The Government’s post-Brexit “Better Regulation Committee” is reportedly looking at ways to improve on EU regulations.[1],[2]Policy Exchange’s recent report, Post-Brexit freedoms and opportunities for the UK, is one contribution to that debate.[3]Understandably, most of the focus has been on state aid, financial services and workers’ rights. One area that I think isn’t getting enough attention is energy markets.
The natural monopolies provided by electricity and gas networks and the UK’s commitment to Net Zero carbon emissions all but guarantee long-term Government intervention in the energy sector. This is perhaps one reason why the Business Secretary Kwasi Kwarteng has said that there’s nothing better than his time as Energy Minister “to convert someone from being a radical free marketeer to seeing virtues of government action”.[4]
However, there are post-Brexit opportunities to develop more competitive energy markets; banishing large, socialised costs and hidden cross-subsidies in favour of modern market designs like those in the United States, New Zealand and Singapore.
Government intervention in energy policy is almost inevitable.
Electricity markets don’t lend themselves naturally to completely free markets, in part because electricity networks are natural monopolies. Without regulation, there would be chaos caused by multiple providers digging up roads to install cables to homes and businesses, accompanied by higher prices for customers. This didn’t stop Margaret Thatcher and Nigel Lawson from reforming the UK’s electricity sector in the early 1990s by privatising electricity generation and transmission and opening up competition between generators. Today, we can see that these reforms have led to a highly competitive market for owners of power stations, wind farms, solar farms and energy storage projects, as evidenced by their diverse and international ownership. Over time, the Thatcherite, liberalised model has been partly replicated by the EU, via its Internal Energy Market, and others globally. It’s a model that should be used much more around the world if we want to see the investment that will deliver a global transition to sustainable energy.
More recently, governments of all sides have repeatedly intervened in energy markets; despite good intentions, these interventions are damaging to competition and risk raising customer bills. In the early 2010s, the Coalition Government’s programme of Electricity Market Reform was a major intervention to ensure security of supply (i.e. to keep the lights on) and to reduce carbon emissions from their electricity sectors.[5] One consequence of these reforms is that the Government now provides financial support to almost all electricity generators through the Capacity Market and the Contracts for Difference scheme, which supports renewables and new nuclear power.
Government intervention hasn’t stopped competition because the UK has used competitive procurement between project developers at every stage, as well as harness competition between technologies; this approach has driven the cost of new offshore wind farms to record lows,[6] but it does reduce the role for the market in deciding what gets built. The current design of the UK’s electricity market should be uncomfortable for policymakers, and particularly for Conservatives, who should be looking to increase competition and the role of the market whilst still meeting their 2019 manifesto commitments to Net Zero carbon emissions and to keeping bills low.
In a recent report, Powering Net Zero, Policy Exchange argued that existing support schemes can be reformed to increase market competition, particularly the Contracts for Difference scheme for renewables.[7] In the longer term, these reforms would allow the Government to play a smaller role in the market. However, this will take time.
Great Britain’s electricity market has a fatal flaw.
In the meantime, the Government can improve competition in the energy sector by reforming the wholesale electricity market, through which generators and suppliers buy and sell electricity. The Thatcher-Lawson reforms in the 1990s established a competitive market for wholesale electricity. However, they put in place a market design that is actually blunting market forces, as evidenced by large, socialised costs and unintended cross-subsidies between market participants. That trend is getting stronger over time.
The Thatcher-Lawson reforms established a market where the wholesale price of electricity is the same everywhere in Great Britain at any one time, a system called ‘national pricing’.[8] One benefit of national pricing is that it’s simple to understand, something that’s often lacking in the energy sector.
However, national pricing ignores the underlying physics of the electricity network, which is made up of electricity cables with a finite capacity. So, whilst the market assumes that all generators can supply all customers at all times (and reflects this in a single price ), in practice there are fixed constraints, defined by physics, that mean a generator in Scotland can’t always transmit their electricity to customers in England and Wales, and vice versa.
This mismatch between the market and the physics means that the Electricity System Operator (run by National Grid) increasingly has to take over, typically paying to turn down wind farms in Scotland and paying to turn up gas-fired power stations in England.[9] These ‘constraint costs’ are socialised across all electricity generators and customers in Great Britain, creating a cross-subsidy from some generators and customers to others. For example, an industrial energy user in East Anglia, with offshore wind turbines or solar farms nearby, is effectively subsidising the bills of users in London where energy demand is high and supply is low. Overall, everyone is paying a higher average energy bill because of the way the market is set up.
In the 1990s, national pricing worked fine because, in a system with a few large power stations and a strong transmission grid, the potential for socialised constraint costs and hidden subsidies was small. Roll forward to 2020, however, and constraint costs are close to £1bn per year.[10] These rising costs are driven by increasing renewable energy generation, particularly wind farms. Some would take these rising costs as evidence that wind farms are unfit to compete in competitive electricity markets, but really the wind farms are just exposing the limitations of the current market design. The challenge now is to reform an electricity market that hasn’t kept pace with changing technology.
Local electricity pricing holds the key to a Net Zero energy system.
To deal with rising constraint costs, the Government should look to international markets that have solved this problem. Several US States use a system of local electricity pricing, also known as ‘nodal pricing’.[11] With local pricing, the price of electricity varies across the country, higher in areas with high demand and low supply, and lower in areas with high supply and low demand. Any economist would recognise that these are efficient market dynamics. In markets with local pricing, generators and suppliers react to changing local supply and demand for electricity. Market participants are always exposed to the true cost of energy rather than a muted price signal and large, socialised costs like in the UK. Similar systems of local pricing operate in New Zealand and Singapore.
At part of our recent report, Powering Net Zero, Policy Exchange commissioned quantitative modelling from the consultancy Aurora Energy Research to estimate the benefits of moving to more local markets for electricity in Great Britain.[12] Aurora’s analysis showed potential benefits of up to £2bn per year; a substantial saving for customers.
As part of the EU, the UK was signed up to the European Commission’s ‘Target Model’ for electricity markets, which discourages local pricing. Depending on who you talk to, the Commission’s aversion to local pricing is in part due to a desire in Germany to maintain the same electricity price for industrial customers across the country.[13],[14] Outside the EU, the UK can and should consider major reforms to the electricity market to increase competition, encourage innovation, and to reduce costs. We recommend that, this year, BEIS and Ofgem should run a full cost-benefit analysis of a more competitive, local electricity market design.
One big barrier to local pricing is the potential for winners and losers in different parts of the country. In particular, it’s probably not fair to expect households in some parts of the UK to pay substantially more for electricity than others. To address this concern, markets that use local pricing tend not to pass this through to households. In Powering Net Zero, Policy Exchange has proposed measures to make local pricing work fairly for domestic customers, something we plan to explore in more detail later this year.
On the other hand, evidence from other markets shows that local pricing reduces electricity bills overall, creating savings that the Government could use to compensate any losers, at least in the short term. In Great Britain, local pricing would benefit industrial users in the UK’s coastal industrial hubs, who would see lower electricity prices due to their proximity to cheap and abundant electricity from offshore wind farms. Local pricing is therefore consistent with the Prime Minister’s agenda for Levelling Up and for a green industrial revolution.
Competitive energy markets are integral to the UK’s post-Brexit plans.
Over the last decade, UK energy policy has increasingly put the Government in charge of what gets built. In addition, the rise of renewable energy has demonstrated that our electricity market is falling short of delivering competitive and free-market competition. As described above, Government intervention in energy policy is almost inevitable given the presence of local monopolies for electricity networks and the Government’s Net Zero agenda, but the UK could still move towards a more competitive system.
Regardless of your view on Net Zero and subsidies for low-carbon technologies, we should all agree that the underlying design of our markets should be as efficient as possible. This means seriously exploring local pricing for electricity as part of the UK’s post-Brexit review of rules and regulations, continuing the Thatcher-Lawson philosophy that competitive markets are the key to lower electricity bills.
[1] Hope, C. The Telegraph (January 2021). Rishi Sunak to chair Whitehall taskforce to lead bonfire of EU red tape. Link
[2] Owen, G. Mail on Sunday (January 2021). Let’s make Britain the Singapore of Europe! Link
[3] Policy Exchange (March 2021). Post-Brexit freedoms and opportunities for the UK. Link
[4] Pickard J, and Thomas, N. Financial Times (January 2021). Kwasi Kwarteng, the free marketeer leading benefits of state action. Link
[5] DECC (June 2014). Implementing Electricity Market Reform (EMR). Link
[6] KPMG (September 2019). Blown away, CfD Round 3 delivers record low prices for offshore wind. Link
[7] Policy Exchange (December 2020). Powering Net Zero. Link
[8] The market initially covered just England and Wales. In 2005, the market was extended to Scotland, creating the ‘GB electricity market’. Across Great Britain, there is a uniform price for wholesale electricity in each 30-minute trading period.
[9] The Electricity System Operator (ESO) is part of National Grid PLC. Link
[10] In 2020, constraint costs were £911m. Source: NG ESO Monthly Balancing Services Summary (December 2020). Link
[11] US States and regions with local pricing include: California, New England, PJM (Eastern US), Southwest Power Pool, and Texas.
[12] Aurora Energy Research modelled splitting the GB electricity market into three zones, i.e. a system of regional pricing. See Appendix 1 of Powering Net Zero. Link
[13] With local pricing, electricity prices in Germany would likely be much lower in the north of Germany than in the south, due to constraints on the transmission network.
[14] Deign, J. Greentech Media (March 2020). Germany’s maxed-out grid is causing trouble across Europe. Link