Locational power pricing would be ‘high risk for little reward’

Introducing locational wholesale power pricing would be “high risk for little reward,” a new report has concluded.

Any economic gains from zonal or nodal pricing would be “overshadowed by the scale wealth transfers between parties” and could easily be wiped out by higher financing costs for renewables.

Afry modelled the economic impact of locational pricing across 11 zones or 511 nodes in the Consumer Transformation and System Transformation scenarios from the Electricity System Operator’s (ESO) Future Energy Scenarios in 2022.

The consultancy said the very earliest locational power pricing could be implemented is 2028. It estimated the net benefits of zonal pricing between then and 2050 at £4.2 billion in both scenarios. It put the net benefits of nodal pricing at £4.5 billion in the Consumer Transformation scenario and £4.4 billion in the System Transformation scenario.

Afry said these benefits would amount to less than 1% of total electricity bills during the period of £466 billion in the Consumer Transformation scenario and £397 billion in the System Transformation scenario.

These estimates assume hurdle rates for new generation projects – the rate of return necessary to secure investment – increase by 100 basis points for renewables without Contracts for Difference (CfDs) and by 50 basis points for open-cycle gas turbines. Renewables with CfDs are assumed to see no increase.

Since the introduction of the scheme, Afry said the revenue stabilisation provided by CfDs has reduced the hurdle rates for onshore wind and large-scale solar projects by 120 and 100 basis points respectively.

Although renewable investors would continue to receive this protection for the duration of their CfDs, Afry said locational pricing would “increase the risk in the merchant tail.” Despite being heavily discounted when compared to the initial CfD period, the consultancy said this merchant tail can “still have a very material effect on project returns.”

The report said the estimated gains from zonal and nodal pricing could be completely wiped out if hurdle rates for CfD generators increased by 52 basis points in the Consumer Transformation scenario and 56 basis points in the System Transformation scenario.

It said a 100-basis-point increase in hurdle rates from zonal pricing would result in net losses to consumers of £8.9 billion in the Consumer Transformation scenario and £6.2 billion the System Transformation scenario.

Afry said locational markets would be more resilient to delays to transmission network upgrades but “the cost of delays would be unevenly felt – with winners and losers depending on location.

“The impact of delayed grid build is severely negative for generators who end up being held behind an export constraint for longer, with the risk of some generators going out of business because they happen to be in the wrong place. This effect is especially harsh if generation investments proceed in expectation of grid build which does not materialise.”

The consultancy said the increased complexity of locational markets could also create barriers to entry: “Exposure to unforeseen events would increase for generators in a locational market, with an associated cost in time and resources devoted to understanding and managing them.

“Furthermore, the number of active market participants is likely to decrease if the market is segmented into locations. Fewer buyers and sellers could have an adverse impact on market liquidity.”

Afry said the main benefit of locational pricing would be improved dispatch incentives, particularly for interconnectors. Lower prices in Scotland would see more power exported to Norway, whilst higher prices in the south of the UK would see more power imported from countries such as France and Belgium.

The consultancy said zonal or nodal pricing may also strengthen locational price signals for investment over the short term. But it said these signals may actually be weaker by 2035: “Longer term, and contrary to conventional wisdom, today’s national market with locational transmission network charging would provide a stronger and more robust locational investment signal.”

It said any benefits from improved investment signals could be replicated with “simple changes” to locational grid charges. Although these changes would not provide the same improvements to operational efficiency, Afry said these benefits could perhaps be replicated through time-of-use transmission tariffs and reformed charges for interconnectors.

Both zonal and nodal pricing are being considered as part of the government’s Review of Electricity Market Arrangements although it recently signalled scepticism towards such reforms. Locational pricing has faced strong opposition from some quarters, including renewable developers, although the ESO insists it is “essential,” with nodal pricing being its preferred option.

Afry noted that the introduction of nodal pricing – requiring centralised co-optimisation and dispatch of energy, ancillary services and network capacity – would be much more difficult but would provide limited additional benefits when compared to zonal pricing. It therefore called for nodal pricing to be abandoned as an option for market reform.

It said any further exploration of zonal pricing should look at ways of mitigating the associated risks.

Afry director Stephen Woodhouse said investor confidence will be vital to achieve the government’s target of decarbonising the power grid by 2035: “We do not recommend a move to a nodal market, which would be a severe departure from today’s arrangements.

“We have found rather small potential benefits of a move to a zonal energy market, but this would come with risks which could outweigh the benefits which must be mitigated if zonal markets are to be considered further.

“Alternatively, the continuation of a national energy market should be accompanied by efforts to improve operational efficiency, especially for interconnectors and plants behind constraints. We reaffirm our recommendation of evolutionary rather than revolutionary market design to maintain the pace of investment.”