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

The Review of Electricity Market Arrangements (REMA for short) turned one on 18^th July 2023. At this age, it’s shown an ability to crawl but not to walk independently, and it can babble a few words but hasn’t yet put together a complete sentence.

When it was born, REMA seemed like it could upend our electricity world:

“it is unlikely that the significant investment needed to decarbonise the power sector will be delivered cost-effectively by our market arrangements in their current form […] and the most cost-effective route to a net zero power sector by 2035 will require changes to markets to optimise both investment and dispatch”

But as we’ve got to know it better, its potential impact can be summarised as touching on the following three elements:

1. Whether small changes should be made in the short-term to existing mechanisms, such as the Capacity Market
2. Whether power generated from renewable sources should be sold and bought in a different way to other power
3. Whether the market should have different prices depending on where energy is produced and used

Later this year, the Department for Energy Security and Net Zero is expected to publish its views on point one, and to signal the extent to which it will continue exploring points two and three.

What is Locational Marginal Pricing?

By far the most debated of the three elements is point three. Specifically, whether Britain’s electricity market should adopt Locational Marginal Pricing (LMP, also known as ‘nodal’ pricing). This is a method of pricing electricity that reflects the cost of generation at different locations on the grid. This means that the price of electricity varies depending on where it is produced/consumed, as well as the time of day. In contrast, Britain’s main wholesale market for electricity pays no regard to where it is produced or used.

How does Locational Marginal Pricing work?

LMP is similar to how Uber matches users to the nearest available drivers. It is calculated by the system operator, based on offers from each participating generator about its cost of producing electricity and the amount of electricity it can produce.

This is then compared by the system operator to the amount of demand and the status of the grid. When the grid has enough capacity to match supply and demand, prices converge across locations. But when the grid is constrained – for example, because a transmission line is down for maintenance – prices could be different in locations on either side of the constraint.

LMP is a dynamic price, which means that it changes regularly as the mix of generation and level of demand changes. This helps to ensure that the price of electricity reflects the true cost of supplying it.

A brief history of Locational Marginal Pricing

LMP is a well-established way of pricing electricity – it was first introduced in eastern and central states of the United States of America in 1998. Meaning that it has been used for selling and buying electricity longer than the approach we currently use in Britain, which was first introduced for England and Wales in 2001 and was expanded to include Scotland in 2005. Since 1998, the use of LMP has grown to cover the majority of electricity trading in the US, as well as New Zealand, Singapore, a number of South American markets and parts of Canada.

Introducing LMP in Britain has been considered several times over the past decade, including as part of Ofgem’s Access and Forward-Looking Charges Significant Code Review and in the Competition and Markets Authority’s investigation of energy markets. The difference this time is that the case for change has been unequivocally articulated in the REMA consultation.

The benefits of Locational Marginal Pricing

There are four main benefits to LMP:

• More efficient location of investments. At the moment, renewable generators are largely shielded from their impact on the system. This means they could locate in an area that’s frequently constrained, but still be able to earn revenue above and beyond the value of the energy they produce. This isn’t the case with LMP, which means there’s a strong incentive to locate new projects where the power is most likely to be dispatched – saving money for consumers. Of course, price is only one consideration in where a generator locates – favourable wind/sun conditions, planning permission and grid connection are all important. But, as well as influencing siting of some projects, pricing can encourage generators to co-locate or contract with storage or flexible demand, to mutually maximise their value.
• More efficient dispatch and operation of the system. Currently, electricity is traded without regard to the physical realities of the system, and then re-dispatched (‘balanced’) by National Grid ESO in real time to respect the laws of physics. It is usually wind in Scotland that gets turned down and gas or coal generators in England that are asked to increase production. The LMP calculation internalises those physical realities, doing away with the need for re-dispatch and in doing so saving money and carbon.
• Supporting investment in flexibility. Flexibility is essential in a future electricity system that relies mostly on wind and solar power. The British electricity system supresses the value of demand-side flexibility and storage by having a single national price in the wholesale market that does not reflect local constraints, and by dispersing the value of balancing actions across multiple sub-markets. LMP would provide locational and dynamic for flexibility, and would combine into one the wholesale and balancing markets. Figure 2 shows that battery storage is disproportionately located in US markets that use LMP: despite only making up 58% of grid capacity in the US, those markets make up 74% of large-scale battery storage power capacity (GW) and 72% of energy capacity (GWh).
• Signalling whole system value. Electricity is going to be the backbone of a zero carbon economy. This means that much of its value is in the way the electricity system interacts with transport (e.g. charging / discharging of electric vehicles), heat (e.g. smart use of heat pumps) and other sectors. The locational signal provided by LMP – combined with a place-based approach such as Local Area Energy Planning – can inform choices about how to decarbonise that best meet communities’ needs.

Overcoming the challenges of Locational Marginal Pricing

Introducing LMP in Britian is not without its critics. Incumbent generators worry that it would be disruptive, making it more difficult for them to deliver the scale of investment in renewable generation that’s needed. We investigated this concern closely and found no evidence that US markets that introduced LMP suffered a slow-down in investment in generation.

Another challenge often raised is that LMP would result in winners and losers across different locations in Britain, due to price differences between those locations. But modelling by FTI Consulting – which we were involved in – found that LMP would reduce electricity prices for consumers in all locations in Britain compared to continuing with the current market design. Some locations – particularly in Scotland and the North of England – are expected to have the lowest electricity prices in Europe if LMP is introduced, which could support regional growth agendas.

Some argue that the aims of LMP could be achieved by scaling up investment in the grid, and/or by introducing stronger price signals into the balancing market or network charges. We certainly should be building a lot more grid if we are serious about decarbonising – National Grid ESO estimates that investment in electricity transmission will need to be 8 times larger this decade compared to the last decade. But even with that rate of investment, the ESO estimates that constraint costs on the grid would treble to more than £3 billion per year by the end of the decade.

So, we can’t just build out constraints – in the same way that adding lanes to a motorway does not eliminate traffic congestion during rush hour. As for introducing price signals elsewhere in the system, almost five years since Ofgem launched a Significant Code Review designed to do exactly that, progress has been very slow owing to challenges raised by industry. It’s not at all clear that there are easy and effective alternatives to deliver dynamic and locational prices.

Making the puzzle pieces fit together

A year on from the launch of REMA, we’re still waiting on the direction of travel from government. But a picture is starting to form: National Grid ESO is recommending a market design founded on LMP. FTI Consulting found that LMP could deliver large savings for energy consumers – as much as £50 billion over 15 years, or approximately £120 per household per year. Citizens Advice has identified a range of options for protecting consumers if there are concerns that some might be disadvantaged by LMP (e.g. because of their energy use patterns). And we have found evidence that international energy markets with LMP can deliver large scale investment in both generation and flexibility.

Of course, LMP is not the be-all and end-all of decarbonising the electricity system. We’re also going to need whole-system strategic planning and a lot more investment in the grid. A lot of the transition will also be happening in homes and communities – and it may be years before it is feasible to apply LMP to the local distribution systems. But when applied to the national transmission system, LMP can be the foundation for an electricity system that is low carbon, low cost, and works better for people.