Money out – Cost structure

This section addresses what needs to be paid for in running the energy system – where the money goes out of the energy system. The way money flows between parties within the energy system is discussed here

Main costs include:

  • Generation of electricity
    • Power station construction
    • Operation and maintenance
    • Fuel
  • Purchasing of other energy 
    • Import of gas
  • Transport of energy through networks
    • Construction of electricity and gas networks
    • Operation and maintenance of these networks
  • Billing and customer service
    • Reading meters
    • Customer service – call centres etc
    • Sending bills and collecting revenue, including chasing debts
  • Market, trading and administration
  • Design, forecasting, innovation and research
  • Lobbying, policy and rule development, decision-making

Unfortunately, it is not easy to find a break-down of energy system costs in these categories. 

There are two ways of looking at costs:

  • Looking back at the costs we are paying or have paid for current infrastructure
  • Looking forward to the costs we will be paying for new energy infrastructure

Cost of Capital

Both of these include an additional type of cost, the cost of capital – i.e. the money paid to investors to get them to put upfront capital money in to enable construction (of new electricity generation, of network infrastructure, of home retrofit, of meter upgrades) to take place.  In forecasting, this cost of capital is usually wrapped up in the various other itemised costs, rather than added separately as a line item of its own. This obscures the way that the cost of capital affects long term investment decisions.  

In brief, the cost of capital and the human tendency to prefer to pay more later rather than less now are conflated as a ‘discount rate’, which makes costs that take place in the future (e.g. buying fuel, operation and maintenance) look small relative to costs that take place upfront (e.g. construction). This leads to short-termism being built into economic decision-making, and makes energy with high upfront costs and low running costs (most forms of renewable energy generation) look bad, whereas energy with high running costs and low upfront costs (most forms of fossil fuel generation), or high disposal costs in the distant future (e.g. nuclear power) look good.

Illustration by Liz Snook

The structure of this economic analysis is discussed in more detail in the section on the Levelized Cost of Energy.

Changes in the cost structure of the energy system

The cost structure of the energy system is changing. 

In electricity generation there is a shift from thermal power stations with low setup costs and high running costs, to renewable energy with high build costs and low running costs. At the same time, the utilisation rate (how much they are used) of the thermal power stations is changing: they are still needed to provide balancing in the gaps when renewable energy doesn’t generate, but the amount of time that they are running per year is reducing. This changes the ratio of the fixed costs (costs per year to cover the construction and general maintenance, which don’t change regardless of how much they are used), to variable costs (fuel and other costs that go up the more energy is generated each year).  As generators’ business models are based on being paid per unit of energy they generate, the costs per unit of energy becomes less predictable and more expensive. This is why the capacity mechanism was developed, as described in the ‘money in’ section

This is also the case for the network infrastructure, as generation takes place more locally. The fixed costs of network infrastructure remain the same (and make up most of the cost). However, using energy locally means that fewer units of energy are being transported across the network. This reduces the energy losses, but not the cost of maintaining the network. The network is still necessary, as everyone is relying on it being there on the occasions when energy is not available locally, so again the utilisation rate is reduced.  Additionally, the connection of new electricity generation to the network often requires grid reinforcement, and there is an active discussion about how the costs of this should be allocated. These debates about how network costs should be paid for are described in more detail below.

Proposals for more localised energy systems e.g. microgrids or local balancing have some good qualities, but they need to be designed carefully so as not to create a freeloading situation where the wider network is still relied on but not paid for.

Generation of electricity

In 2016, the government (BEIS) commissioned a study comparing the ‘levelized cost of energy’ for different energy generation technologies that could be built by 2020 or 2025. These are shown below. It would be good to be able to show the undiscounted costs of energy in addition to the levelized (discounted) costs. A request has been made to BEIS to provide the relevant data to make these calculations. 

The terms levelized cost, and hurdle rates are explained in the section on Levelized Cost of Energy. What it means is that future costs are discounted relative to present costs. If they weren’t, the fuel costs, operation and maintenance (O&M) and carbon costs, all of which are spread over the lifetime of the project, would be higher.

As capital costs are a higher proportion of the lifetime costs of renewables than for fossil fuel generation, this works against renewable energy. However even with this factor working against renewable energy, the graphs show that for projects commissioning in 2020, onshore wind and solar PV are more cost effective than the standard ‘combined cycle gas turbine (CCGT), when carbon costs are taken into account, and significantly cheaper for projects commissioning in 2025.  The cost of carbon is a way of taking into account the climate externality of fossil fuels. This is based on a carbon price assumed to be £18/tCO2 to start with, and increasing to £35/tCO2 in 2030, and £200/tCO2 in 2050. (BEIS cost of electricity report, p11).  Additionally tax breaks for fossil fuels are not taken into account with this analysis.

Other organisations publish levelized costs of energy internationally. These include:

Transmission and distribution costs in gas and electricity networks

Current operational and maintenance costs

Transmission and distribution costs make up 25% of a typical dual fuel bill, and so are an important part of the energy system’s costs. These are supposed to be paid for according to the principle of cost-reflectiveness as discussed previously. Most of the operational costs of the networks are fixed costs, which depend on the peak amount of gas or electricity transported (power), rather than variable costs, which depend on the total amount of energy transported in a day.  This means that the allocation of income from ‘per unit of energy’ bills to the fixed costs of infrastructure is complex, and not easy to do in a way that is straightforwardly cost-reflective. 

Investment costs

With the gas network, there is a limited amount of biogas injection taking place, and there are studies considering the potential to switch the gas network to hydrogen.

Connecting new electricity generation on the distribution network can require:

  • Building the new infrastructure that connects the new generation to the network
  • Reinforcing the network at that level where the infrastructure connects
  • Reinforcing the network at the next voltage level

Ofgem is consulting on how much of these costs should be paid for by the last item to be connected – the development that ‘triggers’ reinforcement, or whether the costs should be shared by the whole system. This is discussed in more detail in the section on ‘transactions and market mechanisms’. 

Supplier costs

Supply companies in the GB system are responsible for:

  • Retail functions for gas and electricity
  • Balancing and settlement for electricity, in contrast to some European countries, where these two functions are separated out.
  • In the gas system, balancing and settlement is carried out by the shipper.

Retail includes costs such as billing, revenue collection and call centres, which have some economies of scale. Costs to the supplier are reduced by whether the customer pays by direct debit (cheaper to collect), by credit (customer actively pays once a bill is received), or by prepayment meter. The differing costs to the supplier of these approaches is passed on to the customer.

Balancing and settlement is a more complex cost structure, and is part of the internal transactions and market mechanisms of the electricity system.

Lessons for energy democracy

Final costs in the energy system include materials and labour costs for new construction and ongoing operation and maintenace of the various parts of the physical infrastructure.

Next: Transactions and market mechanisms