How to Handle Gas Price Uncertainty
This morning’s select committee report into The Impact of Shale Gas on Energy Markets is, mostly, a sensible and sober overview of the potential and risks of shale gas development. The Committee gets many of the big issues right, including recommending that the Government should encourage shale exploration, that strengthening the EU ETS is important for ensuring that shale development helps rather than hinders meeting climate change objectives, and the importance of working with communities, including potential provision of incentives to encourage development of shale resources in the UK.
Nevertheless, one part of the Committee’s report deserves further scrutiny.
The Committee argues that “it is by no means certain that prices will fall as a result of foreign or domestic shale gas development. It would be wrong for the Government to base policy decisions at this stage on the assumption that gas prices will fall (it is possible that they will rise) in the future.” This is correct. However, that is not the error the Government is making. On the contrary, almost all the Government’s current interventions in the energy market are based to a large extent on the assumption that gas prices will rise inexorably. The disruptions to the gas market brought about by shale gas development make this equally uncertain. The only honest answer to the question of what gas prices will be in the future is ‘I do not know’.
Rather than attempting to predict where gas prices will end up, and then planning a prescriptive policy that matches those guesses, the government should adopt a flexible policy that can respond to a range of possible futures. The best way to accomplish this is through market mechanisms (including a stronger carbon price). Unfortunately, the Government is moving rapidly away from energy markets, centralising more and more decisions about the future direction of UK energy policy. As a result, it is very vulnerable to key predictions (like those of future gas prices) being wrong. Our report, Gas Works? found that the Government’s Electricity Market Reform (EMR) policy was assessed by the Government itself, as extremely vulnerable to errors in gas price projections. While the costs of the policy were estimated to be lowest if gas prices ended up being high, they were also estimated to be much higher than market-based alternatives under lower gas price assumptions.
The Government’s proposals for EMR based on Contracts for Difference are unsuited to a world of considerable uncertainty, in particular about gas prices. Some support mechanism will still be needed to nurture immature technologies, but the EMR proposals go far beyond this. They gamble with bill-payers money on a high gas price future, and risk imposing high and unnecessary policy costs on consumers if that does not materialise.