The key priorities for the reform of the UK electricity market are:
The Review of Electricity Market Arrangements (REMA) was launched in 2022 to deliver an evidence base for proposed reforms to the GB electricity market (other markets such as gas and heat are out of scope).
REMA is based on three major objectives that the Government must achieve in order to create a future-ready energy system:
1 Ensure security of supply
2 Decarbonise electricity
3 Deliver cost-effectiveness
The Department of Energy Security and Net Zero (DESNZ) has launched the second of two consultations in March 2024 to gather responses from stakeholders on a wide range of topics, as REMA touches on several technical, financial, and policy elements.
Grant Thornton, along with LCP Delta, were selected by DESNZ to undertake in-depth research on locational marginal pricing (LMP), which is a pricing mechanism used in the wholesale electricity market. LMP is based on 'real-time' electricity prices that include (but are not limited to) the costs of generation and transmission.
Currently, the GB wholesale market is based on a 'national pricing' system wherein buyers and sellers agree prices via private contracts. In contrast to this, 'zonal pricing' is an approach where the GB market would be split into smaller 'zones' and the prices within each zone would vary based on how constrained the electricity network is. Scotland, for example, would be two zones.
Proponents for LMP argue that if the GB market operated on a zonal system, wholesale electricity costs would more accurately reflect market conditions and hence provide transparency to stakeholders. In the context of REMA, this is significant because a shift from national to locational pricing would impact operational, investment, and overall market dynamics, all presenting risks which need to be investigated.
Our study on the ‘System Benefits from Efficient Locational Signals’ (another name for LMP) was published by DESNZ on 12 March 2024, as part of the evidence base for the department's second REMA consultation. It sought to assess the impact of LMP on a GB market that is split into twelve zones based on key transmission network boundaries.
In summary, our report finds that, with no assumed impact on cost of capital, moving to zonal locational pricing would deliver system benefits of £5 billion to £15 billion (from 2030-2050), compared to a national pricing counterfactual. Our modelling results show that moving to locational pricing transfers costs from consumers to producers, with consumer benefits ranging between £24-59 billion. The drivers of these benefits are split into two types: investment efficiency, where more efficient locational signals cause plants to locate in areas more beneficial to the system, and operational efficiency, where cost savings are a result of changes in the operation of the market (without plants changing location). At the same time, this change would result in producer costs increasing by between £19-36 billion
Our study further finds that what is assumed in the national pricing counterfactual, particularly on how interconnectors flow with the respect to constraints, make a key difference to the results. The system benefits of moving to locational pricing are £5 billion, when redispatch inefficiencies in the national pricing counterfactual are assumed to be removed/minimised and £15 billion, when redispatch inefficiencies are assumed in the national pricing counterfactual.
Within the analysis, there are several key uncertainties that will impact the results. The impact that moving to locational pricing could have on the cost of capital of investing in power generation. Our analysis finds that system cost benefits could be outweighed by modest increases in the cost of capital. Uniform increases of 0.3 to 0.9 percentage points in the cost of capital for all technologies (excluding nuclear) results in a move to locational pricing becoming a net cost to the system.
Additionally, the level of network reinforcement is a key uncertainty that could have a material impact. A delayed build in transmission networks can increase the benefits of moving to locational pricing as more efficient location drives higher benefits in a more constrained network. Our analysis shows that a three-year delay in network build can increase the benefits of moving to locational pricing by 10%.
The latest REMA consultation builds on the existing evidence base and will provide stakeholders with the opportunity to understand the aspects of the proposed reforms that will affect them. There are numerous approaches, modelling scenarios and research reports in the public domain that put forth different views on each element of the programme.
Despite uncertainty around the final set of reforms that REMA will deliver, we are confident that our report provides a robust base upon which to assess the impacts of LMP, which will be critical to creating a GB electricity market of the future.
REMA is extremely significant for the UK electricity sector – it heralds the first major reform of the electricity market since the changes that brought in the contracts for difference (CfD) regime and the capacity market back in 2013. While implementation will span well into the tenor of the next Government – there will likely be a limited amount of disagreement between the major parties – who have committed to stretching net zero goals – which are themselves the catalyst for the changes on which DESNZ are now consulting. Locational pricing is a critical component of the REMA programme which will impact on the cost of producing (and therefore consuming) electricity for all UK bill payers.
Source: Review of Electricity Market Arrangements: second consultation (publishing.service.gov.uk)
Our full report is available to read here
For more insight and guidance, get in touch with Alasdair Grainger or Saloni Kapoor.
