Alternatives to locational pricing ‘fail to solve the problem’

The electricity market reforms mooted as alternatives to locational power pricing are “significantly second best or fail to solve the problem altogether,” according to a senior figure at Octopus Energy.

Rachel Fletcher, the company’s director of regulation and economics, said the electricity market is “broken” and requires fundamental change “sooner rather than later.”

Fletcher made the comments after sources told Utility Week last week that government officials have taken nodal pricing – one of two forms of locational power pricing being explored by the government as part of its Review of Electricity Market Arrangements (REMA) – “off the table”.

Under nodal pricing, power prices would vary across hundreds, or even thousands, of nodes across the transmission network, and would reflect the marginal cost of producing more power at each location.

The sources spoken to by Utility Week said the government is still open to zonal pricing, whereby power prices would vary across a much smaller number of zones.

Octopus Energy has been one of the loudest voices in the industry advocating for locational pricing in general and nodal pricing in particular. Other prominent supporters include National Grid Electricity System Operator and the Energy Systems Catapult.

Fletcher said “all of the analysis” done so far indicates that nodal pricing would be better than zonal pricing in terms of improving the efficiency of the electricity system. But she said zonal pricing would still be much better than “tweaks” to the status quo, which would all be “either significantly second best or fail to solve the problem altogether”.

She said none of the proposed alternatives to locational pricing would, for instance, resolve the issue of interconnectors “flowing the wrong way,” which is “exacerbating network constraints in the north of the country and the supply deficit in the south”.

“There is no solution on the table for getting interconnectors to flow in the right direction, not a single one,” she remarked.

Locational pricing, whether zonal or nodal, has faced mounting resistance from renewable developers and investors, who warn it would create new and complex revenue risks and in doing so increase the cost of financing projects.

Critics say its benefits have been overestimated and are not sufficient to justify the huge level of disruption that would be brought by its introduction. They argue that other reforms such as changes to transmission charges could deliver many of the benefits of locational pricing but with far less disruption.

However, Fletcher said transmission charging reform is an example of a second best solution. She said locational transmission charges only provide price signals for investment – ones which do not ultimately determine siting decisions – when the most important issue is operational price signals.

Staying with a single national power price means continuing to let assets “do the wrong thing” and then using the Balancing Mechanism to “unwind all of those operational decisions that didn’t work to keep the system in balance… rather than using the system to incentivise and drive the right behaviour in the first place”.

Furthermore, she said changes to transmission charges would bring much of the revenue uncertainty that investors are railing against in relation to locational power pricing.

In October, Ofgem gave its qualified support for locational pricing, partly based on a study commissioned from FTI Consulting, which concluded that zonal and nodal pricing could save tens of billions of pounds over a 15-year period.

In a review of the evidence base in November, Energy UK said this study and others may overstate the benefits of locational pricing by modelling scenarios with limited expansion of the transmission network, and by failing to make comparisons with counterfactuals in which there are other market reforms. In the case of the latter, Ofgem itself said more work needs to be done to assess the benefits of locational pricing in comparison to the alternatives.

But Fletcher said the current plans for reinforcing the power grid entail “a massive step up in transmission build compared to what we’ve had in the past.” She said it is a “fool’s errand” to assume these plans will be achieved given that they never have been previously and the industry is also facing global supply chain problems and capital constraints. She said analysis of the benefits of locational pricing should in fact be looking at what happens “in a world where the transmission investment we’re planning fails to turn up”.

Although they claim to prefer options such as reforms to transmission charges, Fletcher said renewable developers have “started to object to alternatives to locational pricing and are now effectively pushing back on the case for change”.

“The voices that are shouting the loudest are effectively shouting for a status quo,” she argued. “There is a risk that those extremely loud voices are able to scupper even the achievement of zonal pricing.”

She also disputed the suggestion that locational pricing is incompatible with the move towards more centralised planning of the electricity system: “They are comfortable bedfellows as long as, in doing your planning, you are open to looking at what the market is telling you.”

Fletcher said a major concern for Octopus is how long this process is now taking: “There’s a real speed dimension here that I think is really important and that is arguably not being given enough weighting in the REMA programme.”

She said the longer investment decisions are based around a single national wholesale price, the more inefficient sunk costs consumers will be locked into paying for.

If government officials want to give more consideration to alternatives before making a decision, Fletcher said they should also be having “really detailed and serious talks with renewable investors” about how Contracts for Difference (CfD) auctions would work with locational pricing, and how grandfathering could be used to protect existing renewables from the loss of constraint payments and of merchant revenues following the end of their CfD.

Fletcher said addressing these issues could help soothe the nerves of investors: “The sooner we roll up our sleeves and start talking about what that grandfathering looks like… the more you’ll start getting investors engaging in the specifics rather than fighting back and defending status quo.”

She said renewable investors have managed to survive and then thrive following other major market reforms such as the replacement of the Renewables Obligation with CfDs and will be able to do so again: “The thing that astonishes me is the fiction that investors are not are not adaptable and not innovative.”

Fletcher added that it is “extremely unfortunate” that this discussion is taking place at such a difficult point in the political cycle, meaning her current expectation is “a bit of kicking the can down the road”.