How to think about wholesale market reform: the 'Endgame'
Ministers face a brutal decision on whether to introduce zonal pricing in the UK in the coming weeks. Some reflections on how we got here and how to approach the decision...
(image from DALL-E3: ‘create a poster in the style of 'Avengers: Endgame' reflecting the debate about wholesale electricity market reform and zonal pricing debate in the UK)
A few zonal pricing thoughts for the weekend, as ministers contemplate politically difficult, contentious changes to the way electricity is priced....
First, it is more than FIVE YEARS since we at Energy Systems Catapult started our 'Rethinking Electricity Markets' programme of work. We were into better locational signals before it was cool (and Johnny-come-latelys like Octopus jumped on the bandwagon). The programme was much broader than a debate just about locational pricing (we were pushing for nodal pricing, which would still be the best choice, although sadly ruled out by Government in the UK). The various reports also talked about capacity market reform, alternatives to CFD, an overhaul of governance around codes, system operation, 5-minute settlement period and much more.
Our main report - ‘The Case for EMR 2.0’ by George Day and Sarah Keay-Bright set out proposals for fundamental reform of our electricity system that were pro-innovation, pro-consumer and fit for the much more complex power system we are moving towards (more RE, more EVs, electrified heating, digitalisation). We launched the report in March 2021 (it was still bloody lockdown, that is how long ago we have been at this - an indication on how essential the mission-style pace of action this Government has introduced will be if we at to have a chance of meeting climate ambitions). Sadly, many of the radical proposals have fallen by the wayside during the REMA process - one personal sadness about the whole four year saga is that there was not enough ‘whole system thinking’ in the debate that thought about the interactions between different elements of reform and how a full sets of alternatives packages could work together. Instead, it has become an energy death-match around one question; zonal pricing.
Don't get me wrong, I am strongly in favour of zonal; I think the evidence is compelling (and actually conservative) about its benefits (c.£50bn of benefits in the coming years; some regions with cheapest bills in Europe; no region should pay more; as well as all the benefits for flexibility and flex innovators, where the UK has a massive comparative advantage. But I suspect if you are reading this, you knew what I think on that). But there is a lot more hard, whole system thinking that needs to be done if we are to make the future electricity - and wider energy system - work (see this brilliant piece by former Catapult CTO Eric Brown, now in front of Utility Week’s paywall).
The media debate this week around 'postcode lottery' is the latest example of the woeful quality of debate about serious issues (not just energy) in the UK and part of the reason we are struggling as a country. As a recovering hack, I should not be too precious, of course. This is the game we are playing, and if you want to win you have to play what is in front of you. It is right that you have to win arguments about things like whether it is ‘fair’ that people pay different energy prices.
I think the idea that people pay different prices for different things in different parts of the country (or the world) is pretty sensible. See petrol, beer, curry. I tried to make this point in a Medium blog that tried to channel my inner Swift (now moved to Substack - A Modest Proposal to fix the Housing Crisis).
Either way, the sector has not covered itself in glory. Not enough in-person, open-minded debate (I thought the ESNZ Select Committee was one notable exception. And well done to James Wallin at Utility Week for organising a debate recently). One memory of this period is I was even booed at an Aurora debate (where I was up against Tom Glover from RWE) - a first for me in the normally genteel world of energy wonkery.
There has also not been enough effort trying to fine workable, practicable solutions for both a zonal market and a 'nationally reformed market'. I am probably part of that, which I regret. I do wonder if the remote post-Covid, very online debate makes that harder. I think Sam Alvis makes the case well this has been a poor example of how the industry needs to manage change in our changing system (although I disagree with his characterisation that the Tory Government had a pro-market view - I think the centralisation of energy policy decion-making has been largely one way for 15 years). That said, there is a lot of money at stake, so I can see why it has been hard to find consensus.
On reflection, it has been the most vicious policy fight I can remember in energy (and that includes H2 for heating). I have fallen out with friends, sad to say.... As an aside, I think Johnny Gowdy at Regen has admirably (and relentlessly) made the case for an alternative package, not just said 'zonal will kill investment; don’t do it'. You can read his alternative package here (I think he also spends a little time on Linked:In if you want to find him and argue it out). I agree with most of the proposals, which are urgent and needed, but not sure they are adequate vs the size of challenge, or fix the fundamental problems with the current markets, such as perverse incentives on the demand side for interconnectors and batteries. But they made me think about my own priors, and test my arguments and analysis, which is what good policy debates should do.
If I was in my old spad job, what would my ministerial advice be? Perhaps something like:
Our biggest political risk right now is high energy prices. There is also a fracturing consensus about net zero, in the UK and internationally. We have to provide a compelling example to the rest of the world about why this transition is the right thing to do economically, as well as environmentally.
Electricity is the backbone of our economy, and will become even more important in the future as we electrify more parts of that economy. This future system is radically different from the one we built in the last century. If we do not align our markets with the physics of the future system, it will continue to send the wrong signals to assets like interconnectors and batteries which should be helping balance the more complex, renewable-heavy grid. Right now, they are often doing the opposite. It will also mean we do not take advantage of the advantages of renewables; ie their low marginal cost. Since we can’t control when the wind blows or when the sun shines, we need market arrangements that fully incentivise other forms of flexibility to ensure the system is balanced. The current creaking of the system will just get louder if we do not make reform. In addition, rising constraint costs could create a toxic background to CP2030/Net Zero if network build does not come as planned.
The status quo is therefore not an option. We have one option on the table - zonal - which is well-established in many markets around the world and is supported by independent institutions like Ofgem and NESO, as well as, crucially, Citizens Advice. It is not particularly radical, although it is a substantive change. The analysis shows it will save money for consumers. While there are genuine debates about the analysis - they are actually not that far apart when you scratch under the surface and even the analysis of some of the strongest proponents has many conservative elements. But there are genuine risks to current investors in the short term which need to be managed through grandfathering. Again, this is nothing new, and we have managed it in the past through programmes like Electricity Market Reform. You will need to be satisfied that the current plans for that grandfathering are robust. We know that markets that do have greater locational granularity have not seen a slow down in renewable deployment. Of course, there will be an adjustment, which may create some risks for Clean Power 2030 specifically and your upcoming auctions. This change should be seen as an evolution, a directional change with clear protections for those who have made investments.
If you are satisfied with the overall case, your key secondary risks are around perceptions of a ‘postcode lottery’ and its impact on energy intensive sectors. On the former, you need to decide whether to fully shield domestic consumers, which risks reducing some of the overall benefits, but is what has happened to some extent in some other markets. I would advise making it clear that there will be different prices in different parts of the country, as there are already (and as there are in lots of other sectors of the economy), but that no regions will see their bills rise (and make the appropriate policy decisions to reflect that). On the latter, you should commit to the principles of the current ‘Supercharger’ protections where they are needed, while pointing out that many of the industries are located in parts of the country which would benefit the most from more granular signals (I would have analysis mapping zonal beneficiaries and energy intensives ready when we announce). In both cases, and the investor uncertainty, this would urge going as fast as possible to implement zonal, if you decide that approach (or indeed if you go for alternative reforms).
If you are unconvinced of the benefits because of cost of capital risks or think the risks to the upcoming auction are too great, you have two options:
You could find a way to delay. I would not advise this, as it is not clear there is much benefit to upcoming auctions and investors would be suspicious and probably price in zonal changes anyway.
Rule it out clearly. You will have to have a clear story about why this is better for consumers not to do it, and a clear plan for alternatives reforms which will solve the problems identified above (and include things like making networks charges much more locationally differentiated (ie much more expensive for Scottish generators), which may be as controversial, and less efficient, as zonal. A package of other ideas like locational or deemed CfDs, local constraint markets, reforms to the balancing mechanism will need to be driven centrally and relentlessly to avoid the go-slow by industry (which has been the case over the past 10 years on things like network charging reform). It is not clear that such a patchwork package would be less controversial or faster to implement (although some elements may be).
Politically, the Conservatives may oppose a decision to move to zonal (although their manifesto committed to greater locational signals). Reform will likely oppose, which is why showing clearly: why this will benefit manufacturing and heavy industry will be essential; and why households in every region will benefit (although some more than others). It is not right that a pensioner in Glasgow is subsidising the energy bills of a stockbroker in Surrey - that kind of narrative will be powerful. Zonal could be important for Holyrood elections next year, where a move to zonal could be a galvanising political message. Overall, this decision should be positioned as a crucial step towards lower bills.
There you go - that is what I would write. Sadly, I don’t have time to write a Boris-style alternative. Either way, a decision seems imminent. As a recovering spad, this is undoubtedly a very tough call. There is no easy, obvious path which leaves everyone a bit unhappy, although I am not as skilled as some of the brilliant civil servants in DESNZ at elegantly navigating through such minefields.
That said, if you are not in the game for this kind of decision that will shape Britain's energy system for the coming decades, there are much easier (but less fulfilling) ways to make a living...