Pulling back the curtain on marginal cost pricing

Robert Bagnall is the Green Party’s prospective parliamentary candidate for Totnes. Here he discusses the ‘con’ of marginal cost pricing for energy.

Wind turbines at sunrise
Wind turbines at sunrise
Robert Bagnall

Imagine you’re in the supermarket. Into your basket, you put a bottle of wine and an apple. At the till your organic, Fairtrade cab sav is £9. The apple: also £9. And everything else in your basket: £9. Unless, say, you’ve added a bottle of scotch, in which case the apple, the bottle of wine, and anything else shoot up to £20 each.

Bonkers? Certainly. We’d never buy our groceries like that, but that’s exactly how we buy our electricity. If you’re not surprised, I suspect you’re in the minority who have heard of marginal cost pricing. Otherwise, you may want to take a moment to let the indignity and sense of injustice subside. 

Of course, my shopping basket analogy rapidly breaks down. Units of electricity are fungible – mutually interchangeable – in a way that items on Tesco’s shelves are not: a unit of electricity is a unit of electricity, so you can’t distinguish between those produced by wind, wave or solar from those that come from coal, gas or nuclear. Suppliers buy electricity from generators on the wholesale market, to resell to us on the retail market in such a way as to ensure supply always matches demand. So, the argument goes, we have to pay a price based on the production costs of the most expensive, otherwise not enough would be produced to satisfy demand. Hence ‘marginal cost pricing’: setting the price based on the unit that makes up the margin between demand and supply.

I’m no economist. I only stumbled across marginal cost pricing in the last year or two as I’ve tried to get my head around why the rapidly falling cost of generating renewable energy wasn’t being reflected in our power bills. I found understanding what it was fairly easy. Understanding why it was has taken me longer.

Put ‘when does marginal cost pricing make sense’ into Google and the response starts, “If customers are willing to buy products or services at a robust margin”. And therein lies the problem: trying to deliver public services through market mechanisms more suited to private enterprise. We aren’t just ‘willing’ to buy energy – we have to.

 To quote Yanis Varoufakis, former finance minister of Greece:

“The absurdity stems from the delusion that states can simulate a competitive, and thus efficient, electricity market. Because only one electricity cable enters our homes or businesses, leaving matters to the market would lead to a perfect monopoly – an outcome that nobody wants. But governments decided that they could simulate a competitive market to replace the public utilities that used to generate and distribute power. They can’t.”

I suspect MPs may be on the same learning curve as, last month, the House of Commons Library published an article entitled ‘Why is cheap renewable electricity so expensive’ (I’ve seen less loaded titles!). But I also have no sense of it being on the radar of other political parties. The Conservatives won’t change it, Labour aren’t talking about it, nor are the Liberal Democrats. Perhaps it’s regarded as being too technical? But try my shopping basket analogy on the doorstep and you’ll soon have people agreeing that current arrangements are scandalous at any time, in the midst of a cost of living crisis doubly so.

Putting aside the need to rip up the system and replace it – Varoufakis’ preference is for public energy networks supplying electricity based on average production costs plus a small margin – there are some uncomfortable consequences whilst it’s something we have to live with.

Firstly, whilst per capita demand for energy in the UK continues to fall, we are seeing a shift towards electricity: newbuild homes will have to go without gas and oil-fueled boilers from 2025, and electric cars proliferate on our roads. Add in a growing population, and even with the supply of green energy increasing that will have no impact on bills if demand for electricity grows and the last unit that makes up the margin, setting the overall price, becomes even more expensive than at present.

Secondly, there’s a risk of reputational damage for renewable energy itself if the public are being told how much cheaper it is to produce whilst simultaneously failing to see it reflected in their out-goings. People know when they’re being duped, but if they think renewables are the con rather than an opaque and objectionable pricing structure, advocates of green energy risk looking like charlatans.

And, whilst I’m not a conspiracy nut, if you were an energy company CEO, wouldn’t you be tempted to make sure the cheap energy never accounted for 100 per cent of demand, meaning your income was always pegged at an artificially high rate? If a system can be gamed, it eventually is.

The Green Party’s energy policy is some 1100 words long, with significant detail on how energy should be generated and what we should be doing to promote its efficient use. Hidden away, almost thrown away, is a reference to developing policy on ‘energy pricing and regulation’ – a policy to develop a policy! There’s an open goal for us here, an opportunity for us to pull back the curtain on how our energy is priced and set out a fair alternative. Let’s get the injustice of marginal cost pricing into the public consciousness, alongside clear plans for what we intend to do about it. At the next general election, we may be the only political party doing so.