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UK seeks to sever link between soaring gas and electricity prices

As the biggest state intervention in modern history to protect British households from soaring energy bills came into effect on Saturday, attention has turned to sweeping reform of wholesale markets in energy to try to prevent the crisis from happening again.

In his controversial ‘mini’ budget last month, Chancellor Kwasi Kwarteng promised an overhaul of a system ‘where gas sets the price for all electricity’ into one that mirrors ‘British energy sources, less expensive and low carbon emissions, which will reduce consumption bills”.

The move is similar to an EU move as Russian President Vladimir Putin continues to arm gas supplies to Western Europe.

Why do wholesale electricity prices follow gas prices?

Pricing in the wholesale electricity market in Britain, as on the Continent, is based on ‘short-run marginal costs’. Each power producer makes a bid, but the daily market price is set at the level that ensures there will be enough supply to meet demand. In other words, the price is always set by the most expensive plant – usually a fossil fuel plant – required that day.

In practice, this means that gas-fired power stations, which still account for just under 40% of Britain’s electricity supply, set the price of electricity more than 80% of the time, academics say from University College London.

The system worked when the UK electricity system was dominated by coal, gas and nuclear, but renewable sources such as wind and solar, which operate very cheaply once built, are rapidly increasing their market share. Renewable energy generation, including biomass, accounted for 43% of the generation mix in 2021, according to government data.

With gas prices having more than quadrupled since the start of 2021, consumers and businesses are therefore paying far more for their electricity than the average cost of generation in the market.

“What we’ve seen in the last year is that as gas prices have gone up, electricity prices have also gone up, so some renewable power producers are making very big profits. Politicians and customers are rightly asking if this is the right system,” said Ed Birkett, energy and climate manager at think tank Onward.

What would the changes look like?

Key reform options include splitting the wholesale market in two to separate renewable energy pricing, or an approach based on pricing customers based on the type of generation capacity in their area, known as localized”.

There are different ways to divide the market, but basically it would involve creating a separate pool for cheaper but intermittent renewable generation, which could be extended to nuclear, and a second for traditional fossil fuel power plants which can produce when requested.

The dual approach would reduce the prices charged for low-carbon electricity by decoupling them from the cost of gas.

Professor Malcolm Keay, a senior fellow at the Oxford Institute of Energy Studies and one of the architects of a shared market approach, said one of its attractions is that consumers could save money if they adapt their use to coincide with an abundant supply of renewable energy.

“They could install batteries or other forms of storage in their home or their supplier could use central storage. In the future, people will have things like electric vehicles and heat pumps and such. . . can be designed to meet the price of the moment,” he said.

Critics point out that the split approach is largely conceptual and would be difficult to implement if the EU markets to which the UK power system is linked did not adopt a similar model.

‘Localized pricing’ is designed to address another big anomaly in electricity markets: under existing deals, wind farms in Scotland are paid hundreds of millions of pounds a year to switch off when they produce too much electricity for local grids to handle.

Bar graph of renewables expanding, but gas still largest source of generation showing Britain's electricity generation mix (%)

The approach would require hundreds, if not thousands, of different price points across the country to reflect local supply and demand. On windy days in Scotland, for example, prices plunged.

Proponents say this would encourage investment in battery storage in places where excess electricity is generated or, conversely, encourage energy-intensive industries to locate in areas with cheaper electricity.

A study of localized pricing by Energy Systems Catapult, a technology and innovation center, and supplier Octopus Energy found that the approach would produce savings in all regions, although these would be proportionally greater in Scotland and northern England.

The approach is already being used in other countries, such as Italy, but critics say the system would result in a postcode lottery, where consumers pay vastly different prices across the country, although Birkett suggests this could be solved by applying a national average price to household bills.

How fast can the market be reformed?

Estimates vary between one and five years depending on the type and extent of reform, with some energy experts warning ministers against a hasty approach.

“We have to calm our nerves to some extent. . . these are by definition medium- and long-term reform options and the gas crisis is an immediate short-term problem. There is a risk of using the wrong tools to solve the problem,” said Tom Luff, senior advisor for electricity markets and policy at Energy Systems Catapult.

What is the government doing in the meantime?

As a first step, the authorities are negotiating with renewable and nuclear energy producers to accept 15-year fixed-price contracts below current wholesale market rates. Some still have legacy contracts that pay them a subsidy on top of the prevailing wholesale prices, allowing them to generate windfall profits.

But that effort has its critics, including Labour’s shadow energy secretary Ed Miliband, who warned the government was in a weak negotiating position and could end up agreeing to a fixed price which may be lower now but which turns out to be very expensive over 15 years. .

In the short term, some experts believe a windfall tax could be simpler, although Prime Minister Liz Truss has so far ruled it out.