Ofgem's Embedded Benefit Review: Is this the beginning of the end?

On Friday 29 July 2016, Ofgem published an open letter in relation to the charging arrangements for small-scale (sub-100MW) embedded generation (“Open Letter”). The industry was aware that Ofgem was considering the embedded benefits received by such generators from Ofgem’s forward work programme and references in DECC’s Capacity Market consultation in March 2016 (as we commented on here). The intention of the Open Letter is to enable industry participants and stakeholders to engage early with Ofgem on this issue.

Rationale for the Open Letter

Small-scale distribution connected generation currently receives a range of benefits, known collectively as embedded benefits, which were designed to reflect the value that such generation being embedded provided to the wider electricity network. However, Ofgem has a number of concerns about the current arrangements, including that such benefits are distorting investment decisions, leading to inefficient outcomes and do not reflect the actual benefit such generation provides to the wider system, increasing costs to the consumer.

Ofgem stated that it is considering this issue as a matter of priority due to the increase in these benefits, both in terms of their cost and their scale, as there has been a major increase in generators connecting to the distribution network in recent years.

TNUoS Demand Residual

One element of embedded benefits, known as the TNUoS Demand Residual, is the particular focus of the Open Letter. Embedded generators that generate during triad periods (which are the three half-hour periods each winter when electricity demand was highest) receive a payment from suppliers for doing so. This payment is in recognition that such output reduces that supplier’s liability to pay the Demand Residual element of the Transmission Network Use of System charges (TNUoS), which relate to the fixed costs of the transmission system.

Ofgem believes that the main beneficiaries of the TNUoS Demand Residual embedded benefit are controllable non-intermittent embedded generation that guarantee export during triad periods e.g. small-scale gas, diesel reciprocating engines etc. Of renewable technologies, it states that solar tends not to benefit due to triad periods usually falling within the hours of darkness and wind projects having little control over whether they can guarantee output during such periods.

The TNUoS Demand Residual element of embedded benefits was just over £10/kW in 2005/6, but is currently estimated to be around £45/kW. Ofgem forecasts that it will be £72/kW by 2020/21. Ofgem asserts that the level of TNUoS Demand Residual embedded benefit is distorting the market by:

- leading to an inefficient mix of generation by encouraging smaller distributed generation to the detriment of larger-scale (and potentially more efficient) generation;

- affecting dispatch by enabling embedded generators to generate at times where it would not be profitable to do so but for the TNUoS Residual Demand payment;

- impacting the outcome of the Capacity Market; and

- leading to an increase in overall costs to the consumer.

Other embedded benefits

The Open Letter also considers some other embedded benefits:

- the TNUoS demand and generation locational signals;

- the TNUoS generation residual; and

- the Balancing Use of System demand generation charges

However, overall, Ofgem does not believe these elements need addressing with the urgency required in relation to the TNUoS Demand Residual, principally due to the relative size of such embedded benefits in comparison and therefore the overall cost to consumers.

Approach to reforms

Ofgem has proposed that it will not undertake an overarching Significant Code Review in relation to embedded benefits, which was the route that many in the industry had anticipated Ofgem would take. Ofgem states that this is because of the likely time involved in undertaking such a review, the scale of the potential market distortion caused, the rapid increase in such payments and the impact on the Capacity Market. Instead, Ofgem will consider the ongoing CUSC modification proposals in relation to TNUoS Demand Residual payments. The two CUSC modifications currently under consideration are:

- CMP264, which aims to stop any new embedded generation connected after 30 June 2017 from receiving the embedded TNUoS Demand Residual benefit until Ofgem has completed its consideration of the issue and implemented any resulting changes; and

- CMP265, which would prevent any embedded generation with Capacity Market agreements from receiving any TNUoS Demand Residual payment from 1 April 2020 onwards.

Transitional arrangements

The Open Letter also discusses the possible transition arrangements in relation to any resulting embedded benefit reform. Options include an immediate change, a delayed change, a split in implementation and grandfathering. Ofgem states that the initial thinking is that it may be difficult to demonstrate the cost or fairness of any grandfathering of the current arrangements and that any delay in implementation of changes are likely to reduce in consumer benefit.

Further, Ofgem indicates that it may consider preventing any further escalation in the TNUoS Demand Residual payments above the current level, prior to any implementation of reforms.

Next Steps

Responses to the Open Letter are requested by Friday 23 September 2016, however, it is understood that the CUSC modification proposals may enter the workgroup consultation phase prior to this deadline.
It is expected that Ofgem will consider some of the other embedded benefits and the wider charging arrangements in the autumn.

Comment

Ofgem’s embedded benefits review has been widely expected by the market and has resulted in a range of pre-emptive inputs from across the industry spectrum, for example, the Association for Decentralised Energy report analysing the costs of embedded benefits. There has been concern from some stakeholders that piecemeal reforms could lead to unintended consequences. As a result, it will be important for all industry participants to carefully consider the issues set out in the Open Letter, in particular the wider implications of such proposals on the development of generation and network charging in the UK.

In addition to the Ofgem workstream, there are a number of other relevant reviews currently underway that are likely to impact on embedded benefits, such as:

- National Grid’s ongoing charging review; and

- the widely anticipated Ofgem/DBEIS Call for Evidence in relation to energy storage, particularly as embedded benefit revenue is considered a key revenue stream for the development of standalone energy storage projects.

As a result, projects that are not impacted by any modifications resulting from CMP264/265 or Ofgem’s wider review of embedded benefits still may be affected by another workstream.

Currently there is no indication that Ofgem, DBEIS or National Grid will provide exemptions for certain technologies or specific projects and, as a result, the Open Letter is likely to have impact on the development pipeline of sub-100MW distribution connected generation and storage projects.