If you’re a regular CapX reader, the following sentence should be uncontroversial. All things being equal, consumers benefit when prices reflect marginal costs. When you set prices too high like the European Commission did with the Common Agricultural Policy, you end up with mountains of butter and lakes of wine. When you set prices too low like Stockholm does with rents, you end up with a 20-year waiting list for housing.
Here’s another example of the perils of fixing prices: Britain’s electricity market operates off a single national wholesale price. Scots and Londoners pay essentially (there are limited transmission charges) the same price for electricity despite the fact that Scotland regularly produces more energy than it can export. Our electricity market acts as if constraints on transmitting electrons from one part of the country to another don’t exist. The problem is that they do exist. Britain has not built anywhere enough pylons and substations to get all that power generated in the North Sea down to where the majority of the country lives.
A single national price creates the electrical equivalent of a butter mountain in Scotland where so much power is generated that the National Grid has to intervene in the market and pay wind farms to switch off. And they pay a lot: £1.8bn/m this year and £7.8bn in 2030 if Ed Miliband’s plans to massively boost renewable deployment come to fruition.
At the same time, London’s lengthy grid-connection queue – major housing developments in West London are being blocked because they literally can’t get the power – is made worse by the fact that developers (of homes and data centres) have no incentive to locate where the power is.
There’s an opportunity to fix this. As part of the Review of Electricity Market Arrangements (REMA), the Government is mulling over a move to locational marginal pricing. Instead of a single national price, the electricity market would be split into zones designed to reflect constraints on the grid and each zone would have its own price. While not as good as the more fine-grained option that Texas has, it still would be a major improvement over the status quo.
This is a big change and I am not surprised that many vested interests who benefit from the status quo (i.e. renewable developers who are paid to waste wind) are up in arms. I was, however, surprised to see Tim Worstall, a staunch free marketeer, defend a system that generates massive rents for some renewable developers and massive costs for the rest of us.
To be fair to Worstall, he isn’t opposed to locational pricing in theory. I doubt he’d tell Texans to move to a single state price. His concern is that moving to a system that he himself agrees would normally be an improvement would exacerbate problems with the way we subsidise renewable energy.
In economics, two wrongs can make a right. This is known as the ‘theory of the second best’. When the first-best solution isn’t an option, a market distortion can improve outcomes if it cancels out a distortion in the opposite direction. One recent study argued that OPEC (a cartel) was net efficiency-enhancing because it counteracted another market distortion: unpriced carbon emissions.
In this case, Worstall’s concern is the impact locational pricing would have on renewable subsidies. The big benefits of moving to a locational system would be much lower (and sometimes negative) prices in areas where energy is abundant (e.g. the North East of Scotland where many offshore wind farms are located). The issue is that renewables with Contracts for Difference (CfD) subsidies are paid not on the basis of the market-clearing price, but on a pre-agreed strike price.
If prices are higher than expected, like when gas prices surged after Russia invaded Ukraine, then renewable developers (and EDF when Hinkley Point C is built) end up charging less than the market rate.
But when (and this is the case more often than not) market prices are below the pre-agreed CfD strike price, the renewable developer is paid the difference.
Worstall’s fear is that when the wind blows in Scotland, its zonal wholesale price will drop to zero, but billpayers will still end up paying because the CfD will top them up to the strike price. And as prices are lower than they would be under a single national price, the top-up will be even larger. Ofgem backs up his concern stating: ‘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.’
Let’s be clear. Worstall is right that already-signed CfDs will blunt some of the benefits of moving to a zonal system. But his error is in assuming the higher payments to CfD holders outweigh the wider benefits of moving to a zonal system.
For one thing, most of the electricity market isn’t covered by a CfD. In fact, CfDs only cover about a fifth of Great Britain’s renewable capacity. And just because a renewable project is covered by a CfD does not mean they sell all of their power through the CfD.
For the majority of renewables in cheaper zones that aren’t covered by CfDs, locational pricing will mean missing out on rents from what are known as constraint payments. At the moment, when it’s windy in Scotland – the Viking wind farm in the Shetland Islands (and others like it) will bid to sell lots of power at a high national price even though there’s no way of making use of all of that power due to grid constraints. In response, the grid will come in and pay the wind farm to switch off. Locational pricing would end this absurd state of affairs and bills would fall as households no longer had to pay wind farms to switch off. Already this year, billpayers have paid more than £250m in constraint payments.
This is why the strongest opposition to locational pricing has come from renewables developers with large presences in Scotland who have invested and planned investment based on wind speeds and availability alone (as opposed to where it is most useful for households and businesses). Worstall’s claim that ‘we can see why those who own wind farms in remote places might like it’ will be news to developers like SSE, who own wind farms in remote places and have consistently lobbied against reform.
It is true that in the future, more of the market will be covered by CfDs, but future CfD auctions will incorporate locational signals. Competitive pressures will push developers to bid in lower strike prices for projects in places like Scotland where wholesale prices are likely to be much lower.
There are other big benefits from a shift to zonal that need to be taken into account.
Locational signals will, at the margin, shift demand to the areas where power is cheaper. Industries that are otherwise uncompetitive under Britain’s super-high electricity prices may find that Scotland and the North are the perfect locations for their new factory or data centre.
Locational signals will also mean smarter use of our interconnectors with France, Norway and Denmark. If the South East needs power and Scotland has it but is constrained by the grid, then the last thing we want to do is import more energy into the constraint by using the northern-most interconnectors. That’s just wasteful, yet under the status quo that’s exactly what happens. Under a zonal system, locational signals will mean we make more use of our interconnectors with France instead.
Contrary to popular belief, sometimes two wrongs do make a right. But not in this case.
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