I have seen lots of enthusiastic posting about what a great idea this is. And don't get me wrong, I get the frustration with electricity prices spiking so high when gas prices rise. But so far I've seen far too many half baked solutions being thrown around that don't really add up. 🔌💡 (1/12)
news.sky.com
It may seem "unfair" that wind, solar and nuclear plants get paid not based on their low marginal costs, but based on prices set by costly gas plants. But there are good reasons why this a) makes economic sense, and b) can be easily mitigated by policy where it produces undesirable outcomes. (2/12) First, marginal cost pricing has a clear economic logic. If some gas plants are needed to meet demand in a given hour, prices need to rise high enough to cover the cost of running those plants. Otherwise why would they operate? The UK still needs some gas to keep the lights on in most hours. (3/12) Periods where wind, solar or nuclear plants earn surplus revenues (due to gas setting the price) are also key to paying off the high fixed costs incurred to build these plants in the first place. If wind farms were only ever paid their true marginal cost (ie zero) nobody would ever build one. (4/12) Second, there are clear interventions available to policymakers where these so-called inframarginal rents become problematic. One is long-term contracts. Most renewable plants in the UK don't benefit from prices set by gas because they are paid via long-term fixed price contracts (CfDs). (5/12) Where certain renewable/nuclear plants are earning excessive revenues, policymakers can impose a windfall tax on those profits, exactly like they did in 2022. Those tax revenues can then be used to lower prices for consumers, tackling the problem without messing around with market rules. (6/12) The "Breaking the Link" report cited in the article was honestly a mess. The idea that we just needs to move from pay-as-clear pricing to pay-as-bid betrays a serious misunderstanding of 1) how the market works today, and 2) how participants respond to different pricing mechanisms. (7/12) First, large parts of the market *already operate as pay-as-bid!* In bilateral trading and the balancing mechanism (both key ways of trading power and matching supply and demand) power plants are paid what they bid, not a uniform clearing price. This has not "fixed" the concerns being raised. (8/12) Second, moving a market from pay-as-clear to pay-as-bid means participants simply adjust their bids accordingly. Low marginal cost renewables go from bidding their true cost (i.e. zero) to bidding their expectation for the marginal plant, which is... you guessed it... usually a gas plant! (9/12) In reality there are no easy solutions here. Many of the calls to rip up the existing rules and do away with this marginal pricing nonsense still lack a credible proposal for what would replace the status quo, or how such changes could be implemented in a timely, minimally disruptive manner. (10/12) While it may not sound particularly "radical", I remain of the view that long-term contracts and windfall taxes can already do a lot of the heavy lifting here, all while preserving the proven economic incentives for least cost dispatch that sit at the core of the current market structure. (11/12) Ultimately electricity and gas prices will be decoupled, not by fiddling around with market rules, but by the continued expansion of renewable, nuclear and storage capacity to the point where gas becomes an increasingly negligible part of the supply mix. The sooner this happens the better. (12/12) A few follow-up thoughts in light of the various comments/questions in the replies. First, the UK is not an outlier. Electricity markets in virtually all advanced economies operate on a merit order, marginal pricing basis, precisely because it ensures efficient short-run least cost dispatch. (+1) In fact, places like India and China are in the process of moving away from more administrative or command-and-control setups towards this kind of market-based model. Maybe the one area the UK is a bit of an outlier is the frequency that gas plants set the price, although this is changing. (+2) It is true that there are some variations in rules across different countries, but the core wholesale market pricing principles prevail. Complementary markets (forward markets, capacity markets, ancillary service markets) are then layered on top to ensure reliability, hedge risk, and so on. (+3) Second, a related topic that’s been mentioned is locational pricing, where windy Scotland could have different prices at times when England remains reliant on gas. This is somewhat separate from the wider “decoupling from gas” debate, but see here a [long] thread on this particular issue… (+4)
After a lengthy review the UK government recently decided not to pursue locational pricing reforms to the electricity wholesale markets. I figured I’d offer a retelling of this saga and a few thoughts of my own. Energy nerds were out in force for this debate too so other takes are welcome. (1/n)
www.ft.com
Third, this debate is centred on the wholesale price of electricity. Worth noting that wholesale costs are ~40% of household retail bills. Lots can still be done on network/policy costs to reduce retail prices, both in aggregate and vs retail gas/petrol (key for electrifying heating, EVs etc). (+5)
Environmental levies fall disproportionately on electricity bills rather than gas bills, so electricity is artificially expensive relative to gas. In this commentary, Shefali Khanna and John Cui argue it's time to reform energy bill structure.
www.lse.ac.uk
Lastly, on the various other proposals I’ve seen on this decoupling issue, this Common Wealth one has been mentioned a bit and has some interesting stuff, including some of the components mentioned above (eg long-term fixed price contracts for legacy assets to deal with windfall profits). (+6)
Britain is once again on the brink of an energy crisis because of the role of gas in our electricity system. 🧵 Our new briefing explains why this is happening — and how we can reform the system to protect ordinary billpayers. common-wealth.org
www.common-wealth.org
Still, I remain a bit unclear how proposals like this still aim to set short-run hourly prices in those periods where gas plants are running, irrespective of whether those gas plants have been nationalised/regulated etc (which comes with its own challenges). (+7) On the academic side, Natalia Fabra has some good thinking on this decoupling issue post-2022 energy crisis and the experience in Spain. Again though, the core short-run marginal pricing rules mostly remain with various contract/tax/subsidy regimes layered on top to mitigate adverse outcomes. (+8)
www.sciencedirect.com
Which I guess brings me back to the idea that while some transitional measures may make sense in the interim to protect consumers, the bulk of the “solution” will likely come from the huge buildout of wind/solar/nuclear/storage already underway. Expect big changes in the next few years. (+9) Another reasonable question is if the market rules aren't fundamentally at fault, why are UK prices so high? First, UK wholesale prices are comparable to most European peers, although a bit more gas price sensitive. US prices have long been far lower. For much of the 2010s Japan's were higher. (+10)
For household retail electricity prices, UK prices have risen a lot from below the European average to near the highest (just below Germany/Denmark). Now double the US average and well above California. Wholesale costs have played a part, but other network/policy costs have also risen a lot. (+11)