Energy: marginal pricing

By Richard North - February 20, 2023

It seems that the Telegraph needs to get its act together. Fresh from platforming the stupid man’s idiot, Matthew Lynn, to defend the energy utilities’ profits, it gives space to Liam Halligan to rail about the price of energy.

In a piece headed, “Britain’s energy market is blatantly rigged”, he comes rather late to the party to tell us that, “We must tackle the marginal pricing racket to end the scandal of overpriced energy”.

Marginal pricing, for the record, is part of the system of wholesale electricity pricing used in the UK, where “day ahead” supplies are auctioned in half-hour blocks, yet the price for the day paid to every successful participant is that set by the last selected electricity generation offer to meet demand.

The basis of the auction is that the system operator will choose the cheaper operators first, usually renewables. But, if there is insufficient renewable energy for the coming day, the next most costly form of energy is chosen – usually nuclear – and then coal. If supply is still insufficient, which is usually the case, the system operator will top up with gas-generated electricity and the price of last half-hour purchased sets the price for everyone else for the day.

By this means, the actual price of electricity on that part of the market is essentially divorced from the cost of production, and set by the most expensive production source, essentially linking it to the price of gas.

And, as the price of gas had gone up, the market pays more raising the average daily price from around £70 MWh to as high as £647 MWh experienced in August 2022, even though most generators had suffered no cost increases.

It is this mechanism which has driven some of the massive profits reported by energy companies, triggering calls for windfall taxes to recoup some of the excess, unearned income.

Rather than go down this route, however, jacking up an already sky-high tax rate on North Sea energy exploration, Halligan argues that ministers should instead reform how energy is priced – so consumers can finally start benefitting from the big shift over the last decade in the UK’s energy mix.

In principle, the government agrees – or did so back in July 2022 when then energy minister, Kwasi Modo launched REMA, a “Review of Electricity Market Arrangements”.

The aim was nothing less than to “radically enhance energy security and cut costs of electricity for consumers in the long term”, a process which would “include exploring changes to the wholesale electricity market that would stop volatile gas prices setting the price of electricity produced by much cheaper renewables”.

However, as the government recycled through energy ministers, the industry presented an almost united front during the consultation process, speaking out in favour of the existing system which, it argued, had many advantages.

Not least, it was argued, the system particularly favoured renewable operators, allowing them to recover large parts of their investment costs through the market, reducing their need for financial support from public budgets and thereby helping to promote decarbonisation.

Possibly because the system has become an unintended subsidy for “net zero” ministers have been reluctant to pursue change, with the original claim that “the government continues to be on the side of British energy consumers short and long term” forgotten, as plans for reform have been quietly shelved.

Nevertheless, supporters of the system point out that most of Europe and much of the US has adopted a form of marginal pricing, yet it is only the UK which has imposed such steep price rises on consumers.

Here, Dieter Helm, in an exploration of energy policy published last year, explains that the UK has lots of intermittent wind which reads across to greater demand for gas, and that translates straight into the electricity price. The gas and electricity price paths match each other remarkably closely in the UK.

Helm then points to France where the energy mix is different. Around 70 percent is nuclear and the country has a lot of hydropower. As the gas prices have shot up, the cost of nuclear and hydropower has not changed at all.

And, while in the UK, the cost of wind, solar and nuclear generation has not gone up, in France price increases were limited by the state to 4 percent until this year, more accurately reflecting actual cost increases.

EDF, says Helm, understandably protests that this will lose it money (around €8 billion), because it could have sold its power into the EU markets at the spot price. But the €8 billion, he explains, is not a loss, but rather an additional profit that would go to EDF.

Since EDF is largely owned by the French state, the €8 billion would be a taxpayer gain, and stands against a customer gain if the benefits of a stable nuclear power supply go to the French citizens and industry. There is though, another of those unintended consequences, where the Germans benefit from French nuclear, despite having closed its own nuclear fleet.

The problem for the UK is that, even if it went hard for new nuclear, that is a decade or more off. Hence, Helm also raises the question of why UK citizens are paying the marginal cost of gas for that proportion of generation that is not gas.

It is true, he says, that there are some renewables which receive a fixed price independent of the wholesale market, but it is also true that there is a long legacy tail of older renewables generation and all the current nuclear, which does not.

There is some coal too (DRAX) which is again benefiting from the higher spot price of gas. Thus, he argues, as does Halligan, the general point remains: in a system with lots of zero marginal cost generation, the price of electricity for all the electricity generation should not equal the spot price of gas.

Halligan though, as befits a Telegraph writer, argues somewhat superficially that what’s needed are serious energy industry rule changes – along with a more solid provision of constant “baseload” energy, preferably using nuclear, concluding that we need to tackle this marginal pricing racket and end the scandal of overpriced UK energy.

Helm, as one might expect, takes a more nuanced view but, as a supporter of “net zero”, he is keen to develop mechanisms which will ensure that targets are met. He would redesign the market completely, addressing fundamental flaws in current policy.

In another piece he reiterates his belief that while energy suppliers have made windfall profits from the old-style twentieth-century wholesale spot market pricing approach, they should not have, and customers should not be paying for all this windfall.

Stressing the need for urgency of reform he points out that this should not wait until the consumer prices have become unbearable. That is already happening, he says. The increase in the average household bill to almost £2,000 per annum has created a political earthquake.

But while the increase in gas prices is partly to blame, Helm points to other factors, including the preference for spot pricing to promote competition, instead of long-term contracts, the lack of strategic gas storage, the growing cost of the balancing market, and the costs of distribution company failures. Behind all of these, he adds, is the lack of a coherent market design fit for the decarbonising purposes.

Yet, with one of these pieces written last year, the chances of seeing meaningful reform are slim. And in the absence of any capability or intent to secure such reform, the industry does what it always does. It sticks out its hand for more money, expecting the hard-pressed consumers to pick up the tab, abusing the legal system in the process.

And when customers and voters rebel or are simply unable to pay, what do they do then?