The power system challenge for the new government: Review of Electricity Market Arrangements

The market reform journey
We have been on a constant journey to improve electricity trading arrangements since the industry was privatised in 1991. Initially, the task was to work out a wholesale price which ensured the cheapest cost generators were used to meet electricity demand – the so-called system marginal price.
The renewal of the energy system required to reduce emissions placed a much greater importance on the costs of investment for assets such as wind and solar generators. The government responded in 2013 by introducing mechanisms to lower investment costs by reducing revenue uncertainty (feed in tariffs followed by contracts for difference and capacity mechanisms).

New challenges
These changes worked well whilst the proportion of renewable generation was relatively low. However, as renewable generation increases, it is necessary that renewable generators respond to market conditions to help the system operator balance supply and demand efficiently. Separately, the simplified calculation of system marginal price, whereby a single number is assumed for the whole country, is proving increasingly inappropriate. True system marginal costs vary significantly between locations and the signals provided by a single price are causing increasing difficulties, and costs, for the system operator.
A Review of Electricity Market Arrangements (REMA) was initiated by government primarily to deal with these emerging challenges. After two years it has reviewed many options for market reform. These have now been narrowed down and are being taken forward for more detailed appraisal. Much of the (often vociferous) debate has related to a proposal to replace the single system marginal price with several that vary by location. Opponents have argued that this will inject uncertainty and halt investment, just when this needs to accelerate. However, these concerns are misplaced. Mechanisms are available to insulate producers and consumers from these prices if that is deemed necessary to lower investment costs or control the impact on bills. With more accurate price signals in place, future policy makers can decide what level of insulation is appropriate given the challenges of the day,
It is now more important than ever that the market reveals accurate system marginal costs. System efficiency is no longer just about ensuring the operation of the cheapest generators. A renewables-based system requires that demand and generation are co-ordinated to make the most of the cheap electricity that is available. Accurate system marginal prices will be necessary to ensure this happens.

Delivering outcomes
Perhaps the biggest deficiency in the REMA process so far is that it has failed to recognise the impact that market design plays in supporting outcomes aligned with decarbonising the power system at pace. Government sets targets, and markets must be in place to ensure the right assets are procured and the system operates efficiently.
Current government targets will require renewable generators to be built at a rate that will test the limits of the supply chain, and a potential future Labour government may be even more ambitious. In this situation, competitive allocation of contracts could lead to very high prices or, perhaps more likely, a scale-back of ambition and failure to achieve the desired outcomes. Some form of open book regulated procurement, or even direct government investment, seems more appropriate to meet the challenge of rapid deployment. However, in the absence of a clear plan to deliver power sector decarbonisation targets, the REMA process has only considered a continuation of the current contract allocation process.

Local markets
A second problem is that many of the changes associated with the power system transformation are happening in homes and businesses. For example, increases in demand through the electrification of heat and transport, and the deployment of small-scale renewable generation. Distribution system operators, who run the local power networks, are developing their own markets to ensure they can operate their systems effectively, including by using demand side response. It is a matter of urgency to establish how national and local markets should combine, whether they are attracting the investment needed, and if the correct market signals are in place to minimise overall system costs.
REMA has spent too much time agonising over locational pricing. A laser-focus on achieving outcomes and providing government with options to manage impacts on bills is needed to put the process back on track. The National Energy System Operator is expected to produce a Strategic Spatial Energy Plan in 2025. This will define the key market outcomes that must be delivered. REMA conclusions must be published alongside this plan to demonstrate how these outcomes will be delivered. The consistency of these initiatives will be critical if the power system transformation is to succeed.

Simon is Director of Trilemma UK and a Senior Associate at E3G. He has worked in the power industry since before privatisation, including 5 years as Director of Strategy and Policy at E.ON UK. His recent work has focused on supporting climate think tank E3G deliver on its goal to translate climate politics, economics and policies into action

Further reading
See New Power’s interview with NESO’s Julian Leslie here