A shake up of 'Marginal Pricing'?

Ajouté : 2026-05-08

[00:00:00]is electric.

[00:00:02]Electricity is the tool that we have that that will power our cars, heat our homes, and generally keep the world turning for the rest of our lives. It's the key tool that we have for reducing emissions in response to climate change.

[00:00:15]And electricity in the UK is increasingly clean. With more renewables and other clean power coming online each year.

[00:00:23]But there is a concern that the cost of electricity is a problem.

[00:00:28]With high electricity costs potentially preventing progress on climate change here in the UK. But more than that, high electricity cost cost driving inflation, a cost of living crisis, and making our economy uncompetitive, unproductive, and risking standards of living.

[00:00:44]Electricity is so important.

[00:00:47]But at the moment, it's potentially so costly.

[00:00:52]In the last week or so, government have announced a few things that could help reduce costs.

[00:00:58]As well as reducing emissions in the process.

[00:01:01]So, let's have a look at the market now.

[00:01:03]How is it all set up, and how might that change going forward? First, let's just dig into what causes high costs. How is the market set up? How does the electricity market work?

[00:01:14]Well, it is fairly complicated, but I'm going to try and talk it through bit by bit. So, please stick with me because there are a few layers. The first thing we'll look at is the wholesale electricity market. At any time throughout the week, we have a demand for electricity. For kettles that are boiling, for fans whirring, ovens cooking, lights lighting. And because electricity tends to need to be used instantly, if we ignore batteries and capacitors, all that kind of stuff for a minute, we need to match that supply with the demand. So, what we generate with what we need. And to do that in the UK and in many other countries, we pay electricity suppliers through what we call marginal pricing.

[00:01:53]And this is a mechanism that sets the wholesale price for electricity. And it's one of the ways that we ensure that we have enough power to keep the lights on at any time. And this is how it works. So, we have a number of suppliers of electricity, we call generators, that want the grid to buy their supply. They want to sell electricity to us because that's how they make their money. So, they want to guarantee that their electricity will be used. And to do that, they bid to provide electricity at as low a price as they can get away with. The lower they bid, the more likely they are to be picked, the more likely we are to use their electricity.

[00:02:27]And as demand increases, every extra portion of demand means an extra generator's bid might be needed. And because the lowest prices are picked first, every extra bit of demand means an increase in price until we reach that point that we don't need any more electricity, or what we call the marginal generator. And that's where we reach the price of electricity in that moment. And this is the kicker that make that both makes the system work and risks high prices.

[00:02:55]All those generators that bid low and guaranteed that they'd be used get paid the same price as the last generator. And surely that doesn't make any sense. Well, well, from some perspectives, it does make some sense.

[00:03:08]It guarantees that generators are bidding as low as they can, so their product will be bought. And that helps that should help drive down costs. In our old system that was dominated by big coal and big gas power plants, the marginal pricing mechanism worked really well. But with the energy transition and a range of different sources of energy, the system risks being, well, I guess, exploited. So, just sticking with that wholesale market for now, let's look at some of the renewable generators who bid in this market. A wind turbine's costs are very low. A solar farm's costs are very low. There are there's no fuel, there's minimal maintenance costs. So, they can bid as low as they want to ensure their power gets bought. And if their costs are really that low, the difference between their costs and the price that they'll eventually be paid at that marginal cost could be large. And they could potentially make a lot of profit. In the marginal pricing structure, this doesn't bring the price down necessarily. Except for that we'd avoid the next more expensive generator because the wind turbine or solar panel is providing some electricity that we won't need from someone else. Rather than driving down costs for renewable generators like marginal pricing might have done for traditional generators, the marginal pricing system could just mean large profits for those renewable generators. There is one low carbon technology that could potentially play a part in the more conventional marginal pricing system, and that's a battery, battery storage. Batteries don't necessarily want to bid as low as possible because part of the way that they make profit is by buying low and then selling high. So, they have to bid at a price that makes sense for them, that means that they can sell some energy and be picked by the process, but not too low that means that their finances don't work.

[00:04:56]And this potentially means that battery storage could bring costs down, avoiding the need for gas power as the marginal generator. Because this is what happens for the majority of the time. Gas is the most expensive generator, and that sets the marginal price, and therefore sets the whole price for the wholesale market. And that's because of wholesale costs of buying the fuel, buying natural gas, as well as some policy costs that are put on gas generation as a polluting source of electricity. This includes carbon price support, so a tax on fossil fuel generators charged at a rate of 18 pounds per ton of CO2 emitted. And there will be some people who argue that the marginal cost of electricity set by gas is based on a skewed cost of gas because of those taxes. And risking that we inflate electricity costs more broadly.

[00:05:43]And government have some plans to reduce that skewing and to help with that, which I'll come back to. On top of wholesale prices being set in the way I've outlined, older renewables in this part of the electricity market in the marginal pricing mechanism may also have a subsidy through the renewables obligation.

[00:06:02]This used to be levied on our electricity bills, but has been removed this April and moved into general taxation. So, it still exists, but but not as part of our bills.

[00:06:11]And the number of schemes that will get renewables obligation subsidy will keep dropping until it ends in 2037. So, there's still a cost to to us for a meaningful period of time. That's the marginal pricing part of the market in the wholesale market. As well as highlighting a couple of taxes and subsidies that play a role in contributing to costs in the market. But there's something else going on as well.

[00:06:34]Let's look at some other parts of the system before we get into how we might change the system to drive down costs.

[00:06:40]So, first, the first big part of the system that we should look at is contracts for difference. These are ways of paying for electricity that guarantees a price over a number of years. Therefore, attracting investment to build a generator in the first place.

[00:06:54]It's how we're paying for new nuclear at Hinkley Point, and tends to be how we've paid for renewable generators since 2017. Generators under contracts for difference don't form part of the marginal pricing market in the rest of the wholesale market. They're separate to that market. Some people who want who tend to want to rubbish renewables call CFDs a subsidy.

[00:07:14]It isn't really a subsidy, it's just a guaranteed price for a length of a contract. I guess like a fixed tariff or a fixed rate mortgage. What CFDs do is they give certainty in a variable world.

[00:07:28]Under CFDs, the electricity costs what we call the strike price for each contract. And this varies based on every project and every contract and every CFD auction. With some offshore wind that was bid back in 2019 of having a strike price at around 45 pounds per megawatt hour or 4.5 pence per kilowatt hour.

[00:07:47]Some biomass generators like Drax or Lynemouth power station, they had a price a strike price around 150, 160 pounds per megawatt hour.

[00:07:54]Some floating offshore wind at 230 pounds per megawatt hour. Hinkley Point C at 130 pounds per megawatt hour. So, contracts for difference have a range of prices. And these contracts are administered by the low carbon contracts company, which is a government-owned but private company that looks after payments through CFDs. On the low carbon contracts company website, you can see a list of all the projects and their strike price. It's a website with a lot of interesting detail. Including detail about the solar farm I talked about in a video a couple of weeks ago. That will be providing electricity very soon at just under 68 pounds per megawatt hour.

[00:08:31]So, each renewables auction, the government sets the amount of potential funding that could be given to any technology.

[00:08:37]And developers bid at a price that they think that they could make stack up for the next 20 years. Competing with others to get get part of that pot of funding.

[00:08:46]They're paid for electricity at that price for the length of the contract despite what the rest of the wholesale market does. And if the marginal cost for electricity is lower than the CFD that they've bid, which it will be for many of them, through the CFD, they are given an an inflated price for electricity. If the marginal cost is above, which will be for most of the time for many offshore wind and solar projects, particularly more recent ones, the CFD is discounting electricity for all of us. In 2026, about 13% of our electricity comes through CFDs.

[00:09:18]But with many more to come online that have already been bid for, including some of the cheapest ones that are just about being commissioned, the share of the electricity market governed by CFDs will rise. With some analysis suggesting that around 50% of electricity will be provided through CFDs by about 2031, 2032.

[00:09:37]But as more CFD generators come online, it does a few things to the market. It reduces volatility to begin with, giving a known price for electricity over the next period of time, which means that energy bills will swing up and down much less, and means that energy retailers will have more confidence in pricing for their tariffs. It could mean that prices come down, particularly as the newer contracts for difference that tend to be cheaper start generating.

[00:10:04]But, a reduction in costs because of through CFDs is not necessarily guaranteed because we don't know what the gas price will do in the short, medium, or long term.

[00:10:13]If gas prices were very low, this could mean that some CFDs are a rate that is higher than the wholesale cost. Ed Miliband, as part of the response to this energy crisis, has brought forward the next auction for renewable energy. But, with interest rates for finance high at the moment, making finance for any development more expensive, it will be interesting to see what the bid prices are through this next auction in the summer. Okay, so that's the wholesale market and contracts for difference, and that's basically how we pay for electricity across the board. There are other costs in the electricity market that I'm not going to go into too much detail on here, but you can see a breakdown on the website electricitybills.uk.

[00:10:52]And we split costs into generator subsidies, distribution, and transmission costs, and things like balancing and the capacity market.

[00:11:00]Some of these costs could go up because of investment in the grid and to balance a variable system because of the transition to renewables. But, that's also investing in our infrastructure for the next generation, which unlocks a range of benefits that will drive our economy for years to come. We could call some of these costs on our bills costs, just cost.

[00:11:22]But, I think we could also call this investment. Long-term investment for the future. But, maybe that's another video and not for now. But, that's basically it, other than some supplier costs and profit and a couple of other policy costs that contribute to warm homes and to fuel poverty schemes. That's how we pay, that's how our costs for electricity are made up. But, let's jump back to the news story at the moment.

[00:11:46]There is a lot of discussion about changing the electricity market so that costs are lower. And that may mean altering the marginal pricing structure to decouple electricity costs from the marginal price or from the gas price.

[00:11:59]And there are a few ways that have been proposed to do this and some that government have announced that they will be doing. So, let's have a little think about that. The one that's fairly simple and wouldn't change the market significantly is the one that the government have discussed this week. And that's the plan to increase taxes on renewable generators.

[00:12:21]And at first, this seems counterintuitive. Surely, we want to encourage renewables, but we're now adding a tax to punish their success.

[00:12:28]That seems wrong. Well, it could actually make sense. Those renewable generators that are in the marginal markets and not on a contract for difference, well, they've made an additional profit over this last 5 years because of the high prices of gas.

[00:12:43]And that additional profit would be taxed on as a windfall. And this is a policy that's actually already been in place since 2023, where tax is levied on renewable electricity if the wholesale price is above 75 pounds per megawatt hour, with a windfall tax of 45% above that figure, with a few other caveats.

[00:13:02]So, this wouldn't be levied on electricity through the contracts for difference scheme, and the tax becomes income for Treasury, and it wouldn't lower bills directly. But, the idea is that it could be used to sup- by the Treasury to support low-income families with bills. But, also it could incentivize some renewable generators to enter into long-term fixed-price contracts at a reasonable price.

[00:13:25]A bit like or maybe using the phrase contracts for difference. So, the government has announced plans to increase the windfall tax from 45% to 55% above that 75 pounds per megawatt hour price, as well as working to transition those legacy renewable generators to sign up for long-term contracts, reducing costs when compared to existing volatile markets, and guaranteeing a price for the long term. Instinctively, I struggle with a tax on renewable energy, but I think increasing this tax makes a level of sense. Inflated income that they've experienced in this way is is unearned. It's a windfall renewable generators wouldn't have anticipated or budgeted for. A tax like this doesn't structurally change the market and bring down costs, which is why the transition to long-term contracts also makes sense.

[00:14:11]But, there there are other more radical proposals that could be looked at. So, what else could they try? Some commentators talk about changing the marginal pricing structure. So, instead of electricity being paid for at the cost of the marginal supplier, the idea is generators could be paid at the level that they bid. So, what we call pay as bid rather than pay as clear. Again, this makes some sense. If some generators are much cheaper, we'd all benefit if those generators were paid at the cost of making the electricity, so the the cost that they've bid plus maybe plus a margin of profit rather than the cost that someone else has bid.

[00:14:47]Although, this may well require a level of regulation and new legislation to force a generator to be transparent on their costs. If the policy was pay as bid, generators or actually probably speculators in the city could guess what the likely marginal price would be in the future and bid just below that.

[00:15:04]Rather than bringing costs down, it may result in minimal changes to prices.

[00:15:09]But, if we were able to pay for electricity in this manner, bringing down the wholesale costs, that could be beneficial. But, it would be a meaningful change to the way we do things. A different approach that's been discussed is to separate renewables from the marginal pricing market altogether or separate gas from that market. The first of those is kind of happening over time through the contracts for difference scheme. Renewables under CFDs will be separated from the rest of the market because they'll be paid at a set price. And I mentioned earlier that in the next five or six years, CFDs will make up about 50% of all electricity generation. The rest will come from those legacy renewables and some gas, making up a smaller wholesale market.

[00:15:53]And as I've already mentioned, this could bring costs down, but it will definitely reduce volatility because some of electricity will be purchased at a steady rate, allowing for more consistent pricing as a longer-term hedge in prices. For the rest of the wholesale market, we could remove renewables from that market and convert their payments to a form of contract for difference like's been like's been proposed, which is gives them a guaranteed income over many years, but limits costs to us consumers. So, this is what is being has been proposed and and looks like might happen through Ed Miliband's statements in the last couple of days. And a similarly drastic step would be to remove gas from the marginal market and pay for it in a completely different manner or in a dedicated marginal market. And I think this brings some complication, but with effective market design, could help minimize costs for electricity. Gas only supplies about 25 to 30% of UK electricity in 2026, with that share dropping year on year with more renewables coming online. So, it shouldn't at that at that share of the market, it should really shouldn't set the price for the majority of electricity.

[00:17:00]Its role, increasingly, would be to ensure that we can meet demand at peaks or in times of low wind and low sun. So, it could be that it's treated in that manner, paid as a backup power supplier rather than setting the price for the majority of the market.

[00:17:15]Government have announced one change that will reduce costs slightly, and how much it will reduce cost depends on the amount of gas on the grid, but could mean two, maybe three p per kilowatt hour off the marginal price and therefore off bills. And that's the removal of the carbon price support on electricity generation. I mentioned this earlier in the video, and this is a tax on fossil fuel generation that's partly credited for the end of coal generation in the UK. The tax is 18 pounds per ton of CO2 on electricity that's been generated, and that's going to be removed in April 2028, so in 2 years' time. The impact of this will be reduced as more of electricity comes from contracts for difference, but because the marginal price is set by a generator with this tax that goes on top of it, it will reduce costs for some of the market, which is a positive thing. And people seem to suggest it's not needed in move and helping us move away from high pollution generation anymore. There do appear to be ways that the electricity market could change to help reduce costs.

[00:18:15]And I see the argument that reducing costs is important reducing emissions in other parts of our society. Lower cost electricity would really help make heat pumps more attractive and EVs more attractive, as well as supporting our economy more broadly. But, the whole conversation gives the assumption that low-carbon technology, electrified technology, is expensive today and is preventing people from switching. And actually, I would challenge that as a narrative. It's not necessarily a reality for everyone. Through time-of-use tariffs, charging an EV at home can give substantial savings versus an efficient petrol or diesel car.

[00:18:54]Powering a heat pump with time-of-use tariffs can be similar. If in in installing a heat pump, a household can remove a gas meter, there's a saving on on standing charges for that meter. If a heat pump replaced an oil boiler, the the savings can be really significant.

[00:19:09]And both EVs and heat pumps, supported by solar PV or battery storage, can be even lower cost to run. From my perspective, it's easy to assume, even lazy to assume, that today's electricity prices mean that low-carbon technology is more expensive to run. I don't think that's true. Okay, I think that's everything I wanted to say in this video. There are likely to be areas that I've dumbed down a bit in trying to make a shorter video for YouTube, and there are bits of complexity that I'm sure I have missed, but I hope that gives a bit of an overview of the electricity market and what is being done and what could be done to reduce costs in the short and long term. I don't think there's much that government is doing that will drastically reduce costs this year, but it does appear that some actions will have an impact in the medium term.

[00:19:57]What do you think?

[00:19:59]How do you think this could be approached? How do you see things differently? Please do comment below. I try to read and respond to a majority of comments on my videos. I'm sure I miss a load of them and but I would love to hear your thoughts and I'll try to to read and respond as as you share them.

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