What's wrong with the case against local power pricing?

The problem is only going to get worse. Reform is overdue.

The tide is turning against Britain’s single national electricity price. At Prime Minister’s Questions two weeks ago, PM Keir Starmer told Orkney and Shetland MP Alistair Carmichael that the status quo where Shetland’s bills are high despite hosting the UK’s largest onshore wind farm “is not acceptable.” He joins Ofgem, the Citizens Advice Bureau, and the National Grid’s Energy System Operator in pushing for change. Meanwhile, on the continent, Mario Draghi’s EU Competitiveness Report called for reform to electricity pricing in Europe to “better reflect underlying network constraints.” In other words, locational pricing.

Support for local power pricing isn’t universal however. Renewable UK, which represents the renewables industry, are opposed as they believe it will push up the costs of financing new wind and solar farms. (It should be noted not all RenewableUK members accept this analysis.) Make UK, the manufacturers trade body, and UK Steel have also spoken out against plans to move the UK to a system of zonal power pricing. Their main concern is that factories in high-demand zones could lose out and would have limited options to move. Then there are the completely understandable concerns of consumers in high-demand areas who fear their already too high energy bills will go up even further. Politicians will also be acutely concerned that local power pricing could create a ‘postcode lottery’ where some benefit more than others.

These are all reasonable concerns and they deserve answers. But, it’s important to establish at the outset the status quo is barely tolerable as it is and will come under increasing public pressure in coming years. Over the last three years, bill payers have had to collectively fork out £500m per year to pay wind farms to switch off. By 2030, wind curtailment payments could rise to £3.5bn, or £200 a household. If that happens, the political fallout will be massive. It threatens to fatally undermine public support for the shift to clean domestic power.

When we talk about the impact on bill payers and on renewable investors, we shouldn’t compare zonal, the most likely form of locational pricing, to the status quo, but rather some bolted-on solution. This might take the form of more fine-grained transmission charges or it could mean more power for the National Grid’s Systems Operator to interfere in the wholesale market. No remedy on the table is without drawbacks.

Objection 1: Locational pricing will mean investments are harder to finance.

The main argument against local power pricing is its impact on the cost of capital. Unlike gas or coal, wind and solar are capital-intensive forms of energy. Building a new wind or solar farm means incurring large costs upfront, for example, Orsted’s 3GW Hornsea Three wind farm will cost £8bn to build. But, once they’re in the ground (or sea), wind turbines are extremely cheap to run. In other words, the cost of financing is a much bigger deal for renewables (and nuclear) than it is for gas, oil, and coal where the stuff you burn is a bigger part of the cost. The recent hike in interest rates is a major reason why the last Government had to re-run its CfD auction at a significantly higher strike price.

Renewable industry incumbents, whom it must be said benefit a lot from the current system of constraint payments (to the tune of around £500m per year), argue that a move to a zonal pricing system for energy would make it harder to finance future investments in renewables. This would, in turn, further push up CfD strike prices and ultimately, wipe out the benefits of shifting to locational pricing.

Why might locational pricing push up the cost of capital? First, there’s the general risk of policy uncertainty. Will it be zonal or nodal? If it’s zonal, where will the zone boundaries be? Investors may be reluctant to invest if they’re concerned they’ll be dragged into a zone where prices are low. This is a short-term problem, but the short-term is important, particularly when you factor the Government’s 2030 Clean Power target. 

The problem is this debate won’t go away. If, as planned, renewables play a much bigger role on our grid than they do now and transmission build out fails to keep up, as is sadly likely, then large constraint payments will keep locational power pricing on the agenda. And some of the most likely alternatives to locational pricing could exacerbate uncertainty. A shift to finer-grained transmission charges, for example, wouldn’t eliminate uncertainty, but bake it in with opaque transmission charging rates constantly under review. 

Why else might locational pricing deter investment (or at least push up CfD strike prices)? Well, as it stands generators are paid both when they bid in to supply power to the grid and paid again if network constraints force the systems operator to step in and pay them to switch off. If they’re only paid for the former, then all things being equal, it stands to reason that they’ll need a higher CfD price to get over the line. But, let’s be clear this isn’t an argument against reforming the way power is priced. It is surely better to fund new infrastructure through a transparent upfront price set at a competitive auction rather than a lower upfront price supported by opaque (and uncertain) charges down the line.

The main argument, however, against locational pricing on financing grounds is that it introduces a new risk and investors require a reward to compensate for any additional risk. Imagine, for example, a wind farm developer choosing where to put a new wind farm considering a site in a transmission constrained location near demand. The problem is high prices due to a constraint may be temporary. Major investment in the National Grid may soon follow. Developers are therefore likely to discount short-term high prices given the risk. On the flipside, developers in low price regions that are likely to benefit from future grid investments may decide to hold off until grid upgrades are confirmed.

I think there’s a few responses to this point. 

First, it is not entirely accurate to say moving to locational pricing introduces a new risk. Rather, it transfers existing risk to generators. As it stands, it is consumers who pay the price for any locational risk, with no ability to reduce that risk. Nor is risk, in this case, something that it is desirable to eliminate (or socialise) altogether. Locational risk is real and pretending it doesn't locks us into bad states of affairs.  

Risk ought to be managed rather than hidden. Financial markets have developed products known as ‘financial transmission rights’ (FTRs) that allow generators to lock-in price differentials caused by grid constraints. In return for less of an upside, generators can substantially reduce their exposure to big changes in transmission constraints. FTRs are widely-used and well understood features of energy markets. Every year, tens of millions of dollars worth of FTRs are traded across the US.

Second, in most markets, businesses make investments knowing there’s a risk that complimentary investments simply aren’t made. App developers still invest in new services in the knowledge that there’s a risk that Apple might change iOS’s privacy policies or that investments in digital infrastructure (e.g. 5G masts) don't come forward. In general, few people advocate eliminating price signals in such cases to lower financing costs. Why is energy special?

Third, investment in renewables doesn’t seem to be depressed in markets that have locational pricing systems. Over the next 18 months, Texas is set to switch on 35GWs worth of renewable capacity in the next year. Despite having more than double the population, the UK only switched on 2.5GW in 2023. Per capita, this means Texas is switching on 31 times the renewable energy power. Texas, it should be noted, has the ‘freest’ electricity market in the world without the Contracts for Difference that cut risk for developers in the UK. Renewable developers RWE, Vattenfall and Orsted have over half of their renewable capacity in markets with either zonal or nodal pricing. When the Energy Systems Catapult looked at US markets, they couldn’t find causal evidence of locational pricing pushing up the cost of capital. One reason why a shift to locational pricing doesn’t appear to lead to higher financing costs is there are a number of risks under the status quo. The constraint payments under the status quo are vulnerable to both locational risks (e.g. new transmission removing constraints) and to wider market reform.

Objection 2: What about households and factories in high-cost areas?

What would ending Britain’s single national electricity price mean for bill payers? The immediate fear of politicians and, crucially, the voters they represent is that while a shift to local power pricing may mean lower bills for many, it may also mean higher bills for some. And that the people facing higher bills are likely to be angrier than those benefiting from lower bills will be grateful.

A single wholesale national price seems to imply two things. Prices are artificially high in some parts of Britain (e.g. Scotland) and artificially low in others (e.g. London and the South East). All things being equal, if prices reflected actual transmission constraints the result would be higher wholesale prices in the parts of the country where prices are artificially low and lower wholesale prices in the parts of the country where prices are artificially high.

This may make decision-makers nervous, but the mistake is to conflate wholesale electricity prices rising in some parts of the country and dropping in others with the final bill consumers pay.

The wholesale electricity price is a major determinant in the final electricity bill consumers pay, but it isn’t the only one. First, there are what are known as ‘policy costs’, which are both the costs of subsidies and regulations designed to support the rollout of renewables, but also things like Warm Homes Discount which helps poorer households heat their homes. Then there’s also the cost of building and maintaining the pylons and transmission lines that bring power to our homes, and crucially, there’s the cost of balancing the grid.

The reason we are debating locational pricing is precisely because the grid balancing part of our electricity bills is far too high and is set to grow even higher. If a shift to local pricing slashes balancing costs, as Ofgem estimates it will, then it is possible for the final bill households pay to fall in every part of the country even if the wholesale part of their electricity bill goes up.

Existing market arrangements push up costs for everyone. Moving to a system of locational pricing will reduce the need for expensive last-minute balancing actions. Ofgem’s analysis of moving to a system of locational pricing suggests that under the most likely to be adopted model, zonal households in all parts of the UK see bill savings, ranging from £28 per year in Northern Scotland to £1.70 per year in London and the South East.

If Britain went further and moved to a more fine-grained system of nodal pricing, then the benefits would be even larger, varying from £68 per year in Northern Scotland to £3 per year in London and the South East. In one scenario Ofgem modelled, which included a larger investment in the transmission network, high renewable penetration, and fine-grained nodal pricing, they found some households in London would be worse-off (by about £10 per year). 

Ofgem’s regional modelling focused on inflexible households, that is to say, households who are unable shift their energy demand around for example with a heat pump, EV, or battery. But households who can use new green tech to flex their demand would see even greater savings both because they can shift their demand to times when local prices are lower and because they use more electricity in total.

Yet, even under this extreme assumption (e.g. network build doesn’t respond to locational pricing and households are unable to shift their demand), on average households in every region of Britain see lower bills.

It is possible to protect consumers by either grouping together ‘nodes’ into larger zones for pricing – the approach New York and California take, moving to a system where consumers are able to opt-in to more fine-grained local pricing – the approach used in Ontario and a large number of US states, or only exposing some energy users, such as industrial users or those on special tariffs (e.g. EV owners). (Citizens Advice Bureau has a useful summary of the options available.) 

Ofgem’s not the only organisation to find large benefits for consumers from the shift. Analysis by the Energy Systems Catapult and Octopus found that a shift to locational pricing would generate savings equivalent to £1,000 per household from now until 2035.

While all households in all parts of the country are likely to benefit from a shift to locational pricing, some areas will benefit more than others. Some might complain of a ‘postcode lottery’. Personally, I believe in levelling up not levelling down. It feels absurd to me to deny Scottish people much cheaper energy bills because Londoners only benefit a bit.

For large energy users (e.g. factories) in high-price zones, the prudent approach may be to grandfather in existing arrangements. This may blunt some of the benefits of moving to a location pricing system, but in the case of large capital-intensive manufacturers their ability to shift their demand around is likely to be limited. Grandfathering in some of the constraint payments heavy-power users can access at their current level will still be a much lower-cost option compared with sticking with the status quo’s ever-growing balancing payments. And we shouldn’t forget that a move to locational pricing will reduce costs for many manufacturers in Scotland and the North. It might even attract new ones.

***

Just a few weeks ago, the National Grid had to switch off a staggering 6.5GW of Scottish wind power because of transmission constraints. This is just the start – as more and more renewables come online constraint payments for renewables will only grow and grow. It is clear Britain’s single national electricity price needs reform.