Transformation is about walking the walk, not just talking the talk – the embedded generator saga and codes governance

Matthew Lockwood, IGov Team, 13th March 2017

A major row has blown up over the apparently obscure issue of ‘embedded benefits’. These are payments that are made to electricity generators attached to the distribution network, as opposed to the higher voltage transmission network, so called because these generators are ‘embedded’ further down the system closer to sources of electricity demand. They are also sometimes called distributed generators. Technically, embedded benefits are based on the contribution made by embedded generators to reducing demands on the transmission network, especially during the three half-hours with highest demand in the year, known as the ‘Triad‘ (nothing to do with gangs in Hong Kong…). The Triad benefits have a locational element, which varies according to the distribution network area and a residual element, which is a fixed amount across the GB system.

Ofgem has said that it is minded to approve a large cut in the residual element, taking embedded benefits from a current value of £47.30 per kW of capacity to less than £2 per kW over a 3 year phase-in period. Not surprisingly, this will have a big impact on the economics of distributed generation of all kinds as well as the nascent storage industry, as several others have pointed out – see here, here and here.

It is pretty clear that this move has been prompted by the fact that bids from embedded diesel generators have played an unexpectedly large part in the Capacity Market auctions, and the Government and Ofgem have been keen to shut this down, as evident in open letters in July and December last year.

In fact they are so keen that the approach Ofgem has said it is minded to approve will be applied retrospectively to the Triad benefits for embedded generators with a Capacity Market contract. The regulator says that this is to avoid creating two different classes of embedded generators, but as Cornwall Energy point out: “the approach adopted ignores the practical realities that drive investor sentiment and ultimately decisions on existing plant closures.” They go on to say that: “In our view Ofgem has underestimated the impact of this change on the economic viability of certain embedded units in its modelling assessment, and risks triggering capital flight from certain parts of this market.”

The purported rationale for slashing embedded benefits is that it creates more of a ‘level playing field’ for centralised and decentralised generation. Ofgem also argues that it will save consumers money. But cutting the residual Triad benefit is a very blunt instrument to solve a particular problem (really the issue with diesel is not that it is embedded but that it is high carbon) which will have spillover effects on all embedded generation more widely. At the same time, Ofgem’s impact assessment has been challenged on the basis of unrealistic assumptions about future Capacity Market bids and the wholesale price.

But the embedded benefits saga is also a prime example of why codes governance arrangements are not well suited for the type of transformational change that the electricity system is now going through, a major theme of our work here at IGov (see here and here).

What Ofgem is ‘minded to’ do in the case of embedded benefits is to approve a certain change to an industry code, known as the Connection and Use of System Code (CUSC), which governs how transmission charging is set. Codes can be changed by industry parties proposing (or ‘raising’ in the jargon) what are called modifications. Modifications for major cuts to embedded benefits were originally raised by two of the Big Six utilities – Scottish Power and EDF – in May 2016, in CMP 264 and CMP265. These were combined and then taken to a working group process.

However, the working group did not lead to any kind of consensus, and 23 alternative proposals (Working Group Alternative Change Modifications, or WACMs) for modifications on embedded benefits were produced. This included options for new ways of calculating embedded benefits that ranged from a complete cut (i.e. £0/kW) to virtually no change (£45.33/kW). The options were put back to the Panel that oversees CUSC, which then voted on them. The most votes went to one of the alternatives (WACM3) proposed by Uniper – E.ON’s fossil fuel arm – which would set embedded benefits equal to avoided investment at the Grid Supply Point, currently estimated at £1.62. In the event, Ofgem is minded to adopt WACM 4, proposed by SSE, which is virtually the same as WACM3.

The embedded benefits case is striking because it pits large established generating companies, whose assets are mostly transmission connected, against smaller newcomers with embedded generation. The raising of the original mods by two large vertically integrated companies looks like a defensive move. The two groups squared off in the working group process, which one participant characterised to me as a ‘rushed process’, and Cornwall Energy (which took part in the working group) describes as a ‘largely adversarial process polarised between large generators on the one hand and small generators on the other’. The process cannot be criticised on the basis that the small generators were excluded, since a number participated in the working group. However, we know from evidence to the Competition and Markets Authority energy market investigation that in such circumstances the larger companies tend to have an advantage because of their ability to mobilise more resources, i.e. time and people, to devote to meetings and analysis.

The options then went back to the CUSC Panel for voting. Here the composition of the CUSC Panel comes into play. Many code panels are dominated by members from large incumbent utility and network companies, and the CUSC Panel is no exception. Excluding the independent chair and alternate and the Ofgem observer, the Panel has ten members, of whom six are drawn from companies with generating assets that are largely or solely transmission connected. It is perhaps then not surprising that the preferred options in the vote all involved slashing embedded benefits.

However, the biggest problem with the treatment of embedded benefits in the codes governance system is not that the working group or panel processes suffer from bias, but rather that Ofgem (and by implication the government) has delegated what should be a strategic and joined up rethink of charging in a transforming electricity system to a siloed narrow reform of one part of a complex landscape. Cutting embedded benefits in isolation (moreover in a process instigated and overseen by a set of incumbents) makes no sense in a charging regime in which there are, in the words of Cornwall Energy, ‘deeper and wider distortions that result from increasingly anachronistic rules which dwarf the Triad benefit issue’. These include Balancing Mechanism costs that are proportionately higher for smaller generators, restricted access to ancillary services markets and perhaps most importantly, an undervaluing of the services that embedded generation could provide to distribution networks.

As my colleague Catherine Mitchell will argue in a follow on blog from this, there needs to be a holistic review of the value of different resources to the system, and these should form the basis for a broad reform of charging. Others have also called for such a reform.

As we have argued at length, codes governance, which has been designed for small, marginal changes, is particularly ill-suited to this kind of major reform. Holistic charging reform will involve change across a number of different codes, and mechanisms for coordination are still not adequate for such a view. As code panels are dominated by transmission-connected incumbents, there is little incentive for these to lead a process of change in which embedded generation needs to be properly valued.

Instead, such a review needs to be instigated from outside. Until last week, Ofgem had failed to do this, but a Targeted Charging Review (TCR), which may be led by Ofgem as a Significant Code Review, has now been signalled. This is a welcome step but it comes too late; it could take several years and in the meantime embedded generation will suffer from the multiple distortions in the charging regime without the compensation of embedded benefits.

It is not that the government and Ofgem do not grasp the key issues in the transformation of the energy system. At a senior level it is clear that there is some good strategic thinking. The recent BEIS/Ofgem call for evidence on a smart, flexible energy system was widely recognised as a very serious and impressive piece of work. But the major changes that are coming have implications for detailed system rules, and incentives have to be aligned right through the system or high level aspirations will simply not be delivered. There is a need not just to talk the talk but also to walk the walk.

At the same time, it is not clear that Ofgem is equipped with the skills and resources that will be needed to handle holistic major code reforms swiftly and well. That is why we have argued not only for ending the system of self-authored regulation by which incumbents write their own rules, but also for the creation of a new independent, dedicated and resourced codes body that would take over that function.

Posted by: rhoggett

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