Energy industry addiction to short-termism will hike bills and reduce support for renewables

A comprehensive plan to reform the electricity market to make it fit-for-purpose for the transition to renewables, and reduce costs for households, has been met with howls of complaint from the renewable generation lobby:

Industry leaders were quoted as saying: “these proposals are too complex – they are unworkable, and they are looking more and more like a train wreck… This will expose consumers even more to price volatility. It's taking the risk of volatility away from the generators, who are best equipped to deal with it, and passing it on to consumers."

All of this is very familiar to those who have been following debates around the government’s Review of Electricity Market Arrangements (REMA) proposals to move the electricity market to a system of zonal pricing.

The catch? The quotes above are from 12 years ago.

The reforms in question were Electricity Market Reform (EMR) and its proposed ‘Contracts for Difference’ (CfDs), removing a blunt renewables subsidy system and replacing it with a support mechanism that offered better value to bill payers. Despite opposition from the renewable generation lobby, it ended up being a staggering success. British renewables capacity grew from 9GW in 2010 to 56GW in 2023. And today the renewables industry praises CfDs as a world leading innovation.

It is hard not to think about the boy who cried wolf when listening to the renewables sector complain about market reform today. Change is difficult. Sadly the trade body RenewableUK risks becoming the voice for inertia. In a recent blog it complained that a move to zonal pricing ‘would significantly increase the costs of financing projects across all technologies, due to the extreme price volatility it brings and the greater potential risk for investors as a result.’

Twelve years on from EMR the same arguments are being made all over again. Has RenewableUK forgotten the supreme ability of businesses and investors to adapt to change? Lobbying for an easy life will stand in the way of clean energy, green growth and lower bills. John F Kennedy said "Do not pray for easy lives. Pray to be stronger".

Why do we need to overhaul electricity markets?

The energy transition is happening and change is coming. The old energy system was dominated by fossil fuels being burned in power stations down the middle of the country. These were easy to turn up and down in response to demand. The new energy system will be dominated by renewables, with solar and wind farms in different places to the old power plants. Wind and solar are the cheapest forms of energy generation humanity has ever known. But we can't control when the wind blows or the sun shines. In the future energy system we will have long periods of abundant energy with short periods of scarcity. Thanks to digitally connected devices, like batteries, electric vehicles and heat pumps, demand can be flexibly shifted around the weather.

Today's electricity markets were not designed for this new world. They were designed in the late 1990s before the renewables boom. Britain has one national electricity price even though at any point in the day the cost of producing electricity differs radically around the country. It costs money to move electricity from where it is produced to where it is needed. Under the current market, if an offshore wind farm in Scotland produces more electricity than the network can handle it is paid to turn off, or ‘constrained’. A gas fired power plant in the South of England is then paid to turn on. These ‘constraint costs’ are huge. In 2022-23 they amounted to £1.5Bn and are projected to rise to £3.7Bn by 2030 and £4.5bn by 2035. This is a staggering waste of electricity. Britain is throwing away enough electricity to power 2 million homes each year. What is more shocking is that the companies that cause the congestion don't bear the cost. ‘Constraint payments’ are collected from end consumers' bills. This is a form of socialism for private companies. According to a former Chair to the Energy Select Committee, it is ‘the next Post Office scandal’.

It would be foolish to try to decarbonise while sticking with a market designed for a bygone age. This would be like expecting the 19th century rules of the road for horse-drawn carriages to be suitable for today’s motorways. In 2022 the last government tried to grapple with this problem. It launched the Review of Electricity Market Arrangements. One of the options being considered is zonal pricing, which would split Britain into several different geographical zones with each having a different price based on its level of supply and demand. This would make the energy system much more efficient, for example, helping match demand to when energy is plentiful, cheap and green in any given location.

RenewableUK’s flawed argument

RenewableUK acknowledges the government’s own figures that show that consumers could benefit to the tune of £25-49Bn with a zonal market. The author describes these benefits as ‘theoretical’, but then goes on to make a number of ‘theoretical’ observations on why zonal might not work:

1. “It will be difficult to implement and will take a long time”
2. “It won’t work because renewable generators won’t move locations”
3. “It will lead to an increase in the cost of financing which will slow down building infrastructure”

These points have been rebutted many times. But for the record let’s go over this again.

1. Zonal pricing will be difficult to implement and will take a long time.

This is illogical. It is like saying we shouldn’t do something we know would be good in the long run because the transition involves some additional effort. It is perfectly possible to implement market reform at the same time as building infrastructure (we can ‘walk and chew gum’).

Britain has a strong heritage of successfully executing complex energy programmes - from the conversion to natural gas to the nuclear programme in the 1960s-1970s to the introduction of the ‘contracts for difference’ in the last decade. It is perfectly possible to implement zonal pricing quickly and efficiently. Other countries have done it in under four years and we can easily beat that. Britain would benefit from the moment a decision is made because companies would start to make different decisions on where they put new batteries and generation. This could make a significant contribution to the 2030 clean energy mission.

2. Zonal pricing won’t work because renewable generators won’t move locations

RenewableUK claims that ‘there is limited evidence that zonal pricing would deliver the locational behaviours it claims… [because] factors such as wind resource, planning regulation, seabed leasing and grid connection are all much stronger determinants of location than price’. This is a distraction tactic. No-one advocating zonal is suggesting that the price is the only factor that determines location. But companies do have a choice of different plots of seabed and land, and price signals will be helpful to steer these choices. There are businesses that can move around geographically - for example battery developers, onshore wind farms, large data centres and hydrogen electrolysers, factories choosing where to locate. Under zonal pricing Scotland would have some of the cheapest electricity in Europe, which would be a boon for its economy. Zonal pricing in Sweden has helped to attract new, green industries like green steel and gigafactories.

But even in the vanishingly unlikely scenario that zonal pricing has no impact at all on where renewables locate, we'd still get around 75% of the benefits. The vast majority of the value comes from changes to the way generation assets and batteries are operated, not where they locate. For example, in a zonal market batteries and the subsea interconnectors to other countries would face much clearer signals when to draw in and dispense power.

3. Zonal pricing will lead to an increase in the cost of financing which will slow the rate of investment and building infrastructure

RenewableUK says zonal pricing will significantly increase the costs of financing projects. It claims this is ‘due to the extreme price volatility’ that zonal brings and the ‘greater potential risk for investors’ as a result. They also claim there could be a ‘hiatus of investment’. This is wrong. Just as 12 years ago sections of the renewables industry were wrong about the ‘contracts for difference’.

Firstly, there is no evidence market reform leads to uncertainty and an increase in the cost of financing. There are so many other macroeconomic factors at play, mainly interest rates and other government support schemes that de risk investments (like the ‘contracts for difference’). The cost of debt for European electric utilities fell between 2004 and 2021 despite numerous major electricity market reforms. What does lead to an increase in the cost of capital is policy uncertainty, which is what we will have forever if we stick with the current market structure. No investor thinks the current model can survive the next decade. It will become politically unjustifiable to charge customers gargantuan sums to manage network congestion.

Secondly, there is no evidence that zonal pricing specifically leads to an increase in the cost of financing or a slow down in the growth of renewables. California went zonal in 2009 and wind doubled and solar boomed. The Nordic states have a zonal market structure and have the same cost of capital as the UK. Italy went zonal in 2004 and the cost of financing fell dramatically.

Thirdly, it isn’t the case that zonal pricing will introduce greater price volatility for very large scale ‘capital intensive’ projects like offshore wind. The ‘contracts for difference’ scheme, which provides renewable developers with a stable price, could easily be replicated for each of the new zones.

Fourthly, a move to zonal pricing will not create any new risks that can’t be managed with a bit of creative thinking on the parts of companies. In the current system the citizen-consumers of Britain are the ones that bear the risk. If the network can't transport electrons then generators are paid to turn off and the cost is spread across all consumers. In a zonal market if there is too much electricity supply the price will fall and renewable generators may have to turn off without being compensated. But there are plenty of things forward thinking companies can do to manage these risks. They can invest in assets in multiple zones. Or match building solar and wind farms with storage and batteries. Or buy financial products like ‘financial transmission rights’. Or they can sign corporate power price agreements which would give them a fixed price. RenewableUK’s point is really that investors will face additional risks if renewable companies don’t find a way to manage market risk.

Companies and investors are adaptable. Both adapted quickly to the ‘contracts for difference’. Zonal pricing is not some untested idea. 50% of the electricity capacity in the OECD countries operates under a zonal model. Many RenewableUK members are already active in these markets, so they must know how to make it work. Of course it is easier for investors and companies to push all risk onto end consumers, but that doesn’t make it the right thing to do.

RenewableUK’s blog strays into fear mongering on zonal pricing but doesn't mention the risk of sticking with the status quo. It is politically unsustainable for investors to base their business cases on being paid to turn off and consumers making them whole. RenewableUK is failing its members by defending the status quo, and leading them down a dangerous path.

The alternative wont work

RenewableUK’s alternative is a series of complicated half measures while ploughing on with building infrastructure. RenewableUK claim that market reform would be an ‘inappropriate risk at a time where the priority must be the rapid development of the country’s renewable energy capacity’. This is key.

RenewableUK has focussed on capacity, but capacity doesn't necessarily translate into useful electricity. If a wind farm with 1 MW of capacity sits dormant in Scotland and a gas fired generator is paid to switch on instead, this wind farm is pointless. The mission of the electricity system should be to ensure as much energy demand as possible is met with green electricity at the lowest cost.

The mission shouldn’t be to just build stuff. RenewableUK also claims a bigger problem is lack of network infrastructure. They say ‘fundamentally, the most impactful thing the Government can do is to build more grid infrastructure.' But the government doesn't build grid infrastructure, private companies do. And they make profit by spending money to grow their ‘regulated asset value’. Like ‘constraint costs’, the costs of building electricity network upgrades are also pushed onto end consumers.

RenewableUK wants the government to stick with a market that means its members are paid to build regardless of whether the infrastructure is being used effectively. This is a short sighted strategy and will be rumbled at some point. It will mean building an overpriced, oversized, inefficient system. This can't be undone. We must make fundamental changes to markets quickly, before we get too far down this path.

What is motivating opposition to reform?

RenewableUK says there is a ‘consensus across developers, supply chain companies, financial institutions, and asset managers’ that zonal pricing is a bad idea. This is unsurprising. These are all companies that benefit from keeping the status quo. Let's look at the organisations that are in favour of zonal. The National Energy System Operator and Ofgem, two not for profit organisations that are responsible for delivering net zero, protecting consumers and keeping the lights on. The Energy Systems Catapult, the UK’s energy innovation agency. A number of left-leaning and right-leaning think-tanks. The supporters of zonal are the kind of organisations that don't have a vested interest in keeping things the same.

Octopus Energy also supports zonal pricing. We serve 7 million customers and are the largest electricity retailer in the UK. We also operate a portfolio of renewable generation assets worth £7Bn. We are a member of RenewableUK.

We have as much a stake in the energy industry as any of the companies that RenewableUK says are opposed to zonal. But we can see that the current model is not sustainable for the long term and will saddle consumers with unnecessary costs at a time many are struggling.

In markets which work well, retailers exert pressure on the supply chain to cut costs for their customers. It is their primary responsibility. Energy needs to be the same. That’s why Octopus will not relent on this topic. Of course, it’s easier for many in the energy sector to enjoy huge income for unnecessary and inefficient infrastructure, loaded on to consumer bills. But it is not acceptable to force all households to overpay for a lazy, bloated system.