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The Cost Reflective Pricing project investigated whether or not the fixed charges on energy bills – for network, environmental and social costs – are efficiently distributed between the standing charge and unit (per kWh) price of electricity and gas tariffs.
Working with the Oxford Martin School of Oxford University, Energy Systems Catapult found the arrangement of fixed and volumetric charges within electricity and gas tariffs, may inadvertently distort market behaviour towards favouring investment in decentralised generation technologies, like solar PV and diesel, over demand technologies like heat pumps.
An energy system with a significant increase in heat pumps and electric vehicles could add to the capacity requirements of both the generation fleet and electricity networks, particularly at peak load times and if energy prices faced by consumers remained constant throughout the day and between seasons. Conversely, if consumers were incentivised to spread their demand throughout the day, as happens with railway pricing, the same energy could be supplied with fewer power stations and network upgrades.
How costs are allocated through energy bills contributes to the following market decisions:
If energy pricing is not cost reflective, there is a risk of distorting decisions by both producers and consumers, leading to inefficient decisions and higher overall costs to the energy system.
Energy bills are comprised of a combination of market and fixed costs. There is a wholesale market for the cost of the actual gas and electricity, while administrative arrangements recover the fixed costs of transmission, distribution, environmental and social policy.
The Cost Reflective Pricing study looked at the administered components of pricing for electricity and gas. It examined how these largely fixed costs are distributed across the standing charge and unit (per kWh) price of tariffs, and whether they reflect and recover their true underlying costs for supplying each consumer.
Cost Reflective Pricing in Energy Networks
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Under current tariff pricing, different consumers pay different contributions for the same fixed costs of making energy supply available. This is because costs are recovered as a % of the unit price. This approach means:
This meant that overall consumers are:
The Cost Reflective Pricing study also found that rebalancing fixed and volumetric charges into the standing and unit prices respectively would more recover fixed costs more efficiently. In addition, if environmental and social costs were moved away from energy bills to general taxation, this effect would be greater. As a result, the marginal cost of operating a heat pump would be lower than a gas boiler because gas bills did not contain these environmental and social policy charges. If it was not possible to move environmental and social costs to general taxation, spreading them more evenly between gas and electricity bills would improve the efficiency of the system.
The following actions recently taken by Ofgem are consistent with the argument that network charges should have a larger fixed component and a smaller per kWh charge:
Decisions about which fuel to use and what electricity generating plant to build/run would be improved by cost reflective pricing. This may support the adoption of low carbon technologies, such as heat pumps and electric vehicles, although there are many other factors at play in their uptake.
Behind the meter generation technologies, such as solar PV and diesel generators, may be over-incentivised in the current arrangements. While not within the remit of this report, the findings underline the potential of time of use pricing to realise a more efficient power system.
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Find out moreFind out more about how Energy Systems Catapult can help you and your teams
Find out more about how Energy Systems Catapult can help you and your teams