Locational pricing: Will it create a market of winners and losers?

The electricity industry is seriously exploring how to introduce locational pricing to the market to stimulate investment and cut costs for consumers, but what would the effect be on domestic customers, and are there ways to mitigate the risks while reaping the benefits? Lucinda Dann investigates.

Introducing locational price signals to the electricity market could result in lower bills for consumers overall by avoiding reinforcement and balancing costs.

This is because the market would send stronger signals to both generators and flexible energy resources, encouraging them to connect where they would be most profitable – benefitting themselves, network operators and in theory, customers alike.

In 2020, Aurora Energy Research produced a report for Policy Exchange estimating the average system savings from introducing nodal pricing – the most granular form of local pricing – would be £2.1 billion per year in the period 2025 – 2050.

But some customers could find themselves to be winners, and others losers, as the introduction of locational pricing to the energy market would mean a move away from the current flat wholesale price enjoyed across the whole of Great Britain.

Opinions in the industry are divided over how acceptable locational prices will be, or how far to push the concept, with several models on the table for how to reform the energy market.

The Energy Systems Catapult (ESC) has recently explored the impact on consumers of the three different options on the table, while National Grid Energy Systems Operator (ESO) is currently undertaking its own study.

Here, Utility Week explores opinions in the industry, the findings of current studies and the potential to mitigate creating a market of winners and losers.

The wider subject of the potential of location data is also covered in a new report by Utility Week, which is available to download for free here.

How far should customers be exposed?

Although there is currently a single national price for wholesale electricity, energy supplier Octopus Energy is trialling locational pricing through its Fan Club tariff.

Introduced last year, the tariff allows customers to benefit from local renewable energy production by reducing the price of electricity by 20% when their local wind turbine is spinning.

This increases to 50% when wind speeds increase about a set level.

Currently, only customers in Market Weighton, East Yorkshire, and Caerphilly, South Wales can sign up for the tariff, but Octopus is planning to invest in another six turbines before moving into solar, and ultimately plans to invest £4 billion in local renewable energy.

Octopus Energy-owned Flexibility provider KrakenFlex’s chief executive Devrim Celal believes the introduction of locational pricing is the only way to create proper markets at distribution level.

He says it would bring a whole host of benefits, including increasing storage assets in congested zones and properly informing investment decisions.

He also believes that in order to realise its  full potential, consumers should be fully exposed to locational pricing.

However, he cites its acceptability with politicians and the regulator as one of the main barriers to its adoption.

“The moment you have locational pricing some people pay more or less than others,” says Celal.

“We seem to have a barrier in the political context that accepts that bread, milk, bus tickets, a pint, and rent is different locationally but for some reason electricity cannot be.”

However, as one energy expert points out, such variations in the cost of living reflect average salaries across the country – something that would not be a factor in setting locational electricity prices.

The signs from politicians are not encouraging for locational pricing, with then minister for energy and climate change, Andrea Leadsom, in 2015 stating that “it is not right that people face higher electricity costs just because of where they live”.

In a Westminster Hall debate in 2016, the MP for Ross, Skye and Lochaber, Ian Blackford said there should be “fairness and a universal market.”

“Why should people in Scotland pay more for their electricity than people in London, and why should people in London pay higher prices for gas? It is not right. We live in a unitary state.”

Despite the position of politicians on the subject, Celal believes consumers would be in favour if the energy industry has “honest trust-based conversations with the consumer”, explaining that variations in prices are likely to be temporary as high prices will drive investment, which in turn will lower prices over time.

While Kraken is in favour of fully exposing consumers, Conor Maher-McWilliams, head of flexibility at Ovo’s flexibility platform Kaluza, believes such an approach also risks creating an overly complicated market for consumers.

“The energy market is already a difficult enough industry to understand, we need to make sure there are the right market incentives while also rewarding consumers in a way that is really simple,” he says.

Maher-McWilliams believes that managing the complexity of locational pricing should stay with suppliers rather than being passed onto consumers.

One way to do this would be to offer all consumers a single tariff which would be an average of the different locational prices across a certain area.

Suppliers would therefore make a profit on some customers and a loss on others, while the market was still receiving the necessary signals to drive investment.

The different options for locational pricing

In order to introduce locational pricing into the electricity market, the market would need to be reformed using one of three options.

National wholesale market – This model is similar to the current arrangements but with more granular network charging. This model is similar to the old pool market in England and Wales, and the markets in Greece and Poland.

Zonal wholesale market – The locational element would be largely removed from network charges, and a small number, probably around six, wholesale market ‘zones’ would be established. This is the model that is used across much of Europe including in Italy, Norway and Sweden, and also in Australia.

Nodal wholesale market – This option would see the formation of a local market clearing price at different nodes in the electrical system. The price at each node reflects the cost of energy as well as the cost of energy losses and congestion incurred in delivery. This market design is already in operation in the USA , Ontario in Canada and New Zealand.

Which option is best for consumers?

Each of the three market options have a range of pros and cons which must be considered, with key areas being how they each deliver investment signals, consumer equity, complexity for market participants, costs for consumers, price volatility and market power.

For example, nodal pricing delivers strong investment signals but at the potential expense of consumer equity, market complexity, price volatility and might create market power issues.

Meanwhile, a national wholesale market would avoid many of the issues nodal pricing could create but would not provide the strong investment signals needed.

The electricity system operator (ESO) is currently undertaking a project examining the changes to the current electricity market design which will be required to achieve net zero, including the three options for locational pricing.

The Net Zero Market Reform project, which was started in early 2021, is expected to deliver recommendations for a high-level package of reforms in April this year.

Although it has yet to deliver its recommendations, the project has already released its analysis of how well each option delivers against a set of criteria.

It has concluded that a national wholesale market would give a positive outcome for consumer fairness, with only moderate disparity between what consumers pay based on location.

Similarly zonal pricing has been deemed to give a positive outcome, with reduced average disparity in consumer costs by location but potentially greater disparity by load profile.

The ESO has decided that nodal pricing would give the least fair outcome for consumers, as it is likely to increase locational disparities in consumer costs.

However, while the ESO is still weighing up the options, nodal pricing appears to be the front-running option in the industry, despite its potential consequences for consumers.

The Energy Systems Catapult (ESC) has also explored the differing approaches and is now recommending that nodal pricing be adopted as the “first best approach” for introducing locational pricing to the electricity market.

In a report published in November last year the ESC says nodal pricing would result in more efficient location of new resources and expansion of the network.

The report makes a series of recommendations for transitioning to nodal pricing, including designing a targeted set of provisions to ensure fairness and address impacts on low-income consumers.

Senior adviser, markets, policy and regulation team at the ESC, Sarah Keay-Bright, says that transitional arrangements are needed as there will be impacts at distributional level with winners and losers.

What those impacts will be is yet to be determined, with the regulator Ofgem due to shortly announce the winner of a £350,000 contract to deliver a technical assessment and an understanding of the associated costs, benefits and distributional impacts of introducing nodal pricing to the GB electricity market.

Keay-Bright hopes part of the scope of the work will be to look at how nodal pricing was introduced in other locations, how the transition was managed and what design features are needed.

She adds that while there are ways to mitigate disparity between customer bills during a transition period, customers with large loads such as electric vehicles and heat pumps must be exposed to locational price signals.

She acknowledges though that given the current cost of living crisis, anything that is likely to raise prices for consumers is going to be an issue.

“It’s complicated, you have to distinguish between a short-term fix which would help address the immediate issues and impacts of the current price crisis versus developing a better enduring strategy for the long run.”

Despite having been considered and abandoned in Great Britain several times before for various reasons, Keay-Bright believes any risks and issues associated with nodal pricing can be mitigated and it is the best market design option for achieving net zero.

“This is the trouble with nodal and zonal pricing, we’ve discussed it in this country many times before and it’s the same old arguments that come up again and again, but I insist that you have to unpick those arguments and look at those pros and cons the next level down and beyond, because there are always going to be trade-offs, and everyone isn’t always going to be happy. There are various ways to manage downsides,” she says.

While those risks and issues could be mitigated for in nodal pricing, she does not think the same can be said for zonal pricing.

“I think it is much harder to deal with the issues under zonal pricing. ESO is doing an assessment and it says that nodal pricing is politically more difficult, but I would disagree as evidence in other jurisdictions shows how politically challenging or impossible it is to agree zonal boundaries and ensure their timely update.”

How to mitigate the effects of locational pricing on consumers

Two ideas have been put forward by researchers to mitigate the effects of locational pricing on consumers which could be used during a transition period until investment can bring more equality to prices.

In its ‘Beyond Energy Crisis” report, Policy Exchange has said that initially domestic consumers and small businesses should be able to opt-in to locational pricing for four years, which would allow Ofgem to implement any necessary mitigating measures.

However, there is the risk that only consumers in Scotland would opt-in as wholesale prices are expected to be lower there than in England, so a correction factor to average out all bills would be needed.

As part of Policy Exchange’s 2020 report ‘Powering Net Zero’, Aurora Energy Research found the average household electricity bills in the north of Great Britain could be a third lower than those in the rest of the country.

Policy Exchange said variation on this scale is unlikely to be politically acceptable, so to mitigate this a correction factor measured in p/kWh could be implemented by the government and Ofgem to bills.

The correction factor would be applied at all times of the day to maintain local price profiles, but prices in Scotland would be adjusted up and prices in England would be adjusted down.

Another option put forward by researchers at Oxford University and the University of Edinburgh is inspired by the Italian PUN, or National Single Price.

All consumers pay an average price based on the various zonal prices for each hour, whereas generators get zonal prices.

In the UK this could allow “traditional” non-flexible consumers who want to avoid price volatility to co-exist alongside “flexible” users who want to be exposed to the full effect of locational pricing.

While there are ways to introduce pricing without unfairly disadvantaging some customers, politicians will soon need to indicate what level of price variation will be acceptable if plans are to move forwards.

What is clear is for the system to run at maximum efficiency, some variation will be necessary, but a balance will need to be struck.

Find out more about how the power of location data can be unleashed in a new report from Utility Week