Understanding the spark gap: why gas prices impact electricity costs

The spark gap is the difference between the price we pay for each unit of natural gas and electricity we use in our homes, which is called a kilowatt-hour (kWh). Currently, natural gas is much cheaper than electricity: on average, gas costs around 6p per kWh, while electricity is priced at around 25p per kWh. This is partly due to how electricity markets work and partly because the government places a larger share of policy costs, like renewable subsidies and carbon taxes, onto electricity bills.

This price difference makes it harder to adopt low-carbon technologies such as heat pumps, despite their inherently higher efficiency - heat pumps are up to four times more efficient than gas boilers! However, despite this advantage, heat pumps are still more expensive to run because electricity costs more than four times as much as gas. Given that domestic heating is responsible for around 60% of energy use in UK homes and contributes 14% of our total emissions, resolving the spark gap is crucial if we want to transition to clean, electrified home heating and hit our Net-Zero targets.

Why is electricity more expensive than gas?

Wholesale electricity prices are still heavily influenced by the gas price. This is because although renewable energy provides 46% of UK electricity generation, gas is still the largest single source of supply and accounts for 32%. Another reason is due to how the electricity market works. While many power plants sign contracts long in advance, electricity is also traded between 48 hours and up to 30 minutes before it’s needed. This allows suppliers and consumers to account for changes in the forecasted weather and demand. 

However, the prices paid for this electricity are set by the most expensive generator needed to keep supply and demand in balance. Although renewables and nuclear power plants are cheap to run, they can't always meet demand, so costly gas generators drive up prices, especially during peak hours. As a result, any rise in gas prices, like in 2022/2023, goes straight into increasing electricity bills. This is called marginal cost pricing and is applied to about 40% of electricity sold in the UK.

Electricity bills also include a greater number of policy costs than gas bills. These added policy costs fund government programmes for low-carbon development, energy efficiency, and include support for vulnerable households. Such programmes have played a key role in reducing emissions as electricity has become much cleaner since the 1990s, when coal dominated our supply. However, these costs now make electricity more expensive, inadvertently encouraging households to stick with fossil fuels. It's ironic that policies designed to lower emissions may be having the opposite effect.

How can we close the spark gap?

Heat pumps do not need price parity to become cost effective. In fact, heat pumps only need an electricity-to-gas price ratio of around 3:1 to lower the running cost of heat pumps to less than those of gas boilers. That’s because for each kWh of electricity they use, they can produce 3 to 4 kWh of heat, in contrast to the 0.85 kWh of heat gas boilers generate per kWh of gas. That means despite costing significantly more than gas boilers, the high efficiency of heat pumps leads to them they require far fewer kilowatt-hours over their lifetime than fossil fuel heating. 

However, it is unlikely that the UK will move away from marginal cost pricing. A 2022 government review of how electricity is priced found that marginal cost pricing was effective at increasing competition and market transparency, and is not a candidate for reform. Instead, the government hopes that long-term growth in electricity generation from solar, wind, and other forms of renewable energy will reduce the ability of natural gas to determine the electricity price.

Short-term relief is more likely to be found in changing the way that policy costs are applied to electricity bills. Shifting a proportion of the costs onto gas bills could help narrow the spark gap, incentivising the move to electric heating whilst increasing the cost of gas. However, it is important that this is done in a way which does not excessively punish gas users. While the upfront cost of heat pumps is widely expected to come down over time, the significant investment needed to install a heat pump means most customers are locked in until their current boiler reaches the end of its life and may struggle to make this investment.

Instead, another option is to shift a proportion of the policy costs onto general taxation. While this would increase fiscal pressure on the government, these costs could be shared more equally across society and remove barriers to adopting low-carbon heating. Although short-term costs could increase in some areas, incentivising the shift to low-carbon heating will reduce the risk of misguided investment and help meet emissions targets in a more cost-effective way.