Comment by Ben Shafran, Head of Markets, Policy & Regulation, at Energy Systems Catapult.

Before the New Year, the Department for Energy Security and Net Zero is expected to set out its much-anticipated next steps in the Review of Electricity Market Arrangements (REMA). By far the most debated bit of REMA is whether Great Britain (GB) should adopt Locational Marginal Pricing (LMP, also known as ‘nodal’ pricing).

Under nodal pricing the price paid for electricity varies across the grid to reflect how much it physically costs to deliver electricity to each ‘node’ or supply point.

For over a year now, we have worked with FTI Consulting to advise Ofgem on the implications of introducing nodal pricing (as well as a less granular variant in which electricity prices vary by zone). This article sets out the Catapult’s view of nodal pricing and provides a flavour of the content that is presented in our report with FTI Consulting.

One third of markets use nodal pricing  

Nodal pricing in markets has not only existed for decades, but it’s on the rise. Since 2000, there has been a 25% surge in Organisation for Economic Co-operation and Development member states (basically, the world’s rich countries) using nodal pricing to structure their energy systems. Countries and regions such as New Zealand, Singapore, parts of Canada and the United States of America, and several South American markets all make use of nodal pricing.

Markets with nodal pricing have facilitated investment in both renewable generation and storage – two essential components of a decarbonised electricity system.

Nodal pricing will cut consumer energy bills in GB

We’ve found that introducing nodal pricing could reduce electricity bills by as much as £51 billion between 2025-2040, equivalent to £120 per household, per year.

Of course, the average price earned by renewable generators in the wholesale market and any top-up from Contracts for Difference (the blue and grey blocks in Figure 2, respectively) increase relative to the current market. But this is more than compensated for by savings from better managing congestion on the grid (the red block) – by only paying generators when they run.

Nodal pricing generates ‘congestion rent’ from the price differences between nodes. International electricity markets allocate congestion rent in different ways between consumers and generators. FTI Consulting’s modelling assumes that all congestion rent is returned to consumers – helping to further reduce energy bills (the green blocks in Figure 2) – but even if it isn’t, there are net savings on consumer bills.

Some critics of nodal pricing are concerned that it would benefit consumers in some regions at the expense of those in other parts of the country. Such fears are unfounded. FTI Consulting’s modelling found that consumers in all parts of GB would benefit from lower electricity bills under nodal pricing.

This is not to say that a reduction in energy bills will not vary across the country. Figure 3 shows that by 2040 Scotland, northern England and northern Wales could have the lowest wholesale electricity prices in Western Europe under nodal pricing. This could help attract heavy energy users to locate into these regions (rather than elsewhere in Europe), which could support regional growth and create new jobs. For example, separate analysis by FTI Consulting for Octopus Energy shows that a data centre could reduce its wholesale electricity costs by 65% under nodal pricing, simply by re-locating from the south of England to Scotland.

Nodal pricing is pro-growth, pro-consumer. Our study proves that consumers across GB can benefit from a switch to nodal pricing – easing the financial burden their electricity bills place on them.

Easing consumer demand and cutting emissions

One of the ways in which nodal pricing reduces the cost of electricity is by making more efficient use of flexible assets on the system such as interconnectors and electric vehicles (EVs).

For example, in our current arrangements with a single national price, we frequently witness the absurd situation of importing electricity from Norway even when there is plenty of Scottish wind, and exporting electricity to France even when we need more clean electricity to power London and the south-east. Markets should be incentivising electricity to be imported where/when it’s needed and exported where/when it’s not. But our current single wholesale price often leads to the exact opposite.

Figure 4 illustrates EV charging behaviour during an evening peak in which there is a constraint affecting the south of England and southern Wales. Under current market arrangements, there is a single wholesale electricity price nationwide. EVs in the south charge en masse, exacerbating the constraint, requiring the National Grid Electricity System Operator (ESO) to turn on additional generation – likely to be expensive gas peaking plants.

Under nodal pricing, the difference in wholesale electricity price north and south of the constraint leads to different charging behaviours. EVs in the south do not charge, waiting for the price of electricity to drop. In doing so, they reduce the cost of managing the system and help cut carbon emissions.

More generally, nodal pricing will support faster reductions in emissions from electricity generation – equivalent to a societal value of up to £18 billion (based on a 100MTCO2 reduction) – by reducing the curtailment of renewable generation and reducing the need to rely on fossil fuel generation.

Improving efficiency – whatever size grid we have

Nodal pricing acts as a form of insurance against the risk of not being able to deliver the huge scale of investment in the transmission grid that’s required to decarbonise the electricity system.

Nobody is denying that a decarbonised electricity system will require huge amounts of investment in the transmission grid. National Grid ESO estimates that investment in electricity transmission will need to be eight times greater this decade compared to the last decade. However, targets are not guaranteed outcomes. The challenges for timely grid delivery on this scale are immense, and should not be shrugged off.

Our work supporting the Energy Networks Commissioner set out ambitious actions to speed up investment in the grid. But even if our recommendations were to be adopted in full, the scale of investment required presents an enormous challenge across finance, skills and the supply chain, regulation, and governance. If we can keep that cost down, it increases our chances of getting to a net zero grid as soon as we can. And nodal pricing ensures that – whatever size grid we have – it is operated efficiently.

The findings hold under different sets of assumptions

We stress-tested our results by running the model with different inputs and assumptions, and found that our conclusions hold. For example, critics of nodal pricing argue that renewable generation is not able to respond to price signals. We tested this assumption and found that consumer savings would be £39 billion over the period 2025-40 even if we make the very conservative assumption that introducing nodal pricing would have no effect at all on the decision of where to site new renewable energy generators.

Some critics have argued that nodal pricing would make investment in renewables riskier, with the higher costs of finance flowing through to increased electricity bills. We found no evidence that this has been the effect in international markets with nodal pricing. In fact, markets with nodal pricing have developed a wide range of contracting structures and approaches that complement the pricing structures and help manage risks around energy generation and storage projects. In many such markets, Financial Transmission Rights are auctioned to enable market players to manage their exposure to locational price risks.

We tested what it would take to eliminate the savings from nodal pricing. We found that renewable generators would need to see a permanent increase in their cost of capital of 341 basis points for this to be the case. That’s roughly the difference between the interest rate on UK government borrowing and that of Peru, or 3.5 times the impact that the 23 September 2022 ‘mini budget’ had on UK government borrowing costs.

There are also reasons to believe our assessment may have understated the benefits of nodal pricing. For example, FTI Consulting’s modelling did not account for the impact of large energy users relocating to lower-priced regions in response to the locational price signals, or for any influence on the choices made about which generation or flexibility technologies to deploy, or for any impact on the rate of innovation in technologies that are better able to respond to real-time price signals. We at Energy Systems Catapult know as well as anyone the incredibly exciting, innovative companies who are ready to harness the potential of digital and flexible technology, if they get the right market signals.

Implications for REMA

There is broad consensus within the energy sector that decarbonising the electricity system requires the introduction of better locational signals. The debate is not on whether we should have locational signals, but what kind of signals and who should be exposed to them. Past initiatives to improve locational price signals – such as Ofgem’s Access and Forward-Looking Charges Significant Code Review – have focused on reforming network tariffs, and have often stalled because of concerns raised by market participants about unintended consequences.

Nodal pricing, which affects the wholesale market rather than network tariffs, has the benefit of being tried and tested internationally – in a widely diverse set of electricity markets, some of which are similar to our own. Our work with FTI Consulting shows that the size of the prize is too big to ignore. With an estimated saving of £51 billion when implementing locational pricing – for comparison, the government’s estimated savings from rolling out smart meters is £6 billion to 2034 – we have an opportunity to make a tangible difference to the lives of consumers, particularly amid a cost of energy crisis.

We need to make a change today if we’re to meet our Net Zero targets. This change needs to work for consumers and enable them to benefit from the changes implemented on the network. Nodal pricing is a ticket to reduced emissions and lower energy bills.