REMA is too important to be kicked into the long grass - Tom Luff & Tim Chapelle

Comment by Tom Luff, Senior Adviser (Electricity Markets & Policy), and Tim Chapelle, Energy Policy Adviser.

In summer 2022, the government consulted on potentially far-reaching reforms of electricity markets (Review of Electricity Market Arrangements or REMA). An update from the Department for Energy Security & Net Zero (DESNZ, formerly BEIS) is expected imminently, sharing what the team has heard from stakeholders and setting out the direction of travel for the coming phase of the review.

At this stage of the political cycle there is a risk that change is kicked into the long grass. It is the view of Energy Systems Catapult that:

  • REMA shows current electricity market arrangements hinder the integration of low carbon electricity generation, increasing costs for consumers and putting Net Zero in jeopardy
  • Markets and policy should be designed to stimulate investment in all low carbon technologies and approaches. Shielding industry from risk – and not incentivising companies to mitigate it – means an unfair deal for consumers
  • We need an ambitious package of reform to unlock greater system flexibility (e.g., storage and demand side response) to complement low carbon generation
  • A phased blueprint for reform is essential now to set clear expectations, realise change and accelerate investment.

REMA demonstrates why the current market arrangements will not deliver our Net Zero ambitions

The 130 pages of analysis and options published last year by the Department for Energy Security & Net Zero  (formerly BEIS) present a clear and compelling vision of a future Net Zero electricity system. Achieving net zero by 2050 depends on fundamental transformation of our electricity sector, which will not only have to phase out fossil fuels but must also expand its generation capacity to accommodate a doubling of demand due to the electrification of heat and transport.

The first stage of the transition to Net Zero power was to scale up investment in renewables, and we have seen significant success on this front in great part by reducing financing cost with government backed Contracts for Difference (CfDs). But the challenge we now face is how to modernise our systems and markets in order to integrate renewables onto the grid.

This is a big challenge and one that is pushing up costs for consumers. We examine it systematically in our Rethinking Electricity Market report and it is well covered in REMA. Three issues are worth highlighting in particular.

Firstly, we have seen an 8-fold increase in the cost of managing congestion on the transmission network since January 2010 (see Fig.1) – and this trend is set to increase to up to £3bn per year by 2035 even after more transmission and distribution lines are built. Preliminary modelling results from FTI Consulting/Ofgem’s October 2022 stakeholder workshop indicated that constraint costs under the national market design option could exceed £5bn by 2035. The Electricity System Operator (ESO) – originally envisaged as purely a residual balancer to reposition the market – is increasingly acting more as a central dispatcher, frequently re-dispatching more than 50% of demand (compared to only 10% in 2008).

Figure 1. ESO Balancing services costs

Figure 1. ESO Balancing services costs

Secondly, current arrangements provide weak incentives for flexibility (e.g., storage and demand side response) which is needed to complement the inherent intermittent nature of renewables such as wind and solar and reduce overall costs. For example, the Capacity Market – which helps reduce the risk of outages – is heavily stacked in favour of gas generation (see Fig.2).

Figure 2. Capacity Market by Primary Fuel Type

Figure 2. Capacity Market by Primary Fuel Type

Thirdly, retail and wholesale market arrangements limit the opportunity for consumers to benefit from their flexibility and take action to reduce their bills. There are few flexible tariff propositions on the market and concern about their commercial unsustainability under current arrangements. The value of flexibility is suppressed due to there being a single national price in the wholesale market that does not reflect local constraints. And value is dispersed across multiple sub-markets (e.g., different balancing services purchased by the ESO; local flexibility procured by the Distribution Network Operators at the local level).

The challenge of system integration of low carbon technologies is not, therefore, an abstract, academic concern that we can choose to ignore. REMA’s analytical conclusions are clear: “current arrangements will not deliver a fully decarbonised power system by 2035, as renewables alone will not be enough to meet our 2035 targets, and the Capacity Market is unlikely to bring forward low carbon flexibility at the pace required.”

A radical and holistic package of modernisation is needed to upgrade the market framework, overhaul the planning consents process and create retail offerings built around consumer needs.

Build fast, build smart

We must pull out absolutely all the stops to build new infrastructure at unprecedented speed. Connecting the new generation needed by 2030 will require an eight-fold increase in the delivery of large transmission reinforcement (overhead lines and underground cables).

Figure 3. Average annual transmission reinforcement expenditure

Figure 3. Average annual transmission reinforcement expenditure

Network build could be the weakest link in our Net Zero power plan. We are beholden to this if we rely on the current market arrangements. More than ever, we must make the best use of the assets we have and build out wisely.

Building consensus on flexibility and ambitious reform to unlock it

Greater flexibility across the power system is crucial for using our low carbon energy assets efficiently and for reducing costs. This means having policy and market arrangements that most effectively guide the siting and operation of these assets. Fundamental to this is: (I) locational and temporal price signals in the market; (ii) a “level playing field” for all types of low carbon technologies and approaches (both supply and demand) and (iii) better data to show where system investment is needed.

Energy Systems Catapult developed a package of reforms for modernising the power system to make the best use of our home-grown resources. Central to this is locational marginal pricing (‘nodal pricing’), an electricity pricing system – used by markets in the USA and New Zealand and is being implemented in Ontario, Canada – which better reflects the physical reality of the system in real-time.

Locational differences in prices are not new to Great Britain. Charges for using the energy network already vary across the country (e.g., the distribution and transmission network charges known as DUoS and TNUoS). But these are blunt signals, with methodologies containing approximations and assumptions that quickly become out of date.

As innovators Octopus Energy explain, “a market price that reflects the fundamentals of the system would provide accurate information that reflects the value of different technologies in different areas, and only then can we realise the optimum technology mix needed to balance a decarbonising grid.”

Avoided costs; cheaper power

Shifting to a more flexible system should result in huge consumer benefits by improving overall efficiency. Preliminary analysis from Ofgem and FTI suggests that an electricity market with nodal pricing could save consumers £55bn over the period from 2025-40, reflecting more efficient location and dispatch of generation and storage across the system and more efficient use of network infrastructure.

We think locational pricing should be considered as part of a wider package of complimentary reforms. Other intervention remains necessary to scale up the shift from fossil fuels to renewables. But the current approach of centralised contracting transfers risk to consumers, distorts price signals and limits incentives to unlock innovation. Our Rethinking Electricity Markets report highlighted alternative approaches based on outcome-based policies, such as a Clean Energy Standard (placing the onus on suppliers to reduce the carbon of the power they sell).

All this could unlock exciting new propositions and business opportunities to help consumers save money. The Demand Flexibility Service has been successful and popular. With greater opportunity to save money and technology to automate consumption changes, it could be a game-changer.

Careful planning should ensure investor confidence is maintained

Amid heightened competition for capital investment from the USA (e.g., with the Inflation Reduction Act) and the EU, there is concern that ambitious market reform could make the UK energy sector less attractive for investors. A recent paper by the University of Strathclyde suggested that nodal markets increase generators’ exposure to “dispatch risk” (where a generator is not dispatched if it is in a constrained part of the network and, therefore, is unable to earn revenue from the electricity market during that settlement period).

The authors argue that this could lead to a higher cost of capital or potential investment hiatus for renewable generators. Others have found limited evidence that moving to nodal or zonal pricing impacts the cost of capital for market participants.

Our own recent research on learnings from international examples suggests that the cost of capital risk is perhaps over-blown, and the introduction of locational pricing has not created investment hiatus​ – as shown Fig 4. This is because nodal markets – and financial markets in the respective jurisdictions – have adapted to offer complementary financial instruments that help achieve a desired level of risk exposure for different market participants. In doing so, they support investment in both renewable generation and flexible capacity.

Figure 4. Investment continues after introduction of Locational Pricing

Figure 4. Investment continues after introduction of Locational Pricing

Arguments around investment hiatus were made during the last major reform of the GB electricity market. With good planning, a clear pathway to change and well-designed mitigations (e.g., grandfathering policy), these risks were averted. We should have confidence in investors and developers adapting to new market realities. What matters is that those market realities better align with the characteristics of a Net Zero system to best serve consumer interests.

Standing up for consumers

Electricity market reform gets very technical. But at the end of the day its purpose is to make things better for consumers. Shielding industry from exposure to risk – rather than incentivising market players to manage and mitigate it – means consumers underwrite the costs.

REMA must go hand in hand with retail reform. Exciting new retail propositions are what will bring it all to life. As we described our Clean Energy Retail report, competition should focus on improving customer satisfaction and supporting Net Zero. New providers must be able to enter the market if they have offerings that consumers want. Consumers must be able to access the benefits of being flexible and unlock their “decarbonisation dividend” with confidence that their interests are protected.

We want a system that produces suppliers who are trusted by their customers to give them the best deals, incentivised to help them balance the grid while reducing their carbon footprint and who can unlock opportunities for vulnerable and low-income consumers. Aided by tech and data, a modernised system could help realise exciting new propositions – building on flexible tariffs, heat as a service, local energy, etc – to give consumers the low carbon, affordable energy they want, when they want it.

How can DESNZ see this through?

REMA is too important to be kicked into the long grass and it is crucial the government maintains momentum for change. Key to this will include:

  • Keeping consumer interest at the heart of the decision-making process (including by addressing retail questions in parallel)
  • Building a technical consensus around principles for change – focusing on the need for greater flexibility – and assessing packages of options against them…
  • … and building a political consensus around ambition. Permanently cheaper electricity bills should be a voter winner and supports multiple government objectives (inflation reduction; growth; levelling-up; etc)
  • Carefully scrutinise claims of investment hiatus and challenge industry to “own” the solutions in relation to meeting Net Zero objectives
  • Set out a blueprint for change and overall strategic direction in the coming months to guide market players and set clear expectations
  • Test and pilot new approaches if necessary to build confidence and awareness.

Tough decisions will be needed. But without reform, we risk getting locked into a high-cost power system and facing public backlash against Net Zero. The last 18 months have demonstrated what happens if we lose control of energy prices. It is vital, therefore, that the system we build puts consumers at its heart and makes the best use of our assets.

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