Dr Mark Carney, Governor of the Bank of England, has recently called for government to cease using to the widely discredited Retail Prices Index (RPI), for example when index-linking to offset inflation. This follows a recent House of Lords report on the indices used to measure consumer price inflation which drew attention to the fact that due to an error in the methodology used by the UK Statistics Authority (UKSA) the RPI is greater than the Consumer Prices Index (CPI), with the difference tending to increase (see Figure 1).
As the House of Lords report states, this error has created both winners and losers. Examples of losers include students and commuters whose loans and rail-fares are linked to the higher and more rapidly increasing RPI. Amongst the winners are holders of RPI-linked gilts and also, recipients of renewable energy subsidies under the Renewables Obligation (RO), the Feed-in-Tariff (FiT) and early adopters of the Renewable Heat Incentive (RHI). Since the RPI is used to calculate the inflation proofing of these subsidies there is now significant and unjustifiable over-support, with the scale of the problem being particularly significant in the largest of the schemes, the Renewables Obligation.
Figure 1: The Retail Prices Index (RPI) and the Consumer Prices Index (CPI), from 2010 to 2018. Source: ONS. Ofgem sets the RO buy-out price by taking the buy-out price from the previous obligation period and adjusting it in line with the change in RPI for the previous calendar year. E.g. For the obligation period 2016-17 the price was set at £44.77 per ROC an increase of 1% (2015 RPI) from the 2015-16 value of £44.33.
However, the most recent of the renewables subsidies, the Contracts for Difference, is indexed against the Consumer Price Index, as have those registering for the RHI since April 2016, suggesting that government is now aware of the excessive annual uplift provided by the RPI linkage and recognises that it should no longer be used for this purpose. This is to be welcomed, but it is difficult to see why government ever accepted the case for RPI index linking for the Renewables Obligation. A significant part of the difference between RPI and CPI arises from the treatment of housing costs in the RPI, and the cost of housing has no bearing on the cost of generating renewable electricity, making the RPI an obviously unsuitable index for the purpose of inflation proofing subsidies to that sector. A second component of the difference is the way in which price changes are weighted. The RPI uses a method that is quite inappropriate for companies that have incurred most of their costs during the construction phase, as is the case with renewable energy projects. Overall, the use of RPI does not reflect either the costs or the investment incentives appropriate to renewables developments. It was simply the wrong choice, as government implicitly admits by using the CPI for the Contracts for Difference.
However government has not yet acted to correct its error in relation to the Renewables Obligation and other schemes. This is particularly puzzling since in other instances, government acted promptly. For example, in 2011 government changed the index-linking of pensions and other welfare benefits from the RPI to the CPI. Why did it not at the same time apply this change to the index linking of the Renewables Obligation electricity subsidy where consumers foot the subsidy bill? This failure in relation to the RO has, we estimate, already needlessly cost consumers over £1 billion and we estimate will cost a total of at least £9 billion up to the end of the Renewables Obligation in 2037. £6 billion of this excess subsidy would go to wind power generators. It is obviously wrong, indeed iniquitous, that investors in renewable generation should be treated so much more favourably than pensioners and those on benefits.
To put this in technical terms, continuing to use RPI to adjust the RO buyout price means an expected subsidy of over £80/MWh generated in 2036-2037 by comparison with £64/MWh had the Government switched from RPI to CPI in 2011.
It is not too late for government to act, and, at a minimum, if the switch to CPI is implemented now to the Renewables Obligation, we estimate that this measure alone would save consumers at least £3.6 billion in undeserved subsidy payments over the remaining lifetime of the Obligation.
However, the detrimental effect on consumers is so significant that we believe that the government should go further and cut the RO buyout price to the level it would now be at if CPI indexation had been applied from 2011.
Such a move would reduce the buy-out price for the 2019-2020 period from £48.78 to £45.31 per MWh. If the Government predictions for the size of the Renewables Obligation prove accurate, this change would save consumers around £400 million in subsidy for this one year alone, and about £7.7 billion in total up to 2037.
About one third of these savings would affect domestic consumer electricity bills directly, while the other two thirds would benefit households indirectly through the reduced costs of goods and services provided by industrial, commercial and other consumers. It would also benefit households by alleviating the downward pressure exerted by the Renewables Obligation on wages and on rates of employment.
The renewables industry would doubtless protest at such reforms, but the subsidies are already generous, delivering a rapid return on capital, and the industry can have had no reasonable expectation that these subsidies would be indexed at a rate above that of inflation.
In addition to reforms of the Renewables Obligation, government should also investigate the possibility of reforms to the index-linking of the Feed-in Tariff and further retrospective reforms to the Renewable Heat Incentive.