What would be the impact of the April 17 OPEC meeting on the UK electricity market?
By Giorgio Castagneto Gissey, on 13 April 2016
A freeze in output would stop adding to the excess supply that has caused prices to collapse from levels above GBP 70 per barrel seen in June 2014. Oil is very rarely used for electricity generation, only about 1-2% of the times in the UK. Given that the UK electricity system is based on the merit order of electricity generators in the country – i.e. the marginal cost of producing an extra unit of electricity, by which electricity generators with progressively higher costs are dispatched as demand increases, in order to minimise prices for consumers – oil is always used as a last resort because it always has the highest cost. In such a system, when the marginal generator is used it always sets the price. Thus, when oil is used it always sets the electricity price.
If the OPEC agreement is reached on April 17, the supply of oil will be cut, meaning that oil prices will likely increase. The fact that oil always sets the electricity price when it is used (i.e. when demand is very high) implies that electricity prices will be higher at times of peak demand, usually around 12 pm and 6 pm. This does not directly affect consumers immediately but will certainly affect them in the short-term, as little as a few weeks to months from now. Initially, producers burning oil will be hit the hardest, but they will pass on this extra cost to suppliers which will in turn pass them onto consumers. Because consumers pay a fixed electricity price (throughout periods of months), this means that the average price they will pay for electricity from the next few months will be higher. On the other hand, suppliers deal with producers in the wholesale market which is characterised by a dynamic price, meaning that they too will be subject to higher prices but also higher volatility, thus market risk. In order to counteract this increased market risk, suppliers could increase their activity in the derivatives market, which might increase the price of derivatives, thus potentially also increase future electricity prices further.
The higher cost of oil will represent both a drawback and an opportunity. The drawback is indeed the higher electricity price for consumers in both the short-term and longer term. The higher cost of oil means that more gas (and coal) could be needed. A higher need for gas (and coal) will also increase the gas price (and the coal price), leading to a further increase in the electricity price, even when demand for electricity is not so high. In fact, fuel prices are inherently inter-linked, leading to a potential domino effect in other fuel prices.
However, an opportunity arises for the electricity system. The higher cost of oil means that it could be completely displaced by gas, at least if oil prices stay high in the coming months. If gas were to displace oil, then the price suppliers pay for wholesale electricity when demand is high will be much lower. Hence, if this is the case, after an initial period (possibly a few months) of electricity market reorganisation, gas would become the main fuel to supply the highest levels of electricity demand. Keeping in mind that it is far easier for the UK and other European countries to access gas than oil, if this occurs, electricity consumers can expect to pay a lower price for electricity.
Finally and importantly, Iran’s probable failure to comply with the agreement could lead to a relatively lower oil price for oil coming from Iran. Iranian oil prices will also likely increase but not as much as the OPEC oil price. This means that Iran will likely profit substantially, while other countries such as the UK could but their oil from Iran, in which case domestic electricity prices would still increase but not as much as in the previously described case.
Dr Giorgio Castagneto Gissey is a Research Associate in Energy Economics; Research Co-Investigator on electricity market design, RESTLESS Project (EPSRC) at the UCL Energy Institute