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The costs of Locational Marginal Pricing outweigh the benefits, it’s time to look at other reforms.


Over the last year, a relatively small number of organisation and individuals have proposed the UK adopt a radical new system called Locational Marginal Pricing (LMP). This blog details how the costs of LMP vastly outweigh the benefits, and how we can take a more measured approach – evolving the system we have instead of overhauling it.


Nick Hibberd, Junior Policy Analyst with a focus on Economics and Markets

Background:


The UK has taken big strides in its journey to establishing a low-cost fully decarbonised electricity system by 2035 - in 2022, a record 40% of electricity came from renewables. But we’re now in the midst of a crucial moment in the transition.


Our current electricity system and market was designed around fossil fuel generation but as we move to a net zero system,we need to reassess how these operate, as highlighted in the government’s recent ‘review of electricity markets arrangements’ (REMA for short) consultation.


Add to this that much of the UK’s current and future energy generation is and will be located away from major demand centres in the south (i.e. cities like London and Birmingham) due to planning restrictions (de-facto onshore wind ban in England) and the location of natural resources (In terms of wind, wave and tidal located mostly around the coast, pumped hydro located in Scotland).


Finally, it’s critical to note that around 200GW of new clean energy capacity could be needed by 2035, up from around 100GW today – requiring £280-400 billion in public and private investment. This means over 10GW of new capacity is required on average each year until 2035, against a historical average of 5-6GW.


When you add this all together, you can see the need for reform, and an intervention like REMA.


Locational Marginal Pricing (LMP):


One market design option under investigation in REMA to solve these issues is Locational Marginal Pricing (LMP). It has recently received a lot of attention from some in the industry as a radical solution to grid issues which could steer new energy generation investment to areas where it could alleviate constraint as well as making the system operate more efficiently and therefore providing greater system benefit.

LMP could be implemented in one of two ways:

  • Zonal where the GB market is divided into several different price ‘zones’ depending on common constraints around the grid. For example, the South of England, Wales, and the south of Scotland, could all be potential zones with generators and consumers facing different prices in each.

  • Or nodal, where price is set at several thousand ‘nodes’ across the grid. Think of it as pricing-based on postcodes.


The theory is that this market design would incentivise new generators to site closer to high demand zones/nodes to take advantage of higher prices where natural gas plants set the price more often, for example London. This has the potential to mitigate the need to build new grid and reinforce existing grid. On the other side of the coin, demand, i.e. consumers, could move to zones/nodes where prices are low like Scotland with its abundance of wind generation.


But LMP is not a silver bullet, and the potential costs of the system significantly outweigh the potential benefits.


Why is evolution of the current system would be better for billpayers than a radical solution like LMP?


The disruption of such a fundamental change to the British market as LMP is highly likely to significantly increase the costs of capital for renewables developers, and the costs of our energy bills as a result. Why so?


First, there is a real risk of an investment hiatus during LMP’s (potentially lengthy) implementation period.


There are major concerns over the feasibility of implementing LMP within the next decade. Examples from other markets show that this implementation process is complex and is prone to delay. In Texas a move to LMP was decided in 2003. While initially intended for implementation in 2006, it ultimately took until December 2010. Similar reforms in Ontario, Canada are likely to be implemented in 2025 – 9 years after the implementation work began in 2016.


LMP has been taken off the table in Australia due to investor confidence concerns. After a lengthy development process (~7 years), plans to implement LMP in Australia have been dropped due to concerns that moving to a locational approach is a disincentive for renewable energy investors.


The most frequently referenced modelling of the roll out of LMP in GB, conducted by FTI, has an indicative implementation date is 2025 – which is completely unrealistic based on the practical experience in other contexts. The ESO has also poured cold water on this timeline for implementation.


The GB market is significantly more complex than the above examples, which raises further concerns over the feasibility of this date. Given that a large proportion of the theoretical benefits of LMP are realised by reducing constraint costs from 2025 to 2030 – it is highly unlikely these benefits will materialise.


Secondly, Locational Marginal Pricing introduces extreme price volatility – which investors will almost certainly respond to by demanding greater returns for their investment, increasing the overall cost of raising finance for projects.


Because new local electricity markets would be so much smaller, they’re at greater risk of unpredictable price volatility than the UK as a whole.


For example, if you’re a wind farm developer in North Scotland trying to model how much revenue you might make in the 30-45 years it’s up and running, you currently don’t have to account for the risk that ten more wind farms could be suddenly developed near you – the price is UK wide. Under LMP, a sudden glut of new local wind farms could completely change the local electricity price and your revenues – and investors are going to demand that you price in that risk. As a result, the same wind farms are more expensive to finance under LMP.


This uncertainty has massive cost implications. A single percentage point increase in the cost of capital for low carbon generation would add £45bn to the costs of delivering net zero up to 2050, and analysis suggests the impact of LMP could be as high as 2-3 percentage points. In short, the additional costs of LMP could be around £90-135bn, surpassing any theoretical benefits of introducing LMP.


Investors currently know how the GB energy market works, and they understand how to operate within it. Time is of the essence – it is not the right moment to take major risk, particularly when the USA and EU are introducing ambitious subsidy policies that are only increasing their attractiveness.


Thirdly, LMP creates a postcode lottery for consumer prices.


Areas in Scotland, which have a large volume of renewables would have much cheaper prices than most of the UK. Areas located near a node in proximity to a large gas or coal plant will, by contrast, face relatively higher prices (assuming the decision is made to expose demand side to LMP). The unequal distribution of prices undermines the principles of a just transition – a fact that is further exacerbated by the absence of democratic processes in the current push for LMP. Furthermore, LMP could feature high levels of curtailment costs which would be passed on to consumers and generators.


Finally, there is limited evidence that LMP would deliver the locational benefits it claims to.


There is limited evidence that LMP would significantly affect the siting decisions for both generators and demand side end-users for electricity.Factors such as wind resource, planning regulations, seabed leasing, and grid connection are much stronger siting signals than price. Many projects currently in development would not be able to respond to LMP by changing location. Offshore wind projects would not move due to their seabed lease arrangements, and onshore projects could not move to high demand areas (England) due to the highly restrictive planning laws (don’t forget, at the time I’m writing this there is still a de facto ban on new onshore wind). Many industries and demand side users of energy are also less likely to respond to LMP than other factors such as “existing assets, access to raw resources, and closeness to final customers”.Investments made will already have created sunk costs and relocation would likely be prohibitively expensive.



So what should we do?

Evolution, not revolution, will allow us to address the challenges of a net zero energy system. Some of the evolutionary changes are still significant departures from the current status quo and would yield major benefits, which are explored in detail in a new report by Cornwall Insight. A change in market structure would also not address the fundamental issues stemming from inadequate grid infrastructure. At a time where the priority must be the rapid development of the UK’s renewable energy capacity, it is not appropriate to take such a significant risk for theoretical benefits that may be overstated and that are underpinned by unrealistic timelines and modelling scenarios. Any benefits gained from LMP – which there is reason to be highly sceptical of – do not outweigh the risks of not achieving the UK’s legally binding net zero targets.


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