This article by Simon Skillings first appeared in Energy Spectrum, hosted on the Cornwall Insight portal.
Energy regulator Ofgem has recently announced the appointment of the market operator company Elexon to ‘facilitate’ the development of local electricity markets. This is aimed at harnessing the ability of consumers to reduce their energy costs by changing the time they charge their electric vehicles or fire up their heat pumps.
Separately, the government has been running a multi-year process to review electricity markets (REMA – Review of Electricity Market Arrangements). Amongst other things, it is considering introducing different wholesale electricity prices across the country – a proposal which has triggered much controversy.
It is not clear how these processes interact. However, they should be closely aligned and driven by a roadmap to digitalise the power grid and markets to create a smart, modern electricity system.
Locational pricing explained
It is important to meet demand for electricity in the cheapest way possible. To do otherwise would waste vast amounts of money and drive-up energy bills. This means there is a cost – the marginal cost – that marks the threshold above which resources are not needed because they are too expensive. Turning this cost into a price is the way markets make sure we use the cheapest resources.
However, supply and demand are spread around the country and connected by transmission lines. We cannot always transport power from the cheapest sources to meet all demand. This means that the marginal cost will vary by location. Currently, resources plan their activities based on a single system-wide marginal price which assumes there are no transmission constraints. The system operator must then buy and sell electricity in different places to balance supply and demand based on the relevant local system marginal cost.
As more renewables are built and the power system changes, the system operator has been finding this task increasingly challenging. Put simply, its systems are not up to the job, and it often fails to buy the cheapest resources available. It has asked for help with a market rule change that would set different marginal prices in different locations. This would change how different resources plan their activities and reduce the amount of buying and selling that is needed.
Controversy
The introduction of locational marginal pricing would be a big change to the market, potentially creating both winners and losers. For example, generators based in regions with power surpluses could see reduced earnings. This has resulted in strong opposition, with suggestions that the change would stifle investment in renewable generation just when government wants it to accelerate.
Most investors in renewables receive contracts from government through various subsidy support schemes and they would be largely unaffected provided the contract price is increased to cover reduced earnings from the market. However, it is fair to point out that if the system operator improved its processes, then the market could possibly operate efficiently without any rule change being needed. The modernisation of these processes with digital technologies is without question a key imperative.
The changing energy system
Any consideration of market reform should focus on the needs of the future rather than the past or present. We are on the cusp of huge changes as more people use electricity to power their cars and heat their homes.
This will create a surge in electricity demand and lead to an increase in network constraints, many of which will be on local distribution grids. Millions of devices, such as electric vehicle chargers and heat pumps, will likely need to adjust consumption to operate when electricity is cheap and plentiful.
The current market arrangements would require centralised systems of huge sophistication to control all these devices and accommodate a multitude of consumer needs reflecting differing individual circumstances. Whilst not inconceivable, it is difficult to imagine how we achieve this outcome within a decade without imposing constraints on the way people use these devices.
The importance of innovation
Perhaps the most important consideration is to understand how market arrangements can support innovation in consumer-facing products and services that will encourage the uptake of technologies such as electric vehicles and electric heating. Electricity pricing arrangements that are simple and transparent would allow innovators to focus on understanding evolving consumer needs as opposed to trying to ‘win’ in centralised markets that require a deep understanding of complex system operational practices.
We must recognise that we are on a market design journey that is inextricably linked to a parallel journey in the deployment of digital technology. The task for REMA and Elexon should be coalesced around delivering a modern, smart, decentralised energy system and the next steps that are taken should be chosen to achieve this goal.
