Introduction to the domestic energy market
This briefing introduces the domestic energy market in Great Britain, explains how energy bills are calculated, and what the current challenges are.
Electricity is increasingly generated from renewable energy in the UK, and the cost of renewable generation has significantly decreased in the past decade.
Despite this, the price paid for wholesale electricity on the ‘spot market’, where, according to the Competition and Market’s Authority around two fifths of electricity is thought to be sold (PDF), is largely determined by the price of natural gas.
This Insight discusses the ‘marginal cost pricing’ system, which prices electricity from all sources according to the most expensive source, and its effect on the price of electricity from various sources.
How much electricity is produced by renewables?
The proportion of electricity generated from different sources has changed over time. The chart below shows that the proportion generated by renewables has increased from 3% in 2000 to 42% in 2022, whereas the proportion generated by fossil fuels has decreased from 73% in 2000 to 41% in 2022.
How is the electricity market structured?
There is a wholesale market for electricity across Great Britain, with separate arrangements for Northern Ireland. Wholesale electricity prices are set by trades between generators and suppliers, which are ultimately passed on to consumers in the retail market as the largest component of their electricity bills (as shown in the image below). Supply must always match demand.
How is wholesale electricity sold?
Trades ahead of time
The final report of the Competition and Markets Authority’s energy market investigation in 2016 found that approximately three fifths of electricity is sold through direct, bilateral trades done ahead of time between generators, suppliers and ‘non-physical traders’ . Electricity may also be sold directly to some consumers through Power Purchase Agreements or through Contracts for Difference arrangements.
The ‘spot market’
The same report found that outside of bilateral trades, approximately two fifths of electricity is sold at ‘day ahead’ and ‘same day’ auctions, closer to the time it’s available to use. This is known as the ‘spot market’. Their share of trades has fallen over time and is thought to be around 30% in 2022 (PDF).
Prices in the spot market are set using a system called ‘marginal cost pricing’, and they can vary greatly depending on market conditions. Spot market prices usually serve as the price reference in long-term contracts.
After bilateral trades and auctions, any discrepancies between predicted and actual supply and demand are settled in near real-time through the ‘balancing mechanism’.
What is marginal cost pricing?
Marginal cost pricing is where units of electricity are sold at the price of the most expensive unit needed to meet demand at a particular moment in time.
When reviewing the electricity market arrangements in 2022, the Government said the marginal cost pricing system provides an efficient signal for supply and demand decisions, is transparent and incentivises costs to be kept down.
Merit order
In each half-hour trading period, each electricity generator bids the price it will accept to generate electricity, according to how expensive the electricity is to produce.
The bids are accepted in ‘merit order’ until the demand for electricity is met; the cheapest first, and the most expensive last. However, the price of all units of electricity is set according to the bid price of the most expensive unit needed to meet projected demand: this is the ‘marginal cost’.
The example in the chart below shows how different types of generators (renewable, nuclear and gas) bid until the demand is met.
Renewable generators typically have the lowest costs (because they do not have to buy fuel to burn) and so are the first to meet demand. Fossil fuel generators (including gas) often have the highest costs as they must buy fuel to burn, which also has a carbon price on it.
As a result, although most electricity is produced using sources with low marginal costs (42% by renewables and 15% from nuclear), the price that is paid for electricity traded on the spot market is often higher, at the marginal cost of generating electricity with gas.
How much cheaper are renewables than fossil fuels?
Renewable electricity generators have become increasingly cheap, with prices declining as capacity increases.
Between 2010 and 2021, the global average cost of electricity generation for a renewable generator over its lifetime (including building and operating costs) declined by 88% for solar photovoltaic (solar panels), 68% for onshore wind and 60% for offshore wind, as shown in the chart below.
In the second half of 2021 and most of 2022, the price of gas significantly increased because of market changes after Covid-19 restrictions were lifted and Russia’s invasion of Ukraine. This has made renewables comparatively even cheaper.
Even before the rise in gas prices, new renewables schemes were able to generate electricity more cheaply than fossil fuels. In 2021, the global average lifetime cost of electricity generation for new solar panels and hydropower generators was 11% lower than the cheapest new fossil fuel generator, while onshore wind was 39% lower.
Why are some non-gas electricity generators making large profits?
Marginal cost pricing means that the recent increases in the cost of gas have also increased the revenues of other electricity generators, such as some renewable and nuclear generators. These generators operating costs are unlikely to have increased to the same extent.
Many companies have therefore announced large profits. Centrica, which owns British Gas, made £758 million from its electricity generation business in 2022, of which £753 million was for nuclear generation.
However, generators’ profits vary depending on how they sell electricity. For example:
- Renewable generators who are part of the ‘renewable obligation’ government scheme may profit from selling electricity to the wholesale market and by selling renewable obligation certificates (issued for each unit of electricity generated), but they may have already sold the electricity at a lower price ahead of this.
- Contracts for Difference Contract for Difference (CfD)renewable generators selling into the wholesale electricity market will not profit as they receive their agreed ‘strike price’ whether the wholesale price is above or below this.
To respond to large profits, the Government introduced the Electricity Generator Levy which is a 45% charge on exceptional profits from low-carbon electricity generators. It will be in effect for large generators until March 2028.
Why does the UK still use gas?
Because renewable and nuclear generation is not yet enough to meet total demand, gas is used to provide two fifths of electricity generation (see the first chart).
Gas generators can also quickly burn more or less to match temporary spikes in demand for electricity during a day. Most renewables, including solar and wind, cannot be increased on demand as they are intermittent and depend on favourable weather conditions.
Will renewable energy prices be separated from gas prices?
The UK Government has said it will investigate how to separate electricity prices from gas prices with its Review of Electricity Market Arrangements (REMA).
A consultation ran from July to October 2022, a summary of responses was published in March 2023, and another consultation in autumn 2023 will put forward reforms.
Some of the proposed changes include:
- Introducing incentives for consumers to draw electricity from the grid at cheaper rates when demand is low or more renewable energy is available.
- Creating separate markets for renewable and fossil-fuel generated electricity, so renewable energy prices can be set independently from gas.
- Reforming the capacity market to increase low-carbon flexibility technologies that are more responsive to changes in demand and supply, such as electricity storage.
Further reading
- House of Commons Library, Introduction to the domestic energy market
- POST, Electricity market reform
- House of Commons Library, Gas and electricity prices under the Energy Price Guarantee and beyond
- House of Commons Library, Domestic energy prices
About the author: Iona Stewart is a statistics researcher at the House of Commons Library, specialising in energy.
Photo by :Whitcomberd on stock.adobe.com
Corrections and clarifications
This Insight was updated on 14 September 2023 to clarify the approximate proportions of electricity sold on the spot market using the marginal cost pricing system and sold ahead of time through bilateral trades.
The title of this Insight was amended on 6 March. It originally read ‘Why is cheap renewable electricity so expensive?’.
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