E-FWDThe E-FWD logo.

analysis

Locational pricing and the revenge of geography

Government deciding to push ahead with the construction of new gas-fired capacity has been the main thrust of this week’s announcements. So far, so expected.

But talk of a move to potential “locational pricing” serves to highlight just how the electricity market must change to enable the energy transition.

Secretary of State for Energy Security and Net Zero Claire Coutinho set out the plans at Chatham House. The government is sticking to its goal of reaching a “net zero” power system by 2035, but to do so requires keeping fossil fuels in reserve, she said.

“We know that with around 15 GW of gas due to come off the system in the coming years, we will need a minimum of 5 GW of new power to remain secure. That might mean refurbishing existing power stations, but will also mean new unabated gas power stations until clean technology is ready,” she said.

Real world complexity

The minister clearly felt there were political gains to be made in such discussions. Countinho talked of a need for realism and “common sense”. Prime Minister Rishi Sunak, in the statement, said there was a need for “tough decisions”.

Algerian LNG tanker visits the Isle of Grain
The Lalla Fatma N’soumer LNG tanker. National Grid.

Coutinho went on to say that Labour Party talk of decarbonising power by 2030 was “pure politics”.

Leader of the opposition Keir Starmer’s plans were “for a made-in-China energy transition, but I want one that is made in Britain”, Coutinho said. “That’s made in Teesside, in Cornwall and Aberdeen and everywhere in between.”

Cielo Energy’s Stuart Lloyd-Evans noted the political drivers around the topic of power. “There’s been a lot of rhetoric in the last few years, while much of the REMA work has focused on economic purity. This is the start of a recognition of real world complexity,” he said.

Building out alternatives

Labour, in its response, said there was a clear need to replace retiring gas-fired power plants as part of a decarbonised energy system.

Shadow energy secretary Ed Miliband said the Conservatives were “specialists in failure when it comes to our clean energy future: persisting with the ludicrous ban on onshore wind, bungling the offshore wind auctions, and failing on energy efficiency”.

Gas demand has been trending downwards for some time now. “A few years ago gas generation could operate around 80% of the time, now it’s around 50%. Within a few years it will be down to 20%,” the Cielo official said. “Hinkley C was supposed to be operational five years back – so there’s a gap that needed to be filled with non-intermittent generation.”

Aurora Energy Research senior associate Tom Smout highlighted the difference between capacity and generation.

“You can build new gas capacity and get fewer emissions, if you also are effective at building out CCS or nuclear or renewables,” Smout said. Progress on building out these other decarbonised power plans will have a greater impact than additional gas plants.

Pricing reform

This political blustering, though, overshadowed discussions around locational marginal pricing (LMP). 

Coutinho said that central to “everything that we do in energy” is to keep bills down and the lights on. “Bills are most people’s only experience of the energy system. It’s through costs that people will judge our success and that’s why we’re leaving no stone unturned to cut bills.”

As such, she said, the department was launching the next phase of the Review of Electricity Market Arrangements (REMA) to consider factors including locational pricing.

Describing it as the “biggest electricity market reform in a generation”, the minister said REMA was keeping zonal pricing on the table.

“This is a potential supply side reform which would encourage companies to build infrastructure closer to where energy is needed. It would mean our energy system would be smaller and more efficient and less energy infrastructure would be needed overall, leading to lower costs for consumers.”

Other places that have already taken steps in this direction are Norway and Denmark, she noted. A move to zonal pricing could provide savings of up to £45 per year per household.

Coutinho stressed the link between zonal pricing and cutting bills. Improving the energy system – making it “smarter” – can reduce peak demand by up to 11%, she continued, commenting on work to shift demand to when power is cheapest.

Zones to the fore

Zonal pricing is an attractive option economically, as it will maximise efficiency. However, it would also have the impact of increasing prices in areas that have less generation capacity. In areas with more power capacity, prices will fall.

“In terms of having a wholesale market that functions well, a move to a zonal pricing system is probably a move in the right direction,” Aurora Energy Research senior associate Tom Smout said.

The move would fragment the market into smaller areas. “But at the same time, it really solves a lot of issues with the balancing mechanism where the lack of liquidity has become a real problem for market settlement. To put it bluntly, at the moment, the wholesale market is working much better than the balancing mechanism.”

Lloyd-Evans of Cielo said there was a lack of liquidity in the wholesale market. He warned “breaking prices into areas, there will be even less liquidity”.

A move to location pricing “runs the risk of seeing English taxpayers subsidising Scottish taxpayers, as everyone pays the same subsidies for renewables to be built. I would lean towards [location pricing] not happening. It would have massive ramifications,” Lloyd-Evans warned.

Smout noted the inverse problem for a single power price. “If you live in the south of England, you benefit from the fact that there’s a single national electricity price, and if you live in Scotland, then you face higher costs for it.”

Consumers, in general, would prefer mid-term certainty on pricing, Lloyd-Evans continued, rather than chasing short-term price settings. He pointed to “large industrial market still using flat-priced products 25 years after it opened”.

Time shifting

Another aspect of a move to variegated pricing would be shifting demand in the day. Alastair Martin, chief strategy officer of Flexitricity,

“Geographical pricing, fundamentally, is a particular form of temporal pricing. The point is that in your area, prices vary with time, in accordance with the renewable resource that’s available in your area right now. That is a nuance that’s missed,” Martin said.

There is scope for demand to shift in transport and domestic heating, he explained. There are 18 million homes in the UK with a drive or garage, Martin said, which could house an EV charge point.

Should 18 million EVs be charging for 10 hours a week, that demand comes to around 120 GW. “The grid has never transmitted more than 61.3 GW. Those customers can be a massive supply problem – or a massive balancing resource.”

Martin said heat pumps with the ability to store heat would also play a role in balancing demand and supply.

Planning power

Countinho raised the prospect of increasing efficiency by targeting higher-demand areas.

The Conservatives have been hesitant in the past to encourage, for instance, onshore wind turbines. A move to zonal pricing would provide more incentive to build in areas under served by generation, perhaps most notably the counties around London, rather than in less densely populated Scotland.

Such a move might face resistance from Conservative heartlands in the southeast of the UK, which have typically pushed back against construction of wind turbines and solar plants.

However, Labour has talked of its plans to reform planning restrictions. Miliband has said that, if elected, he would ease the path for onshore wind projects on his first day in office.

There may be a degree of industrial relocation, but such decisions are a sum of various different factors, including access to workers, customers and transport links. Power prices alone will be unlikely to shift projects, at least in the short term.

Relocation

There would be some impact around new plans, Aurora’s Smout said. He cited the instance of hydrogen production, which could shift to areas with low power prices.

“My concern is that it then also puts hydrogen far away from offtake. Right now, for the hydrogen industry, finding offtake is the number one bottleneck. I think that hydrogen production will be very heavily driven by offtake requirements.”

Existing generating assets may benefit. “There are definitely winners and losers, like dispatchable assets in the south will be happy and dispatchable assets in the north will be unhappy,” Smout said.

Martin, of Flexitricity, said the idea of project relocation was not “particularly credible”. However, what it may drive is a recalibration of project timing plans. “You can emphasise wind farms in the southern North Sea over the northern North Sea – and actually that’s what the wind industry has already been doing.”

Interconnection drivers

Underscoring all the discussions on flexibility is the importance of the grid. Regulators have taken steps to overhaul the queue for projects to connect up and major projects are making progress.

At the beginning of the month, for instance, SSE Transmission and National Grid reported the signing of contracts for the Eastern Green Link 2 (EGL2). This 2 GW HVDC subsea link will run from Peterhead to Drax and is due for completion in 2029.

“That’s the exciting bit, opening up market access and allowing participants to genuinely bring their megawatts to market,” Martin said.

Changes to pricing structure, and new gas capacity, cannot skip the need to build more grid, Smout said. He noted the pace of change had been too fast for the market to react.

“There is just a need to build a lot of grid infrastructure. We’ve run up against the limits of what you can do without building more grid. Ultimately, the grid that we have is about 60 years old, and it reflects the realities of the energy system as it was then, and the grid that we’re trying to get to reflects a very different energy system.”

North Sea Link. National Grid
North Sea Link. National Grid

Taking this a step further, Smout pointed to the import of power internationally. Power imports from Norway are triggered by the wholesale price, even when the transmission system may not be able to allocate the input.

A location price in Northumberland, for instance, might deter such imports – and may even trigger exports.

Tough choices

Energy policy must always find a way between striving for maximum efficiency, as seen by economists, and political acceptability. Locational pricing may be one of the tools in the government’s kit, but there is no getting away from the need for more construction.

Confirming the plans for new gas plants is a first step that the government can take. The move was lambasted by environmental NGOs, but politicians can see this as a necessary move. Building out the grid – while similarly accepted – may run into more localised community challenges. Whichever party is in power come 2025, they will need to pay serious heed to securing local support, or further risk the UK’s net zero plans.

Related Content