Wholesale electricity market is ‘no longer fit for purpose’

The wholesale electricity market is “no longer fit for purpose” and, if left unchanged, will impose excessive and unnecessary costs on consumers, National Grid Electricity System Operator (ESO) has warned in a new report.

The ESO said the current market design, based on a blanket national wholesale price for electricity, is contributing to a dramatic rise in constraint cost and inefficiencies in balancing the power grid, whilst also undermining the delivery of demand-side flexibility.

In some cases, the body said national pricing can create perverse incentives for flexible assets, worsening network constraints.

The ESO said its favoured option for reform is “nodal pricing” combined with central dispatch. The transmission network would be divided into different nodes, each with their own wholesale electricity price which reflects the cost of supplying electricity at that location.

The body said this would create opportunities for low-cost, low-carbon electricity to be harnessed when and where it is abundant, contributing to lower overall electricity prices for consumers. It would also facilitate the efficient management of the electricity system, incentivising the optimal location and operation of flexible assets.

“Incorporating locational value into the wholesale energy price through nodal pricing enables congestion to be resolved as part of the market clearing process rather than by the system operator via redispatch,” the report explained.

“This delivers considerable efficiency and innovation benefits. It also shifts some financial risk to market actors that are best placed to manage it.

“Evidence shows this would provide value for money by enabling more efficient utilisation of existing infrastructure, particularly flexible assets, substantially reducing Great Britain’s network congestion costs in operational timescales.

“Over time, substantial whole system cost savings and benefits would be realised through more efficient siting of generation, storage and demand as well as reduced network build.”

Regarding its preference for central dispatch, the report stated: “When Great Britain’s self-dispatch model was originally introduced, ESO’s role as residual balancer was expected to reduce. The reverse has been happening over the last decade as ESO redispatches an increasing proportion of the market but without the appropriate market infrastructure and tools.

“The status-quo self-dispatch design does not appear to be an enduring solution for a net zero future without substantial investment or reform.”

It continued: “The capability of nodal pricing combined with central dispatch to unlock major efficiency savings is synergistic, with nodal pricing enabling markets to coordinate supply and demand at each node and central dispatch enabling balancing of the system as a whole using the full diversity and capabilities of available energy resources.”

The ESO also considered a “zonal pricing” model in which the transmission network would be divided into zones, each with their own wholesale price.

It said this model would deliver many of the same benefits of nodal pricing but to a much lesser degree and would also present its own problems: “Zonal pricing would not be an efficient and enduring solution, as the fast-evolving nature of the GB electricity system would require zone boundaries to be both granular and adaptable to changes in congestion dynamics. This would be highly challenging to achieve and would add significant regulatory risk to market participants.”

The ESO said its proposed model of nodal pricing and central dispatch would require legislative and regulatory changes but could be credibly implemented within five years.

The report was produced for phase three of the ESO’s Net Zero Market Reform programme.

Cian McLeavey-Reville, senior manager for markets development at the ESO, said: “This landmark study, which captures a wealth of ESO and industry insight, sets out how we can design flexible and efficient electricity markets that can deliver net zero at the lowest cost to the consumer.

“The options presented today lay the groundwork for a future energy system which is secure, reliable and offers value for money. We must transform our markets, not only to encourage renewables onto our energy system but also to ensure that clean energy can be delivered when and where it is needed for maximum consumer benefit.

“Markets are one piece of a broader picture and cannot be looked at in isolation from holistic network design and capacity adequacy – they must be structured to incentivise dispatch and investment decisions critical for clean energy and consumer value. Electricity market reform is an ambitious, complex endeavour and working together with our newly-formed Markets Advisory Council, industry, government and regulatory partners, we can make it happen.”

The next phase of the programme will assess the implementation and implications of nodal pricing and central dispatch, including what complementary market reforms would be required. It will also investigate stakeholder concerns such as how nodal pricing would affect different cohorts of market participants and to what extent different consumer segments should be exposed to locational price signals.

The ESO said it will additionally support Ofgem with its technical assessment of locational market options and the Department for Business, Energy and Industrial Strategy with its Review of Electricity Market Arrangements.

A recent report from Octopus Energy and the Energy Systems Catapult concluded that locational electricity pricing could reduce electricity system costs by £35 billion by 2035.