Published in March 2024, the Government’s second ‘review of electricity markets arrangements’ (REMA) highlighted the need to reassess the UK’s energy market in light of the shift away from fossil fuel dominance. Fundamentally, REMA seeks to identify routes to reform the UK’s markets and transport us to a decarbonised electricity system where renewables will make up the largest share of generation.
This blog examines one specific proposal within REMA, known as ‘zonal pricing’, and assesses both the risks and potential benefits of overhauling the system by introducing it.
What is zonal pricing?
Zonal pricing is a proposed reform which would split the electricity market in Great Britain into several different geographical ’zones‘, with each zone having different electricity prices based on their respective levels of supply, demand and available grid. Areas with high volumes of renewables and low demand, such as Scotland, would see lower prices, whereas areas with low volumes but high demand, such as south-east England, would see higher prices.
The Government had previous considered implementing this on a ‘nodal’ basis, but has now discounted this as an option.
What are the theoretical advantages of zonal pricing?
In theory, this market design would incentivise new electricity generators, such as onshore wind farms, to develop sites closer to high demand zones like London, where natural gas plants set the rates more frequently, and take advantage of higher prices. This could theoretically help mitigate grid constraints in the medium-term, as commercial and industrial demand, such as data centres, moves to zones where prices are low, like Scotland with its abundance of wind generation. This dynamic incentivises more efficient electricity consumption and production due to sharper price signals. In theory, this reduces the cost of the entire system, as it would help alleviate the ongoing costs stemming from an underdeveloped grid network.
What are the disadvantages?
Aside from a handful of organisations and individuals, the industry consensus is that the risks of overhauling the system in such a radical manner would vastly outweigh any potential benefits. A move to zonal pricing would significantly increase the costs of financing projects across all technologies, due to the extreme price volatility it brings and the greater potential risk for investors as a result.
The Government's own modelling suggests the theoretical benefits of a move to zonal could save between £5bn and £15bn. However, there is near consensus across developers, supply chain companies, financial institutions, and asset managers that such a large and high-risk market reform could lead to increases in the cost of capital, with an increase of 0.3% to 0.9% enough to wipe out any modelled savings to system costs. Analysis suggests the impact could even be as high as two to three percentage points, meaning the capital cost increases would dwarf any theoretical benefits of zonal pricing.
Additionally, there is limited evidence that zonal pricing would deliver the locational behaviours it claims. Factors such as wind resource, planning regulations, seabed leasing, and grid connection are all much stronger determinants of location than price, and the overwhelming sunk costs of many projects would leave them unable to respond by changing location. Offshore wind projects would not move due to their seabed lease arrangements, whilst restrictive planning laws would prevent onshore projects moving to high demand areas.
Could it be implemented quickly?
We currently need around 9.5GW of new fixed bottom offshore wind each year across upcoming auction rounds (AR6, AR7 and AR8) to achieve Labour’s target of 55GW by 2030. We are also off track in achieving 2030 targets for floating offshore wind (5GW by 2030), as well as aims to radically increase onshore wind by 2030. Calls for massive escalation of deployment ambition were echoed by the latest progress report by the Climate Change Committee (CCC), who estimated that annual offshore wind installations must increase by at least three times, onshore wind installations will need to double, and solar installations must increase by five times by 2030. Additionally, there is a need to attract investment to deliver the transmission network needed to support this new capacity.
Based on the lengthy implementation process required to establish a zonal market in Great Britain, such a radical reform is unlikely to be feasible prior to 2030. The uncertainty of such a lengthy implementation process could also lead to a hiatus of investment, further stifling development and jeopardising the new Government’s clean energy mission. The focus therefore needs to be on rapid investment and deployment, and anything that could jeopardise this must be viewed as a distraction.
So what is the solution?
Evolution, not revolution, will allow us to address the challenges of a net zero energy system without damaging investor confidence and derailing the pipeline of existing projects. A change in market structure such as zonal pricing would not address the fundamental issues stemming from inadequate grid infrastructure, and therefore represents an inappropriate risk at a time where the priority must be the rapid development of the country’s renewable energy capacity.
Any benefits gained from zonal pricing, which may be overstated and underpinned by unrealistic timelines and modelling scenarios, simply do not outweigh the risks of failing to achieve the country’s legally binding net zero targets.
Evolving current market arrangements and correcting ineffective investment signals can yield significant holistic benefits without introducing major risk to the GB market. This will also be less costly, lower risk from an investor’s perspective, and will be less likely to see delays to implementation, given much of the work is already ongoing. The primary challenge to the creation of a net zero system is the lack of delivery of the infrastructure to transport clean energy and so, fundamentally, the most impactful thing the Government can do is to build more grid infrastructure. Alongside this, other beneficial measures would include:
Improved interconnector operation with greater alignment with European system operators, more efficient trading, and improved interconnector participation in system balancing.
Reformed Transmission Network Use of System (TNUoS) charges to improve long-term predictability and reduce volatility.
Introducing constraint management markets to reducing the cost and occurrence of constraints and better utilisation of data and digitalisation in system operation.
Balancing mechanism reform by building on the principles of increased competition and transparency alongside progressing options to shorten settlement periods and gate closures.
By Nick Hibberd - Policy Analyst Economics and Markets, RenewableUK
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