The government has said it is “keeping most options on the table” on wholesale market reform, including introducing locational pricing and having separate markets for firm and variable power.
These are included among a bevy of options in a consultation on the Review of Electricity Market Arrangements (REMA).
The consultation, which was promised in April’s Energy Security Strategy, covers options for reforming the wholesale market and Balancing Mechanism, as well as the evolution of, or alternatives to, the Contracts for Difference (CfD) and Capacity Market.
The Department for Business, Energy & Industrial Strategy (BEIS) said REMA would run alongside the refresh of its energy retail strategy, noting that many of the options under consideration would require an expanded role for suppliers. This could include an obligation on suppliers to directly procure green electricity either straight from generators or through an intermediary.
The consultation is the first part of a process that will see BEIS engage with the sector over what reforms are needed this year and next, with a delivery plan to be implemented from “the mid-2020s”, aimed at driving forward the pledge of creating a net zero power system by 2035.
The review sets out five challenges to meeting the 2035 target – scaling up the pace and breadth of investment in generation capacity; increasing system flexibility; minimizing system costs through the use of efficient locational signals; retaining system operability; and managing price volatility.
In assessing the multiple options available for reform of market arrangements, BEIS stressed that it would be mindful of cost, deliverability, investor confidence, whole-system flexibility and adaptability.
Introducing what he described as potentially “the biggest electricity market shake up in decades”, energy secretary Kwasi Kwarteng said these markets would be “the backbone of this future electricity system”. He added: “So it is critical that they are designed right, with renewables (and the wider ecosystem they require) in mind. The last major programme of electricity market reform was 10 years ago, and left some key parts of our market structure unchanged from the time when fossil fuels were the dominant source of energy; it is time to look again at whether they are fit for purpose, or whether reform is needed to deliver a clean, secure and low cost energy system for consumers.”
Wholesale market reform
Setting out the case for overhauling the wholesale electricity market, the consultation points to a growing mismatch between trading arrangements that were designed around fossil fuels and the very different needs of a system dominated by renewables. It identifies a number of challenges that are likely to grow more profound over the coming years, including prices being set by the most expensive plant (often gas), even if it is not the most abundant; the lack of suitable price and investment signals and the limited visibility of generation and demand at the distribution level.
The main approaches BEIS is considering to address these and other challenges are listed as:
- Splitting the market into separate markets for variable and firm power
- Introducing locational pricing, either zonal or nodal
- Reorienting the market towards the distribution network
- Moving to pay-as-bid rather than pay-as-clear pricing
- As well as, maintaining the fundamentals of the status quo, with incremental reforms of parameters such as gate closure
The consultation stresses that these options remain at a high level with further analysis required but all will be taken forward for further consideration.
The approach to market splitting is based on work Malcolm Keay and David Robinson, with the consultation making clear that there are no live examples and that “a wide range of crucial design questions remain to be answered”. Under this model, prices in the variable “as available” market would be set on the basis of the long-run marginal cost of renewables while prices in the firm “on demand” market would continue to be set by short-run marginal cost.
Advantages of this model mentioned in the consultation include decoupling the electricity and gas price in the variable market; enabling the discovery of the value of flexibility and representing a potential alternative to continued government support for investment in the long run (noting that support would be needed in the short term to safeguard investor confidence.
However, potential disadvantages listed include the complexity involved, the risk of reduced competition and the potential for disengaged consumers to be disadvantaged.
An alternative option to be explored is the concept of a “green power pool”, managed by the system operator alongside the existing wholesale market. This is described in the consultation as “in effect, a centrally co-ordinated Power Purchase Agreement (PPA) market”, with optional participation.
REMA will examine the merits of both nodal and zonal locational pricing. In the former, the price is set in each location of the transmission network (or “node”), reflecting the marginal cost of consumption at each point. In the latter the market is split into multiple bidding zones, each with its own clearing price.
It will also look at the concept of “local markets”, in which the wholesale market is re-oriented to a distribution level, either through new market structures or locational imbalance pricing. The latter would see the network divided into local zones at each grid supply point, with suppliers facing charges if there were both an imbalance and a constraint between the location of their consumers’ demand and their generators’ supply.
Under a “pay-as-you-bid” model, participants in the wholesale market would receive the price of their bids/offers, rather than that of the highest priced generator. While pointing to the potential to reduce the influence of the gas price, the consultation also accepts that strategic bidding may take place under this model and that price limits may have to be set, perhaps based on the estimated marginal cost of particular technologies.
Options to evolve the status quo include changes to dispatch arrangements – from self-dispatch to central; amendments to settlement periods and gate closure to increase temporal granularity in the market; and changes to the Balancing Mechanism, such as introducing improved locational signals.
Mass low-carbon power
The consultation celebrates the impact of the CfD scheme since it was implemented in 2014 but accepts that its design comes “with some limitations”.
Alongside considering the merits of the existing CfD scheme, REMA will explore different “variants” of the model with increased price exposure, either during the length of the contract or based on shorter contracts. It will also explore decoupling payment from output, either through a deemed generation CfD or a revenue cap and floor.
The consultation also covers a decentralised approach to choosing the capacity mix. This would be achieved through an obligation on electricity suppliers to procure green electricity directly on behalf of their consumers. This would see the government set a trajectory of maximum carbon intensity of electricity that suppliers could sell to their customers.
Flexibility, capacity adequacy and delivering operability
Elsewhere in the consultation, BEIS stresses the need for more accurate market signals to incentivise flexibility. It says that such market signals could deliver much of the flexibility needed for the 2035 commitment but certain challenges, including around investor certainty, may mean a mechanism to de-risk investment on an enduring basis could also be required.
Options under consideration in this section include:
- A revenue cap and floor
- Introducing flexible auctions within the Capacity Market
- Introducing multipliers to the clearing price within the Capacity Market
- A supplier obligation
On delivering capacity adequacy, BEIS says it is not minded to consider a decentralised approach. Instead the main options under consideration are a reformed Capacity Market, a centralised reliability option scheme and a strategic reserve.
When it come to delivering operability on the system, the consultation weighs up whether small modifications to current practices would be sufficient, or if a more substantial change is needed. Examples cited include giving Distribution Network Operators and local markets a greater role, co-optimising frequency and reserve under a central dispatch model, or making changes to the design of the CfD or Capacity Market.
Feedback to the consultation is being invited before 10 October with a response expected in the winter.