Cover of Watt's Wrong?

Watt's Wrong?

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A comprehensive guide to what's wrong with Britain's electricity and energy system

by Ben Watts

Chapter 18: Interest Rates

I learnt early in my career that the single most important figure in short term electricity markets is the gas price. In long-term electricity markets, the equivalent metric is the interest rate.

Starting my career in 2011 and despite having studied economics I have to admit that I didn't realise until really quite recently how profound the effect of near zero interest rates was over the 2010 decade. And while many people have learnt the hard way how it's unravelling the rise in interest rates post 2021 has changed the world of property, business and vehicle finance, It couldn't have happened at a more prescient and disruptive time for the Energy transition.

In Economics, you learn that the interest rate is the connection or the price between now and the future. High interest rates mean that investors require a greater return on the capital in order to be better off than simply putting the money in a bank account or low risk investment like government bonds. All things equal, higher interest rates make it more attractive to put off any sort of capital or upfront investment like insulating a building, replacing a vehicle, installing a battery.

Fossil versus Low Carbon

The biggest Divide between fossil fuels and the appliances we used them in and low carbon technologies brackets including renewables is the amount of extra upfront investment you need if you want to pursue the low carbon option. This paradigm holds true in all different levels and sectors of the energy system:

Gas Power versus Nuclear/Wind

The upfront cost of a state-of-the-art CCGT power station is around £800-£1,200 per kW. The equivalent figure for a nuclear plant like Hinkley Point is £6,000-£8,000 per kW. For an offshore wind farm it's around £3,000-£4,000 per kW. However, when it comes to the running costs or marginal costs of these technologies, the pattern reverses. Wind farms don't require fuel. Nuclear fuel is usually under £10 per megawatt hour of power generated. Gas power even at today's relatively low prices costs upwards of £60-£80 per megawatt hour, given CCGTs are at best 55% efficient and power stations face carbon taxes as well.

Energy Networks

Separate from the cost of generating electricity, there are profound differences in the cost of the network and infrastructure needed to support a renewables oriented grid. Wind and Solar are less dense in terms of their footprint on the ground than traditional large scale power stations. They also tend to be much further from natural centres of demand in big cities, partly because land prices are higher around cities and partly because the windiest places tend to be quite remote isolated and either high up offshore or coastal. An access factor in the UK is the role of NIMBYs in deterring many renewable projects from less isolated parts of England.

Either way, renewables end up needing more miles of electricity cables, pylons and substations to run the grid than would be needed from traditional fossil fuels. And the cost of building this infrastructure is very capital intensive. According to analysis from the Energy Bills website, the contribution of energy network costs in household energy bills has increased from around 20% in 2015 to 25% in 2025, making it one of the biggest drivers in energy bill increases. This represents a significant shift from operational costs (fuel) to capital costs (infrastructure).

Gas Boiler versus Heat Pump

The gas boiler is cheap to manufacture and easy to install, particularly for replacement jobs. For a typical home, a replacement gas boiler might cost £2,500 and in a typical year might result in a gas bill of £1,250. Retrofitting a heat pump might cost upwards of £12,000 without government grants and might result in annual electricity costs of £750, or potentially lower if the house also has a battery and/or solar PV installed.

ICE versus EVs

The most expensive component in an EV is the battery, costing upwards of £8,000-£12,000 toward the typical cost of a family-sized car. In a traditional petrol car, the equivalent is a simple fuel tank which costs around £200-£400 and holds 10 times as much energy. The cost of driving a mile in a typical petrol car - let's say a 1.5 litre VW Golf achieving 45mpg with petrol at £1.50 per litre - is around 15 pence per mile. For an identical size EV, the cost of driving that mile on cheap overnight electricity taken from the grid (at around 8p/kWh) would be more like 2 pence per mile.

Compounding - the effect on gearing

The effect of higher interest rates has another knock-on effect through the impact it has on the balance sheet of utilities and other investments in the energy sector. Debt is cheaper than equity, or shareholder money, and borrowing money from a bank enables energy investments to be done at a lower cost. However, the banks or other lenders that provide such finance have limits in terms of how much they think it is safe and reasonable to lend. And when interest rates are higher, the cost of servicing debts is also higher, meaning that a project cannot sensibly borrow as much without running the risk of running out of money and not being able to reliably service debts. This creates a knock-on effect where projects have to stump up more shareholder or equity money, which being more expensive further drives up the cost of capital on investments in the energy sector and results in higher costs to consumers or less investment taking place. You can see this dynamic playing out very clearly in the annual CFD auctions for offshore wind, which have increased from £73 per MWh in 2022 to around £103 per MWh in 2024.

Compounding - when the cause is supply side inflation

Inflation can have different causes. In 2022, the shock was largely one that started in energy and commodities. At the same time, the hangover effects of Covid furlough schemes meant a simultaneous shock took place in labour markets. For renewable projects that are capital intensive and require large amounts of both specialist labour and materials that require lots of energy such as steel and concrete, there was a perfect storm for cost inflation.

This meant that renewable projects have had to deal with cost increases from two simultaneous drivers: the cost of engineering and the cost of financing that engineering over the lifetime of the project.

It's the real interest rate that actually matters

One common misunderstanding with interest rates is to ignore the impact of inflation. If interest rates are 6% (called nominal rates), but inflation is running at 5%, then in real-terms, interest rates are only 1%. Viewed through this lens, real interest rates across the 2010-21 period were not just low, but for much of the period negative, particularly following the monetary and quantitative interventions following the financial crash, eurozone crisis, Brexit vote and pandemic.

This perspective shines a different perspective on the consequential 2021-2 period, when the reopening post-pandemic hit a massive inflationary shock. In the UK, interest rates set by the Bank of England didn't peak until August 2023 at 5.25%, by which point inflation was 6.7%. Even if 5.25% sounded like a high interest rate in nominal terms by the standards of the last few decades, it was actually -1.45% in real terms.

Since 2022, inflation has gradually slowed from its peak of over 11% in 2022, but remained stubbornly above the traditional 2% target, averaging around 4-5% through 2023-24. Despite this slowdown, the Bank of England has been extremely cautious about cutting interest rates, with only modest cuts by early 2025, leaving rates at 5.25%. This means that real interest rates have been positive and significant (around 1-2%) for over two years now - a dramatic shift from the negative real rates that prevailed for most of the previous decade.

This is particularly damaging for infrastructure investments like offshore wind and nuclear, because the upfront construction costs are financed at nominal interest rates, while the long-term returns are inflation-indexed. When real rates are high, this mismatch squeezes the economics of big capital projects, making them much harder to finance and build.

The becalming of Offshore Wind

The current state of the offshore wind industry provides a helpful metaphor for the effects of the last few years. The prolonged period of ultra-low interest rates and rising climate change concerns led to unparalleled investment in offshore wind between 2010 and 2020. There were massive improvements in the supply chain and efficiency of building offshore turbines. The size of turbines increased from around 3 MW to over 15 MW, which increased yields and reduced the number of foundations required.

Even going into the initial energy crisis of 2022, offshore wind maintained momentum. The spike in fossil fuel prices left offshore wind looking incredibly attractive, and some of the cost rises had not fully worked their way through the system yet. Interest rates had not yet peaked in real terms because inflation was high, but the market hadn't realised quite how long interest rates would need to stay at elevated levels in a bid to control the persistent inflation that had crept into the system.

New offshore wind farms bid for long-term, fixed-price contracts to sell their electricity before they start construction; the fixed price they receive is inflation-indexed and guaranteed by bill-payers under the Contract for Difference (CfD) scheme. Arguably, the high watermark for optimism in offshore wind was the CfD AR4 auction in July 2022, when 7 offshore wind farms totalling 7 GW agreed to an equivalent long-term price of £52/MWh (£37.35/MWh in 2012 prices). This price was astonishingly low; at the time, wholesale gas prices were around £200/MWh. There was a widespread optimism that the early investment in offshore wind had paid off, and that Britain was on the verge of a new era of cheap, clean energy.

Since 2022, things have gone into dramatic reverse. A number of offshore wind farms under development have been abandoned, including several that had qualified and won long-term CfD contracts. Getting to this stage is a massive investment in itself, costing £50-100 million and involving a team of 50-100 people including engineers, lawyers, environmental consultants, and project managers over 5-8 years of development work. In 2023, the CfD AR5 auction failed to attract any winning bids from new offshore wind farms - the first time this had ever happened, despite offering a maximum price of £44/MWh in 2012 prices (equivalent to around £62/MWh in 2023 prices, up 19% from the AR4 auction). In 2024, under the new Labour Government, the maximum price offered to offshore wind farms was hiked by another 40% from 2023 (£103/MWh in 2024 prices), and 3 wind farms won contracts. However, one of them, the 1.5 GW Hornsea 3 project, then pulled out only 8 months later, citing cost concerns despite the significantly higher price on offer. Another CfD auction (AR7) is expected in September 2025, however, major developers including Ørsted have indicated they may not participate unless prices increase further, highlighting the ongoing challenges facing the sector. Ørsted's own troubles - including a rights issue to raise €4 billion, political controversy over its US projects, and a share price that has fallen from over €1000 in 2021 to under €200 in 2024 - illustrate the broader financial pressures affecting the offshore wind industry.

The Case for Low-Hanging Insulation Fruit

In this environment of higher interest rates, there's a compelling argument for focusing on the low-hanging fruit - energy investments that offer lower risk and more stable returns. Rather than pursuing ambitious capital-intensive projects like new offshore wind farms or nuclear plants, policymakers and investors should prioritise technologies and measures that deliver quicker paybacks with less financial risk.

Insulation and energy efficiency improvements represent the most obvious example. While retrofitting homes with proper insulation requires upfront investment, the payback periods are relatively short and the returns are often attractive even in a high interest rate environment. While insulation savings do depend on energy prices (higher prices mean faster paybacks), the relationship is straightforward and predictable - unlike renewable energy projects that depend on volatile electricity markets and complex wholesale pricing mechanisms, energy efficiency measures deliver direct, proportional savings on energy bills. Importantly, insulation is fuel-agnostic: whether a home is currently heated by gas, oil, electricity, or will transition to heat pumps or other renewable technologies in the future, the insulation investment continues to deliver savings. This makes insulation a particularly attractive investment in an uncertain energy transition landscape.

The appeal of insulation goes beyond just financial returns - it's also remarkably simple to understand and explain. Any intelligent homeowner can grasp the basic logic: less heat escaping in winter means less energy needed to maintain comfort, which translates directly into lower energy bills. The variables are straightforward: upfront cost, annual energy savings, and simple arithmetic to calculate payback period. Compare this to the complexity of renewable energy investments, which depend on wholesale electricity markets, grid connection costs, policy support mechanisms, and technological risk. Insulation offers the rare combination of good economics and intuitive appeal.

Perhaps even more importantly, insulation creates a virtuous cycle that unlocks cheaper heat pump installations. A well-insulated home requires a smaller capacity heat pump, which costs significantly less upfront. For example, a poorly insulated Victorian terrace might need a 10kW heat pump costing £10,000-£12,000, while the same house after insulation might only need a 7kW unit costing £7,000-£9,000. The savings are enhanced because smaller heat pumps can operate at lower flow temperatures (45-50°C rather than 55-65°C), which improves their efficiency. Heat pump efficiency (Coefficient of Performance or COP) typically improves from around 2.8-3.2 at high temperatures to 3.5-4.0 at lower temperatures - meaning 15-25% less electricity consumption for the same heating output. This cascading benefit means insulation doesn't just reduce energy demand, it makes the remaining demand cheaper to meet with clean technologies.

Even if a homeowner can't afford a heat pump immediately, or faces planning restrictions or space constraints, insulation investment makes the property "heat pump ready" for the future. When the time comes to replace the gas boiler, the smaller heat pump requirement, existing radiator compatibility (or smaller radiator upgrades needed), and lower flow temperature requirements make the transition much more straightforward and affordable. This future-proofing aspect adds significant value to insulation investments, particularly in an era where heat pump adoption is accelerating but installation costs remain a barrier for many households.

Insulation Measures: Costs and Paybacks

Based on Energy Saving Trust data and industry analysis, here's how the main insulation measures compare (assuming gas prices of around 6-8p/kWh, typical of 2024 UK energy costs). The scale of opportunity is substantial - with around 28 million homes in the UK, millions could still benefit from these improvements:

Cavity Wall Insulation:

Solid Wall Insulation (External):

Floor Insulation:

Double Glazing:

Triple Glazing: