Zonal pricing: Let’s hope the government has done its homework

The UK government is weighing up a total redesign of the wholesale electricity market – the biggest market restructure in a generation. The choice is whether to introduce zonal pricing where the country is split into a dozen or so zones, or more gradual reforms that retain a national market. Prices in a zonal market are set by supply and demand in each zone, although consumers could be insulated from such differences through further regulation.

The public debate on the issue has been polarised. The advocates of zonal pricing claim high savings for consumers through effects like more efficient dispatch of generation in the face of constraints, more efficient trade across interconnectors, and congestion rents paid to intra-zone connections. Opponents claim that the increased revenue uncertainty from volatile zonal prices will increase the cost of capital and reduce investor appetite – just as we need to quadruple the annual investment in energy to £40 billion for Clean Power 2030.

The government aims to publish a decision this summer, but further balanced consideration is needed before a decision is made. This is a technically complex issue that can only be resolved by careful analysis of the positive and negative impacts of the options. The government has not yet published their modelling of the options and scenarios, covering a full assessment of the costs and the benefits.

There is also the sheer volume of change facing the energy sector to consider. These range from technological change, to global trade upheaval disrupting supply chains, to major changes from the introduction of the NESO, the SSEP, CNSP, connections reform and planning regime reforms, as well as fairly significant changes to the CfD regime.

Where is this headed?

The objectives for REMA when it began were to accelerate investment towards net zero, reduce consumer bills and enhance energy security. Ed Miliband and Keir Starmer made the argument at the Future of Energy Security Summit in April 2024 that the answer to all three of those questions could be more renewables, more nuclear and more CCUS generation.

The challenge for the government is to either agree the transmission investment necessary to support increased renewables in our remote and windy regions, or to design a set of market structures that manage the expanding cost of curtailment. Whichever way you look at it, the impact on consumer bills will need to be assessed in the round. Opponents of zonal pricing will need to explain how the national market can stop rising balancing costs from outweighing the cost reductions from continued technological improvements in wind, solar and other low carbon energy.

The challenge for advocates of zonal pricing is to explain how the UK energy markets can quadruple annual investments to £40 billion a year, while introducing a completely new market design, and address the argument that increased risk will lead to increased financing costs. There is also the objection that voters generally do not want a postcode lottery for energy prices. While this can in principle be avoided in a zonal market through additional regulation, it does run against the grain of the market design.

Has rapid technological change been factored in?

One of the bugbears of long-term energy system modelling in recent years has been the difficulty of capturing major innovations, and sustained technological improvements. A case in point is the IEA’s energy modelling repeatedly underestimating the deployment of solar PV and battery storage.

It is not clear whether the zonal market modelling conducted so far has taken sufficient account of the cost reductions in battery storage and other longer duration storage technologies which could decrease the costs of curtailment even without zonal pricing. There is also the prospect of large EV fleets being used as battery storage fleets and contributing to the balancing of the system. The potential for unanticipated changes blindsiding the market is illustrated by the two Chinese companies (BYD and CATL) recently announcing breakthroughs in rapid EV battery charging.

This means there is an added risk in restructuring the market before the effect of those technological changes are clear.

What do we need the energy market to do?

In an era where more and more of the investment and operation of the energy sector seems to be directed by government support schemes, the question then arises of what do we actually need the market for?

The economic study of market design for electricity markets has tended to highlight two important roles for the market and the market price signal. The first is to incentivise investment. High prices signal high demand which should encourage new build, new entry and capacity expansion. In a zonal market it may also signal where new build is most needed. The second role is to incentivise efficient dispatch to balance supply and demand over various time horizons.

However, few countries rely entirely on the market for either of these important functions for the operation of the electricity system. Most European markets have financial support schemes such as the CfD or a green certificate scheme (like the RO) to incentivise investment in renewables, nuclear or CCUS. For dispatch in real time the market tends to be replaced by a system operator (like NESO) to balance the market by turning up some generators and down others. So rather than a single wholesale market that requires reform, there are in fact a complex set of interconnected markets, and non-market procurement regimes like the CfD, ancillary services and the balancing mechanism.

Protecting investors and realising market efficiencies

If the government did want to achieve both cost efficiencies and the investment acceleration needed for net zero, then further protection under existing schemes such as the CfD and the RO will be needed. DESNZ recently held a webinar for the energy sector outlining some emerging thinking about grandfathering arrangements which would give investors confidence in a transition to a zonal market. Extensions of the CfD period to make investors less dependent on the market, and additional regulatory mechanisms to compensate for volume risk were discussed.

The details were however vague, and investors targeting the renewable CfD auction (AR7) later this year, have only a few months to try to interpret what government policy means for their project’s business cases. This creates a real risk of a confused, or a failed auction.

With this much at stake, the hope is that the government has done more analysis behind closed doors than has currently been shared with the market. The UK’s ability to both accelerate investment to net zero, reduce consumer bills and enhance energy security relies on the government getting this decision right.

This article was first published in Utility Week.