Locational Or National Pricing: The Great Energy Debate Dividing Experts
6 min read
Do we tackle climate change via locational or national pricing? Adam Bell, director of policy at Stonehaven, explains the increasingly fraught debate that is pitting economists against each other.
When two or more energy policy geeks gather together, the conversation inevitably turns towards Texas. Not because this particular class of wonk is more disposed to big hats or second person plurals than any other, but because Texas’s electricity market represents the platonic ideal of power market design.
Market design is absolutely fundamental to how any non-nationalised power system works. Electricity is not like other commodities. One certainly could stand up in a marketplace and shout, “I will sell you sixty pounds of the finest electrons.” But one would have no way of getting those electrons to a buyer, short of loading one’s bike with batteries and peddling round every so often, like Michael Faraday’s milkman. You need a cable that crosses public – or someone else’s private – land.
And as soon as you invoke the public sphere, key questions arise. Who has the right to build these wires? Who has the right to use them? What is an appropriate method of enabling access? And when you have more than one generator – and more than one company – involved in the buying and selling of electricity, how do you possibly ensure your customers are paying for the right amount of electricity?
This is an irreducibly complex set of questions that have been solved in multiple ways around the world. The UK, since the early 2000s and the dawn of the snappily titled New Electricity Trading Arrangements, has solved the last question through a set of heroic assumptions. We assume domestic consumers fall into one of a very limited number of archetypes and charge suppliers to ensure there’s enough generation to meet that archetype’s assumed demand for power. Suppliers buy enough electricity to do so every half hour. We further assume that when a generator puts electricity onto the transmission network – the very high voltage cables that form the backbone of the system – that electricity exists everywhere all at once, and so can be bought by any supplier regardless of where their customers are. This is known as national pricing. When there is a glut of power at the national level, prices are low, and when there is a scarcity, prices are high.
This creates a number of exciting distortions, including that when a wind farm located in Scotland has sold its power to customers in England and there’s too much wind to get through the narrow set of wires linking the two parts of the grid, that wind turbine has to be switched off and a generator in England powered up instead.
Texas, by contrast, has a separate price for generators at each ‘node’ of the transmission network they’re connected to, and solves the resultant thousands of separate prices by running an algorithm every 15 minutes to find the least cost solution across all nodes to meet demand. Prices are formed by scarcity at a node, not by scarcity across the state.
Because this system uses prices to better reflect the underlying physics of the system, market design wonks adore it. It has downsides, however: an emphasis on price means generators don’t pay for extravagances like “having a roof” which led to many snowed-under gas generators freezing solid in the winter storm of 2021. Prices soared to thousands of dollars per unit, something politically unpalatable in the relatively cosseted UK.
In recognition that our market design might not be optimal, DESNZ’s predecessor in April 2022 announced the Review of Electricity Market Arrangements (REMA) to consider, amongst a range of other topics, a move towards locational pricing as in the Texan model. This kickstarted a debate so ferocious it has occasionally spilled out of the rarefied air of wonk land and into the media.
Understanding this debate is key to understanding one of the internal dynamics of DESNZ. Teams can have competing priorities and sorting between them involves trade-offs, which often have to be made by a minister in the face of advice from both teams that has been very carefully worded to avoid the impression of an argument.
The ammunition of this war has been projections for benefits to consumers, produced by the munitions houses of the big economics consultancies.
If your task is to build more renewables, you want national pricing. It’s the status quo, all our policies are based on it, and moving away from it will prompt an investment hiatus while banks figure out how price formation is going to work under the new regime. It also enables wind to continue to be built behind tighter bits of the power grid while the networks are slowly built out.
In contrast, if you want to maximise the benefits of flexibility – generators that can switch on and off, and consumers with the right assets – you want locational pricing. Prices are spikier in smaller markets, so you can make better returns. As a consequence you encourage people to take up those low-carbon technologies that have inbuilt flex like heat pumps or EVs.
Both of these objectives must be fulfilled if we are to decarbonise, but one has to lose out depending on the market design that is chosen. Advocates for each can reasonably believe that their approach will maximise our ability to respond to climate change. And so the debate has taken on the fervour of a religious war, playing out both in Whitehall and beyond.
The ammunition of this war has been projections for benefits to consumers, produced by the munitions houses of the big economics consultancies. Formerly staid economists have found themselves in the equivalent of knife-fights on LinkedIn, as there is considerable professional reputation at stake for being the firm that got the numbers right.
After thirty months of this effort, we are no closer to finding a definitive answer. The most recent rumour is that the team delivering REMA has landed firmly on locational pricing, which coincidentally is a much better outcome for their careers than spending two years and not delivering any change. At the same time, the Department for Business and Trade is rumoured to be against it, as it will likely increase prices for businesses in the South East. To answer this, the REMA team are again turning to the economists for what they hope will be a final round of numbers that will show every business in the UK will benefit.
We are now therefore in extra time, as REMA was due to conclude by the end of 2024. This final debate should be done by the summer, and one team will take away the prizes. But its sheer protracted nature demonstrates that if you want to stop DESNZ from getting things done, give them a debate where both sides could reasonably win.
PoliticsHome Newsletters
PoliticsHome provides the most comprehensive coverage of UK politics anywhere on the web, offering high quality original reporting and analysis: Subscribe
