Q3 2022: Locational pricing for Britain’s electricity?

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Dr Iain Staffell, Professor Richard Green, Professor Tim Green and Dr Malte Jansen – Imperial College London

The government is looking at whether to let wholesale electricity prices vary across the country.  This is one part of the Review of Electricity Market Arrangements (REMA) that was discussed in last quarter’s Electric Insights.  At present there is a single price for electricity across the country in each half-hour trading period, regardless of where it comes from or where it is consumed.  Changing this could make the system more efficient, but it would create winners and losers.

Several European countries have separate prices in different regions, and the power markets in the United States calculate hourly prices for the thousands of nodes on their transmission networks. The benefit of these locational marginal prices (LMPs) is that it gives generators incentives to operate in ways that do not overload the transmission system.  For example, if more local generation is needed to overcome a constraint on how much power can flow into an area, prices can rise in that area to encourage more generators online.  Similarly, areas with surplus generation would see lower prices, encouraging some stations to turn down their output.

With the nationwide wholesale prices we have in Britain, generators don’t have these incentives and National Grid must pay them separately to change their behaviour to keep the transmission system operating within safe limits.  This increases the overall cost of the system: balancing actions now add £7.50/MWh to the wholesale cost of electricity, in excess of £2 billion per year (see figure below).  As Britain progresses towards net-zero electricity, more renewable generation located far from demand will increase flows on the transmission system, and hence the risk of these costly constraints.

National Grid charges generators for using the transmission system, and varies this cost around the country to reflect how much they would have to spend to upgrade the network in each area.  These charges do not capture day-to-day changes in constraints and their impact on costs, so while they might help guide investment to the right places, they don’t help to make operations more efficient.

The cost of balancing the national grid, showing the rolling sum of the previous 12-months.

Locational prices can reduce the cost of dealing with constraints, but will increase the financial risks faced by generators. Building a new wind farm would have a minimal effect on national power prices, as it is small compared to country-wide demand.  But if it is built near an existing wind farm, it may noticeably reduce that farm’s LMPs, as it is big compared to local demand and transmission capacity.

Generators could reduce this risk using ‘financial transmission rights’: contracts that offset price differences between two points on the network and can reduce generators’ day-to-day risks without blocking the price signals. However, the risk reduction only lasts for the life of the contract; next year’s contract will cost an amount that reflects expectations of the price differences it is going to hedge, so unless someone offers very long-term transmission rights, generators could be left facing the risk of newly-built power stations undermining their revenue.

Prices don’t only vary for generators, consumers are also charged based on where they live.  Electricity retail prices in Britain are a mix of the ‘postcode lottery’ and ‘postage stamp’ pricing.  The ‘postcode lottery’ refers to variations in outcomes based on where you live; a term often used to criticise uneven delivery of public services. 

Regional variation in the amount that households pay for electricity (left), and the amount that generators are charged for providing it.

Shetland and Northern Ireland are not shown as they are not connected to National Grid’s transmission network. The Western Isles and Orkney are blank as they do not have any generators subject to national tariffs. 

‘Postage stamp’ pricing reflects the fact it costs the same amount to deliver a letter in the UK regardless of whether it travels a short distance within the same city, or from Land’s End to John O’Groats.  The former costs much less to deliver, but having a uniform national price could be viewed as part of a ‘social contract’ that guarantees everyone a similar service, wherever they live.

Each distribution network operator (DNO) has a common tariff for all domestic customers in its area, so that a household in Bristol would pay the same amount, per kWh and per day, as one in a small village on the coast of Cornwall at the end of much longer lines – that’s the postage stamp.  The level of that tariff varies between DNOs – that’s the lottery (see figure, below left).  The cost of serving a customer in reasonably flat and densely populated areas like the Midlands is much lower than the cost in North Wales, which is mountainous and sparsely populated.

While the DNOs are required to have tariffs that don’t discriminate between urban and rural customers, National Grid is obliged to make its charges cost reflective. It estimates how much extra investment would be needed to connect a new generator in each part of the country. With electricity usually flowing from the North of Scotland to the South of England, new power stations in the north would require expensive investment, while those in the south would save money (see figure, below right). The Torness nuclear station near Edinburgh pays about £20/kW per year to use the system, while Sizewell B in Suffolk pays only about £2/kW. On the current tariff, Hinkley Point C in Somerset would be paid about £5/kW, although its arrival on the system is likely to affect the calculations. 

The reverse is true for electricity consumers.  More demand in the north of Scotland would reduce National Grid’s costs, just as extra demand in London would increase them.  Taking transmission and distribution charges together, the average household pays around £200 per year for getting electricity from the generators to their plug sockets, about 5% of current bills.  There are plenty of options available for making electricity prices better reflect the different costs faced around the country.  There are pros and cons to having more or less variation, but with bills being so high, any reforms which could change how much people pay will be the subject of intense debate.

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