Sunday 26 January 2014

The Future of Energy Bills

Getting to an inflation rate for domestic energy

Electricity generating renewable energy technologies have been sold as financial investments as much as energy saving products since the Feed in Tariff was launched in the UK.  These financial returns can be very sensitive to assumptions about the future of electricity costs.

The Department of Energy and Climate Change (DECC) has revealed that its own modelling is based on an assumed of electricity cost inflation of 2.6% a year over and above general price inflation (this figure is called the real rate of inflation).  Responsible industry bodies such as the Solar Trade Association have used this rate of inflation for calculating the financial returns from solar photovoltaic systems.

In 2014 a range of renewable heat generating technologies such as heat pumps, wood pellet stoves and solar heating panels will benefit from a ‘Feed-in tariff for heat’ called the domestic Renewable Heat Incentive.  In presenting the financial case for these technologies, industry will need credible assumptions of future costs for domestic gas and heating oil as well as electricity.

Where has the 2.6% figure come from for electricity?  What are the equivalent values for heating oil and for gas?

The Past as a Guide to the Future

No one has a crystal ball to know about price rises in future, so it’s common to substitute a simpler question “What have energy price increases been in recent times?”

DECC publishes data collected by the Office for National Statistics in compiling the Consumer Prices Index (CPI).  The table below shows prices of various fuels for the most recently published data range that covers the fourteen years from 1998 to 2012.

The chart at the top of the page shows the prices from the table rebased to set prices in 1998 to 100.

General inflation increased costs by 37% over the whole for the fourteen-year period.  It can be seen that all energy costs have risen by much more. Electricity has risen by 100% in the same time, gas by 195% and heating oil by 428%.

What can also be seen is that prices have not risen steadily.  Fuel oil prices in particular are volatile with prices falling back before rising steeply again.  Any measure of fuel inflation is therefore very sensitive to the choice of start and finish date of the period considered, a fact that can be used by those who want to present a biased picture.  For example choosing a period from 2000 to 2009 produces a real inflation rate of 4.7% a year for heating oil, whereas selecting 1998 to 2008 yields an eye-watering 14.3%.

If our goal is to assess an unbiased and justifiable inflation rate for industry to use to present financial to potential customers, then we need to make sure that we're not open to such criticism.  I calculated the real rate of inflation for each and every start and finish date possible in the data set. 

The chart below shows the resulting rates of real annual inflation plotted against the length of the period for domestic electricity prices. 

Predictably, the shorter the period considered the wider the range of results, which narrow as the period covered lengthens.  Also shown on the plot is the average for each period length (diamond shape).  The best fit line for the averages is a real rate of inflation of 2.8%, an identical figure to that used by DECC for forecasting future price changes of electricity.

The analysis was repeated to produce a real rate of inflation of 5.8% for gas and 8.5% for heating oil.

Based on this analysis of government statistics, the rate of energy price rises above inflation can be summarised as:

Fuel Type
Real Rate of Inflation
Heating Oil