Why are we paying wind farms to switch off while energy bills remain high? The UK’s electricity system is broken, and locational pricing is the key to fixing it. Simon Skillings draws on his experience of every stage in the GB electricity market design journey since privatisation to conclude that the introduction of locational pricing is the right solution for clean, affordable energy.
A bitter debate has broken out between electricity industry players over whether wholesale electricity prices should be set regionally rather than at the national level as it is now. Those in favour argue that it will lead to cheaper electricity, especially for people who live near wind and solar farms when clean power is plentiful. Those against suggest prices will increase for everyone since introducing new wholesale price risks will make investing in renewable projects more expensive. But history shows financial markets adapt quickly, and investment has always followed well-designed reforms.
The case for locational pricing
Everyone agrees that some change is needed. The transmission system cannot cope, and a lot of cheap renewable electricity is being wasted because there is not enough local demand. The choice is about how far reforms should go. The Secretary of State must now decide and do so quickly to ensure the flow of investment continues. Having worked on electricity market design since privatisation, I’m convinced that he should bite the bullet and support locational pricing.
A renewables-power system can be cheaper to operate than the existing electricity market where the wholesale price is dominated by the volatile cost of gas, and we must act to achieve this goal. This can only be done by harnessing the power of competition and innovation to ensure the cheaper cost of renewables reaches households.
We need to avoid the situation where we are all paying wind farms to turn off. Planning and building the right grid will help but this will not be enough. We also need to make it easy for communities across the country to use electricity when it is plentiful and cheapest. We are a long way from this consumer-focused system. Innovation in products and services will be needed. This requires a simple price signal that values electricity at every location and time, allowing innovators to focus on identifying and meeting people’s evolving needs and making the most of the cheap electricity that is available.
Lessons from past electricity market reform
Electricity market reform has been a constant feature of the energy policy and political agenda. In 2001, the Government and regulators had to step in to push through major changes after industry resistance. The original electricity pool was abolished and replaced by new electricity trading arrangements (NETA). This move from centralised control of the system to one where market participants determined their actions was a huge change – far more significant than the introduction of locational pricing that is currently being contemplated. The industry was vehemently opposed, citing adverse impacts on investment, similar to the arguments being made today. However, the financial markets were quick to adapt. They are populated by smart people who are focused on ways to make a good return on their investments. It did not take long for them to embrace the new market design and investment continued to flow.
This major change was only the start of an on-going reform process. A series of changes to the incentives on generators and suppliers have been implemented over the years, all with big commercial implications. The market adapted every time without any hiatus in investment.
Protecting consumers while driving innovation
Locational pricing is the next step on this market design journey. It comes at a time when digital instrumentation and control technologies open a whole realm of new opportunities for households and businesses. Some may not be able to take advantage, and it is important that they are not exposed to higher prices that they cannot control. Citizens Advice has set out how certain categories of consumers could continue to pay a weighted average national price. There is, therefore, no reason to use consumer bill impacts as an excuse to halt the march of innovation.
Helping those with electric vehicles and heat pumps to lower their costs will improve overall system efficiency, bringing lower prices to all. Wholesale prices form only part of the energy bill. Finding smarter ways to recover all the costs, such as those needed to operate local distribution networks, will take time. However, this is necessary to encourage the innovation that will continue to drive down bills. Locational pricing is not the end of the market reform journey but is an important step that must be taken.
The Secretary of State must be brave in the face of heavy industry lobbying as his predecessors have been in the past. Financial markets will easily be able to adapt to market reforms provided they are clearly defined. Measures are available to ensure fair outcomes for everyone, wherever they live. Above all, market reform can unleash an exciting future where new technology makes it easy for people to access cheap, clean power. Locational pricing is a critical step on that journey.
Simon Skillings was part of the team which designed the original electricity pool in the late 1980s. He was a member of the Pool Executive Committee which oversaw pool reform through the 1990s and was appointed by government to the Development and Implementation Steering Group which led the implementation of NETA in 2001. He also advised government on the Electricity Market Reform design process after the 2010 election.
