Pointing the way for locational energy pricing

Locational pricing can reduce costs for consumers – but it comes with implications for market participants

December 11, 2023
  • Jinkai Chan
  • Andreana Todorova

From the US to the UK, where electricity is generated and how far it travels has sparked debate around cost.

In the UK, a review is currently underway on how electricity is traded. The potential introduction of different pricing for wholesale electricity depending on location is one area of review.

Two mechanisms, zonal and nodal, are being considered. Zonal pricing implies different electricity prices in a few large regions, while nodal pricing breaks down prices to specific locations or nodes within the electricity grid which could result in hundreds or thousands of price points.

Why is wholesale electricity pricing under review?

Currently, the wholesale price of electricity is the same everywhere in the country - and electricity generated far away from demand benefits from the same price as electricity generated close to it. The higher the requirement to transfer electricity between remote locations, the bigger the investment required in the transmission network and the more common the occurrence of network constraints.

When generators are unable to export electricity to the grid due to network constraints, they are compensated with costs recovered from consumers' electricity bills.

With the rise in renewable energy deployment, the total balancing costs reached £2.4bn for 2021/22, of which constraint management costs totalled £1.2bn based on National Grid ESO reporting. It is expected that constraint management costs alone will increase to £2.5bn in the late 2020s. The UK Department for Energy Security and Net Zero is considering the introduction of locational pricing to help mitigate constraint costs through better siting of generation. 

What does it mean for owners of generation and flexible energy assets?

While locational pricing is considered likely to lower costs for consumers, it could also significantly change market participants’ risk exposure and incentives to build and operate generation (wind, solar, conventional power plants) and flexibility energy assets, such as batteries.

Impact on siting

In a locational pricing system, wholesale power prices are expected to be higher in areas close to demand thus to benefit from this generator, will need to be located near high-demand urban areas. However, grid capacity or land are not readily available in urban areas, while many types of generation such as nuclear, wind or large-scale solar PV are not suitable for these locations. At the same time, renewable generation requires windy or sunny locations which don’t necessarily coincide with areas of high demand, particularly for onshore wind being developed mainly in Scotland and offshore wind which operates at sea. A potential mismatch between areas with high power prices and areas with abundant resources suitable for generating assets could impact generation projects’ viability and economic returns.

Impact on generation assets revenue

Under current market arrangements, projects connected to the transmission network are compensated when they are required to stop exporting electricity in order to restore system stability. Participants in zonal pricing are expected to retain such rights only for their zone, while participants in nodal pricing may not be compensated for lost revenue based on the recent consultation. This potential reduction or removal of compensation increases the risk and uncertainty for future revenue for generators. Mechanisms are currently being proposed to protect generators from transmission constraints in a locational pricing system, however discussions are still early stage. 

Impact on investment

The complexity of locational pricing and especially nodal pricing poses challenges for investors. The requirement to take a view on future power pricing in multiple locations in conjunction with the availability of land, grid and other resources could make investment decision processes more complex. This may then lead to increased cost of capital and could favour experienced investors, leaving limited opportunities for new entrants. Understanding and navigating the locational pricing system can create barriers to entry and reduce liquidity. 

Implications for existing generation asset owners

Impact from the possible introduction of locational pricing on existing generation assets may differ based on factors such as their current capital structure, location and any potential changes to the contracts under which the assets sell their electricity, among other factors. While some asset owners may find new opportunities to add value in locations where they currently operate, those with higher leverage may be exposed to increased volatility of cashflows or lower cashflows altogether, potentially affecting ability to meet debt obligations.

Implications for batteries

Batteries currently benefit from charging at periods of low demand, when wholesale electricity prices are low, and discharging electricity to the grid when demand and prices are high. A potential transition to a granular pricing model could create an opportunity to also benefit from differences in wholesale power prices across different geographical areas over time. However, interzonal trading specifically for batteries will be closely related to the level of liquidity in the market and the size of the different zones as well as the market design on the accessibility for trading between zones or nodes. On the other hand, if the introduction of locational pricing reduces the requirement to transport electricity between remote locations and in turn the occurrence of constraints, less batteries may be required.

Evolving landscape

As the debate continues around locational pricing, it may incentivise the development of generation assets and batteries in specific locations. However, it is uncertain whether the signal would be strong enough, considering the economic viability of projects is driven largely by the availability of land, grid and other resources.

Both existing renewable energy generators and flexibility asset owners, as well as new market participants and investors, will need to navigate what is an evolving landscape to capitalise on the potential value-creation opportunities offered by optimised asset placement in a maturing industry.