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Priorities for electricity market reform and Net Zero

By Owen Bellamy, Head of Power

The Government have committed to fully decarbonising electricity generation by 2035. To understand the challenges this will pose for electricity markets, and what the solutions might need to look like, the CCC has published the report of an independent Expert Group.

Meeting the Net Zero target across the economy as a whole will require at least a doubling of electricity generation by 2050, from decarbonised sources. The cost reductions seen over the past decade mean that renewables – especially offshore wind – will have a major role to play in the future UK electricity mix.

However, renewables have very different characteristics compared to the coal and gas plants that have dominated electricity generation for the last century. This therefore indicates the long-term fundamentals of how electricity markets operate will need to be adapted to meet Net Zero. Coal and gas plants are able to generate on demand and most of their costs are operating (fuel) costs rather than the capital costs of their construction. In contrast, renewables have large up-front construction costs, but close to zero operating costs from the free wind and sun. Because renewables generate when the wind blows or the sun shines, rather than on demand, future markets will need to incentivise the new technologies needed to support the electricity system when these renewables are not generating. Those include low-carbon alternatives to gas (e.g. gas with carbon capture and storage, or hydrogen-fuelled turbines), but also other options including forms of storage (e.g. by converting excess electricity supply into hydrogen) or ways to smooth demand to avoid excessive spikes (e.g. through smart charging of electric vehicles).

To deliver the Government’s aim of fully decarbonising electricity generation by 2035, the market structure will need to support large-scale investment in renewables, reward new flexible technologies, and take a whole-system perspective to ensure incentives for both demand and supply. The Committee’s advice on the Sixth Carbon Budget recognised this issue and recommended the Government develop a strategy for identifying and undertaking the reforms that are needed. And the Government have recently published a consultation on a Review of Electricity Market Arrangements (REMA), which aims to do just that.

To feed into that process, and to help develop its thinking, the Committee set up an independently chaired Expert Group to consider these issues in more detail. The work of the Group was completed before the REMA consultation was published, but a priority for the Group was to try and develop a consensus around the key questions and challenges market reforms should be trying to address and, from those, recommendations for next steps. The report reflects their views, not those of the CCC.

The Group agreed that current policies are not sufficient alone to meet the challenges identified for fully decarbonising electricity generation.

They considered that the biggest challenge in the 2020s will be mobilising the huge investment needed in low-carbon generation, storage and networks. In the 2030s the biggest challenges will be the efficient operation of the low-carbon electricity system, with a much more dynamic demand side once electric vehicles and heat pumps are more widespread.

A key criterion for the Group was the need to avoid an investment hiatus, given the pace and scale of investment needed over the coming decade. This suggests that an evolutionary approach is needed in the near term (2020s), with any more fundamental reforms such as full location-specific pricing considered for the 2030s.

Looking at some of the options that have been proposed for market reform, the Group concluded that evolutionary reform of current Contracts for Difference, combined with a greater degree of location-based pricing, and associated changes to the Capacity Market could address a number of the challenges identified and ensure stability from an investor confidence perspective.

The Group identified there are other key challenges that none of the options satisfactorily addressed. This included the need for solutions to address energy mismatches. For example, hydrogen production can absorb excess renewable generation when wind speeds are high, but clarity is needed to ensure good alignment of incentives for how this could operate within the wholesale market. And a framework needs to be provided for engaging consumers to realise the potential flexibility of local assets (e.g. smart electric vehicle charging).  More work is needed to develop options which address these challenges.

The Expert Group’s report is helpful for clarifying priorities for the REMA process and the delivery of rapid investment in low-carbon capacity over the coming decade. The Committee now intends to publish a new report in early 2023 on how an operable, low-carbon electricity system can be delivered by 2035 – in the new context of the Government’s recent interventions to tackle energy prices and rapidly reform various aspects of the wholesale market.