UK: Oil Price Volatility - Risks And Opportunities In 2015 Update 7

Update 7 - How will declining oil prices impact on the UK's renewables sector?

The dramatic fall in global oil prices and its impact on the UK renewables sector should be considered in the context of existing developments in the electricity market. Coinciding with the collapse of oil prices and industry concern over the long-term viability of the UK's North Sea oil and gas sector, the UK Government has rolled out its policy on electricity market reform (EMR), which it has framed as the "biggest reform to the electricity sector since its privatisation". Two critical objectives of EMR are security of electricity supply via the new Capacity Market mechanism (aimed at keeping the lights on during peak demand) and decarbonisation via the new feed-in-tariff Contracts for Differences (CFD) regime (a mechanism for subsidising renewables through competitive auctions).

The Capacity Market and the CFD regime represent a classic tension between the security that flows from carbon-based generation (primarily coal and gas in the UK) and the decarbonisation benefits flowing from ever-more competitive renewables such as wind and solar, all of which are, in reality, reliant on government subsidies and political support to survive. So, what, if anything, does such a dramatic fall in global oil prices mean for the burgeoning renewables sector in the UK? Will a long term drop in oil prices, together with a trailing drop in European natural gas prices, undermine momentum behind the UK's policy on decarbonisation and market reform?

The first factor to note is that unlike some other regions of the world, oil makes up very little of the generation mix for electricity in the UK – less than 1% - with gas being the primary (cleaner) substitute. As a result, oil does not compete with renewables such as wind or solar for electricity generation. Instead, its primary use is in the transport sector, where it remains dominant and has a direct impact on the consumer wallet at the pump or indirectly on the supermarket shelf with transport costs reflected in the price of goods. Oil does, however, compete with plant derived biofuels such a bioethanol, which may start to look like a more expensive option in the fuel mix if oil prices remain low. The recent 'temporary' closing of the Ensus biofuel factory in Teesside is an example of how the drop in oil prices and the corresponding drop in bioethanol prices can impact the sector. Yet even in this example, the reasons for closure are more complex. The factory's owners have stated that rather than declining oil prices, the most significant contributing factor for the closure was continuing uncertainty at the EU level over limitations on the amount of food-based biofuels that can contribute to the EU's objective of achieving 10% of its transport fuels from renewables by 2020.1 The biofuel sector is therefore exposed to risk from falling oil prices, but other unrelated factors are clearly very relevant in how such a drop will ultimately affect biofuels.    

The second factor to consider is that when oil prices significantly declined in the past, the renewables sector was still in its developmental infancy, lacking the current levels of competition and economies of scale which have driven down costs. Electricity generated from wind and solar is now highly competitive with carbon-based sources and a significantly cheaper source of electricity generation than diesel, even at oil's record low prices. Despite the continued need for government subsidy, the renewables sector is now far more robust, price competitive and structurally embedded in the energy mix than in the 1980s and 90s when technologies such as solar suffered as a result of declining oil prices

A third factor is the considerable political and structural momentum behind renewables and decarbonisation. The UK is committed to its carbon reduction targets at the national and EU level, commitments which should remain largely unaffected by declining oil prices, whichever party is in power after the May general election. Of course, it is difficult to predict how oil prices may affect decisions at the United Nations Climate Change Conference in Paris this coming December, which has as an objective a legally binding and global agreement on climate change. Oil rich nations, particularly those currently marginalised by broader geo-political events, such as Russia, are unlikely to be interested in the shift away from fossil fuels.

In our view, investment in proven renewables technology is likely to continue largely unaffected by declining oil prices in the short to medium term, although biofuels are exposed. Cheaper long-term gas would pose some threat in the UK, but perhaps only a minor one given green policy commitments and the considerable foothold wind and solar already have in the electricity generation sector. Gas has a clear and ongoing role to play for the foreseeable future in the UK's energy mix, and was, for example, the dominant winner in the Capacity Market auction with the majority of capacity contracts going to combined cycle gas turbine plants given the large-scale certainty of supply they can deliver. Arguably, cheaper gas could reduce political will and support for nascent renewable technologies, such as tidal power, given the need for government subsidies and political support if these technologies are to prove their efficacy and competitiveness in the UK's energy mix – but the jury is out on this. Notably, some commentators have suggested that the question should be reversed and we should look at how the rise of renewables has contributed to the decline in oil prices, rather than on how declining oil prices will affect renewables. This would be difficult to quantify, and we may have reached a tipping point where renewables are immune to a long-term drop in the oil price whether or not renewables have contributed to that very decline. Despite the collapse in the oil price, the growth horizon for renewables looks positive.



This update is the seventh in our series on the impact of oil price volatility. To read the previous updates, please click here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Brett Hartley
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