Devolving power: strategic choices for the future Net Zero energy system

Published: 11 February 2021

By Guy Newey, Strategy and Performance Director, Energy Systems Catapult

The next phase of decarbonisation in the UK will likely have two characteristics: it will need to be much more consumer-friendly, and it will need to be much more sensitive to local contexts.

We have made tremendous progress in electricity decarbonisation over the past 10 years, but those changes have been essentially hidden from people; when I go home and turn the lights on, they still come on. From a consumer experience point of view, it doesn’t really matter if the electrons come from a coal-fired power station or from a wind turbine. Any additional cost in the unit price of electricity to pay for innovation in renewables has been largely offset by more efficient products, such as LED lightbulbs.

Heating and transport decarbonisation, the next two big chunks of emissions, are not like that. Owning and running an electric vehicle is a different experience from running a car with an internal combustion engine. And low carbon heating systems, in particular heat pumps, provide a very different heating experience from that of condensing boilers, which many of us are very used to. Coming up with consumer offers that people actually desire is essential to meet the speed of transition required for Net Zero.

In addition, for both heat and transport, geography matters. In order to build an EV charging infrastructure that meets drivers’ needs, you need to understand transport patterns at a local level (as well as the state of the local power grid). For heat, an understanding of local geography is even more important. You need to understand: the state of the housing stock (eg. is it suitable for heat pumps without any retrofit requirements; where are the pockets of fuel poverty to be targeted); the potential for different forms of heat networks; the interaction between gas and electricity networks (if it is close to a significant source of hydrogen, for example), as well as the capacity of the local power grid. And you need to consider both heat and transport together if you want to avoid digging up the roads every time someone in the street gets a Tesla or a Daikin.

At the same time (and indeed linked to this), the energy system is starting to unlock the potential of digitalisation, potential that will help to facilitate a much more active demand side (your EV charging when the wind is blowing or when prices are low, your heating coming on a bit earlier to flatten the evening peak etc). This poses a new set of difficulties for policymakers and regulators, including how to ensure consumer protection in a ‘smarter’ energy system, and how to avoid creating new digital monopolies.

So, what should policymakers do when faced with these challenges? Well, in our view at Energy Systems Catapult, a problem with these characteristics requires a rethink of the architecture of the energy system. Right now, it is not clear who has responsibility for thinking about that new architecture (it is a mixture of BEIS, DfT, Ofgem, Ofcom, National Grid ESO, etc). This requires significant coordination and clearer allocation of responsibilities.

The characteristics of a much more active demand side (as well as a more variable power supply market thanks to the large and growing penetration of wind and solar) and more uncertainty about consumer and technology choices, call for a more devolved approach. What might that mean in practice?

1. Decentralised markets

Policymakers first step when architecting a new framework to meet the challenges set out above should be to try and get as many decisions made in markets as possible. The kind of solutions you need in heating, for example, need to be sensitive to what householders want from their heating system and the building’s characteristics, which could be very different for different consumers. Market forces are a much better way to reward innovations that work and punish those that do not, than through Government fiat about particular technologies.

To be clear, when we say decentralisation, we do not mean decentralised technology. For too many in the environmental movement, the electron or therm produced close to people’s houses, is somehow more virtuous than that produced in a large power station or offshore wind array. For me, I only care about two things: how much carbon was emitted to produce the unit of energy; and how much it cost to get it to me. If energy produced on my roof ticks those boxes, great. If 3.2GW nuclear power station and a sophisticated transmission and distribution grid do the same, no problem. While decentralised technologies, including on the demand side, are already becoming more important, a trend that is very likely to continue, rolling out more of them should not be an objective of energy policy.

Rather, the key characteristic of decentralised markets is that decisions are made by market participants, not by a centralised institution, such as Government. This is not because companies or consumers are somehow better decision-makers than brilliant people in Whitehall or Canary Wharf or at the ESO in Warwick. But because the scale of their decision-making is smaller, it allows rapid experimentation and feedback, which ultimately leads to better outcomes for consumers.

However, the current trend in UK policymaking is towards more centralised decision-making. Electricity Market Reform created Contracts for Difference and the Capacity Market, for very sensible reasons. They have been extraordinarily successful at driving down the cost of the technologies they support, in particular in driving down the cost of capital. But they are essentially very successful innovation policies. Now Government (or bodies on behalf of Government) have to make a large number of decisions: how much offshore wind to procure; what should be the floor price for different technologies; how much capacity to buy and when should it be available; what should be the particular derating factors for different technologies based on their performance characteristics. While competition in this framework, once those centralised decisions have been made, has worked in driving down costs for the favoured technologies such as offshore wind, it is not clear that, in the medium-term, this is the optimal approach for a low-cost system. The Energy White Paper also, to some extent, recognises this

  • “We will also be asking about the broader evolution of the electricity market (see ‘Energy system’ chapter). We will seek a balance between options for further reform of the market with maintaining the success of the CfD in deploying low-cost renewables at scale.”
  • Other parts of the paper are more forward-leaning: “We will work towards a market framework which ensures that national and local electricity markets are fully co-ordinated and satisfy the full suite of system requirements.”

The current market design risks stifling distributed and demand-side technologies, such as batteries and heat pumps, which are likely to become much more important in the coming years as transport and heating electrify. A more flexible demand side is likely to be essential in keeping the costs of the transition as low as possible and helping manage a windier system. CFDs and the capacity market distort the wholesale market, dampening price signals for the kind of innovations that lots of the companies we work with at ESC think they can deliver. As a result, too often the market drivers for flexibility are not there or are very complex to navigate.

Our preferred model is that you get as many of those decisions made in the market as possible, rather than in Whitehall. How would you do that, while creating a driver of decarbonisation as strong as the CFD, but one that also reflects real system costs? The steps you would need to take are:

  • More granular power market price signals in time and location;
  • Reform of charging regimes (see Cost Reflective Pricing report for further discussion);
  • Aligning carbon incentives (currently a bit of a mess – see Danial Sturge famous chart). We would do this in different ways in different sectors, but focus on moving towards obligations in line with carbon budgets (on suppliers for the power sector, and, potentially, building owners for heat) to replace CFDs as the primary driver of decarbonisation;
  • Decentralised approach to reliability, which could include applying a reliability requirement to suppliers’ portfolio, replacing the capacity market.

This is a much bigger debate than space allows for in this post, and ESC plans to publish a report in the coming weeks on electricity market reform (we think there is a need for EMR2.0). Crucially, you need to consider reform as part of the whole energy system. The silos between heat, transport and power are breaking down all the time, and markets need to reflect that, as well as ensuring they are constructed to take advantage of new technologies, including new digital technologies. Oh, and that they are as aligned as possible with the physics.

So, your first step in devolution is aligning your market signals and structures with the Net Zero targets. Markets are a form of devolution, perhaps the most powerful. We need to harness them.

2. Planning for infrastructure

So while your first principle when designing the future energy system should be to get as many decisions made in the market as possible, there will still be a set of residual decisions for assets with monopoly characteristics. Where do you locate heat networks in cities (reminder, heat networks are likely to be a much larger part of the future energy system – our modelling says a 10-fold growth in output by 2050)? What upgrades are needed to electricity networks to make sure the local area is ready for low carbon electrified heating (or alternatively, what investments in energy efficiency or smart tech can be made to ensure you don’t have to)? What is the suitability of a local area for a switch to hydrogen; where should EV infrastructure be located? Etc etc.

Right now, we do not have the right institutional arrangements to facilitate such decisions and investments. Decisions on heat networks are made on an ad-hoc basis, with minimal consideration for the wider system. Network price controls separate gas and electricity (Ofgem has recently taken steps to try to align the two in its ‘whole systems’ work, although it will have to be seen how this will work in practice). Ofgem inevitably finds it hard to work out what is a credible Net Zero investment, and what is a network simply looking to capture more returns. Energy efficiency measures are driven by obligations on suppliers, and not yet aligned with policy on clean heat.

We at Energy Systems Catapult think the unsexily-titled process of Local Area Energy Planning would provide a crucial part of the answer. In short, Local Area Energy Planning (LAEP) builds a map of the current energy system, models potential future transition pathways, and then works with stakeholders in a local area to deliver a plan, and identify the priority projects (eg. a new heat network, energy efficiency programme, fuel poverty intervention, electricity network upgrade) which are likely low regrets for the particular area.

This would allow a consistent, data-driven approach to assessing the transition needs in different areas (ESC and the Centre for Sustainable Energy were commissioned by Ofgem last year to set out the first draft of a methodology which should be followed to deliver a robust plan). Decarbonising Cornwall will not be the same as decarbonising Glasgow – LAEP provides a way to navigate the local complexities of that challenge. Such an approach would help Ofgem manage the trade-off between different energy vectors; it could also provide compelling evidence about the RIIO price control re-openers, in a consistent and open way. Indeed, it could be the lynchpin of the flexible, responsive approach that Ofgem is keen to introduce to the price control process. It will also force gas and electricity networks in particular geographies to work together in a practical way, and navigate the transition.

In addition, the more accurate and granular signals provided by the market reforms set out above would also inform local plans – helping identify areas of constraint on the network for example.

Crucially, LAEP would also allow local stakeholders – or, as they used to be called, people — to participate in working out what is a desirable transition, reflecting the local energy geographies [1]. At the moment, we have lots of political aspiration at a local level (300-odd Local Authorities, about ¾ of the total, have declared ‘climate emergencies’) but few have created actionable, investable plans [2]. LAEP could be a vehicle for building local consent for the actions needed for Net Zero. Local Authorities would be at the heart of producing the plans and builds on a core LA competency – planning – as their appropriate role in the transition. Such plans could provide the basis for demonstrating a fast-track Net Zero transition in particular cities, towns and areas across the country. Such ‘Net Zero Pathfinders’ would build on the work of programmes like Prospering from the Energy Revolution, and are linked to ideas such as the Hydrogen Village in the PM’s 10-point plan. Having a formal process for people to engage with can also help create markets, by raising awareness of low carbon technologies among citizens.

3. Enablers

Beyond the core steps of market reform and a more co-ordinated, ‘whole system’ sub-national planning regime through Local Area Energy Planning, Government and Ofgem should also take a set of enabling steps that will help unlock the potential of innovation, particularly on the demand side. I discussed some of these in my ‘Systems Approach to Net Zero’ blog, but they include:

  • Opening up data, in line with the recommendations of the Energy Data Taskforce (great progress is being made here, I should stress, including by Ofgem, and there should be more to come in the Digital Energy Strategy due this year). This could help create better consumer offerings, with a much richer understanding of consumer behaviour, as well as better policy decision-making and more agile regulation (e.g. strategy/policy evaluation and market monitoring).
  • Ensuring the new digitalised energy system does not create a series of new monopolies, with people trapped into suppliers of particular tech (this is about thinking deeply about the different types of interoperability, and having a place to test new market arrangements, see how consumers respond, and then rapidly feedback to implementing the new arrangements — we have built and are expanding our Living Lab of real homes to provide that test environment).
  • Code Reform. Our work through the Future Power System Architecture programme with the Institution of Engineering and Technology identified a more strategic approach to code reform as a key enabler of unlocking the potential of new technologies and business models. It is currently a slow, incumbent-dominated process, which needs urgent reform – the Energy White Paper announced a consultation on it later this year.
  • Skills. It is likely that many, if not the majority, of homes, will need to be switched to low carbon, electrified heating systems in the next 30 years. That will require tens of thousands of heating engineers who can install well-functioning heat pump systems that work for consumer needs. The people with the skills we need do not exist in the numbers we need (part of the problem the Green Home Grant scheme has faced). Getting market signals right will help encourage more people to train in this way, but they will likely need support, particularly those who go first.
  • Consumer protection. Ofgem and Government will need to think about new forms of consumer protection in a smarter energy system. How do we ensure people don’t get locked into a 15-year supply contract because it was tied to their new heat pump? How do we ensure smart controls help people get greater control of their heating, and make it easy for them to save money if they can? How do we ensure this smarter system does not create new types of fuel poverty? This must not be about preventing the fuel poor from taking advantage of new technologies, but rather ensuring the innovations work for everyone, including vulnerable consumers. Again, we have designed our Living Lab to help test new arrangements.
  • Institutions. Do we need a new body in charge of the architecture of the power and energy markets? Do we need new delivery bodies to drive the decarbonisation of our heating system, and help organise skills and installers, as the CBI and Birmingham University Heat Commission proposed? Perhaps what is most urgent is assigning very clear roles and responsibilities (or functions, as my engineering comrades would mumble) to different parts of the existing institutional arrangements, which is currently quite opaque. Ofgem’s recent letter about the future of the Electricity System Operator provided real urgency to this debate, building on the White Paper.

It is worth saying that there are real tensions and large strategic questions that would have to be resolved in order to move to the model I set out above. How to ensure Local Area Energy Planning and new market structures are complementary, and not in conflict. How to balance Local Authority ambition with Ofgem’s responsibilities to protect consumers, and not to agree every mad-cap clean energy scheme proposed by local authorities? How do we integrate local plans with a national planning to ensure the transition works at a national level, as well as a local one? How do you ensure new regulatory market frameworks, such as decarbonisation obligations on suppliers can drive the level of investment in new low carbon capacity we are going to need, and that the potential increase in the cost of capital vs CfDs is more than offset by a more efficient system with a more responsive demand side? Who has the authority and capability to architect the future energy system?

This approach also opens up fundamental questions about the future model of the retail energy market. Are we happy with the current paradigm, where success is measured by the number of switches and harm is protected by the price cap? As a result, we have a largely undifferentiated market, that is failing to provide low carbon heating solutions at the scale we need, for example. Or should we be aiming for one where retailers are not just providers of commodity, but providers of services, with a much richer relationship with their consumers, a market that tries to explore and understand what people actually want from their energy, and where suppliers get rewarded fairly if they are able to meet those demands?

Decentralised vs centralised markets. The balance of local vs national responsibilities. Markets vs planning. Retailers as commodity providers vs retailers as service providers. These are the key strategic questions facing the energy sector.

Of course, these tensions exist whether you make the reforms identified above or not. We think such market and institutional reform is essential to navigate the transition. The alternative may be a messy stop-start approach, with potential disruption to supplies, supply chains and, most importantly, poor consumer outcomes. That could erode the high level of public support for climate action, and ensure the public invokes its potential Net Zero veto.

[1] While LAEP is certainly different from a pure Community Energy approach, it also helps show where community energy projects would add the most value to the system.

[2] Some of the leading areas, such as Greater Manchester, have developed good strategies (ESC has often been a partner).