Carbon Tracker makes the case for sweeping reforms to the energy market to better protect electricity prices from gas market volatility and drive down the cost of the net zero transition
As the government's review of how to reform to the power market rumbles on, fresh analysis from Carbon Tracker has today highlighted how current approach to electricity pricing is costing UK energy consumers billions of pounds.
Research published by the influential financial think tank this morning concludes wholesale power market costs would have been £7.2bn lower between January 2021 and October 2022 if the price of electricity had not been tied to the price of gas.
The analysis compares Britain's wholesale market electricity costs with an alternative scenario where power prices were calculated through a system that separates the pricing of variable renewable power connected to the grid from the pricing of other energy sources, such as gas-fired power plants.
Since the 1990s, Great Britain's energy market has operated under a marginal pricing system, whereby all electricity generators get the same price for the power they are selling at any moment. The spot, or 'marginal', price is set by the cost of the most expensive megawatt procured, which for many years has been set by gas plants, as the cost of solar and wind projects has plummeted.
As part of its response to the escalating energy costs sparked by Russia's invasion of Ukraine, the government is exploring plans for an overhaul of the power pricing system so that households and businesses can more directly benefit from the lower cost power provided by solar and wind projects.
A review of Britain's existing energy market architecture launched by former Prime Minister Boris Johnson's government is ongoing, after a consultation on how to deliver lower energy costs to consumers and maximise the energy security potential of low-carbon energy sources ended in the autumn. The government has indicated it intends to develop, refine, and narrow down its options this year.
The Energy Prices Act, which passed in October, has primed government for the shake-up. It gives Ministers new powers through a temporary 'Cost-Plus Revenue Limit' mechanism to sever the link between renewables, nuclear, and gas prices in England and Wales, in addition to a mandate to press ahead with plans to launch a new type of Contract for Difference for older renewable generators that should also serve to cut costs for energy consumers.
The marginal pricing system has been heavily criticised during the energy crisis as households and businesses have been hit with sky-high energy bills as prices have soared to record highs as gas prices have climbed. But Carbon Tracker has stopped short of calling for the existing system to be completely overhauled, warning a significant shift in design could threaten the power market's progress towards the goal of delivering a net zero emissions system by 2035 because it would introduce uncertainty over the revenues renewable power generators can expect.
The think tank said its longer-term view is for gas demand to peak and prices to decline as renewables gain market share, meaning that a move to a "split market" could end up proving to be an expensive exercise that would fail to recoup its own costs and may not be required to reduce bills in the future.
Power analyst and report author Lorenzo Sani counselled that a split market had its downsides, including the potential to weaken the business case for developing the energy storage technologies required to balance a net zero power grid.
"A split market, by effectively putting a floor on wholesale prices, removes the price signals needed to deploy the flexible technologies that can ensure the stability of a renewable-based power system," he said. "A net zero power market must provide incentives for the clean technologies that are currently struggling to be profitable. Flexibility providers - for example battery storage and demand response - will support system stability while electrolysers would take advantage of the low-price periods to produce green hydrogen to be used during cold winter days."
Instead, Carbon Tracker has recommended retaining the marginal price system but introducing measures, such as utility hedging obligations, which would reduce the impact future gas market price spikes would have on power market. The think tank has also called on the government to reform the existing Contracts for Difference system by removing loopholes that allow producers to delay the start of agreements, which can drive up power costs for consumers.
Taken together, these reforms would reduce energy consumers vulnerability to volatile gas prices as the power market decarbonises, without the major disruption and high upfront policy reform costs associated with shelving the marginal pricing system altogether, Carbon Tracker said.
After considering alternative redesign structures, including locational pricing, the analyst concluded that retaining the current marginal pricing structure, together with reform of CfD agreements, represented the lowest cost and lowest risk policy option.
The report's headline £7bn figure, however, underscores the case for progressing with some form of market reform. The analysis highlights the UK is more acutely exposed to volatile gas prices than its European neighbours, noting it is the country whose consumers are most vulnerable to spikes in fossil gas prices, alongside Italy. Under the existing system, Britain's power prices have largely tracked gas spot prices recorded by the UK's NPB gas hub, it warns, despite the grid's growing reliance on renewables projects that could deliver wholesale power at lower prices if allowed to do so.
"Our findings show the extent to which the global gas market has over the past two years skewed British power prices to levels unreflective of the technological makeup of today's generation mix," said Jonathan Sims, senior analyst and report author. "While continuing with marginal pricing for wholesale power market design is preferable to ensure significant changes do not dent investor confidence in the renewables sector at this crucial juncture, government must protect against any future gas price spikes pulling power market prices up with them."
In response to the report, the Department for Business, Energy and Industrial Strategy declined to comment on Carbon Tracker's specific policy proposal but pointed to its ongoing Review of Energy Market Arrangements (REMA), as well as its recent decision to add a levy to the profits of clean energy generators.
"We have already launched a major review into Britain's electricity market design to radically cut costs of electricity for consumers in the long term, including consulting on changes to the wholesale electricity market that would stop volatile gas prices setting the price of electricity produced by much cheaper renewables," a spokesperson said. "To reduce the burden on billpayers in the short term, we have introduced a temporary Electricity Generator Levy on extraordinary returns being made by low-carbon generators, which will help fund energy bill support for households and businesses."
However, the clean energy industry and climate experts have warned the government's levy on clean energy generators could deter much-needed investment in the renewables projects required to wean the market off volatile and expensive gas prices.
Meanwhile, there is just 12 years remaining to reach the government's target to deliver a net zero emission grid and the government is already behind its initial schedule for REMA reform. When then Businesss Secretary Kwasi Kwarteng launched the consultation in July, it said it would respond to the consultation by the end of 2022, but a summary of the 225 responses is still yet to appear. The project, like many others, appears to have been delayed by the political chaos that dominated the autumn.
Officials tasked with power system reform have a challenge ahead of them. Redesigning a power market that has been in place for over 30 years is no mean feat, but there is a growing consensus that significant reform is required to both accelerate the clean energy transition and guard against a repeat of this winter's energy price spike. Carbon Tracker's detailed analysis on how the economic benefits of decarbonisation can be more quickly and directly passed on to households is a useful addition to a complex but vital debate.
* This article was originally published here