The need for change
The electricity wholesale market was created at privatisation with the intention it would decide the energy mix, balance supply and demand, and drive competition and innovation in retail supply. This was always going to be a challenge, but with a fast-evolving energy system, it has become an impossible ask. The wholesale market is no longer fit for purpose, and consumers are paying the price. It is time to bite the bullet and recognise that achieving energy independence through a renewables-based power system at the same time as lowering bills for consumers requires a fundamental change in approach.
The solution is to end the wholesale market in electricity and for the government to take control of balancing supply and demand to minimise costs for consumers. Replacing the wholesale market with a system of long-term contracts based on location will move the focus of competition from short- to long-term costs, optimise available grid capacity, and allow the system operator to manage operational challenges. A demand pool (or pools) can be established to provide price signals that enable consumers to optimise demand and minimise bills as well as supporting real-time system operation.
This can be delivered in a phased approach with bills starting to reduce as soon as the necessary legislation is passed. Unlike ‘big bang’ reforms, it can boost investment by creating a clear and credible direction for the market that reduces policy uncertainty.
Breaking the gas/power price linkage
Significant cracks in the market have started to emerge over recent years. Many people remain angry that all electricity consumed is charged at the highest cost of supply – often from gas-fired power stations. Various policy contortions have been considered to address this issue, but the Government position is essentially that the problem will go away when we build enough renewables. Unfortunately, this ignores a fundamental flaw in current market arrangements.
Wholesale markets were intended to incentivise investment in new power stations, and this required the expectation of future profits. Consumers paying at the level of the most expensive source of power duly delivers profits to new and cheaper generators. However, there is a problem – no investments are now made on this basis. They are all underpinned by some form of long-term Government-backed contract. The result is that consumers are paying a heavy penalty for no reason and they will continue to do so because sources of electricity have different costs. Commonwealth and Oxford University have calculated consumers could save between £130 and £268 on annual electricity bills in 2030 by moving to a system based on long-term contracts.
This is not just a problem caused by domestic gas power stations. Trading electricity with other countries avoids expensive domestic investments to balance supply and demand. However, it also means that the price in the cheaper country increases to that of the more expensive one. The huge benefit of sharing resources with neighbours is offset by the threat of importing high prices.
Consumer focus
There are other significant problems. Technology provides great potential for suppliers to help consumers radically reduce their costs. For example, through solar and battery systems and/or time of use tariffs[2]. However, suppliers remain hamstrung by the overriding business imperative to manage wholesale market risks and consumers continue to pay a premium to ensure suppliers meet tough capitalisation requirements. Replacing the wholesale market with a cost-based tariff would remove this risk and release their full innovative potential to focus purely on developing and selling new products that bring down costs and improve service to customers.
Future proofing the system
NESO, the System Operator, is also encountering problems. Operating a system with a lot of renewables is different to operating one primarily using fossil power stations. NESO is learning that it cannot rely on the wholesale market to ensure supply balances demand. They are already looking to take a more active role, controlling the operation of some assets in parallel to wholesale trading.
And then there is the grid. Thirty-five years ago, it mattered little and was largely ignored when markets were designed. It is now front and centre of the policy agenda. Building enough grid quickly and using it efficiently will be key to ensuring renewable power is not wasted and costs are reduced. We are now in a situation where it is necessary to anticipate future supplies and demands, and it is necessary to ensure these materialise in the right place – a very different challenge from the one the wholesale market was established to meet.
Finally, we will need lots of electricity storage and a strategic reserve of firm power to manage fluctuations in supply and demand within day, day to day, week to week, month to month and year to year. It is inconceivable that wholesale markets can optimise operation of storage assets and deliver a secure electricity system.
A strategic compass
The challenge is not about whether to reform, but how to reform. All the issues above are already recognised but the solutions under consideration lack a coherent strategic compass, creating uncertainty for investors. Government needs to establish a clear direction of travel and focus on the most cost-effective transition pathway that avoids costly and risky cliff-edges whilst accelerating changes that deliver benefits to consumers.
By creating a clear and credible reform pathway this is an agenda that can deliver for the investment community as well as consumers. Now is the time to commit to removing the wholesale market and establish a Consumer First Power Market.
This article was originally published in Utility Week.
