As the biggest state intervention in modern history to shield British households from soaring energy bills came into effect on Saturday, the focus has turned to a sweeping reform of wholesale energy markets to try to ensure there is no repeat of the crisis.
During his controversial “mini” Budget last month, chancellor Kwasi Kwarteng promised an overhaul of a system “where gas sets the price for all electricity” to one that reflects “the UK’s homegrown, cheaper and low-carbon energy sources, which will bring down consumer bills”.
The move is similar to an initiative by the EU as Russian president Vladimir Putin continues to weaponise gas supplies to western Europe.
Why do wholesale power prices track gas prices?
Pricing in Britain’s wholesale electricity market, like on the continent, is based on “short-run marginal costs”. Every electricity generator puts a bid in but the daily market price is set at the level that ensures there will be sufficient supply to meet demand. In other words, the price is always set by the most expensive plant — usually a fossil fuel-fired one — required that day.
In practice, this means gas-fired power plants, which still account for just under 40 per cent of Britain’s electricity supply, set the power price more than 80 per cent of the time, according to academics at University College London.
The system worked when Britain’s electricity system was dominated by coal, gas and nuclear but renewable sources such as wind and solar, which run very cheaply once built, are rapidly growing their market share. Renewable generation, including biomass, accounted for 43 per cent of the generation mix in 2021, according to government data.
With gas prices having increased more than fourfold since the start of 2021, consumers and businesses are therefore paying much more for their electricity than the average cost of generation across the market.
“What we have seen in the last year is that as gas prices have gone up, electricity prices have also gone up so some renewable energy generators are making very big profits. Politicians and customers are rightly asking if that’s the right system,” said Ed Birkett, head of energy and climate at the think-tank Onward.
What would any changes look like?
The main options for reform include splitting the wholesale market in two to separate out pricing for renewables, or an approach based on charging customers according to the type of generating capacity in their region, known as “locational pricing”.
There are various ways to split the market but broadly it would involve creating a separate pool for cheaper but intermittent, renewable generation, which could be extended to nuclear, and a second for traditional fossil fuel power stations that can generate when called on.
The dual approach would reduce the prices charged for low-carbon electricity by delinking them from the cost of gas.
Professor Malcolm Keay, senior research fellow at the Oxford Institute of Energy Studies and one of the architects of a split market approach, said one of its attractions is that consumers could make savings if they adapted their usage to coincide with plentiful supply from renewables.
“They could install batteries or other forms of storage in their homes or their supplier could use central storage. In future, people are going to have things like electric vehicles and heat pumps and these . . . can be designed to respond to the price at the time,” he said.
Critics point out that the split approach is largely conceptual and would be difficult to implement if the EU markets that the UK electricity system is linked to did not adopt a similar model.
“Locational pricing” is designed to address another big anomaly in the power markets: under the existing arrangements wind farms in Scotland are paid hundreds of millions of pounds a year to switch off when they are producing too much power for the local grids to handle.
The approach would require hundreds or potentially even thousands of different price points across the country to reflect local supply and demand. On very windy days in Scotland, for example, prices would plunge.
Supporters argue it would encourage investment in battery storage in locations where excess power is produced or conversely encourage energy-intensive industries to set up in regions offering cheaper electricity.
A study into locational pricing by Energy Systems Catapult, a technology and innovation centre, and supplier Octopus Energy found the approach would produce savings across all regions, although these would be proportionately greater in Scotland and the north of England.
The approach is already in use in other countries, such as Italy, but critics argue the system would result in a postcode lottery, where consumers pay vastly different prices around the country, although Birkett suggests this could be solved by applying an average national price to domestic bills.
How quickly can the market be reformed?
Estimates range between a year and five years depending on the type and extent of the reform with some energy experts warning ministers against a rushed approach.
“We have to some extent steady our nerves . . . these are by definition medium to long-term reforms options and the gas crisis is an immediate short-term issue. There is a risk to use the wrong tools to solve the problem,” said Tom Luff, senior adviser for electricity markets and policy at the Energy Systems Catapult.
What is the government doing in the meantime?
As a first step, officials are negotiating with renewables and nuclear generators to accept 15-year fixed price contracts below current wholesale market rates. Some are still on legacy contracts that pay them a subsidy on top of prevailing wholesale prices, allowing them to generate exceptional profits.
But this effort has its critics, including Labour’s shadow energy secretary Ed Miliband, who has warned the government was in a weak negotiating position and could end up agreeing to a fixed price that may be lower now but turns out to be very expensive over 15 years.
In the short-term some experts believe a windfall tax may be simpler, although prime minister Liz Truss has so far ruled this out.
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