Merlin Weekly Macro: How clean can electricity become?

Reeves banging the drum for investment and reform

She wants to be the greenest Chancellor ever. Rachel Reeves is on a mission. Her determination is commendable. Gov.UK tells us that this week she has been to North America, visiting New York and Toronto seeking investors with deep wallets: “There is no credible plan for growth without private sector investment. That’s why I’m breaking down barriers at home and banging the drum for Britain abroad as we gear up to host the International Investment Summit,” she says on the government website. That summit to which she refers is one she will lead in October. The aim is laudable; however, the means of achieving it begs more questions than she provides answers to.

In this context there are two barriers Reeves is intent on breaking down: first, in partnership with the Deputy Prime Minister, Angela ‘Angry Ange’ Rayner, significantly reforming the UK planning laws by removing the public right to object not only to both new house building developments and degradation of the Greenbelt but also to National Strategic Infrastructure Projects (NSIPs) anywhere (those opposing this policy are almost certain to challenge the infringement to human rights either in the Supreme Court or, failing satisfaction there, in the European Court of Human Rights); second, her determination that what are essentially government controlled local authority defined benefit pension funds are pooled and encouraged to invest a higher proportion of their estimated £360 billion of aggregated assets in UK ‘alternatives’ and unlisted securities.¹ Her inspiration for public sector pension fund reform to unlock that capital is Canada where the ‘Maple 8’, being the eight principal Canadian public sector pension funds, already operate under such an umbrella scheme: hence her visit to Toronto.

Carbon zero by 2030: a case of 2+2=3?

Much of the investment she seeks is being targeted at infrastructure, particularly in renewable energy where the Labour government has an explicit target to have carbon-free electricity generation by 2030. Carbon-free generation is itself not an impossible target, so long as there is a permanent base-load capacity for when the sun doesn’t shine and the wind doesn’t blow. The only immediately available and proven carbon-free technology to provide that consistently is nuclear. However, as the National Audit Office reports, “the UK has eight second generation nuclear power stations, accounting for around 16% of UK electricity generation in 2020. Seven of the eight stations are Advanced Gas-cooled Reactors (AGRs), which are all due to stop generating electricity by 2028.” The new ‘C’ projects at Hinckley Point and Sizewell, both being built and operated by EDF (100% owned by the French government) are unlikely to be on-line before the mid-2030s. Natural gas still accounts for a third of UK electricity generating capacity.

Energy secretary Ed Miliband is determined to switch off all our gas-fired power stations no later than 2030. The nuclear decommissioning programme has very little leeway for relaxation because of safety margins on the ageing power station fleet. It is not difficult to see a yawning gap opening in the early 2030s in our ability nationally to generate sufficient electricity to maintain full power for domestic consumption. Fifty percent of our total capacity is due to be closed within little more than five-and-a-half years, all of it of the reliable variety. Apart from the new nuclear projects (which will almost certainly suffer over-runs both to budget and when they come on-line), all the new capacity to come on stream will be from variable solar and wind power. That replacement capacity investment will struggle just to bridge the gap to meet today’s demand requirement, let alone begin making provisions for the future when UK households will be rapidly accelerating towards full use of electric vehicles and industry and commerce are forecast to be benefiting from voraciously energy-hungry technology driving the artificial intelligence revolution.

The National Grid estimates that UK electricity consumption will increase by at least 50% by 2036 compared with 2022, and will double by 2050. Mass adoption of EVs will also change our consumption habits: most of the populace will be charging their cars overnight, driving up night-time consumption when the solar fleet is obviously dormant (and if it’s winter, high pressure and there is no wind, there is a real risk of the country literally grinding to a halt). How will we reliably keep the lights on and keep moving? Society has expectations; progress cannot mean going back to the Middle Ages and resorting to candles for lighting or an open fire for cooking or a horse and cart for transport simply because the Grid has run out of juice (that may be an exaggeration but any South African with experience of the post-Apartheid economic boom will tell you what happens when electricity supply fails to keep up with demand in a first world economy and regular and frequent energy-saving, total power cuts by district become the norm).

Big Oil: a target on the companies’ backs

While appealing overseas for investment and reforming public sector pension schemes at home, both Miliband and Reeves have made it perfectly clear that in their view the UK’s primary energy companies, those involved in the extraction of oil and gas, are entirely the problem and in no way part of the solution towards a smooth transition and to avoid a pending self-imposed cliff-edge event. Miliband has forbidden the authorisation of any new North Sea drilling licences for gas, ensuring supply depletion as exhausted wells gradually expire (just to prove a point, he is also considering retrospectively revoking licences awarded by the Tories to as far back as 2022); Reeves has reinforced her determination that oil companies are to remain subject to punitive corporation tax surcharges (here is an irony: such taxes are described as ‘windfall’ yet the companies seemingly get zero credit for investing in wind and other renewables).

 We have previously dubbed what we are entering as the ‘Climate Change Compression Period’ when international competition for materials, labour and capital will be acute. While such populist policies as Miliband’s and Reeves’ appeal to the political left-wing and the zealous green activist movements, in practice they show a pronounced level of strategic immaturity and naivety in safely navigating the world’s sixth largest economy through the biggest industrial revolution since the 1700s, and all to happen in only a handful of years.

Reeves’ plans make it difficult to see how the UK economy expands or benefits directly from such investments. Of the big NSIP solar developments either approved or in planning, virtually all are funded using foreign capital and the financial returns accrue to overseas investors; construction jobs are short-term and not necessarily local; future maintenance is intended to be minimal; all the main construction components (e.g. panels and inverter boxes which convert direct to alternating current) are sourced from overseas. It is much the same with wind power: most of the investment is foreign; the UK has no indigenous turbine production capacity; given the long paybacks on building such factories, and the short time horizon for installation of additions to the existing fleet, it is unlikely that any will be built. We will benefit from clean (but not cheap: see below) energy but little else economically.

Rags and riches: asymmetric returns in the same industry

Then there are the asymmetric economics of the developments themselves when the uniform output price of electricity does not reflect the cost of how it was produced. You instinctively know that something is awry when, simultaneously, two subsectors of the renewable generating industry have such widely differing reactions.

Solar is attracting significant funding; as we analysed in a previous column (‘This blue and pleasant land’: Merlin Macro 25 May), the UK solar industry is in a full-scale gold-rush with developers quoted as saying investing here is ‘like being in the Klondyke’. That immediately tells you that the internal rates of return on such projects are so fantastically favourable for all parties in the development chain that financially it is irrational to turn them down; those sky-high returns can only be because costs are very low or the selling price is very high (or both).

At the same time, the costs associated with wind developments, particularly offshore with all their technical and physical challenges, are so high that without extensive subsidies to the turbine manufacturers and energy price backstops in place for the developers and operators, those projects are entirely uneconomic as stand-alone investments (since coming into office, Miliband has already increased the government subsidy to the 2024/5 round of wind licence auctions by £500m, taking the total to £1.1 billion after the autumn 2023 auction produced no bidders at all; so much for wind power providing low-cost electricity sourced from free ‘fuel’).

The National Grid: the indispensable Cinderella

Reeves may well find that it is far easier to crowd fund flagship projects such as individual solar parks or wind farms, those that developers can show off to potential investors, than it is to raise capital for the mundane but essential. Here we are talking about the National Grid infrastructure; simply having sufficient power line capacity available and having it in place from the sources of production (with wind, often remote areas in the north, and in Scotland, and offshore) to where it is consumed (mainly in the populous south-east and the industrial northwest). This is essential but dull and most definitely unsexy in investment terms but without it, all the generating capacity is useless if the electricity cannot be transmitted easily from A to B often covering distances of hundreds of miles. As it is, the Grid is so short of capacity in the right places that on days of persistently strong blows, the wind generators are paid to switch their turbines off: in 2022 the National Grid paid out £1.3 billion in such ‘balancing out’ payments to suppliers. Ultimately, the tab is picked up by both the taxpayer and directly by the consumer. That this situation persists reflects bad planning and bad economics.

Crystal ball gazing

As we look forward to the end of the decade it seems as though there are three possible outcomes:

1. the least likely is that the government’s plans all work perfectly: the transition to carbon-free electricity in 2030 is seamless, all the replacement projects are built on time and to budget, and there is no generating capacity shortfall.
2. the execution is flawed: we crack on shutting down ageing nuclear and politically unacceptable gas on schedule but the renewables fleet is incapable of making up the shortfall for the decommissioned reliable sources of power and we have to import the balance from France, Holland and Denmark; this assumes they have surplus production available to sell to us when we need it (we are already investing in cable capacity to import Danish electricity generated by wind which will come ashore via the new Viking Interconnector facility near Boston on the Lincolnshire coast; however, in periods of atmospheric high pressure in which we have windless days, it is quite possible that high pressure covers the North Sea and Denmark and Holland are similarly blighted by low production and have nothing to sell to us). This outcome is the antithesis of a secure energy policy: we have neither security of supply when we need it nor are we self-reliant.
3. with power outages an increasing likelihood as the electricity deficit becomes obvious in the approach to 2030, consumers and the Grid appeal to the government to relax the gas guillotine until such time as the permanent load shortfall can be covered elsewhere (i.e. the new nuclear ‘C’ projects at Hinckley and Sizewell, or the entirely new plant at Wylfa on Anglesey if it ever goes ahead which, even if it does, will be unlikely to be complete before the mid-2040s at the earliest).

We are legally committed to carbon net-zero by 2050, enshrined in law by Theresa May immediately before she left office in 2019. How we get to net-zero is largely but not entirely up to us but a clear path with defined, realistic milestones is a prerequisite of good strategic planning. Make no mistake, this is the UK’s biggest and most radical strategic infrastructure project in generations. Ambitious targets are laudable; political zeal with no greater aim than scoring populist points is unhelpful. Whether Labour’s plans for carbon-zero emissions in generating electricity are achievable or not will be known soon enough. It is beyond mid-2024 already: 2030 will be upon us in the blink of an eye.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

¹Alternative Investments are those outside of traditional asset classes of stocks and bonds. Alternatives include commodities, hedge funds, private equity and unlisted companies. An unlisted asset is an investment not traded on a securities exchange.