What is locational marginal pricing?

Is locational marginal pricing a silver bullet to streamline the UK’s energy industry, or could it jeopardise our energy stability? 

Locational marginal pricing is one of the hottest topics in the energy industry right now, with advantages and disadvantages on both sides. Some say it could be the answer to network issues and put money in the pockets of consumers, while others say it could cause investment to slump and put the UK’s position as a climate leader at risk.

In this article, we’ll look in more depth at locational marginal pricing (LMP). We’ll define it and lay out the pros and cons. Then, you can make up your own mind. Let’s get started.

LMP defined

Currently, as we’re all aware, suppliers charge customers for electricity based on their tariff, with no other factors taken into consideration. That means that someone in Aberdeen will pay the same per unit of energy as someone in Abergavenny or Accrington – if they’re on the same tariff from the same supplier.

Ofgem, the UK’s energy regulator, believes that moving away from this one-size-fits-all approach and charging people based on where they live could save consumers money and make it easier for suppliers to run their networks. This is called locational marginal pricing, or LMP.

Under two proposals currently on the table, the country would be divided into seven zones or 850 ‘nodes’. Each zone or node would pay different prices for their energy based on the cost of supply. So, for example, in parts of Scotland that produce a lot of energy, prices would be extremely low, perhaps the lowest in Western Europe.

It sounds great. But what’s the catch? Let’s look at the pros and cons of LMP.

LMP advantages

The Ofgem study found that switching to LMP could save between £13 and £24 billion by 2040, with the nodal pricing model saving more than the zonal plan. There are several reasons why LMP is projected to save money:

  • It would cost less to deal with network issues where some areas are overloaded while others are underserved. Currently, network issues cost around £2 billion per year to fix
  • Optimised energy distribution would lead to a reduction in CO2 emissions, which no longer need to be offset
  • Consumers in energy production hotspots would pay less for their energy

Ofgem states that vulnerable consumers in areas that would experience price increases would be protected in some way, but even with those protections in place, switching to LMP would still save money.

LMP drawbacks

Of course, nothing is perfect and there are people on the other side of the fence who believe locational marginal pricing could be terrible for the UK’s energy industry.

The main argument against LMP is that it would cause uncertainty in the market, leading to a decline in infrastructure investment. LMP would make it harder to forecast returns on investments across zones and notes, so investors might take their money elsewhere.

If this happens, it would push the cost of capital upwards, meaning consumer costs would actually go up. An Energy UK (EUK) study found that LMP could increase the price of energy to consumers by £28 billion per year.

A decline in investment in decarbonisation infrastructure would also impact the UK’s transition to net zero and jeopardise the UK’s position as a world leader in climate change mitigation. A recent report by the Scottish Future Trust stated that LMP could lead to a decline in investment in new large wind farms in Scotland.

Time for consideration

EUK warns that if the government and Ofgem are to implement locational marginal pricing, more time should be taken to weigh up the decision. For such a fundamental shift, there should be more robust evidence that it’s a good idea, with a high evidence threshold that considers all the risks. 

There may also be further alternatives to the current system that aren’t LMP, such as improving the network’s balancing mechanism that distributes energy to locations where there are supply and demand constraints. 

However, the consumer must be at the centre of every decision made around locational marginal pricing. If it takes time to arrange because we’re safeguarding the customers, that’s a good thing.