element of the retail electricity cost stack. It is hard to imagine that electricity bills will come down before the next election.