Explaining Marginal Pricing for Ed Miliband
A short guide to energy pricing that even Ed Miliband could understand
Introduction
This weekend a few friends and I attended the Battle of Ideas Festival in London. It took place in Church House in Whitehall and was organised by the Academy of Ideas. If you haven’t attended yet, I can’t recommend it enough. We had a table-top stand, promoting our free speech group Politics in Pubs. It was a hectic two days, not least because of the size of the event and the number of sessions to participate in.
The format for each session was the one we use at Politics in Pubs - a panel of speakers gave their thoughts on the topic for a session and the chair then took questions from the audience. The panel responded to these, with usually a second and sometimes a third round of questions. Hence, the audience was really involved and this helped to shape the discussion.
The main focus of the festival was looking at the major political, economic, educational and cultural issues facing Britain today. However, there were also comedy sessions, such as GB News Free Speech Nation (hosted by Josh Howie), and the Thought Police (hosted by Mike Graham and Kevin O’Sullivan). Therefore, it wasn’t all doom and gloom!
With 5 sets of sessions running each day with 12 options in each session, choosing which sessions to attend was no easy matter. Of course, with my interest in climate change and NetZero I was drawn to sessions on this topic.
One session was called “Why is my energy bill so high?” Kathryn Porter, one of the panellists and a renowned energy consultant, explained how marginal pricing is used world-wide to determine the price of energy. During the discussion I was not sure whether this was well understood, so here is a brief guide, made so simple that even Ed Miliband could understand.
The Marginal Pricing System
Electricity is bought through something called the Balancing Market Mechanism which is the system that the electricity grid system operators use to ensure that supply equals demand at all times. This is required because there is very little storage capacity in the grid. This was a relatively simple system when it was easy to forecast demand and supply. However, as renewables further penetrated the grid, we now have much more uncertainty in forecasting the supply side.
This is made more difficult because across Europe, electricity grids are being pushed closer to their limits as spare fossil fuel generation capacity has been de-commissioned. As a result, the UK often has to depend on “the kindness of strangers” by importing electricity from overseas and relying on stand-by power mainly from gas-fired power plants. Neither of these sources come cheap, which prices moving from around £60/MWh to over £2,000/MWh!
The balancing mechanism involves electricity generators bidding an amount of power (in MW) they can supply at a desired price (in £/MWh). Bids are ranked from cheapest to most expensive. This is normally in the order of wind, solar and then nuclear and finally gas. Bids are accepted in this order with the highest priced plant accepted being the marginal plant. Its offer becomes the market clearing price and all generators are paid this amount. The argument in favour of marginal pricing is that it encourages efficiency, provides incentives for investment and reflects the true costs of meeting extra demand.
The interesting thing about this, which Net Zero advocates miss, is that renewable energy companies are rewarded because a) their energy source is free and b) they do not have to pay any system costs to cover the problems introduced by their intermittency. The extra costs include constraint payments for when there is over supply, capacity payments for when there is under supply and grid reinforcement costs to bring renewable energy from remote locations, such as wind farms offshore and in the north of Scotland.
Net Zero advocates also forget that the gas price is high because of the carbon taxes. These are imposed by government and therefore artificially inflate the price – to the point where a third of the wholesale cost is carbon tax. Therefore, if you want to make energy cheaper, rather than decouple electricity from this marginal pricing system, remove the carbon taxes on fossil fuels and make renewables pay for their fair share of system costs. This would of course have the consequence of making renewables uncompetitive.
Some alternatives
Zonal Pricing
Some, like Octopus Energy, have advocated for a system of zonal or locational pricing. This would make energy prices lower in regions with their own generation. For renewables, this would favour Scotland and the north of England, whilst penalising consumers in southern England. In effect, consumers would be charged an increased priced proportional to the length of wire connecting them the nearest generator. Given the huge costs of connecting Scotland to the rest of the UK this could have a dramatic impact on electricity costs in the south of England. I am far from convinced that this would be a popular move.
Pay-as-bid
An alternative to marginal pricing is pay-as-bid, where generators receive the price they bid. This sounds attractive to consumers but then renewables could lose their competitive advantage of zero fuel costs and zero systems costs. They would be forced to bid higher, often in an attempt to game the system, offering a price they expect to be close to the marginal price. This would negate the whole point of this system.
Cost-Plus
Another alternative would be average-cost or cost-plus pricing, whereby generators are paid for their costs of production plus an agreed margin. This could be an interesting model for a grid based on reliable baseload power generation. However, as more renewables enter the grid a serious evaluation is required of what is the true cost of producing renewable energy. I have written previously about Why the Renewables Industry Loves LCOE. The Levelised Cost of Energy takes no account of system costs, such as requiring a significant amount of readily available backup for renewables. As discussed earlier, if these costs are factored in then renewable costs would suddenly become prohibitively expensive.
Split-Markets
Another approach might be to use split-markets where generators are paid for capacity (the ability to supply reliable baseload power) and separately for energy supplied, that being lower than current margin prices. In effect this would reward high quality forms of energy and penalise intermittent renewable energy suppliers.
Final thoughts
If you forget about saving the planet for a moment, it’s difficult to see how renewable energy can survive. At some point the government is going to have to accept that we have run out of sticking plaster. One thing ought to be clear though. Even if we accept that the price of electricity is set roughly by the wholesale price of gas, the additional system costs and carbon taxes levied on fossil fuel, mean that we are a million miles away from having a level playing field.
A final point. It’s one thing to debate the merits of different pricing systems, but in a rigged market heavily favouring renewables, the other conversation we need to have is around security of supply. Renewables not only cost more (once all system costs and carbon taxes are factored in) but also make the grid more unstable. As Kathryn Porter explained, we are rapidly running out of time to switch tracks back to more reliable baseload power using gas and nuclear. It’s not hyperbole to imagine regular energy rationing and blackouts within the next couple of years.