Zoned out: Has the government made the right decision on zonal pricing?

After months of speculation, the government has this morning officially ruled out proposals for a new zonal pricing regime with the publication of its long-awaited Review of Electricity Market Arrangements (REMA).

Much of the energy industry will be delighted that clarity has been provided and disruptive market reforms have been dropped. Others will be furious at what they regard as an enormous missed opportunity and a blatant example of Ministers caving in to vested interests. It is a debate that will rumble on long after the government attempts to draw a line under the lengthy process.

In the government's defence, it faced an invidious choice based on incomplete data, countless variables, and frankly unknowable counterfactuals. 

All things being equal, zonal pricing presented an elegant solution to a real and present problem. Current market arrangements mean the cost benefits associated with renewables are not feeding through to bills, while a lack of grid capacity means wind farm operators are too frequently paid not to generate power. These problems are likely to get worse before they get better, providing opponents of climate action with a very convenient attack line.   

Zonal pricing - which has been successfully deployed in other countries - promised to largely solve these problems by creating regional power markets that would allow those areas with surplus renewable power to offer lower prices. The resulting market forces would attract data centres, factories, and energy storage units to those regions with some of the lowest electricity prices in Europe, curbing the need for both curtailment payments and costly new transmission lines. Energy bills would plummet in Scotland, Wales, and Northern England, but there would also be cost savings right across the UK as lower curtailment payments and grid costs filtered through the system. Lower emissions would also result from the optimised use of clean power and the reduced need for back up gas generation. Some studies put the financial savings as high as £52bn over 20 years. 

But the problem was never with the principle of zonal pricing, and more with the practicalities of getting from here to there. How do you enact such sweeping reforms without introducing risk for clean energy developers that would inevitably lead to further increases in costs of capital that have already ticked up in recent years? How do you ensure energy-intensive companies really do relocate to be close to Scottish wind farms? Is remaking the economic geography of a country really that simple? Could such radical reforms be delivered at the same time as the massive project pipeline required to meet the government's clean power goal and its legally binding emissions targets for the 2030s? 

And how would it all play politically? 'Postcode lotteries' are notoriously toxic with the public. Lower prices in Scotland would be a tough sell for those south of the border even if everything worked as planned and those in the South East did not see a spike in their bills. 

These were the questions opponents of zonal pricing preyed upon, while making it clear to Labour its flagship clean energy and investment plans would be put at risk by such a fundamental shake-up of the market. Critics will now question whether the clean power by 2030 target was necessary and whether it has inadvertently pushed up the cost of decarbonisation by effectively blocking necessary market reforms. But the target was a flagship manifesto pledge and it has helped to ensure clean energy investment and climate action is prioritised by a government battling challenges on multiple fronts.

In this context, Labour's conclusion that zonal pricing is too inherently risky is understandable. The resulting clarity should mean billions of pounds of investment in new clean energy and grid projects will now start to flow, which will be complemented by the government's programme of planning reforms, state investment vehicles, clean power contract auctions, and energy efficiency policies. There is good news to be found here.  

However, it is critical the government (and those parts of the energy industry that have just won an intense lobbying battle) recognise that if there were risks associated with zonal pricing, there are also significant risks embedded in the status quo. 

As the Climate Change Committee's (CCC) Emma Pinchbeck explained in an interview this week with the popular Rest is Politics podcast, the approach to electricity pricing in the UK remains fundamentally flawed, with gas setting the price the bulk of the time and policy costs loaded onto the clean power we should be wanting to use more of. Meanwhile, the problems that zonal pricing were seeking to address - curtailment payments to wind farm operators and the need to build a lot more transmission lines - are not going anywhere. There is an issue with vested interests harvesting generous subsidies and paying companies not to generate power remains a terrible look. New pylons will face vocal opposition. With higher capital costs feeding through into higher renewables costs, questions are starting to be asked over whether the government can deliver on its promise to curb domestic energy bills.  

 Kate Mulvany, principal consultant at analyst firm Cornwall Insight, gave today's decision a pointed welcome. "The government's decision to rule out zonal pricing brings a long-awaited moment of clarity after years of policy uncertainty, but clarity is not the same as resolution," she said. "This move will not solve the deep-rooted issues in Great Britain's electricity market, and it must not be used as an excuse to continue business as usual. The electricity system remains under immense strain, with outdated structures, rising constraint costs, grid bottlenecks, and very high prices for customers. While our modelling of zonal pricing highlighted valid concerns around investor confidence, cost of capital, and risks to existing projects, stepping back from zonal pricing does not, in itself, constitute a strategy."

The government is painfully aware of these challenges. The reason the zonal pricing decision took so long is there are those within Whitehall who understand more fundamental reform is almost certainly needed to deliver an efficient clean energy system and bring down bills. It was notable a government source told the Guardian this week "all the brain power is now being expended" on identifying alternative policies that could encourage businesses and energy storage operators to locate to regions with surplus clean power.

Today's review does feature a number of proposals designed to tackle the issue of grid constraints and high systems costs, including plans for a new Strategic Spatial Energy Plans and reforms to transmission payments for generators. But there is considerable scepticism that proposals that smack of central planning will prove sufficient to bring down energy bills by the next election.   

In the meantime the government's strategy seems to be to hope that removing planning barriers and catalysing investment in clean energy and grid projects will eventually erode the dominance of gas in setting wholesale power prices, allowing for cost savings to filter through to households and businesses without the need to fundamentally reform the market or move policy costs off electricity bills. And if a global gas glut helps bring down energy prices in the interim, then that's all too the good. It may yet work, but it is not without risk.

It is unclear if this is the preferred strategy of the experts at the Department of Energy Security and Net Zero or simply what the Treasury and Number 10 will permit them to get on with. But it is worth noting the CCC and many of the UK's leading energy market experts think that while this approach may deliver much-needed clean energy investment over the next few years, it risks imposing higher costs than are necessary on households and businesses. These critics will continue to argue that if the government really wants to deliver a clean power system and bring down bills by the end of the Parliament then further reforms will be needed, especially when it comes to policy costs on electricity. 

Has the government made the right decision on zonal pricing? It depends on what happens next.