Britain is trying to break the link between rising gas and electricity prices

As the biggest government intervention in modern history to protect UK households from soaring energy bills came into effect on Saturday, focus has turned to sweeping reform of wholesale energy markets to ensure the crisis does not repeat itself.

During his controversial ‘mini’ budget last month, Chancellor Kwasi Kwarteng pledged to overhaul a system “in which gas sets the price of all electricity” to one that “reflects the UK’s indigenous, cheaper and low-carbon energy sources which Consumer bills will come down”.

The move resembles an EU initiative as Russian President Vladimir Putin continues to arm gas supplies to Western Europe.

Why are wholesale electricity prices based on gas prices?

As on the continent, pricing in the UK wholesale electricity market is based on “short-term marginal costs”. Each power producer makes an offer, but the daily market price is set at the level that ensures there is sufficient supply to meet demand. In other words, the price is always determined by the most expensive plant needed that day — usually a fossil-fuelled one.

In practice, this means that gas-fired power stations, which still account for just under 40 per cent of Britain’s electricity supply, drive the price of electricity more than 80 per cent of the time, according to University College London scientists.

The system worked when coal, gas and nuclear dominated the UK electricity system, but renewable sources such as wind and solar, which are very cheap once installed, are rapidly expanding their market share. According to the government, renewable energy, including biomass, accounted for 43 percent of the generation mix in 2021.

Line chart of prices based on 100 um, showing that wholesale electricity prices are very similar to gas

As gas prices have more than quadrupled since the beginning of 2021, consumers and businesses are therefore paying much more for their electricity than the average generation cost in the market.

“What we’ve seen over the past year is that as gas prices have risen so have electricity prices, so some renewable energy producers are making very large profits. Politicians and consumers are right to ask if this is the right system,” says Ed Birkett, head of energy and climate at think tank Onward.

What would any changes look like?

Key reform options include bifurcating the wholesale market to separate renewable energy prices, or an approach where customers are billed based on the type of generation capacity in their region, known as “locational pricing.”

There are various ways to split the market, but broadly this would involve creating a separate pool for cheaper but intermittent renewable energy generation that could be expanded to include nuclear, and a second for traditional fossil fuel power plants that could be used on demand can generate electricity.

The dual approach would reduce low-carbon electricity prices by decoupling them from gas costs.

Professor Malcolm Keay, a senior research fellow at the Oxford Institute of Energy Studies and one of the architects of a split-market approach, said one of its benefits is that consumers could make savings by adapting their usage to an ample supply of renewable energy would.

“They could install batteries or other forms of storage in their homes, or their supplier could use centralized storage. In the future people will have things like electric vehicles and heat pumps and these . . . can be designed to be price responsive,” he said.

Critics point out that the split approach is largely conceptual and would be difficult to implement if the EU markets, to which the UK electricity system is connected, did not adopt a similar model.

“Locational pricing” aims to address another major anomaly in electricity markets: Under existing arrangements, wind farms in Scotland are paid for Hundreds of millions of pounds a year to switch off when they produce too much electricity for the local grids.

Renewables bar chart grows but gas remains the largest single source of electricity generation showing UK electricity generation mix (%)

The approach would require hundreds or possibly even thousands of different price points across the country to reflect local supply and demand. On very windy days in Scotland, for example, prices would fall.

Proponents argue that this would encourage investment in battery storage in places where excess electricity is produced, or conversely encourage energy-intensive industries to locate in regions that offer cheaper electricity.

A to learn Energy Systems Catapult, a technology and innovation hub, and supplier Octopus Energy studied site pricing and supplier Octopus Energy found the approach would result in savings across all regions, although these would be proportionately larger in Scotland and Northern England.

The approach is already being used in other countries such as Italy, but critics argue the system would result in a postcode lottery with consumers paying wildly different prices across the country, although Birkett suggests this can be solved by applying an average national price could be domestic bills.

How quickly can the market be reformed?

Estimates range from one year to five years, depending on the nature and scope of the reform, with some energy experts warning ministers not to rush the move.

“We need to calm our nerves a bit. . . these are, by definition, medium- to long-term reform options and the gas crisis is an immediate short-term problem. There is a risk of using the wrong tools to solve the problem,” said Tom Luff, Senior Advisor for Electricity Markets and Policy at Energy Systems Catapult.

What is the government doing in the meantime?

As a first step, officials are negotiating with renewable and nuclear generators to accept 15-year fixed-price contracts below current wholesale market prices. Some still have legacy contracts that pay them a subsidy on top of prevailing wholesale prices, allowing them to make exceptional profits.

But those efforts have their critics, including Labour’s shadow Energy Secretary Ed Miliband, who has warned the Government is in a weak negotiating position and could end up agreeing to a fixed price that may be lower now but proves very expensive over 15 years.

In the short term, some experts believe an unexpected tax could be easier, although Prime Minister Liz Truss has so far ruled it out. Britain is trying to break the link between rising gas and electricity prices

Adam Bradshaw

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