A major crisis requires a revolutionary solution
In the last year, the price of energy has become a critical issue for consumers, providers, producers and politicians alike. This crisis has come at the same time that Ofgem is evaluating whether to revolutionise the way in which electricity is priced across Great Britain by transitioning to nodal pricing, also called locational marginal pricing. Such a transition would lower households’ prices, but it would also have wide-reaching ramifications across all industries. In this short article, we will explain what nodal pricing is, and what impact it could have on the British power network.
The tricky business of pricing electricity
Electricity presents an almost unique problem when it comes to pricing. Unlike other commodities, the instantaneous supply and demand must always be perfectly aligned to prevent a network failure. Further, the electricity must be distributed across the country along transmission lines which lose energy and are limited to only carry certain amounts of power at any time. This means that someone needs to be ultimately in charge of balancing the network by turning generators on or off and determining which transmission lines to use as the demand varies. In Britain, this role is played by National Grid Electricity System Operator, who are continually calculating the most economical way to securely run the high-voltage network.
In Britain, we have many different generators, all supplying electricity at the same time to the grid, but who each have different generation costs. For instance, maintenance is the main base cost to generate energy from wind farms. When the wind blows, they are extremely efficient, whereas gas turbines are highly dependent on the price of natural gas. So how much should we pay? It’s complicated because it’s collective: our power is a combination of all sources of generation. If one were to fail, then no-one would receive any electricity because there wouldn’t be enough supply to match demand and there would be a blackout.
The answer is the idea of a marginal price. Intuitively, a marginal price is the largest increase in cost to the total network of any one user demanding one more unit of power. To understand this, consider the network in the diagram below where we have three users with given demands and two generators producing power for a fixed price per kWh shown.
Each user has a fixed demand which needs to be met by the suppliers. The connections each have a maximum capacity and some level of line losses. Each supplier can supply up to their maximum energy at a given price for each kWh they supply. We need to route the electricity to meet the demands of the users for the minimal overall cost.
In the above diagram, arrows now show the cheapest way to meet all the user demand. We have highlighted those suppliers and network connections which have reached their maximum limits. Note that this network routing is the same for both pricing strategies but the price each user/supplier pays/receives for their electricity changes – this is shown in the table later.
If we calculate the marginal price of the system, we find it to be £40 per kWh. This comes when Load C hypothetically requests an additional unit of power which must be supplied from Generator 2 as Generator 1 is already at maximum supply. In the current model of a single GB-wide system marginal price, all three loads must pay £40 per kWh for the power they use and both generators receive the maximum bid price of the two generators, in this case, £35.60. Importantly the calculation of a marginal price has considered the costs of transmission line losses. The excess paid by the consumers which is not used to pay the generators either goes to fund the system operator, transmission network maintenance or is distributed to the suppliers.
This is obviously a simplification of how electricity trading works in the UK. Because the UK has a patchwork of different electricity markets it would be impossible to detail the full problem in a single example. However, this example is representative of the day-ahead and balancing mechanism, which make up a significant portion of the prices that consumers pay and can illustrate how the two pricing strategies differ.
What difference would nodal pricing make?
Let’s now explain nodal pricing, also known as locational marginal pricing. Under this system, the marginal price for using one additional unit of power is calculated in each local area e.g. Oxford, or node, and the customers in this area pay this local price. The other major change is that the generators, which are assumed to be their own nodes, are paid their own bid prices, not the national maximum. In the table below we summarise the change in total cost and revenue to the suppliers and users in our simple example.
It is clear to see that consumers save money!
Even better this is representative of the situation in GB. There is a plentiful supply of cheap wind power in the north of Scotland and in the Northwest of England, while the power in the Southeast is generally much more expensive, mostly coming from nuclear, coal or gas-powered generators. We will explore the potential impact on generators in the next section. However, it is hoped that nodal pricing would encourage electricity generators to invest in more renewable sources in currently underserved areas in order to avoid being undercut. It would also incentivise customers to not block wind or solar farms in their local area. This has already been trialled by Octopus Energy, who are giving discounted prices to customers living near renewable energy sources in Yorkshire.
What about in the real world?
Right now, the promise of cheaper electricity sounds like a no-brainer, and incentivising investment in green energy at the same time is even better! But can this be done in reality? Also, what are the possible drawbacks of nodal pricing and what would be the impact for electricity suppliers and electricity-intensive industries?
Firstly, evidence from around the world shows us that it is certainly possible to have electricity markets founded on nodal pricing. The largest such market is PJM which covers the northeast of the USA, but nodal pricing is also used in Singapore, New Zealand and Texas to name a few examples. These markets provide important insight for understanding the differences between our current system and one based on nodal pricing, although we must consider the wider differences between the different countries and the UK. That said, many of these markets implemented nodal pricing some time ago when energy markets in general were quite different.
Secondly, while it is easy to show that prices for consumers will be lower under nodal pricing, it is far more difficult to estimate the cost of a transition. The UK will need to significantly upgrade both its infrastructure and its software to cope with the new data and computational requirements. However, this upgrade is almost inevitable one way or another as the green revolution takes place.
It is also important to consider the economic cost to the electricity industry of cutting their revenue. While there are again arguments that the economic impact will help speed up the shift to green energy through competition, some existing generators may need to adapt their operations significantly. On the other hand, a nodal pricing model holds the potential for less market regulation, thus opening new opportunities for traders and investors. This could also reduce the burden on regulators needing to constantly control the market.
Finally, a transition to nodal pricing could be the first step in a complete revolution in the way we use electricity. It is not inconceivable that we could have devices in our homes that turn themselves on or off depending on whether electricity is cheap or expensive, or if the grid needs balancing in some way. In fact, the technology for such devices already exists but there is little incentivisation to adopt them. This could be the first step towards a subscription model for consumer energy pricing. While certainly some way off, when you consider the underlying similarities between electricity and telecommunication markets it is conceivable that a similar transition from a pay-per-unit to a subscription model could take place for electricity.
In summary, the GB electricity market is in the middle of a crisis that will inevitably take some time to resolve. However, the prospect of nodal pricing which promises to both save money and help drive the transition to net zero could provide a brighter, more sustainable future for everyone.
