The Price Cap and the Spark Gap

While we cannot expect energy prices to fall to pre-pandemic levels any time soon, Ofgem’s Price Cap announcement that household energy bills will fall from £3,280 to £2,074 from July is hugely positive news for consumers, even if many will continue to struggle with bills. Importantly, the new price cap for July to October puts bills below the current Energy Price Guarantee (EPG) of £2,500, and well below the intended new EPG level of £3,000 from July onwards. This means the government will no longer be subsidising bills through the EPG, and that market prices will again be the key determinant in setting household energy prices, rather than government intervention.

This has important implications for anyone working within clean heat. For the last eight months, the EPG brought about a reduction in the relative gap between electricity and gas prices, the so-called ‘spark gap’, a critical factor in determining the economics of a heat pump vs a gas boiler. While heat pumps are around 3x more efficient than boilers (4x more for ground source technology), because electricity is so much dearer than gas this efficiency usually doesn’t translate into consumer bill savings. In the year before the introduction of the EPG, one unit of electricity cost a UK household about 4.7 times more than one of gas. Under the EPG, this fell to 3.5, but Ofgem’s price gap shows a rise back up to 4.4.

Comparison of UK Spark Gaps – July ’21 to September ‘23

This isn’t for a second to bemoan the fall in energy prices, but it does underline the urgent need for the government to take bold action to address the issue. Heat pumps are widely accepted as the key technology to tackling our most difficult decarbonisation challenge, but for mass adoption of heat pumps, unit electricity prices need to be no more than 2.5x more than gas prices. But in the UK, unlike in many other European countries, we have never got anywhere close to this ratio and as well demonstrated by today’s Price Cap announcement, absent of new policy intervention, we are unfortunately likely to be travelling in the opposite direction.  

Comparison of spark gaps in European countries – July ’21 to June ‘22

As the chart above demonstrates, a spark gap of this magnitude isn’t inevitable even in countries with a comparable electricity generation mix such as the Netherlands. Spark gap levels are still largely determined by different power generation mixes, but policy choices and how levies and taxes are applied are starting to play an increasingly important role.

In simple terms, the reasons behind the UK’s particularly high spark gap are:  

• In the UK, due to our generation mix and the way the wholesale power market operates, electricity wholesale prices are almost always determined by the price gas power plants produce at (98% of the time last year according to UCL), even though they only supply around 50% of our power.
•  A gas power plant will consume about 2.3 units of gas for each unit of electricity delivered to a consumer. As such, in the absence of other factors, at best electricity would cost around 2.3 times as much as gas. 
• However, on top of the cost of gas, power plants pay carbon taxes on their emissions, adding to the wholesale cost of electricity. Critically, these taxes don’t apply to gas used in homes and therefore further widen the spark gap.  
• There are also a range of green and social levies on electricity bills but not on gas bills and so they act to increase the spark gap further. These levies are also relatively stable, representing more of a ‘fixed’ cost on each electricity unit. As such, they help create an inverse relationship between gas prices and the spark gap. As gas prices reduce, the relative cost of electricity tends to increase.

We therefore find ourselves in a situation in which electricity is around 4.5 times costlier than gas, and grows relatively more expensive the cheaper gas becomes. If the UK is to have any hope of shifting from fossil fuel to electric heating this must be addressed quickly. So, what can be done?

First it is worth saying that the Energy Secretary’s recent hint that government’s action on this issue will reduce electricity bills by £100 will be insufficient on its own, only reducing the spark gap to 4.0. While some European countries (such as the Netherlands) have taken the route of actively increasing gas prices through taxation, it would be both deeply unfair and unpopular in the UK, particularly at the current time. Instead, the government should, and is likely to, focus exclusively on reducing the cost of electricity.

• All green and social levies could be removed from electricity bills. At around £150 per household, placing these into general taxation would reduce the spark gap, at current wholesale price levels, to around 3.8.
• The government could scrap the largely redundant Carbon Price Floor, reducing the spark gap further to 3.7. Good, but still not enough.
• As part of its Reform of Electricity Market Arrangements (REMA), the government will need to take action to help separate the link between gas and electricity wholesale prices. As clean power generation grows this link will gradually weaken, but consumers could gain access to cheaper electricity prices much sooner if key reforms took place.
• The government’s Energy Generator Levy, in part aimed at encouraging existing clean power generators (who produce about 40% of UK electricity) on to Contracts for Difference, is an important step. With more generators receiving a fixed price for their power, rather than the market clearing price, this would bring consumer electricity prices down.
• Longer-term structural reform of the power market, via decisions made in REMA, will ultimately also be needed to break the link between gas and electricity wholesale prices more decisively.

Today’s Price Cap announcement is welcome news for UK bill payers, but as the EPG’s practical impact comes to an end and the spark gap widens again, it is time for the government to get to grips with this issue and enable the transition to zero carbon heating.