Why you can feel the war in your monthly energy bill

Imagine a supermarket that urgently needs 30,000 boxes of strawberries.

One farm offers 10,000 boxes at £1 each. Another offers 8,000 at £1.20. And another offers 7,000 at £1.50. The supermarket accepts all of these offers, but it’s still short, so it has to buy the final 5,000 from a more expensive grower at £2.50.

In a normal shopping situation, you might expect each farm to be paid its own price. But in a market like Britain’s electricity market, the final and most expensive batch needed to meet demand is what sets the price for all of them. The supermarket would pay £2.50 for 30,000 boxes.

That is, in simple terms, how wholesale electricity is priced before suppliers sell it on to households.

The UK’s marginal pricing system

To understand this properly, it helps to picture the wholesale power market as an energy pool. Making up this pool is electricity generated by sources such as wind, solar, hydro, biomass, nuclear and gas-fired plants. Britain is also a net importer of gas – we use more energy than we create – which is key to the current story of our energy shock.

The price we pay for energy is determined by something called the marginal pricing system. The National Energy System Operator (NESO) forecasts how much electricity will be needed to get us through each half-hour period. Energy producers submit bids for how cheaply they are willing to sell each megawatt-hour’s (MWh) worth, but they only go low enough for demand to bite. And of course, they never go lower than their marginal costs. This dance is played out in fractions of a second.

The bids are stacked from cheapest to most expensive in what’s known as a “merit order”. If we need 30,000 MWh for the next hour, the system starts by drawing on the cheapest energy source first, typically renewables like solar and wind because sunlight and wind are free. When renewables run out, it must go to the next cheapest; hydro. And then the next cheapest; biomass. Then nuclear. Until eventually, we secure all 30,000 MWh. Nearly all the time, we go all the way to using gas plants, the most expensive source of energy.

The key thing is that the final, most expensive unit of electricity sets the price for all electricity. This is wholesale energy bought by providers like Octopus and EDF Energy, who then sell it and deliver it to your home.

It sounds odd that – like the final plane ticket setting the cost of all tickets – if the last 500 MWh’s came at £100 per MWh, all 30,000 MWh’s will be priced at that level. That includes electricity generated by sources whose fuel cost is effectively zero, such as wind and solar. Their price may have been £20 per MWh. The system has been criticised by politicians and numerous alternative ideas have been put forward. But it’s not easy to change. And let’s be clear, the marginal pricing policy wouldn’t be a problem if our marginal provider was reasonably cost-effective and clean. Ofgem says gas sets wholesale electricity prices a large majority of the time, which is neither of these things. Below, you can see the gas share of electricity back in 2021.

Why this matters during the Iran-US conflict

When there’s instability in oil and gas-producing parts of the world, the cost of gas can be very volatile. 

This dynamic is playing out now because of the conflict in the Middle East. Wholesale gas – which sold for around 71p per therm a couple of months ago, was at £1.07 in mid-April. This is because of disruption to the Strait of Hormuz, a critical energy chokepoint through which roughly 20-30% of global oil and LNG shipments pass. Even though the UK isn’t part of the fighting, and only a small share of gas imports come from the Gulf, gas is traded in an international market. When those prices rise, UK wholesale prices rise too.

Keep a tab on our Chief Investment Office’s assessment of the unfurling war in the article below. 

Read more: Iran conflict market update – two-week ceasefire… | Charles Stanley

And there’s a broader knock-on effect for our economy. Higher international prices for gas mean higher energy prices here at home. This drives inflation, which makes the cost of living worse. The latest CPI reading on April 22nd was 3.3%, which can weigh on consumer spending and business confidence, slowing down the UK’s growth. Many experts are concerned that inflation at the same time as slow growth raises the risk of stagflation. All this pain because our energy needs make us reliant on exposure to the outside world.

The article below explores ways to cut your bills amid the crisis. 

Read more: What the Iran conflict could mean for your finances | Charles Stanley

So, why can’t we change the marginal pricing system?

It’s a fair question. Why would we pay more than we’ve already agreed to generators who are first in the merit order? Why wouldn’t we pay each one only what they asked for? Why be ruled by gas in the margin? The issue is too complex to answer fully in this article, but there are some main reasons.

Firstly, when generators name their prices, they are not adding a profit margin. Their ‘bids to sell’ are closer to a true reflection of their marginal cost of producing that energy. Generators wouldn’t run if they only earned the prices they submit, barely that operating cost. Neither would investors put their money into new generators which we’ll need in 20 or 30 years. Niche industries that support energy would shrink. Investors need to be able to predict cash flows and be confident in them. And the existing model gives clarity to that. 

The late great investor Charlie Munger said, “show me the incentive and I will show you the outcome.” If we experimented with an alternative system, there’s a risk that power plants would guess at clearing prices and bid tactically to widen their profit margins. It’s believed prices for electricity would go up as the sector would turn into the wild west with energy generators all gaming each other. They would say that without the assurance given by the old model, their ventures are higher risk and need compensating with higher rates of return. That then translates into more expensive electricity overall. 

But the other crucial argument for the marginal pricing model is that it incentivises clean energy production at a national level. The government is happy that renewable sources get used up because they’re usually cheap and first in the merit order. Ideally, the UK would like to incentivise more wind, solar and hydro plants to open to accelerate our climate transition. This is the country’s strategy to one day push gas out of the energy mix altogether, which is important to achieve for the long-term stability of our economy.

Renewables are a big part of the answer

The government’s ambitious net-zero policies are aimed at largely decarbonising electricity supplies by 2030. If we succeed in that endeavour, the UK’s electricity system should become far less exposed to gas price shocks. Gas simply won’t need importing anymore. The chart below shows the impetus given to renewables after the Ukraine war shook our energy market in 2021. It’s hoped the Middle East conflict will have a similar effect. 

We’ve touched on the UK’s net zero approach in more detail in the article below: 

Read more: Getting to net zero – the UK approach | Charles Stanley

We have no shortage of renewables, but Britain’s challenge is that the wind doesn’t always blow when we need it, the sun does not always shine when demand is highest, and the electricity is often generated a long way from where it’s needed. A windy day in northern Scotland doesn’t help a great deal if the power can’t be saved or moved to homes and businesses down in London. That’s why investment in storage, transmission and the grid will be critical in the years ahead. Storage keeps spare power for later. Transmission is the set of cables and infrastructure that moves power from one part of the country to another. And the power grid ties it all together, importantly needing to be efficient enough not to let energy escape on its journey.

So, that’s the marginal pricing system explained, and an insight into the intended direction of travel for the UK’s energy. For investors, this topic is a reminder that there will be opportunities in how we address the impact on our economy from the conflict around the world, such as the Middle East.