Zonal pricing: The (Cf)Difference

There is no doubt that Scotland’s wind farms are a current powerhouse, churning out surplus electricity thanks to cheap land, strong winds, and crucially the Contracts for Difference (CfD) scheme.

As the UK explores zonal pricing—splitting the electricity market into regional zones—a strange development has arisen, with some in the SNP (and non-nationalists) arguing that Scottish consumers will see cheaper bills as a result. The trouble is those arguing for zonal pricing are only telling half of the story. 

There is a distinct a tension in that argument that actually makes the case for lower pricing based on nothing more than Scottish consumers benefiting from a further UK-wide cross-subsidy, while bills stay stubbornly high. Here’s the broader context. 

The difference

The CfD scheme guarantees wind farms a fixed “strike price” for their electricity, shielding them from market ups and downs. If the UK-wide wholesale price (the “reference price”) is below the strike price, the 'government' (actually the consumer) tops up the difference. These top-ups are funded by a levy on electricity suppliers, which gets passed to all UK consumers through their bills. Scotland, with its 5.9 gigawatts of offshore wind and 8.8 gigawatts of onshore wind, relies heavily on CfDs to keep investment flowing. 

Zonal Pricing

Zonal pricing would notionally set electricity prices based on regional supply and demand. In Scotland, where wind farms often produce more power than locals need, when looking at that on it's own wholesale prices could drop—potentially to £30 per megawatt-hour (MWh) compared to the UK’s £45-50/MWh (2012 prices). 

No wonder so many people are getting excited about it. So why then don't we see the Scottish Government screaming for zonal pricing. If anything they are against it.  It's probably because of the "on it's own" in the above paragraph, you can't argue for zonal pricing without simultaneously explaining what that means for CfDs. 

The difference

Imagine then we keep the fixed strike prices for existing CfD contracts—say, £50/MWh—but switch the reference price from the UK-wide wholesale price to Scotland’s theoretical lower zonal price (£30/MWh). 

The gap between the strike price and the reference price widens, so wind farms get bigger top-up payments (£20/MWh instead of £5/MWh). Scottish producers still get their guaranteed revenue, so they’re fine. But who pays for those bigger top-ups? Currently all UK consumers, through the Supplier Obligation levy.

As we know Scotland is 8.3% of the UK. So, Scottish consumers chip in just a sliver of the extra CfD costs—for example just £83 million if the levy rises by £1 billion. The other 91.7% comes from rUK consumers, especially in high-demand areas like the southeast of England. Meanwhile, Scottish consumers might see slightly lower bills if suppliers pass on the cheap zonal wholesale price. 

But unless the text above you has completely passed you by the lower pricing for Scotland envisaged by zonal pricing is actually created by a higher cross subsidy from rUK consumers to Scotland. 

Hopefully no one will notice

So the plan seems to be Scottish consumers benefit from lower local prices while paying only a fraction of the inflated CfD top-up costs. The rest of the UK just subsidises Scotland’s wind farms, and hopefully no one notices. Here's the issue zonal pricing aims to reflect local market conditions, but a national CfD levy spreads the cost unevenly, potentially giving Scotland a sweet deal. 

No wonder nationalists advocating for zonal pricing expect to have their lower pricing cake whilst also eating their rUK subsidy. 

So what if they do notice?

This tension highlights a flaw in pairing zonal pricing with the current CfD framework without major reform. 

Any solution needs to answer zonal pricing within the context of current and future CfDs. Here's the possible scenarios:

- The CfD reference price remains the UK wholesale price, you are just arguing for a massive (further) cross subsidy from rUK consumers to Scotland (good luck with that). 

- The CfD reference price lowers to the regional wholesale price, existing producers will see their revenue slashed and they will go out of business. There are no super normal profits being made by these producers, they have massive capital costs and with long term interest rates so relatively high their costs of capital are only going up. So with revenue slashed they won't produce electricity. 

There goes Scotland's surplus in production and there goes the entire basis for those arguing Scotland should have lower costs. 

There is a mixed scenario here (the most likely one in any market reform) existing CfDs remain untouched, which means that Scottish consumers won't benefit any more than they already do, but going forward all future contracts will be based on a regionally priced CfD which are then regionally funded. 

However, again, that just means one of two outcomes for future, one prices are not lowered as any lower theoretical price is eliminated by the cost of the local CfD funding. Or if CfD contract strike prices are (somehow) forced downwards then next to no one is going to invest in any future Scottish renewable wind farms. 

The difference

Zonal pricing in reality won't lead to lower costs for Scots, our renewables industry depends on the current high level of pricing, without it there is no renewables industry. Without our industry there is no case for lower Scottish bills. 

Lower pricing, 'the lowest electricity prices in Europe' is great rhetoric but its just a contradiction when you follow it through.  It's a cautionary tale that you really have to read beyond the headlines.