Chart of the Week: The UK’s natural gas problem

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The UK now generates more electricity from renewable sources than from fossil fuels, but prices are still typically set by natural gas. The close link between electricity and gas prices is shown in the chart above. This link is due to the merit order system, where the most expensive source needed to meet demand — often gas — sets the price for all electricity at that moment. Gas is not always the most expensive or marginal source — biomass, imported electricity, pumped storage, and batteries can sometimes be — but gas is typically marginal because it is both abundant and relatively expensive. Since the UK imports most of its gas, it remains vulnerable to global events like the war in Ukraine, which drove a sharp rise in energy prices and pushed energy security to the top of the political agenda. The limitations of the UK’s marginal cost-based pricing system have become clearer as renewable production grows. Renewables have very low operating costs but high up-front investment costs, and developers need stable revenues to cover those. To address these issues, the UK is reviewing its electricity market through the Review of Electricity Market Arrangements (REMA) which began in 2022. The aim is to create a system that supports decarbonisation, affordability, and security of supply. Options under consideration include expanding fixed-price contracts (like Contracts for Difference) for renewables, splitting markets for clean and fossil-based electricity, and introducing zonal pricing. But the latter has caused controversy as it would probably lead to higher prices in the south of the UK relative to the north, due to supply-demand mismatches. Ed Miliband, the UK Energy Secretary, has confirmed that zonal pricing is an option, but says that no decision has been made yet on how to reform the UK electricity market. Watch this space.

The views expressed in this article are the views of the author, not necessarily those of LSEG.

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