Uncertainty and risk
What are the potential impacts of zonal pricing on investment in renewable energy? What would it do to the cost of new developments and how would it affect batteries? The second part of our special edition delves into the costs of locational pricing.
Uncertainty and risk
What are the potential impacts of zonal pricing on investment in renewable energy? What would it do to the cost of new developments and how would it affect batteries? The second part of our special edition delves into the costs of locational pricing.
Within the energy industry, one of the main threads of the discussion over zonal pricing has been the uncertainties and risks it would create for energy developers, the impact these uncertainties and risks would have on financing costs and investment, and the degree to which they could be mitigated.
Developers and investors currently have decades of information on the dynamics of a national market on which to base their forecasts and decisions. Chopping it up into a series of smaller markets, likely operated in a very different way, would completely change the dynamics they face, depending on location. These markets would be less liquid, making them susceptible to volatility and more easily influenced by changes such as the addition of new generation or network capacity.
Many developers have argued that the supposed benefits that zonal pricing would bring, such as the more efficient operation of the electricity system, would be completely wiped out by the additional returns investors would demand to compensate them for the accompanying risks.
This issue is currently exacerbated by the still scant details of what a zonal market would look like in the government’s eyes, including the number and boundaries of zones.
Scottish Power chief executive Keith Anderson told Utility Week the massive investments in the transmission network already underway to meet the 2030 Clean Power target will “radically change the network”.
“It will change whether there are constraints on the network. It will change where those constraints may or may not be. And it will change the power flows and how we use the network”.
The government has previously indicated that the earliest zonal pricing could be introduced is 2032. “I defy anybody to be able to tell me with any great certainty they know exactly how this electricity system is going to work in seven years’ time,” said Anderson.
If ministers decide to proceed with zonal pricing this summer, Anderson said it will be telling investors: “I want you to invest billions of pounds in new generation projects [but] I can’t tell you how they’re going to be funded and how the commercial system will work and how the trading system will work.
“I can’t tell you how many zones there will be. I can’t tell you the differential between the zones. I can’t tell you which zones will be negative, which will be positive, and what… the fluctuations will be”.
Anderson said investors would face “a huge amount of uncertainty,” which would have two outcomes: investors delaying or abandoning investments, or adding large risk premia to their strike price bids: “Neither of those outcomes is good.”
“When you want to deliver all of this by 2030, you’re either going to delay it or you’re going to make it more expensive,” he added.
To relieve them of some of these fears, the Department for Energy Security and Net Zero (DESNZ) confirmed in December that zonal prices, rather than the average national price, would be used as the reference price for Contracts for Difference, thereby insulating contracted generators from price risk.
It later revealed it is considering introducing a scheme to protect existing CfD generators, including those successful in the upcoming auction round, from volume risk; specifically, the risk that they lose out on revenues as a result of the negative pricing rule which has applied from the fourth allocation round onwards and prevents generators from receiving subsidies when day-ahead market prices are negative for an extended period.
Energy Systems Catapult (ESC) chief executive Guy Newey said the hiatus in investment forewarned by Anderson could be avoided so long as the government puts forward “well thought out” transitional arrangements in a timely manner.
“If I’m a developer, I’m obviously looking at a situation where I’m facing some uncertainty because you can’t quite build your financial model at the moment,” he stated.
“But for me, that’s why the government needs to do a couple of things. It needs to be really clear on what is the direction of travel. And then it needs to be really clear on grandfathering.”
He continued: “It’s absolutely right that those transitional arrangements are done in a way that reasonably protects the investments that have already been made.
“Now, there will always be a debate about exactly where they draw that line. You can have a super maximalist approach, which is anyone who’s ever thought of a renewables project gets some kind of compensation.”
Newey said the ESC’s view is that any projects that are “very much in the system and moving forward” should receive protection.
But he said the government statements so far are not sufficient to provide the necessary reassurance to investors: “You need a really concrete written down proposal and I don’t think we’ve got that.”
Risks of doing nothing
Newey also argued that the alternatives to zonal pricing are not without uncertainty themselves: “It’s not like the status quo is risk free for these developers. The REMA process has been really clear that the status quo cannot be maintained.”
“Zonal is often described by its critics as this big radical idea,” he added. “Well, it’s not. It operates in a number of markets around the world. It’s pretty familiar. And we also know that in the markets where it's operating, renewable deployment is booming. And that’s without CfDs.
“Texas is the best booming market in the world for solar. Wind is doing really well. Batteries crucially are doing very well because they’ve got really good price signals to work off the back of. There’s no evidence that there will necessarily be a strong hiatus in investment, but that’s if the transitional arrangements have been carefully thought through.”
He said: “If you announced something on zonal and you gave some clarity on what your grandfathering would be, what you would quite likely find is lots of the developers who are familiar with the current system would go: ‘Oh. Let me get my bids in quickly.’”
Octopus Energy’s Rachel Fletcher says analysis by FTI Consulting, which was first produced for Ofgem but later updated for Octopus with new information, suggests the efficiency gains from zonal pricing would significantly outweigh any increase in financing costs.
Hitting back at criticisms of the study's assumptions, for example, over the future capacity of renewables and interconnectors, she said the analysis is the “most robust, most up to date piece of modelling that has been done”. She said the assumptions align with the government and the National Energy System Operator's (NESO) plans, have been clearly set out, and would actually "lead you to a conservative figure in terms of the consumer benefit”.
Fletcher said the modelling gives “a sense of the order of magnitude” of potential benefits “in a context where one of the allegations is that a one percentage point increase in cost of capital would remove all of the consumer benefits”.
“This modelling suggests you’d have to believe the cost of capital goes up by nearly five percentage points indefinitely in order to wipe out the consumer benefits. And I just don’t think that is a credible scenario.”
FTI said the weighted average cost of capital for new energy projects adversely affected by price and volume risks would need to increase by “4.59 percentage points in perpetuity” to negate the claimed consumers benefits of £54.9 billion between 2030 and 2050. The analysis estimated the net societal benefits of zonal pricing, accounting for transfers between producers and consumers, at the lower figure of £25.2 billion over the same period.
The consultancy also released figures for the cost of grandfathering arrangements to protect existing and in progress subsidised renewables from price and volume risks. It said applying grandfathering to all subsidised renewables online by 2030 would cost £2.3 billion between 2030 and 2050.
Although this would reduce the net benefits of zonal pricing to consumers to around £52.6 billion, the consultancy said the societal benefits would be unaffected.
It said the cost of grandfathering would rise to £6.4 billion if it was applied to all subsidised renewables online by 2035.
Batteries being overlooked
With most of the industry’s attention focused on renewables, Tom Palmer, head of business development at Zenobe, said the potential impact of zonal pricing on batteries has been overlooked.
He said the business case for batteries is built on “stacking lots of different revenues” from the wholesale market, the Balancing Mechanism and balancing and ancillary services, and “there doesn’t seem to be an understanding of the impact on batteries and the risk they face”.
At the moment, battery operators can be certain they will be able to access key markets for balancing services such as frequency response as there is always assumed to be network capacity available to enable them to deliver the service, regardless of their location. NESO then works around these services to manage network constraints.
But Palmer said it’s not clear whether this would remain the case in a zonal market. He said it may be that “you wouldn’t be able to offer the service if you are in zone where there is no network capacity. If there is limited network capacity, and under zonal I’m not allowed to generate, then I can’t provide that balancing service either”.
“If you have a zonal market, you’re more likely to procure those service on a zonal basis,” he added.
Palmer said: “The challenge we have at the moment is it’s a concept. It’s not a design. The details are scant at best. People are making assumptions in modelling analysis that may or may not hold so it’s very difficult to get any comfort in that.”
He said the “lack of acknowledgement” of this issue is “deeply concerning”.
Among batteries, Palmer said there would be both “winners and losers” from zonal pricing: “That’s the whole point of zonal. Some batteries will benefit. Others won’t.”
But he said the overall revenue risks for batteries would be larger than for subsidised renewables: “We have market risk because those markets might disappear in a location or might not be available.”
Palmer said grandfathering therefore also needs to be considered for batteries but “no one’s talked about it”. He said this would be “horribly complex” because of the number of markets in which they operate.
He stressed that “unlike pretty much every other technology, battery storage has been a real success story without requiring government subsidy”.
“The challenge we have at the moment is it’s a concept. It’s not a design. The details are scant at best. People are making assumptions in modelling analysis that may or may not hold so it’s very difficult to get any comfort in that.”
Tom Palmer, head of business development, Zenobe
