Time for divorce: split the energy market to fuel growth

Our Consultant Economist, Matthew Brighty, shares his thoughts on how the government can accelerate energy price reduction for businesses and fast track its growth ambitions by splitting the energy market.

In June, the government will unveil two landmark strategy documents - a 10-year Industrial Strategy and a 10-year Infrastructure Strategy - setting out its vision for the economy and how it aims to achieve its key objective: growth. However, pursuing growth without first addressing the high energy costs suffocating UK businesses risks undermining the very foundation of that ambition. The good news? There is a simple way to cut bills fast.

The current high energy prices are not just a short-term symptom of recent geopolitical shocks, the price of energy had been rising for a long time before Russia invaded Ukraine. Analysis for the UK Foundations Essay shows that the industrial price of electricity rose by 153% between 2004 and 2021, adjusted for inflation. We’ve been failing to tackle rising energy prices for more than a decade, even if energy costs fall back to pre-war levels, those are still much more expensive than twenty years ago. 

The government should recognise that lower energy costs are a crucial component of the growth environment they target. Not addressing energy costs makes their job even harder, and they already face an uphill battle:

• The ONS downgraded the latest quarterly growth figures to zero

• The CBI reported members plan to cut hiring and output in the first three months of 2025

• Gilt yields continue to squeeze fiscal headroom by increasing the cost of borrowing

• The Bank of England halved its 2025 growth forecast

High energy prices are a major limiting factor for growth because they increase costs for businesses, reduce disposable income for households and diminish the UK’s competitiveness - businesses are forced to offshore production to cheaper markets. 

According to an IoD survey more than a third of directors surveyed cited energy costs as having a negative impact on their organisation. The hardest hit are those in energy intensive sectors such as manufacturing and construction.

Lower energy costs would also make cutting-edge sectors more viable. Data centres, the infrastructure behind the internet, have become even more essential in recent years due to the rise of AI. Earlier this year, Google stated the UK was at risk of being left behind without more data centres, which led to the government designating them "critical national infrastructure". A large data centre can require over 100 megawatts of power, more than what’s needed to power 300,000 homes.

The energy price challenge highlights a critical gap in the government’s approach. While the chancellor has prioritised supply-side policies to increase the economy’s productive capacity and ease bottlenecks, one of the UK’s largest constraints—energy costs—remains unaddressed. 

The UK now has a significant number of renewables on the grid. Recently Ed Miliband, Minister for Energy and Climate Change, claimed a huge win, tweeting that “wind power has overtaken gas as Britain’s biggest source of electricity". This should be good news for consumers because once up and running, wind and solar power is cheaper to produce than traditional energy.

So why aren't bills getting any cheaper?

This is to do with how we calculate the wholesale price of energy - a system called marginal pricing. Before any energy is supplied to the grid, producers declare how much a unit of energy costs to produce. Then, as energy is being sourced, the cheapest producers are used first - these are usually renewables - followed by increasingly expensive sources until demand is met. The final source used is called the marginal source. 

Prices are set according to the cost of whatever the marginal source is at the time, regardless of how little it contributes or how much cheaper the other sources are. This is typically gas, and as a result the price of electricity becomes directly tied to gas, making electricity prices more expensive and more volatile. Even your 100% renewable tariff is based on the price of gas! 

The UK is not unique in using marginal pricing, in fact it’s how most commodity markets work: wheat, oil, nickel, cotton, etc. The problem for the UK is how often gas becomes the marginal source. In 2021, fossil fuels set prices for 58% of Europe’s electricity while generating 34%. In contrast, UK gas set prices 98% of the time but produced just over 40%.

The increasing participation of renewables in the system means that, over time, cheaper sources will more often determine the wholesale price. However, we are still far from this becoming the norm. While we should invest more in renewables and nuclear power to reach this point, waiting for new sources to come online isn't an option if we are serious about ‘kickstarting’ growth. 

Growth would arrive faster if we changed how we price energy. The energy market should be split into two: one for ‘as-available’, renewable electricity and another for flexible, ‘on-demand’ electricity. The Green Power Pool (GPP) concept aims to solve soaring energy prices by directly linking consumers with renewable electricity. Instead of routing renewable energy through the wholesale market, the GPP aggregates cheaper renewable electricity from generators operating under government-backed Contracts-for-Difference (CfDs), and to maintain reliability, the GPP buys from the ‘on-demand’ market when renewable output is low.

Initially, access to the GPP can be targeted at energy-intensive industries and fuel-poor households delivering immediate benefits. It can then be extended to more households and businesses, reducing bills across the board. 

Market splitting of some form has been introduced in both Germany and Greece, however, the UK abandoned the proposal in its Review of Electricity Market Arrangements (REMA) where the government confirmed that it will only proceed with a locational marginal pricing (zonal) model. At consultation, while the benefits of splitting were widely acknowledged, concerns were raised about potential market disruption and risks to investor confidence stemming from the idea’s novelty.

Reviving these proposals now, with a sense of urgency and ambition, would be a major win for the government. For Ed Miliband, this offers an opportunity to deliver the manifesto promise to lower energy bills, and on the economy, Rachel Reeves should view this as a low-cost growth measure. She faces mounting pressure to demonstrate a clear strategy for boosting the economy, making this an attractive opportunity to make progress where little has been achieved so far.

By decoupling electricity prices from gas, a Green Power Pool offers a rare opportunity to lower costs for energy-intensive industries, enhance competitiveness and turn complex reform into a catalyst for growth.