British politicians have been teasing for months the need to de-link the price of power from the cost of gas. This summer, we got our first look at how they intend to do it.
The fundamental challenge is that power prices, as in most markets, reflect the marginal cost of production. In Britain, more often than not, that means the price of gas-fired generation. With eye-watering gas prices in Europe at present, consumer electricity bills have skyrocketed even as more and more power is coming from renewable sources.
There are good reasons, believe it or not, that commodities are priced at the margin. Most obviously, if consumers are offered power at a lower price and therefore opt to consume more, then this additional power will cost the marginal price to generate (more gas please). This leads to some rather awkward questions as to who should pay for this generation and, more generally, can lead to inefficient outcomes.
So how can the government get prices down? Well, in July the British Government launched its much-awaited Review of Electricity Market Arrangements (REMA), an open consultation to explore possible options.
Charitable commentators will highlight the Government’s early engagement with stakeholders and willingness to embrace radical reform. Critics will point to proofing oversights as evidence of rushed drafting and half-baked ideas. However, regardless of your political persuasion, the consultation leaves nothing off limits in terms of the scope of possible reform. From centralised nodal pricing to local energy markets and everything in between, no element of the current market design is off the table.
Perhaps most interestingly, the consultation document highlights “the main approaches” the Government is considering to tackle the challenges facing the current market. These include:
- "splitting the market into separate markets for variable and firm power;
- introducing locational pricing, either zonal or nodal;
- reorienting the market towards the distribution network (‘local markets’); [and]
- moving to pay-as-bid rather than pay-as-clear pricing”
To be clear, each of these changes would reflect a radical rethink of how the British (and European) power market has been organised to date and will doubtless trigger considerable debate. However, to give one a sense of just what is being envisioned, it is worth looking in more detail at the first of these proposals: splitting the market into separate markets for variable and firm power.
As made clear in the consultation document itself, this change would entail implementing a totally novel market model, for which there is no known existing counterpart, and fundamentally redesigning both the nature of the product (electricity) and the markets underpinning it.
The key concept, seemingly drawn from a 2017 paper, is to define two new commodities to replace electricity as we currently know it. Specifically, the current power market would be replaced by distinct markets for ‘variable power’ and ‘firm power’.
Variable power, alternatively called ‘as available power’, would include power generation that is non-dispatchable—i.e. which cannot be generated to a specified profile. This would include a range of renewable generation technologies like wind and solar. Firm power, in contrast, would cover power that can be dispatched more or less at will, like gas-fired generation.
Splitting the market like this offers the tantalising possibility of distinct pricing for renewable generation or, in other words, a means to avoid paying wind generators for the cost of gas.
The concept paper cited by the consultation document suggests that the price for variable power will reflect the long-term costs of the relevant generators, thereby overcoming the problem that many renewable generation technologies have marginal (fuel) costs that are close to zero. In contrast, the firm power market will look somewhat similar to the current power market, with prices reflecting the marginal costs of generation.
Suppliers (or consumers) would then buy some combination of firm and variable power. Exactly how the variable power market would work is far from clear. Even the referenced concept paper, described by the consultation document as “the most detailed proposal of this kind”, is forced to rely on a fair amount of handwaving. However, the key implication is that variable power is bought with a risk of non-delivery, for example when wind speeds are low. In such cases, suppliers and consumers will need to either reduce demand to match available generation or possibly purchase more firm power to compensate.
A range of practical questions present themselves at this point. For example, if consumer demand for variable power exceeds supply, how is the available supply distributed among consumers? If prices for variable power are lower than for firm power, what penalties or additional costs limit consumers’ demand for low-cost variable power? If the price of variable power can rise to prevent excess demand, what will stop that price from simply rising to equal the cost of the firm power?
As may be obvious by now, the two-market concept arguably begs more questions than it answers. Of course, all designs have to start somewhere and it would be unreasonable to expect the government to come with a fully formed proposal. However, a lot of thinking will be needed before a two-market model could be implemented.
Perhaps the best way to think about these issues is as the government’s desire to incorporate within the market design a sort of massive multi-project Power Purchasing Agreement for low-marginal cost, low-carbon generation. Consumers will effectively pay in something reflecting long-term generation costs and be credited with some uncertain stream of low-marginal-cost generation. In this respect, these proposals are not so far removed from the German government’s consideration of a collective power financing/purchasing mechanism for industry.
It might be argued that British consumers are already effectively doing this under the current Contract for Difference arrangements. Although the transfers are financial rather than physical, supported wind generators already have to pay back the money earned on higher-than-expected power prices.
There are some fundamental tensions underpinning these initiatives that are going to make for challenging policy design. Most obviously:
- How do you pay for massive investments in low-carbon generation while keeping consumer bills down, and
- How do you keep prices down while still encouraging energy efficiency and demand-side flexibility?
The Review of Electricity Market Arrangements is a call for a radical rethink on how to address these challenges and therefore an exciting opportunity to try and come up with some answers.