Locational electricity pricing could save £30bn by 2035

Locational electricity pricing could save £30 billion – or £1,000 per household – by 2035, according to a new study from Energy Systems Catapult (ESC) and Octopus Energy.

The report, commissioned by Octopus, found that wholesale market reforms could reduce total energy system costs by around £3 billion per year through more efficient location and dispatch of generation and storage, and more efficient use of network infrastructure, including interconnectors to European markets.

ESC said the wholesale market was designed for an energy system dominated by large, centralised power stations connected directly to the national transmission network: “Under current arrangements the whole of Great Britain is treated as a single entity for trading purposes, without any consideration of physical transmission constraints.

“This simplified system no longer makes sense for a changing and more dispersed mix of generation. The result is a growing tension between the wholesale market and physical reality.”

This tension must be resolved by National Grid Electricity System Operator (ESO) which has to correct the market through balancing actions.

These out-of-market balancing actions, including paying generators to switch off, regularly exceed 50% of national demand. The costs have already risen to more than £1 billion per year and are expected to increase further in future.

The report identified a number of specific problems relating to the issue:

• Growing constraint payments to renewable generators to compensate them for foregone subsidies.
• Perverse incentives for storage and interconnectors: The single national price can encourage batteries and interconnectors to export power onto the grid, even when they are located behind constraints.
• Transmission investment is proving costly and difficult: Network reinforcement is expensive and challenging to deliver and delays result in additional costs. The current market does not help to manage demand or alleviate costs ahead of completion.
• Plans for new renewables will put more strain on the network: Under current market arrangements, project developers focus on maximising output, taking much less account of the cost of transmitting their power to market. This means new projects will impose more strain on the network and will be less likely to deliver a least-cost solution.
• Flexible demand and storage are not keeping pace with renewable investment.
• Network pricing signal are complex and too weak: Network charging arrangements have proved hugely time-consumer and complex to reform. Despite multiple revisions, they do not provide operational signals and locational signals for investment are weak (and sometimes perverse for storage assets).

ESC therefore called for reforms to wholesale electricity markets to ensure prices reflect the true balance between supply and demand in different locations in real time. It pointed out that markets in other countries have already successfully adopted this approach.

It said there are two main ways of doing this: zonal pricing, whereby the market would be split into multiple bidding zones, each with its own clearing price; and nodal or local pricing, a more granular option in which prices would be formed at a larger number of “nodes”, reflecting the marginal cost of consumption at each point.

The report said the first model, which has been adopted in places such as Australia, Italy and Scandinavia, would be better than the current arrangements, but would still require the system operator to intervene to resolve constraint within zones. It said the zone boundaries may also become outdated over time and would be awkward to adjust.

The second model, which is use in Canada, New Zealand and most of the US, would provide accurate and efficient signals for the operation and location of generation, storage and demand-side response, with market prices reflecting the physics of the transmission network. However, transitioning to this model could be costly and disruptive, and would create new price risks that could be detrimental to investor confidence.

ESC noted that the estimated saving of £30 billion by 2035 is likely to be conservative as locational price signals were modelled at a “relatively low resolution” of just seven zones when a much higher resolution could be achieved in practice.

Likewise, the modelling only estimated the savings at the transmission level and further benefits could also be realised by improving market signals at the distribution level.

Furthermore, the report said the figure does not take account of innovations that could be expected to arise as market players respond to more accurate price signals.

“If we fail to reform,” the report warned, “we risk spiralling costs to balance the system, and spending billions of pounds of customers’ money on generation and new transmission wires that are poorly located and adapted to our needs. We will have less innovation and more expensive energy for decades ahead.”

ESC senior advisor for net zero policy George Day, said: “Getting energy policy right has never been more important. Surging prices and the war in Ukraine remind us of how central energy is to our cost of living, economic competitiveness and national security.

“But our wholesale electricity markets were designed for a different age, with a single wholesale price, meaning power plants sell their electricity on a national market even if there is no demand for that power or no way of transporting that power hundreds of miles to where it is needed. This is increasingly out of step with reality in a system that is being transformed for net zero.

He continued: “The UK’s generation mix is regionally diverse – a single price across Great Britain masks the underlying reality of major variations in the supply and demand balance across regions.

“This regional variation is growing more marked as we decarbonise the grid and rely more on renewable generation located further from demand.

“Reforming our wholesale electricity markets – as other countries have already done – can unlock major benefits such as incentivising to switch to smarter, cheaper and more flexible technologies.”

Rachel Fletcher, director of regulation and economics at Octopus Energy, said: “Going green should lower energy bills for all consumers and strengthen Britain’s energy security. To get to net zero quickly and cheaply, we need to transform the energy system that was designed for a different era.

“This important report shows that radical changes to the wholesale market are needed to make the most of local green electrons when they are abundant, drive investment to places where it is needed the most and make green energy cheaper for all.”