Break up or not? Europe's zonal pricing conundrum

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Eklavya Gupte:

Welcome to Energy Evolution, an energy transition-focused podcast brought to you by S&P Global Commodity Insights.

I'm your host, Eklavya Gupte, and this week we're looking at the ongoing debate around Europe's power markets, specifically the way in which price zones are divided.

Now, zonal power pricing is where regions are split up into several different price zones, and this is to help incentivize more generation closer to demand hubs and relieve grid congestion. As the energy transition progresses, the geographic location of power generation is also changing. Think more wind in more remote locations and less coal gas, and in some cases even nuclear, in places near demand centers.

Now, this is especially relevant in markets with only one price zone, such as Germany and the UK. And this evolution is starting to raise questions about grid bottlenecks, re-dispatch costs, and incentives for new renewables. I'm joined by our correspondent Camilla Naschert to get into the issue. Hello, Camilla.

Camilla Naschert:

Hi, Eklavya.

Eklavya Gupte:

So under zonal pricing areas with high renewables generation and low demand tend to see lower prices. Now, why is this so controversial?

Camilla Naschert:

Yeah, take Germany for example, a large industrial nation with shores on the north and Baltic Sea, factories and population centers instead are clustered in the south and the west of the country, while tens of gigawatts of new offshore wind are planned in the north, this is already causing grid congestion, this issue of how to move cheap power from one end of the country to another.

And now the question becomes, should there be separate market areas to reflect those very different demand and supply balances? Proponents would argue that it would make trading more efficient and, in the longer term, attract factories to the north and incentivize the construction of renewables like onshore wind or solar in the south.

Now, aside from domestic efficiencies, the decision of whether or not to split Germany into zones affects other markets as well. So Germany's northern neighbor, Sweden, has been pushing for a split to Germany's power price zones to help reduce the price pressure on its southern market zone. And that's because the theoretical northern German price zone with lots of wind in the system is expected to be cheaper.

In reality, it's not also straightforward. In late April, the European Network of Transmission System Operators for Electricity came out with a long-awaited review of Europe's power price zones, with the goal of economic efficiencies and cross-zonal trading opportunities. This review was ordered by the EU. And for Germany, the review recommended splitting the country into five bidding zones to address grid bottlenecks and reduce re-dispatch costs, and they found potential annual economic benefit of up to 339 million Euros.

Germany now has about three months to decide whether to implement the proposed changes or to develop a national action plan to address grid congestion in other ways. And despite the recommendation, this is far from a done deal. For one, German TSOs have expressed strong reservations. They're citing practical challenges and potential risks, and other stakeholders are arguing that a split could negatively impact market liquidity and just introduce new complexities.

Now, the final decision will involve balancing the potential economic benefits and the practical challenges of implementing a bidding zone split. Politics should very much not be underestimated here either. Higher prices in the south and west are seen to be a further hit to German industry, which is already struggling given global competition. And Germany's new government made up of Christian Democrats and Social Democrats has said it does not want a bidding zone separation.

So, for an indication about how this could play out, let's take a look at the UK. It's not an EU member, so it was outside of this review, but it held its own consultation on a price zone split recently. And to explain this, let's bring in Alex Blackburne, senior reporter here in the European Energy News team. Hi, Alex.

Alex Blackburne:

Hi, Camilla.

Camilla Naschert:

Now the UK, as Eklavya said, like Germany, has only one price zone. Can you describe the demand and supply picture in the UK and how that's changing?

Alex Blackburne:

Yeah, so very similar to what you were just describing in Germany. In Britain, there's a disparity in supply and demand. So regions like Scotland and the north of England have a high concentration of renewables generation, particularly wind, but often experience lower demand, whereas the south, particularly London, has high demand but less generation capacity from renewables.

And then the other elements, to just add into the mix, is the transmission grid. So in simplistic terms, when it's particularly windy in Scotland, there isn't often enough capacity to transport that wind power where it's needed. So wind farms are paid to switch off. That's known as curtailment in the industry. And typically it's gas-fired generation in the south, so nearer to the demand that is then paid to turn on in place of those wind farms. And these are called balancing costs in the UK. It amounted to 2.7 billion of such costs in 2024, and that could more than triple by 2030 if infrastructure issues aren't addressed.

Now, under a zonal power pricing system, which is what the UK has just rejected, the theory is that areas with high renewables generation, but low demand like Scotland would benefit from lower bills, and as such, balancing costs would also be lower.

Camilla Naschert:

And you already gave away the fact that, in fact, the decision was a no, but there was, as I said, a review of the bidding zone split. Can you walk us through what exactly was proposed and what the arguments were for and against?

Alex Blackburne:

Sure. So it was definitely one of the most polarizing divisive debates that at least I've come across in the UK energy industry in recent times, and at certain points during the last three years, it got into pretty ferocious territory when at conferences you have people from different sides of the debate going quite strongly against each other.

As mentioned, this has been going on for three years. This all started with the previous conservative government, which launched the review of electricity market arrangements of REMA in 2022, with a proposal to split Britain up into around a dozen different price zones. And it really has divided the industry.

On the one side, you have the proponents such as Britain's largest retail energy supplier, Octopus. They argued that it would lead to a more efficient electricity system. It would lead to lower consumer bills, and as mentioned, it would reduce curtailment costs by better aligning the generation with demand. They believe that creating multiple price zones would encourage large energy users to relocate or even invest in areas with high renewables generation, but low demand.

But it's fair to say that Octopus and its allies were very much outnumbered. We saw significant pushback from major utilities, trade associations, industrial energy consumers, all of whom have warned that such a fundamental change would create too much uncertainty, would stifle investment all at a critical time for the energy transition. Let's not forget, we're only five years away from 2030, when the UK government wants to have a power system that is 95% low carbon.

The many critics, so that includes SSE, Centrica, Scottish Power, they argued that the risks associated with a zonal system such as creating a so-called postcode lottery for consumers outweighed the theoretical benefits. They emphasized that the existing national pricing system, while potentially imperfect, provides the stability needed for continued investment in the clean energy system.

In the end, as we have talked about, the government sided with the utilities and decided not to go ahead with the proposals. And I think at this point it was summarized quite nicely by analysts here at S&P Global Commodity Insights who said, in a trade-off between investment security and economic efficiency, the government has seemingly opted for the former.

Camilla Naschert:

That's really interesting. And terms like a postcode lottery make me think of almost a political debate as well. I wonder if this is the kind of issue that would actually resonate with voters. Do you think that the British voter had thoughts on this one way or another and that played into the decision?

Alex Blackburne:

I think if you look at the surveys and the polling that has been done on the topic, RenewableUK, one of the UK trade associations did a survey earlier this year that found 58% of people in England and Wales are against zonal pricing. There's other surveys that would give you a bigger percentage of people who are against it.

I think what is a question mark is that although as mentioned, this has been a very polarizing debate in the industry, I'm not sure the same can be said for the average voter. I'm also not sure how closely understood the complexities of the energy system is understood or resonates with the average voter. And I think this is one of the other main arguments that the utilities have had.

Centrica CEO, Chris O'Shea, was asked about this on an earnings call last week. For context, Centrica owns British Gas, which was the UK's largest retail energy supplier until Octopus overtook it early this year.

And beyond the arguments for zonal pricing being bad for investment, O'Shea's point was that it is also bad for customers because of simply how complex a system it would create. At the moment, electricity prices in the wholesale market change every 30 minutes, and under zonal system that could be every five minutes, and prices would also differ from zone to zone. So there's a possibility that you'd have a different price to your neighbor, and it's just an extremely complex proposition to communicate efficiently. And O'Shea's point is that that complexity is not good for customers.

Camilla Naschert:

Yeah, I see. Now, this proposal was ultimately rejected, but of course many of the problems, many of the reasons that proponents have been raising they still remain. So is this the end of the story?

Alex Blackburne:

It's definitely not the end of the story. After rejecting zonal pricing, the government has pledged to reform the existing national power pricing system. Now, I think there are legitimate questions around what that will look like, and it remains to be seen whether that reform can deliver efficient price signals to encourage renewables investment in the right areas. The government intends to publish a delivery plan for that later this year.

It also, as part of REMA, is committing to a raft of other reforms. So that includes a strategic spatial energy plan, which will map out energy infrastructure projects through 2050. And it will also look to review so-called TNUoS charges. That stands for Transmission Network Use of System Charges. It's basically the fees that suppliers and generators pay to use the grid network, so in more remote locations like Scotland, those charges are higher. So they're looking at reforming those and bringing in a more fair system.

Then the final piece is an ongoing commitment to upgrade Britain's aging grid infrastructure, which going back to the point about wind in Scotland switching off, that would help cut back some of those curtailments.

Eklavya Gupte:

Thanks, Alex and Camilla. And obviously this might sound like a technical story, but as you explained it, it has real life impact on investment decisions, power market design, and as a result on the pace of the energy transition.

Now, our team of reporters will be closely keeping tabs on these stories, so please check out the Platts Connect and S&P Capital IQ Pro platforms.

Thank you for listening, and please stay up to date with upcoming episodes by subscribing to Energy Evolution on Apple, Spotify, or whatever platform you listen to. If you have any ideas for guests or topics, please email energyevolution@s&pglobal.com. And I'd also like to take a moment to recognize the Energy Evolution podcast team, including Taylor Kuykendall, Karen Willenbrecht, and Dan Testa, as well as our agency partner, The 199, and the Commodity Insights Digital Content team. Thank you for listening.