Can we really break the link between gas prices and energy bills?

As the conflict in the Middle East continues to wreak havoc in global energy markets, UK billpayers are facing rising costs.

Since the war began on 28 February, oil and gas production across the region has slowed or stopped. This has made global prices not just higher, but more volatile, with sharp swings over short periods that make effective planning almost impossible.

In response, the UK government has announced measures to shield households.

Why are electricity prices rising?

Although its use is falling, natural gas is still Britain’s second largest source of electricity.

Only a small percentage of this gas comes from Gulf states. But energy is still a global market. And as the Middle East is a critical global supplier of fossil fuels, the disruption is affecting prices everywhere.

Gas prices have a disproportionate effect on UK electricity prices because power, like other commodities, is priced on a ‘marginal’ basis. Under marginal pricing:

• The electricity system uses the lowest-cost generator first (typically a renewable generator like wind or solar).
• It calls on generators in price order until it meets demand.
• The last and most expensive unit needed to meet demand (the ‘marginal unit’) sets the overall price.

Due to the UK’s electricity mix, gas is almost always the marginal unit. As a result, when gas prices rise, electricity prices rise along with it.

How will the government ‘break the link’ between gas and electricity prices?

Many of the UK’s newer renewable schemes use Contracts for Difference (CfDs), which guarantee generators a fixed price for the energy they produce.

If the market price of electricity goes above this price, the generator pays back the difference. The government uses this to offset consumer bills, passing the repayments on to suppliers, who in turn pass the savings on to their customers.

The government is planning to offer similar, voluntary contracts for generators who aren’t already contracted under this scheme.

As Policy Fellow David Hirst explains: “The focus is on ‘legacy’ low-carbon generators, most notably projects supported under the older Renewables Obligation scheme, plus some nuclear and other long-term contracts.

“This would align them with the latest rounds of wind and other auction contracts, likely locking in current market pricing and reducing uncertainty.”

Gas prices will still have an effect

Will this truly ‘break the link’ between gas and electricity prices? Not exactly.

Generators on CfDs still sell electricity on the wholesale market. And gas still sets the market price. All the contracts do is soften the impact of fluctuations.

So, while they weaken the link between gas and electricity prices, they don’t break it fully.

Is market reform the answer?

Some have argued for scrapping marginal pricing altogether. But Hirst isn’t convinced.

“The issue remains the need for gas during periods of low wind and low solar output,” he explains.

“This will continue until we have a scalable alternative: battery storage, more ways for consumers to manage demand at peak times, or significantly more wind and solar generation, supported by interconnectors, across the UK and Europe.

“The likelihood is that net zero will need all these, plus residual gas infrastructure for decades.”

This means the market will still need to account for high gas prices. In any gas-dependent electricity system, someone must absorb these costs:

• Consumers, via bills
• Suppliers, via losses
• Taxpayers, via government subsidies

Until the system no longer depends on gas, this won’t change, even if the pricing system does.

Is gas the only reason for high electricity bills?

While marginal pricing is the main reason bills are still high, it isn’t the only one.

Bills also account for network costs, which cover grid upgrades and maintenance. This includes modernising the grid to connect new renewable projects.

The network can’t yet accommodate the growth in renewable generation, with some projects waiting years or even decades for connection.

Then there are the costs of balancing the grid to match supply and demand, which is becoming more complex as renewables become more widespread. Wind farms are sometimes paid to switch off (‘curtailment’) because the grid can’t cope with high output.

And there are policy costs: government levies that fund energy and climate schemes (like Contracts for Difference) which are currently also added to electricity bills.

All this means that bills don’t yet reflect the lower cost of renewables.

Rebalancing policy costs can keep bills low

This doesn’t mean that renewables won’t still be cheaper in the long run, however.

Like much of the UK’s infrastructure, the electricity network is ageing and struggling to cope with changing demand. Upgrades would be necessary even without the transition to clean energy.

And over time, the growing use of renewables will reduce the impact of gas on electricity prices and minimise the UK’s exposure to fossil fuel shocks.

Until then, how else can the government ensure bills remain affordable for households?

The Climate Change Committee (CCC) argues for rebalancing policy costs, shifting them from electricity bills to either gas bills (making high-carbon options more expensive) or general taxation.

Doing so could bring the ratio of electricity to gas prices in line with countries like Ireland and France. It would also encourage households to switch from gas boilers to heat pumps – a choice that currently won’t be cheaper for the average household until the mid-2030s.

Public engagement is crucial

The CCC agrees that over time, switching to renewables will reduce reliance on gas, which is the main cause of high electricity prices in the UK and some other European countries.

But policies must respond to people’s needs. Loading policy costs onto electricity bills is not only stopping households from ditching gas boilers (the UK has the lowest heat pump uptake in Europe); it’s keeping industries from electrifying too.

Taking steps to shield investors and consumers from energy shocks is a welcome move and will help keep bills stable.

But a fast and fair transition to net zero, for the whole of society, is the only way to keep them down for good.