Locational pricing for electricity is the idea that where there’s lots of electricity and not much demand for it, electricity should be cheaper. Equally, where there’s not much and high demand, it should be more expensive. As this is the basic idea of markets and prices – it sounds like an excellent idea. Let’s do it then.
But hold on. The locational pricing of electricity is an attempt to increase the profits of the renewables generators at the cost of us all. For what is being proposed is that the price consumers pay changes, but the profit producers gain does not. The difference between those two gets passed on the users of the system as a whole.
That, roughly, is the difference between real locational pricing and the proposal floating around which is called locational pricing. One’s great, and the other isn’t.
It is this which explains the substantial support stemming from the likes of Greg Jackson at Octopus Energy. He actually says this: ‘Britain suffers from a staggeringly inefficient market, reminiscent of the wine lakes and butter mountains of the old European Common Agricultural Policy.’ Which is, if we’re honest about it, a fairly accurate projection of what the plans he’s supporting would create. Even if he’s using it as a description of the current, rather than proposed system. He also mentions that ‘Renewables can deliver incredibly cheap power – as they do in places as diverse as Texas and Scandinavia – but only with the correct market structure’. This is true too, but he fails to remember one crucial point about that Texas market.
Others are supporting the idea, Britain Remade for example, and its Head of Policy Sam Dumitriu. Sam is correct on the technical details he addresses, as Sam normally is. Amazon and OpenAI seem to be in favour, as they could build AI data centres more affordably in areas where energy prices are lower. The independent energy analyst and anti-Net Zero campaigner David Turver is significantly against and he mentions the elephant in the room – Contracts for Difference. Which are, to me, the failure of the entire idea – and the thing that Texas doesn’t have.
So, to give the pencil sketch. We currently have vast wind farms producing energy, which is lovely. The problem is that energy is being produced where no one very much wants to use it. The actual demand for the electricity is some hundreds of miles away. That then runs into both basic and inescapable costs, like transmission losses, and solvable but expensive problems like stringing wires to get power to where people desire to have it.
Currently, the UK runs on the one electricity price – wholesale, of course – for the country as a whole. The idea of this locational pricing is that electricity should be cheaper where it’s more affordable to provide electricity. Seems logical. We do all say that where it’s possible for things to be cheaper they should be.
The result of this should be that people who live where it is expensive to provide them with electricity will be, at worst, no worse off and those where it is cheap to provide will be better. We’ve a Pareto improvement: humanity is better off with no one worse off.
So, what’s the problem with this? In the Ofgem report into this there’s this:
In aggregate, support costs for existing and future CfD holders (borne by consumers) are expected to be greater compared to those which would be incurred under the status quo. Across GB, support costs would likely be higher in the north and lower in the south. This is due to changes in average wholesale prices (which would reflect network conditions) altering the top-up payments CfD-generators receive (eg, a lower average wholesale price in the north requiring a larger top up for generators in this region).
And that’s what the problem is. There is no intention – none at all – to actually move to locational pricing.
First, we need to understand Contracts for Difference (CfD). Everyone agrees that wind farms, for example, are more expensive to build and operate than, say, gas plants. Therefore, to ensure that anyone builds any wind farms at all, we’ve got to offer them a higher-than-market price for the electricity produced. This is our basic climate change problem writ small. If being green really were cheaper then we’d not have a climate change problem as we’d all go green to save the pennies, no plans would be necessary. It’s only true that green is cheaper if we include the externality of climate change itself. An externality is a cost we’re not currently paying for – by definition, it’s something not included in market prices – so designing a system to deal with the externality is just definitely going to be more expensive than one that does not.
A CfD is that guaranteed higher price, calling into being those wind farms that allow us to go green. It’s even possible to suggest they’re a good idea. I tend to run the other way, let’s tax everyone – as Stern and Nordhaus said – for their emissions and see what happens. But fine, having commissioned a report telling us what to do, the British Government decided to do what the report said not to do. Something of an explanation about the modern world there.
But back to this detail of locational pricing. The CfDs will remain in place. Everyone producing electricity in places where few desire it will continue to gain their lovely high prices for their production. Those few people in those areas will pay lower prices for the little they use, true. But that then opens out an ever larger gap between what is collected from the use of the electricity from wind farms and what is paid to the wind farms for the electricity produced.
Perhaps these lower prices will generate enough increased local electricity demand to make up for that gap, as the big tech firms flood in to build out AI data centres. A big perhaps. However, the even bigger problem is that, whatever happens to demand, the proposed system maintains current supply by fixing the supply price. This is exactly what happened with the European Union farming subsidies which led to those wine lakes and butter mountains. The supply price was fixed lovely and high and we ended up with a vast excess of production.
Exactly the same will happen again, because that’s the way the interaction of prices, markets, supply and demand do work out. We’re to offer continued high prices for production in areas where there is little electricity demand, while offering nice low prices to the few consumers in those areas. We’re thus insisting that people keep producing, at high cost, what’s worth piffle.
Actual locational pricing would be as they have it in Texas. Yes, users of electricity pay less where it’s nice and cheap to produce. But so too do producers of electricity, who get nice, low prices where it’s cheaper to produce. Because that’s how markets without price fixing work.
We also can’t move to proper locational pricing on that Texas model because if we abolish the CfDs, then everyone goes bust. Well, actually, we could, but we won’t for obvious reasons.
Actual locational pricing would be an excellent idea. Consumers pay the costs of providing them with electricity and in places where that’s cheaper they pay less, in the more expensive then more. What’s not to like?
What’s being suggested is that the high and fixed national prices continue to be paid to suppliers while a select few users enjoy lower prices. The ever increasing gap between these two then gets dumped into general system costs or, as we can also put it, every electricity consumer in the country. The proposed locational pricing does not, in fact, bring supply and demand any closer into contact with each other – it just changes which pocket gets picked. And likely increases the overall cost of the system to boot.
This isn’t a good idea. Even if we can see why those who own windfarms in remote places might like it.
Now, if we did abolish Contracts for Difference and actually paid renewables producers what their electricity was worth in the place and at the time they produce it, then yes, that would be very fun. But then they’d all be bust, which is why what’s being suggested is not, in fact, locational pricing.
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