How do gas utilities fit into the UK’s carbon neutral future?

30 April 2020
With the UK’s move to renewable energy already underway, what does the future look like for natural gas, and what impact could this have on investments? Royal London Asset Management (RLAM) met with providers to find out.

The UK’s move to net-zero is well and truly happening, as energy providers face mounting pressure to provide renewable, environmentally-conscious alternatives for fuel.

As this transition takes place, RLAM set out to see how different scenarios could impact client’s pension portfolios. Traditionally, fossil fuels have made a relatively safe investment. The credit market views the bonds issued by the UK gas networks as something of a safe bet, supported by a stable regulatory framework, and the expectation that the pipes on which they earn their returns are here to stay.

However, with the future of fuel production set to change, RLAM wanted to see if this would still hold true.

Traditionally, fossil fuels have made a relatively safe investment. 

In 2019, members of RLAM’s credit and responsible investment teams met with gas companies and industry bodies to determine the role gas could play in Britain’s carbon neutral future, if it had one at all. Specifically, they met with SGN, Wales & West, Cadent, and Northern Gas Networks, as well as with operator National Grid, regulator Ofgem and the transmission network.

They assessed the implications of three potential scenarios - to fully electrify, burn something cleaner, or a blend of the two - with interesting results.

Scenario one - Fully electrify

With gas demand already reducing, in this scenario, the gas networks are fully phased out or maintained only for use in emergencies.

Ofgem estimated back in 2016 that aggregate peak demand for heat is roughly five times that of electricity.

While this plan may appeal to supporters of cost-effective renewable energy sources, it’s not as simple as it may seem. A fully electrified network would require a huge surge in the amount of power required to meet peak energy demand for heating, particularly in cold winter months. Ofgem estimated back in 2016 that aggregate peak demand for heat is roughly five times that of electricity.

Other costs of this transition would also be significant. As more consumers moved to electric heating, the costs of the gas networks would rise for the remaining gas customers. This could leave households either unable to pay for utilities or create a surge in customers switching to electricity, and in both of these scenarios, the gas networks could be rendered redundant.

Scenario two - Burn something cleaner

The gas networks are already investigating the potential of hydrogen as an alternate fuel source.

Unlike burning natural gas, burning hydrogen only produces one by-product, water vapour.  While hydrogen is prone to leakage in steel pipes, up to 75% of distribution networks can already carry hydrogen, as distribution companies are already replacing all metal pipes close to residential areas with plastic ones for safety reasons.

This switch would also lead to new boilers and other appliances being required in every home.

However, the cost of producing this hydrogen would still lead to increased costs for consumers. This switch would also lead to new boilers and other appliances being required in every home.

A blended option

Most of the gas companies imagined a future in which networks used a variety of methods to meet their decarbonisation targets.

These included more use of bio-gas, which has no net impact on the total stock of carbon in the atmosphere, and is therefore considered a “green fuel”. Other ideas included the partial injection of hydrogen (up to levels that existing appliances can tolerate), introducing regional hydrogen grids, some carbon capture, as well as alternate technologies such as hybrid heat pumps.

Each of these partial technologies faces their own risks, from a lack of supply (for green gas) to the difficulty in cleanly producing hydrogen at scale without Carbon Capture, Utilization, and Storage (CCUS) and the inefficiency of UK housing stock.

Overall gas demand would still be expected to decline materially under this scenario.

The broader risk to the security of supply and to the system as a whole is that these localised solutions would impede nationwide solutions in the case of extreme weather events in one or all parts of the country, and make it harder to balance national energy supply and demand.

What impact could this have?

No single scenario offers a perfect solution, and with the clock ticking towards 2050, it’s still not clear what strategy the gas networks will adopt.

Whichever strategy is chosen, it will need to strike the balance between managing the short-term nature of regulatory cycles with the long-term investment into infrastructure in order to work. During RLAM’s engagement with the regulator, they highlighted this potential disconnect, and after discussions they expect future regulatory price controls - which set the returns these networks can earn - to begin to reflect the need for a longer-term view.

This research shows the importance of effectively integrating ESG into credit analysis, to help asset managers make better choices about risk and help them to find opportunities as the UK’s energy market evolves. 

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The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.