Locational Marginal Pricing: implications for the cost of capital

 Locational Marginal Pricing: implications for the cost of capital

The debate on Locational Marginal Pricing (LMP) continues to spark discussions across the GB energy landscape.  Should the GB market transition to LMP, there are likely to be important implications for investor risk, raising crucial questions about the implications for their cost of capital.

Today, Frontier publish a second report on LMP and the cost of capital, The Implications Of Locational Marginal Pricing For The Cost Of Capital, in which we respond to some common questions and challenges that have arisen following our initial study in October 2022.

Our initial analysis concluded that, for supported wind investments:

  • investors will face greater earnings uncertainty under LMP;
  • this increased uncertainty is likely to translate into a material cost of capital increase; and
  • we estimated this could range between 2-3 percentage points, although, we recognised any quantitative exercise can only provide an indication of the possible impact.

Over the past year, there has continued to be considerable debate across the industry on the case for LMP.  As part of its own LMP assessment, Ofgem commissioned FTI Consulting to conduct an analysis of the costs and benefits of introducing LMP. FTI’s analysis (which we have commented on separately) presented significant benefits from a move to introduce LMP, but also showed that the extent to which these benefits materialise is sensitive to the potential impact on investor cost of capital.

Our latest report includes discussion on:

  • The likely implications of LMP for other technologies, beyond the supported windfarm investments considered in our first report.
  • The ability of investors to ‘diversify away’ all of the increase in risk introduced by a move to LMP.
  • Our response to specific questions about the quantitative analysis presented in our first report.

This report maintains that the introduction of LMP is likely to have an important impact on earnings volatility and potentially increase the cost of the significant investment needed to achieve Net Zero. Given the scale of investment required, and therefore the material impact of a change in cost of capital, this issue is one which will require careful consideration by the UK’s Department of Energy Security and Net Zero as part of its final decision-making process around the introduction of LMP in GB.


Read our report here: The Implications Of Locational Marginal Pricing For The Cost Of Capital

The report has been commissioned by SSE.