New realities need new forecasting models

As the energy mix changes, it becomes ever more complex – and vital – to be able to predict what wholesale power prices will do.

As the transition towards a carbon-neutral future accelerates, forecasting the power sector’s long-term outlook has never been more critical. Then again, it has never been more challenging or complex. New technologies are evolving rapidly and new business models are emerging just as quickly while society comes to terms with the reality of a low-carbon world.

Inevitably, the prevailing uncertainty raises numerous questions for utilities, investors and policymakers. For example, what role should the wholesale power market have in incentivising the energy transition? What impact will a low-carbon power sector have on household bills? Indeed, can UK plc actually afford to make this transition in the first place?

At EY, we believe a critical step towards the new world of low-carbon power involves understanding the implications of the energy transition on power prices. In the past, price forecasting was relatively straightforward, with power prices principally a function of commodity prices and economic growth. Looking ahead, accurately forecasting power prices means taking into account factors such as technological innovation, policy change, consumer responsiveness to price signals, and the role of power generation in decarbonising the rest of the economy. EY has developed a model of wholesale GB power prices that takes account of these new realities.

While the power sector remains fluid and unpredictable, our work on developing our new power price forecasting model has given us important insights into the way it is likely to evolve. One certainty amid the turbulence is that we will see a significant rise in demand for renewable generation, especially in offshore wind.

The Committee on Climate Change estimates that the UK will need 75GW of offshore wind to reach our 2050 targets – up from 8GW today. Inevitably, meeting this step change in installed capacity will be challenging. Investors are already facing concerns that the sheer volume of generation required may significantly depress average wholesale power prices, as well as the capture prices achieved by wind generators. This is because renewables are increasingly acting as the market’s price-setters and setting low or negative prices in the process.

Seizing the opportunities

However, EY’s power price forecast modelling suggests that the downside impact on market prices from significant increases in renewables will be limited. This is because both commercial investors and policymakers are likely to respond to signals triggered by low wholesale prices.

Policymakers will have opportunities to ensure the wholesale market continues to provide incentives to invest in generation. One possible option involves amending renewable subsidy schemes to eliminate the perverse incentives that currently encourage participating generators to accept negative prices.

Low wholesale prices will also create opportunities for power users with flexible requirements to embrace technologies that make use of cheap electricity. Examples include battery storage technologies, smart charging electric vehicles, and power to gas (using electricity to create “green” hydrogen for use in heating). These technologies will help to smooth power prices across the year even as generation becomes more intermittent.

However, the scale of investment required in flexible generation to manage the intermittent nature of renewables is massive. Our power modelling suggests an additional 26GW of flexible generators will be needed by 2050. It is not clear that the current structure of wholesale prices, ancillary services and capacity market prices will provide the incentives for the necessary investment in flexible backup generation. New forms of remuneration may be required in future to de-risk investment in flexibility, for instance by giving investors some certainty around long-term ancillary service prices, or setting flexibility requirements within capacity auctions.

Balancing the power mix

The work we have done on our forecasting model has incorporated a wide range of innovative technologies that could potentially play a role in a 2050 mix. Among others, these include carbon capture use and storage, steam methane reformation, electrolysers, and small modular reactors. If climate change is truly treated as an emergency, then the UK will need a supportive policy framework to reduce the risk from investing in these technologies and accelerate their deployment. But given that these technologies have yet to be demonstrated at scale, government will need to weigh the risks of making “bad bets” and creating inefficient investments or stranded assets.

Committing to the 2050 net zero target has brought us to the edge of a revolution – not only in the way we generate power, but also in the way society operates. While we do not know which pathway towards 2050 the UK will eventually follow, we do know that a carbon-neutral future awaits us. And it may be more rewarding for those best equipped to forecast it.