Tech Talk | Locational pricing as a possible model for Britain’s wholesale market

A move to locational pricing could offer benefits to the system and customers but these will depend on how it is implemented and the response from investors.

Generally, electricity bills include costs for the transmission and distribution of the electricity that is received and these are normally fixed nationally, regardless of one’s location.

But the decentralisation and digitalisation of the system opens the way for locational pricing, which in essence takes account of the proximity to the generator with several potential benefits, not least reduced bills for customers.

The question of locational pricing for Britain’s wholesale market was identified as a potential reform option by the government and has been reviewed in a recent study by Grant Thornton and LCP Delta.

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For the purposes of the study, a zonal approach was adopted with the country split into 12 zones capturing the key transmission network boundaries – the aim being to capture the most important network constraints, without modelling at a spuriously accurate level of detail.

The findings are thus applicable only to the GB market but nevertheless should be instructive for others.

The first and most obvious finding is that the benefits of moving to locational pricing are subject to various uncertainties around the future makeup of the power sector and how locational pricing is implemented.

For example, key uncertainties are the level of network reinforcement and the impact on the cost of capital in investing in power plants.

It also would impact current policies such as the ‘contracts for difference’ and where power plants can be located.

Locational pricing benefits

The study finds that more efficient locational signals from moving to locational pricing leads to some system benefits, with larger benefits for consumers, compared to the model as currently where plants are located based on current market signals from the transmission use of system charges (TNUoS).

For example, in the government’s net zero higher demand scenario a move would decrease 2030-2050 system costs by £5 billion to £15 billion depending on the redispatch inefficiencies, while consumer costs are reduced from £24 billion to £59 billion.

The drivers of these benefits are split into two types, the study states: investment efficiency, where more efficient locational signals cause plants to locate in areas more beneficial to the system, and operational efficiency, where cost savings are a result of changes in the operation of the market, regardless of the changing location of plants.

However, the system cost benefits could be outweighed by increases in the cost of capital, with increases of 0.3-0.9 percentage points resulting in a move to locational pricing becoming a net cost to the system.

For example, a one percentage point increase would lead to a net system cost of £4-12 billion and a two percentage point increase a cost of £23-30 billion and highlights the impact on investor risk as a key policy consideration when considering a move to locational pricing.

Network reinforcement levels are another vital assumption for assessing the impact of moving to locational pricing.

This is because plants moving to more efficient locations that are closer to demand centres to avoid network constraints is one of the key potential benefits of locational pricing. A more constrained network will lead to higher benefits from moving to locational pricing as plants moving location has more of an impact.

The study finds that a 3-year delay in the network build could increase the benefits of moving to locational pricing by 10% from 2030-50.

Overall the study finds that moving to locational pricing can provide benefits to the system and to consumers but these benefits will depend on how it is implemented and how investors will react to such a significant change.

Moving to locational pricing could provide a stronger signal to incentivise plants to locate more efficiently for the system than the current model.

However, with the benefits removed if the cost of capital for investors increases, government needs to fully consider what the impact will be on investors of such a fundamental change to the market.

The study also suggests that the government should consider if some of the benefits can also be achieved through modifications to the current national pricing model, particularly the operational efficiency benefits which may not be unique to locational pricing.

Jonathan Spencer Jones

Specialist writer
Smart Energy International

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