Ronan Kavanagh

Decarbonization and digitalization are set to shape the electricity market in the coming years. While the impacts of decarbonization and the rising share of renewables in power generation have been widely studied, the impacts of the digital transition have received less attention. This is surprising as digital technologies have the potential to bring about transformative changes in the electricity sector, not only enabling greater efficiency and reducing operational costs, but also creating new energy ecosystems and business models and accelerating the energy transition.

In a recent paper we explored the potential impacts of digitalization on the electricity sector. Most research on the impact of digitalization on the energy sector has primarily focused on efficiency, i.e. how digital technologies can improve operational efficiency and reduce production costs. But the impacts of digitalization on the electricity market are much broader; digitization can bring about new structures, actors, and regulatory practices and frameworks.

The traditional business model in the electric power sector is relatively straightforward. Utilities generate electricity and feed it into the grid, so that customers can consume it and pay for volume. In a stylized model, the organization of the electricity sector could be characterized around the following constraints: The industry structure is comprised of a small number of players with large assets; and a large proportion of these assets remain idle for long periods of time. The challenge then becomes how to minimize operational costs by taking advantage of economies of scale.

Multiple Benefits

Digitalization can relax many of the above constraints. To start with, digitalization can reduce barriers to entry, allowing the participation of more players with smaller assets. For example, digital platforms enable new markets by connecting smaller producers with buyers. Without the intermediation of these platforms, transaction costs would simply be too high for these actors to participate in such a market. This can transform the power sector into one based less on economies of scale, and more on a modular structure that can be scaled up or down in granular and additive steps. This will enable smaller producers to enter the market as entry costs are lower. This could also lead to both fragmentation and aggregation in the electricity value chain.

Digitalization can also increase the flexibility of the entire system by enabling integration across its different parts, including supply and demand. Interoperability would allow the exchange of operational information in real time between equipment anywhere in the energy system, reducing inefficiencies, improving reliability and lowering costs. This enhanced flexibility allows consumers and producers to respond instantaneously to changing market conditions, increasing the utilization of existing capacity without putting operations at risk. This is important at a time when increasing physical capacity in terms of new transmission and distribution networks is becoming more difficult and costly.

Blurring Boundaries

Traditionally, the electricity sector has been organized upstream and downstream in segments of the value chain that follow the flow of power: generation, transmission, distribution and retail. The boundaries between these activities are clear. Digitalization can blur the physical boundaries of this value chain. New segments could arise, such as prosumers, while others could emerge, such as aggregators. But as digitalization also breaks down the boundaries of silos, for instance the boundaries between electricity and transport, which can lead to a new horizontal integration of firms, to take advantage of economies of scale.

Digitalization can also redefine the ultimate products of the electricity sector and launch new ones. Observations of the effects of digitalization on other industries show that the value proposition of some new firms is to take out some activities that can now be standardized due to digitalization. Unbundling of a firm’s activities can lead to an electricity sector where new firms offer hyper-specialized products and services.

Digitalization can impact costs and pricing too. Digitalization shares the same cost structure with some renewables: large upfront costs and negligible marginal costs afterwards. How to deal with close to zero marginal costs is problematic in economic theory. For instance, it can break down the criteria of profit maximization, where prices are equal to marginal cost. Having prices equal to zero is an anomaly though, as the role of prices is to signal scarcity. The zero marginal cost structure of digitalization is even more problematic. While the physical network is constrained by congestion, digital networks are not. The interaction between decarbonization and digitalization will push forward the need for alternative pricing. The zero marginal cost of renewables and the negligible marginal cost of digitalization suggest that pricing services using memberships and two-part tariffs may be more appropriate in the future.

Market Design

Understanding these aspects of digitalization and their impacts on the electricity market are key at a time when the world is accelerating its efforts to decarbonize. Also, 2022 saw extremely high prices in Europe linked to tight global gas markets. The high electricity prices accelerated a policy focus on issues of market design, flexibility, and capacity markets among other factors. The UK and EU are consulting on electricity market design. There are two broad opposing views regarding market design. One side argues that the microeconomics of the current electricity market design is adequate to address these policy issues, and all that is needed is to allow markets to perform their function, which means accepting periods of volatility and high price levels. The problem does not reside in the economics of market design but in the politics. The other view takes a stance on completely redesigning the market, with some radical approaches such as creating two markets for electricity to decouple electricity prices from the price of gas. Regardless of the proposed reforms, these can’t be designed in isolation from the potential impacts of digitalization on the electricity sector.

In conclusion, digitalization presents immense opportunities for the transformation of the electricity sector. Overall, the digital transition will lead to a more efficient and flexible electricity sector. Digital technologies will enable new energy ecosystems, help innovate business models, and accelerate the energy transition itself. But digitalization will also require careful consideration of its implications for the industry structure and pricing mechanisms. Also, there are certain industry structures and legacies in terms of regulation and infrastructure that could facilitate but also hinder digitalization.

Source: energyintel