Radical electricity market reforms ‘must be taken off the table’

“Revolutionary” reforms to electricity markets, such as locational marginal pricing or market splitting, “must be taken off the table,” trade bodies for the renewables sector have argued.

The government should instead focus on “evolutionary” improvements to existing mechanisms such as the Contracts for Difference scheme as part of its Review of Electricity Market Arrangements (REMA).

“Proposals which would introduce increased uncertainty to the market and undermine investor confidence, such as locational marginal pricing, must be taken off the table,” said Claire Mack, chief executive of Scottish Renewables.

“Only then will we be able to focus on introducing the evolutionary reforms which will secure the billions of pounds of investment required as quickly as possible to decarbonise our economy and reach net zero by 2050”.

Renewable UK economics and market manager Michael Chesser said: “Injecting further volatility and uncertainty into our energy market would have very real and very negative consequences for billpayers.

“If locational marginal pricing were to be implemented, it wouldn’t only increase costs across our whole energy system, but it would also create a bizarre regional or local post code lottery of prices for consumers, inflating bills in England especially.”

Renewable UK, Scottish Renewables and Solar Energy UK issued the warning in response to a new report commissioned by the trade associations from the consultancy Cornwall Insight.

The report says locational marginal pricing, whereby wholesale power prices would vary by location across a series of regional zones or a larger number of nodes, would create additional uncertainty over prices and volumes for renewable generators. Investors would demand higher returns to compensate them for this increased risk.

The paper cites analysis by FTI Consulting, which estimated that locational marginal pricing could raise the weighted average cost of capital (WACC) by 0.25 percentage points for assets with Contracts for Difference and 0.5 percentage points for merchant assets. It says the UK Energy Research Centre found that “many developers” are concerned that the increase could be in the range of 2 to 3 percentage points.

One of the main aims of locational pricing would be to incentivise generation to be built in locations where it is most beneficial to the electricity system, with pricing being highest in places where demand exceeds supply.

However, Cornwall Insight says there is “extremely limited evidence” to show that locational marginal pricing would provide sufficient incentives to overcome other factors such as wind and solar resources, land and seabed access, timely network access, and consent and planning permission.

The report highlights the example of the electricity market in Texas, which moved from zonal pricing to nodal pricing in 2010. It says most of renewable generation built in the meantime is located away from the state’s biggest cities of Austin, Dallas, Forth Worth and Houston in more sparsely populated areas.

The paper says the “inherent complexity” of locational pricing means developers would have limited confidence in price forecasts, further limiting any influence over siting decisions. It says these decisions are usually made many years in advance of construction – typically around six years for onshore wind and 13 years for offshore wind.

Cornwall Insight says implementing locational marginal pricing could take more than a decade, risking the achievability of net zero targets. It says Texas’ shift from zonal to nodal pricing took eight years, whilst the planned introduction of locational marginal pricing in Ontario in Canada is currently on course to take nine years.

The report says locational marginal pricing has never been implemented in a mature renewable market such as Great Britain. Previous adoptions have taken place in markets dependent on a smaller number of dispatchable fossil fuel generator. It says an estimated implementation timeframe of more than 10 years is “not unreasonable given the comparative complexity of the GB market.”

It notes that plans to introduce locational marginal pricing in Australia were recently abandoned by ministers after seven years of development due to the same concerns over investor uncertainty raised by the report.

Another option being considered as part of the Review of Electricity Market Arrangements is splitting the wholesale market into separate markets for variable and firm power. The report says this has been proposed as a solution to price cannibalisation and the resulting price volatility, with renewables in the variable market being paid according to their long-run marginal costs.

Cornwall Insight says this approach is “entirely theoretical and would likely need a lengthy development process that would be subject to some unique implementation challenges.”

Incremental changes

The paper instead proposes making “incremental changes” to the Contracts for Difference (CfD) mechanism and explores a number of options including cap and floor strike prices and locational CfDs. It identifies the best options as a cap and floor on revenues or a ‘deemed output’ CfD, whereby plants would be paid based on their potential to generate, rather than their actual generation.

Cornwall Insight says both options would help to overcome one of the main issues with CfDs in their current form – limited exposure to market and dispatch price signals.

It says the present arrangements incentivise generators to maximise their output, regardless of its value to market and whether it benefits the electricity system. This means generators have little incentive to participate in markets other than the wholesale market as any payments need to more than offset the loss of subsidies. The system operator similarly needs to compensate generators for the loss of subsidies when curtailment is necessary. Generators also have little incentive to schedule maintenance during periods when prices are low.

The report says both a cap and floor on revenues and a deemed output CfD would increase generators’ exposure to these price signals, whilst continuing to provide a degree of certainty over revenues.

“We recommend that both options be considered viable pathways for reform, combined with other granular reform options,” the report concludes. “Widespread concerns about attracting investment to low carbon generation could be allayed by the swift implementation of change – following adequate assessment.

It continues: “The more radical options presented in REMA, such as the introduction of LMP [locational marginal pricing], present a significant risk to the delivery of 2035 and 2050 net zero deadlines – LMP could take more than ten years to implement, and even longer to deliver benefits.

“LMP has never been implemented in a market as complex as GB, and investor discomfort would likely add to capital costs, ultimately driving up consumer prices and wiping out potential benefits. Attempting the introduction of a split market would see the GB electricity market operate as an experiment.”

Gemma Grimes, director of policy and delivery at Solar Energy UK, said: “Our members are very concerned about this plan. Over £200 billion of investment is needed by 2037 across the electricity sector to deliver on the UK’s climate commitments, so making energy prices more volatile, disrupting investor confidence and increasing the cost of capital at this time would be deeply unhelpful. Worst of all, it will push up consumer bills, too.”

Scottish Renewables chief executive Claire Mack said: “The Contracts for Difference mechanism will continue to be the workhorse of renewable energy deployment as we move towards the targets that will bring about a decarbonised power sector and a net-zero economy.

“The Cornwall Insight report published today demonstrates the significant potential for the CfD to be reformed while maintaining investor confidence in the UK’s energy transition.”