Friends with Embedded Benefits
Embedded Benefits (EBs) have become a catch phrase in the UK energy industry recently. Indeed just today Ofgem published a letter to industry on embedded benefits, to inform participants of developments prior to the upcoming capacity auction. We (Arup Energy Economics) give our take on why EBs are important and discuss how the relevant decision bodies should address this issue and the live code modifications. You can also find this article on the November 2016 issue of New Power.
For the uninitiated: What are Embedded Benefits?
So what’s all the fuss about?
The concern which brought EB to the spotlight, mainly by recent work and publications from BEIS and Ofgem, stems from the distortive effect of these benefits on the wholesale power and in particular on the Capacity Market (CM). The technology agnostic intention of the CM is seen to have been distorted as a result of EB artificially increasing the competitiveness of sub-100MW embedded generation (EG) relative to arguably more efficient large scale gas fired capacity.
The urgency to take action before the next CM auction in December 2016 (for winter 2020/21) has been the main reason behind Ofgem’s decision to consider EB within the CUSC code modification process rather than opening a Significant Code Review (SCR). Industry did make four relevant Code Modification Proposals (CMPs) between May and August with one even requesting an accelerated timetable due to urgency. This was however denied due to the complex nature of the issue at hand.
Our view is that actually an SCR is the appropriate framework to consider this issue in a holistic way alongside all the parameters it would affect and would be affected by. Our premise is that the charging arrangements should be updated to promote the most efficient use of the system and not as a vehicle to address concerns relating to the generation landscape.
And what is National Grid doing?
National Grid, as the CUSC Code administrator, is currently consulting on two of the first CMPs raised in May, namely CMP264 and CMP265. A common Working Group of 22 industry representatives, set up to consider these two CMPs together, is now faced with over 40 alternative options to decide from. The other two CMPs, CMP271 and CMP 274, are still at the initial proposal stage.
The live consultation which closed on the 4th November shows that there’s not much consensus within the Working Group. The final Modification report was initially to be submitted to Ofgem for approval but an extension was requested and the deadline is now set for 28 November. This effectively means that no decision can be made before the next CM auction but it does not necessarily mean that bidders won’t be changing their strategies. A clear signal has been given to the market that EB might be changing, especially with Ofgem's letter published today. Just by how much though, it remains to be seen.
Wait, what is industry proposing in the first place?
The two original CMPs currently being consulted on, CMP264 and CMP265 as summarised in the table below, are both proposals to remove the EB completely for certain generators. This is by changing the way the TNUoS demand residual is calculated, moving from net demand to gross demand as the charging base.
The difference between them lies on who would be affected, with CMP264 affecting all newly EG after June 2017 whereas CMP265 would affect all EG units with a CM contract, effective from April 2020. Therefore CMP265 will affect a bigger proportion of EG capacity in the short to medium term. Another difference is that CMP264 is intended as a stop gap modification and would expire when Ofgem completes its review of EB.
The diagram above presents other ways of removing or reducing the EB that have been voiced, and illustrates where CMP271 and CMP274 lie within those options. Both CMP271 and CMP274 represent a much bigger departure from the status quo however and are very complex to implement within the time allowed by the CUSC modification process. They could even become redundant once a decision is made through the CMP264/5 consultation.
The alternative options raised within the CMP264/5 Working Group (WACMs) are all on a spectrum of variations across three main questions:
- Will any modification be temporary or an enduring change in the charging framework?
- Who will be affected? Is it all EG, new from 2017 or 2018, only those with CM/CfD contracts, will there be grandfathering and for how long? Or a combination of these?
- Setting the level of EB the EG can recover, ranging from the avoided GSP reinforcement cost, avoided transmission reinforcement costs, the generation residual, a 4-year average of the demand residual, maintaining the current level or a combination.
The diagram above can be used as a mapping tool to visualise the spectrum of options on EB policy. CMP 264 and CMP265 are within two different quadrants since CMP265 would affect a bigger proportion of EG capacity whereas CMP264 would only apply to newly commissioned EG. Moreover, the 40 alternative options of the current consultation (WACMs) are scattered across the spectrum of the mapping tool, each representing a different extent of EG capacity affected and the extent of EB reduction entailed.
What’s Arup’s opinion on Embedded Benefits?
We are of the view that the issue of EB should be considered within an SCR and that piecemeal attempts to address EB could lead to unanticipated consequences. For example, more and more EG could start connecting behind the meter in order to avoid new restrictions or there could be cross effects on the BSUoS generation charge. The benefits of local balancing and flexibility have to be considered, something that Ofgem itself already signalled, and perhaps even the possibility of nodal charging. Moreover, the upcoming DEFRA review on the level of NOx emissions from small scale generation could on its own achieve a big part of the objectives behind the current CMPs.
In the absence of an SCR however, and in the face of a decision to be made in relation to CMP264 and CMP265 in the coming months, we’ll give our view on the short term ahead of us. The table below summarises the key considerations we see as crucial in determining what action could be taken temporarily.
To begin with, we believe that the charging arrangements should be reflective of the relative costs and benefits of demand and generation at different locations on the network. Therefore we believe that the avoided GSP and transmission network reinforcement brought about by the existence of EG should be reflected in their charges (or payments). CMP264 is closer to this objective than CMP265 by at least maintaining this benefit for existing EG.
EG are crucial in the management of the winter peak and their charging framework provides an incentive to target their output to times of tight margin. Removal of the TRIAD signal removes the incentive for EG to generate and provide capacity during times of system stress. However historically “TRIAD” chasing, has also led to market distortion with power plants generating despite having negative spreads.
In terms of the distortion to the outcomes of the CM, CMP265 is clearly more targeted and would have a bigger effect as it would affect all EG which choose to bid in the CM. We also considered security of supply although not directly affected, however there could be a risk that EG already contracted in the CM would withdraw following a removal of EB.
The last three considerations are somewhat interrelated, yet distinct from each other. The extent of departure from the existing framework affects the ease of implementation as well as raising questions of whether a significant change from the status quo is appropriate under a CUSC modification process. We view CMP264 as a smaller departure from the status quo which in our view would also limit the scope for any unanticipated consequences. Finally, the extent to which any changes affect the viability of past investment decisions, especially against a background of recent government policy changes with respect to renewables, is an important consideration affecting general investor confidence. CMP264 limits any effects to existing EG and is preferable by this measure.
Conclusion
As it emerges from our traffic light assessment above, we believe that on the balance of things CMP264 is a better option compared to CMP265. An even better option would be a variation of CMP264 which allows for some of the EB to be retained in order to better reflect the cost reflectivity objective above. Finally, an important advantage of CMP264 is that it’s a clearly temporary modification which would expire once Ofgem completes its review of EB, whether that is through an SCR or otherwise.
We are following the current developments and are particularly interested in the consultation responses and the Final Modification report resulting from the CMP264/5 Working Group. We expect that there will be concerns, and rightly so, over the lack of analysis done by the Working Group itself and any mention of previously unidentified unanticipated consequences from respondents.
We would like to see the industry engaging in a fruitful discussion which will lead to a targeted, balanced and temporary change and hope that our contribution facilitates this. We also hope that such a discussion will highlight the reasons why the issue of EB is crucial in the design of appropriate charging arrangements for a system under unprecedented change which in turn will pave the way for a fundamental review by Ofgem.