This is an extract from a recent report “South Korea’s Power Trilemma” prepared by IEEFA

Misinterpreted Energy Security 

South Korea, lacking abundant natural resources, imports about 96% of its energy supply.  The country’s resource self-sufficiency rate, including overseas energy development, was just 13.3% in 2019, significantly lower than neighbouring Japan’s 34.7%. Against the backdrop, South Korea’s energy security policies and business strategies have been misconstrued to focus on securing fossil fuels for power supply stability and affordability.  South Korea’s transition away from fossil fuels has been slow, despite ambitious targets set in its Nationally Determined Contribution (NDC) to reduce fossil fuel use in the power sector to 23.7% and increase renewable energy to 30.6% by 2036. In 2023, fossil fuels still accounted for 58.5% of the power mix, while renewable energy contributed only 9.64%.

South Korea’s investment patterns also reflect a continued emphasis on fossil fuels. From 2016 to 2021, its financial institutions invested 1.3 times more in coal than in renewable energy, contrasting with the global trend of three times higher investment in renewables compared with fossil fuels over the same period. Since Russia’s invasion of Ukraine in February 2022 disrupted global natural gas supplies, South Korea’s reliance on fossil fuels has faced significant headwinds due to high and volatile LNG prices. South Korea’s heavy dependence on fossil fuels in its power mix, compounded by geopolitical crises, has been a key factor in the surge in power tariffs. Driven by rising international LNG prices, the unit cost of LNG-fired power generation in South Korea doubled to a record $0.21/kWh in the year to November 2022, according to Korea Power Exchange (KPX) data.

Despite LNG fuel costs for power generation nearly doubling amid the energy crisis, the levelized cost of electricity (LCOE) for solar and wind power generation only increased slightly year-on-year, according to the Korean Energy Economics Institute (KEEI). Solar LCOE rose 4%-8% while wind LCOE edged up 1%-4%. Soaring fossil fuel prices, particularly LNG, due to geopolitical turmoil, also pushed South Korea’s system marginal price (SMP) to record high $0.20/kWh in December 2022. The SMP reflects the wholesale price KEPCO pays to electricity generators, and is influenced by fuel costs, operating costs and supply-demand dynamics. 

South Korea’s power market operates on a day-ahead basis. KEPCO procures electricity through the KPX, after forecasting demand and placing emergency power generation orders towards power generators for the following day. During emergency power generation orders, KEPCO prioritises using the most cost-effective power plants from GENCOs and Independent Power Plants (IPPs). Therefore, the SMP, determined by supply-demand equilibrium, is often set by the highest-cost operating power plants, typically fueled by LNG, coal or oil 

The surge in LNG prices during 2022 and 2023 has driven up fuel costs for power generation and pushed SMP to record highs due to the fossil fuel-heavy power mix, significantly affecting retail power prices despite government controls such as SMP caps and tariff freezes. These measures aim to mitigate the effect of sudden price hikes on consumers and the economy. Had South Korea swiftly transitioned its power mix from fossil fuel-centric generation under the guise of energy security, to carbon-neutral and renewable energy power generation, the surge in electricity tariffs since 2022 could have been mitigated. 

With more renewable energy deployed, more of the daytime peak demand could have been met with renewable energy, which would have reduced the need for fossil fuels and saved power. South Korea’s limited adoption of renewable energy sources hinders the full potential of solar for midday peak shaving and wind for evening power balancing. However, evidence from countries with higher renewable energy penetration, such as Australia and the United States, suggests these sources can significantly contribute to meeting electricity demand.

While it is difficult to predict the exact impact of a rapid transition to carbon-neutral and renewable energy power generation, and the impact if Russia had not upended global gas market, there is little doubt that surging LNG prices have triggered soaring LNG fuel cost for power generation, which is closely correlated to power tariffs. South Korea’s total LNG fuel cost for power generation in 2022 reached $25 billion, translating to an estimated cost of $489 per person in 2022, a 114% spike from 2021, assuming constant power generation output.

Analysis shows that reducing South Korea’s reliance on LNG for power generation by 10 percentage points from its 2022 level of 27.5% to 17.5% – bringing the country’s gas generation in line with the average among G20 countries –would have lowered LNG fuel costs by an estimated $9 billion. This translates to a potential per capita saving of about $178 a year.

Analysis estimates that South Korea incurred an additional $12 billion nationwide in 2022 due to the surge in international LNG prices following the Russian invasion of Ukraine. Furthermore, the geopolitical tensions triggered by Russia-Ukraine war are ongoing, followed by aggravating international conflicts, such as the Israel-Palestine conflict and the Houthi rebels’ attacks on shipping assets could disrupt key LNG production facilities and shipping routes. 

Potential operational shutdowns, strikes in Australia, and permit pause and delays in the US and many other various supply regions are projected to contribute to persistent volatility and instability in LNG prices and supply. IEEFA asserts that South Korea’s heavy reliance on fossil fuels for power exacerbates energy insecurity. Moreover, the high dependence on expensive and unreliable LNG within the power mix is a primary cause of the recent spikes in both end-user power bills and KEPCO’s financial troubles.

A Lack of Market Competitiveness

Competitiveness, a core goal of energy policy, has long been overlooked in South Korea. Instead, the energy policy discourse has been dominated by the prioritisation of fossil fuel-oriented energy security over the creation of a competitive and efficient energy market structure. Understanding the reasons behind the link between the lack of competitiveness in the power market structure and the mounting debt of KEPCO and higher consumer electricity bills is crucial. It is determined that South Korea’s uncompetitive energy market has caused significant financial strain on state-run energy companies, especially KEPCO, and increased power bills for ratepayers. 

Competitiveness in the energy sector is often measured by efficiency, which can be largely assessed through two metrics: 

(1) the price-to-cost ratio, or

(2) the degree of cost reduction and product innovation by suppliers. 

As efficiency increases, customer surplus grows, leading to lower utility prices and stable energy supplies. Analysing South Korea’s power market using these concepts could provide valuable insights, where the power market structure is characterised by lack of competitiveness and efficiency dominated by a few state-run energy corporations. With the exogeneous energy crisis triggered by Russia’s invasion of Ukraine, combined with the endogenous problem of inefficient power market structures and a lack of competitiveness, South Korea’s state-run power utility, KEPCO, faced significant financial challenges.

KEPCO’s unprecedented financial instability in recent years is primarily attributed to the rising SMP set by expensive LNG-fired power plants. This is a consequence of South Korea’s fossil fuel-centric power mix. The high SMPs paid by KEPCO to GENCOs and IPPs on the KPX have significantly increased its power purchase costs. However, KEPCO’s electricity sales prices, charged to consumers, haven’t risen as much as its purchase costs. Consequently, KEPCO sold electricity to retail customers at massive losses.

South Korea’s state-run gas utility, KOGAS, encountered similar financial challenges.This occurred mainly due to the discrepancy between gas sales price and the LNG purchase price. South Korea’s power pricing structure has traditionally been government-regulated to prioritise price stability, with aims of reducing the burden on taxpayers, supporting industrial production, and promoting economic growth. Maintaining low power tariff is also politically significant, particularly leading up to elections. Despite implementing the Fuel Cost Pass-Through Mechanism in 2021, intended to reflect fluctuations in fuel costs and ease KEPCO’s financial burden, the system has had limited impact. 

When KEPCO’s power purchase price surpasses the sales price, as observed in 2022, KEPCO requests tariff hikes. However, it requires approval from the Ministry of Trade, Industry and Energy (MOTIE) and the Ministry of Economy and Finance (MOEF). Additionally, the government holds the authority to postpone adjustments during exceptional circumstances, as seen during the Russia-Ukraine war. The Fuel Cost Adjustment Tariff has seen only modest adjustments since early 2022, despite the need for larger increases due to surging international fossil fuel prices, particularly LNG.

South Korea has implemented the strategy of artificially lowering the price-to-cost ratio of power tariffs to control inflation and for political purposes, as “pseudo competitiveness”. In early 2024, the South Korean government announced a freeze on energy tariffs for the first quarter of the year. Speculation suggests that this decision may have been influenced by political considerations before the upcoming general election in April 2024, as well as fiscal measures aimed at mitigating inflationary pressures. As a result, KEPCO, already burdened with debt, was unable to reflect the surge in fuel costs in power tariffs, and had to resort to issuing corporate bonds as a temporary measure to avoid financial difficulties. 

While investments in renewable energy sectors, both domestically and internationally, have been gaining momentum, the focus of many public energy companies in South Korea has remained largely on fossil fuel-based sources. This is reflected in the significantly higher renewable energy generation capacity held by IPPs compared with state-owned GENCOs and KEPCO. As of 2023, IPPs held more than 10 times the renewable energy capacity compared with GENCOs and KEPCO combined, which accounted for only 1.9% of the total national capacity, while IPPs held 19.8%. This underscores the lack of product innovation efforts by the debtors. 

Meanwhile, creditors of state-run energy companies may have less incentive to rigorously monitor these companies’ efforts to improve competitiveness and efficiency due to the perceived implicit government guarantee. This perception, stemming from past practices, has led to higher credit ratings for companies such as KEPCO and KOGAS compared with lower ratings based solely on their individual financial performance. The potential for a “double moral hazard” involving both debtors and creditors, as discussed earlier, may contribute to inefficient resource allocation, such as investments in fossil fuels that may not effectively reduce costs or foster product innovation. 

Since 2018, more than 100 South Korean financial institutions, including the national pension fund, have pledged to phase out fossil fuel investments. The increasing debt burdens of state-run energy companies such as KEPCO could necessitate further government-backed debt issuance. This creates a potential “double moral hazard” where implicit guarantees might reduce incentives for both debtors (energy companies) to prioritise cost cutting and innovation, and for creditors to conduct diligent oversight.

Conclusion: Ending the Vicious Cycle of High Power Prices

This report has examined South Korea’s power tariff trilemma through the lens of three intertwined energy policy perspectives: energy security, competitiveness, and sustainability. This analysis underscores the negative impact of South Korea’s fossil fuel-intensive power mix on energy security and power tariffs. Specifically, surging LNG prices due to the Russia-Ukraine conflict have resulted in a sharp increase in wholesale electricity prices (SMP), disrupting stable and affordable power supply. 

South Korea’s power sector faces a complex challenge due to its reliance on fossil fuels, lack of market competitiveness and delayed energy transition. These factors create a vicious cycle, contributing to rising electricity bills such as those experienced in 2022-2023. The continued dependence on fossil fuels exposes the market to price volatility, as evidenced by the recent surge in LNG prices. Additionally, the lack of competitiveness hinders efficient pricing mechanisms and innovation within the sector. Furthermore, delays in the energy transition make South Korea vulnerable to stricter global regulations, potential opportunity and externality costs.

Breaking this vicious cycle requires addressing all three elements simultaneously. Transitioning to cleaner energy sources such as renewables can enhance energy security and reduce reliance on volatile fossil fuels. Fostering a more competitive market environment can incentivize cost effectiveness and innovation within the power sector. By tackling these challenges holistically, South Korea can achieve a sustainable and secure energy future. 

While recent stabilising trends and lower global LNG prices offer some relief, geopolitical risks such as the Red Sea crisis and Houthi attacks, among other global commodity market disruptions, remain a potential source of disruption for the gas industry. These threats could persistently destabilise the global LNG market, causing renewed price spikes. The shift towards a buyer’s market amid declining prices could prompt gas suppliers to restrict supply, and potentially trigger market instability. Additionally, the diverse strategies of major producers, such as Qatar’s gas production expansion and the US’s temporary LNG export suspension, further add to the complexity of the market, contributing to potential future volatility.

The energy crisis of 2022-2023 could serve as a stark reminder of the vulnerabilities associated with a fossil fuel-dependent power mix. South Korea must acknowledge the critical importance of transitioning from its fossil fuel-dominant power mix and reducing its reliance on volatile fossil fuels. The only viable path to end the vicious cycle and achieve energy security, market competitiveness and sustainable development is to break free from fossil fuel dependence. South Korea must rapidly invest in renewable energy sources, and accelerate the transition to a clean and sustainable energy system.

Key Recommendations

• Reduce reliance on fossil fuels in the power mix and expedite the transition to clean energy sources. 

• Reform power pricing to reflect actual costs and avoid politically motivated determination of electricity tariffs. 

• Address KEPCO’s financial challenges through cost-cutting measures and innovation focused on renewable energy. 

• Accelerate the renewable energy transition to mitigate rising power costs associated with delays and achieve declared decarbonization goals.

Access the complete report here