How higher interest rates could slow our journey to net zero
The transition to net zero requires us to spend a huge amount of capital — building renewables, upgrading the electricity grid, switching to electric vehicles, installing heat pumps all involve significant costs upfront. But this investment should come with a hefty economic payoff (besides reduced emissions): it should reduce our energy bills, both through the lower costs of renewables and the greater energy efficiency of electric technologies. This is an enticing prospect; cheap and abundant energy is a huge aid to economic growth, and we’ve spent well over a decade worrying that we’re short of things to invest in.
But the dramatic economic changes of the last 18 months have changed the underlying maths, in ways that are both good and bad for net zero. On the one hand, having experienced an extraordinary, painful energy crisis, it now looks likely that we will now have permanently higher — and more volatile — gas prices. This is obviously good for net zero, because it makes renewable energy and heat pumps cheaper by comparison. Like many others (most recently the OBR), I have used the increase in gas prices to argue that the switch to clean energy now looks virtually unstoppable.
But there has been another, less positive change: the rise in interest rates. Higher interest rates are clearly bad for net zero, because it requires so much capital. In fact, the cost of some key net zero technologies — especially renewables — are nearly all capital. That makes them highly sensitive to anything that raises the cost of capital. While it is too early to say whether or not the rise in interest rates will be permanent, we need to adjust to the idea that interest rates might be higher in future, and be frank about the new challenges that introduces for net zero.
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The chart below gives a breakdown of how the cost of a unit of electricity generation is typically made up, for renewables (middle 3 bars) and gas (outside 2 bars, marked CCGT). For renewables, the cost is dominated by construction (i.e., capital costs). For gas, fuel costs (i.e., the price of buying gas) is the biggest factor. Note that these figures are a few years old (they come from a government document called Electricity Generation Costs 2020) and do not factor in the higher gas prices and interest rates I’m discussing here.
This difference has an important effect on the electricity market. Renewable energy has virtually zero marginal costs — that is, once you’ve built the kit (and factored in maintenance), you get electricity almost free. The marginal cost of gas-fired electricity, by contrast, is quite high, because generating more means burning more gas. If you’re wondering, nuclear energy is fairly similar to renewables here, with high capital costs and low marginal costs — although its capital costs are much higher in the UK.
These different cost profiles of gas and renewables have an important — and quite damaging — effect on the electricity market. Gas is usually the power source with the highest marginal cost, and so whenever we need some gas power — currently almost all the time — the price of gas sets the price of electricity. That is why electricity prices rose so much during what was primarily a gas crisis. In the (currently rare) moments where we produce enough renewable energy to avoid needing gas, wholesale electricity prices plummet — sometimes even going negative.
This is the big opportunity that renewables present. If we can deploy enough renewables to regularly drive gas out of the grid, we should dramatically reduce the cost of electricity. (Breaking the link between gas and electricity prices should also make heat pumps more attractive by lowering their running costs, too). We are — or were — on track to begin breaking the gas stranglehold by around 2028, by which time our offshore wind capacity should have roughly doubled.
But this is now under threat. Vattenfall this week halted one of the massive new offshore wind projects, citing a 40% increase in costs. I don’t know how much of that 40% is due to inflation in construction costs, and how much is due to rising interest rates, but I’m pretty sure the increased cost of capital will be a big factor. It seems likely other offshore projects will face similar challenges.
Here is a very simple illustration of how the rising cost of capital changes overall costs (although bear in mind I know nothing whatsoever about developing energy projects). If you need to borrow £1 billion over 10 years for a renewables project, raising the interest rate from 2% to 7% increases the cost of borrowing by over £300 million. That’s a *30% increase* without anything else changing on the project. If your project is almost all capital, rising interest rates are hugely expensive.
The issues this creates are twofold. First, it will slow down our progress towards breaking the stranglehold of gas on the electricity market. If renewables projects are delayed, the big pay off of cheaper electricity will also be delayed. Second, higher rates will of course raise the cost of renewables. After years of dramatic, unexpected falls in the cost of renewables, we are likely to see costs begin to rise.
This does not mean renewables are no longer the cheapest form of electricity, however much climate sceptics and inactivists try to seize on this. The strike price for renewables has typically been around £40 per MWh; even a 30% increase would take that to £52, which remains cheaper than alternatives. Nuclear will, of course, be affected by exactly the same issues with increased cost of capital. And gas prices have risen by a lot, and look likely to stay much more than 30% higher. So the story here is about all electricity getting more expensive, rather than renewables suddenly losing their way.
Some people will also point to the higher system costs associated with renewables — because of the (eventual) need for storage, for extra grid capacity and for standby generation needed to cover for renewables’ variable output. Renewables are likely to increase system costs, but not enough to make them more expensive — as the OBR chart below shows with reference to gas. And it’s also worth remembering — and me repeating once again — the scope for renewables to stop gas setting the price of electricity.
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There is no case for turning against renewable energy — it is still very likely the cheapest source of electricity — but higher interest rates clearly pose a problem, both in terms of the cost and speed of renewable expansion. What then, if anything, can government or anyone else do to tackle this?
The first thing to say is that a responsible government can’t just unilaterally lower interest rates. Interest rates — certainly the ones that borrowers actually pay — are largely set by markets’ expectations around inflation, risk, growth and the competition for capital spending. As inflation falls in the UK, there is a reasonable chance interest rates may fall again — especially if growth also looks weak, as it did throughout the 2010s — but this is not a given. Indeed, Andy Haldane has recently argued that — perhaps ironically — the need to invest in net zero will actually drive up interest rates in the long term, because it means more competition for capital.
But while government should not try to engineer interest rates for the sake of renewable energy, there are things it can do to try and lower the cost of capital. The most obvious place to start is by reducing the perceived risk of renewables projects. The government’s Contracts for Difference (CfD) model has done this very successfully up to now, by giving renewables projects a guaranteed price per unit of energy (and saving some money in the process). But some of these CfD prices look too low now that interest rates have risen, potentially delaying projects. Perhaps CfD prices should be automatically linked to interest rates, as well as to a more accurate measure of input cost inflation?
Removing or mitigating some other barriers to renewables schemes — such as planning restrictions and grid constraints — might also help to reduce the perceived risk of renewables projects (as well as generally accelerating delivery).
A slightly more radical option would be for government to use its balance sheet directly to underwrite renewables projects. This in effect means government takes on some of the risk if the project goes wrong, allowing projects to access the (generally lower) interest rate available to government. However, government borrowing can only ever get as low as the risk-free interest rate, which is currently still high.
Most radically of all, government could reconsider the whole way in which renewable energy is funded. Rather than offering CfDs to enable a return on investment, government could directly cover the capital costs of renewables projects, enabling electricity prices to be (potentially) very low. This would imply a major increase in government borrowing, but would also create public assets and potentially dramatically lower energy costs.
None of these options is straightforward or cost free. It may be that government has to accept there is little it can do tackle the effects of higher interest rates, other than trying to reduce inflation (although reducing renewables investment may make that harder).
The changes of the last 18 months — higher gas prices and interest rates — do not merit a change of approach. If anything, a rapid rollout of renewables is even more important than it was before. But we must address the fact that renewables — and the rest of net zero — is likely to get more expensive, after a long period of falling costs. That could make the road to net zero slower and even more bumpy than it already was.
