Alex Simakov is a Senior Research Fellow at Policy Exchange
Alongside immediate support for struggling households and businesses, Kwasi Kwarteng, the new Chancellor, and Jacob Rees-Mogg, the new Business Secretary, have instructed civil servants to redirect their focus towards radically reforming the energy market to drive down bills. Boris Johnson’s Ten Point Plan is out. Decoupling electricity from wholesale natural gas prices and implementation of Locational Marginal Pricing (LMP) are in. Accelerating these reforms will have far-reaching and long-lasting consequences across Britain.
Our organisation, Policy Exchange, has advocated LMP since 2020 as an essential step to managing costs and improving the performance of our electricity system. Presently, there’s a single, uniform National Price for electricity. This reflects supply and demand across all of Britain, designed for a time of large coal and gas plants located near cities. However, the approach fails to account for the significant cost of physical constraints separating sources of generation from end users, such as congestion on the high-voltage transmission lines connecting wind turbines in Scotland with consumers in London.
Managing all of this traffic on an increasingly diverse and distributed energy system is becoming painfully expensive. Collectively called ‘balancing costs’, the National Grid Electricity System Operator (NGESO) regularly incurs over £100 million per month to settle accounts. A new monthly record of £332 million set in June is likely to be broken as the energy crisis continues. LMP would help address these distortions by accurately factoring in the availability (or shortage) of local network infrastructure when pricing payments to generators and costs for consumers at different locations.
The analysis we conducted with Aurora Energy Research in 2020 found that adopting LMP would reduce system costs by £2.1 billion annually. Subsequent study by Catapult and Octopus this May increased that to £3 billion per year. BEIS’s latest consultation paper on the Review of Electricity Market Arrangements (REMA) called for a 5-year implementation, which the new Ministers are now looking to accelerate. Paradoxically, LMP could prove a greater boon for regional development than any subsidy or investment scheme the government could deliver through Levelling Up.
The reform’s foremost beneficiaries would be large consumers located in proximity to renewable generation, namely coastal communities adjacent to off-shore wind fleets such as Teesside, Aberdeen, and Merseyside, along with solar generation hubs in Cornwall and Wales. Under LMP, their current overabundance of local power would mean cheaper local electricity, providing a major competitive advantage over southern zones with relatively costlier power delivery costs. At a time of high and rising fuel prices, this discount would be a major attraction for manufacturing, heavy industry, and other energy-intensive sectors, spurring job creation and economic revival.
Inversely, LMP would expose power producers to more rational revenue streams, accounting for the capacity of infrastructure to deliver their generation instead of paying out full prices under any circumstances. Generators located near consumers or relying upon underutilised transmission lines would receive higher payments. Those in remote locations or using the most heavily trafficked lines would earn less.
These price signals would force future project developers to factor in the expense of physical delivery to customers, instead of cherry-picking the most topographically convenient locations and then leaving NGESO to recover the infrastructure costs from billpayers. Communities would likewise have a direct incentive of cheaper prices to welcome new power projects into their backyards. Opposition to local developments would be paid by foregoing the potential discount.
The economics are undeniable, but anxieties abound. Commercially, tens of billions of pounds of generation projects were developed on the premise of a National Price. A recent report highlights the tremendous legal hurdles and tortuous road to refinancing the underlying contracts under a new pricing regime. For BEIS to simultaneously reform Contract for Difference (CfD) mechanisms adds another magnitude of complexity.
The greater challenge is political. However distortive, the National Price smacks of equality. LMP improves efficiency for everyone, but some more than others. Free market principles or not, is the Government prepared to tell voters in Surrey they’ll be paying higher electricity prices than their cousins in Fife? Or will accurate price differentials be watered down to keep the political peace? Their decision will be worth billions of pounds.
Energy wonks like to equate reforming the electricity market to replacing the engine of an aeroplane in mid-flight. Let us hope that Britain’s new pilots are up to the task.