Last summer the House of Commons Energy and Climate Committee raised questions about the conflicts of interest inherent in National Grid’s role as the electricity system operator and recommended that the government should create an independent SO to mitigate these concerns (described in my previous blog post here). Not surprisingly, National Grid was opposed to the proposal, and last week agreed a compromise solution with Ofgem and BEIS which will see it legally ringfence its system operation activities, but falling short of full separation / spin off. While the new SO business will have its own board, offices and employees from April 2019, it will remain fully-owned by National Grid.

Why it matters

In announcing this change, Ofgem has also launched a consultation, to run until mid-March, on the Future arrangements for the electricity system operator, providing the following context:

“The changing nature of generation, particularly the increase in small generation connected at the distribution level, is highlighting the need for a more holistic and coordinated approach to planning and operating the transmission and distribution systems. The increase in new sources of flexibility also means there is a need for the SO to review how it procures these services. This evolution of the activities the SO carries out means we need to carefully consider the governance of the SO, to ensure that there is sufficient focus on its important role and to address any actual or perceived conflicts of interest between National Grid’s SO functions, TO functions and other business interests.”

Looking at National Grid’s accounts, it is clear that its SO responsibilities, while of major significance to the market, contribute less than 1.5% to the company’s total operating profit, compared with a 26% contribution from the rest of the UK electricity transmission business (excluding interconnectors). This disparity alone provides ample justification for requiring National Grid to create a separately and independently governed SO function.

Expanding the role of the SO

Ofgem is now consulting on how the changing nature of the electricity market should be reflected in the functions of the SO, and in what ways the governance of the SO should be changed to ensure this. This could involve changes to the SO’s licence terms. Ofgem characterises the SO role across four areas of activity and proposes changes to National Grids role in these areas:

Acting as the residual balancer – in operating the system safely and securely in real time, the SO should be thinking more widely about how it can drive greater efficiency in balancing and how its actions in the short term can impact wholesale prices in the long term. This includes providing as much information as possible to market participants and procuring balancing services in a transparent and accessible way.

Facilitating competitive markets – the SO should use its knowledge of the market and system balancing to design how it procures services and to contribute to the development of wider market arrangements in a way that supports effective competition, innovation and better outcomes for consumers. Ofgem believes the SO should take a more active role in influencing the future development of these markets, including supporting or driving changes to industry rules to enable the market to contribute as much as possible to balancing the system, minimising the SO’s own role as residual balancer.

“We have also heard concerns about the extent to which balancing service providers have to exclusively offer their services to the SO, so that they cannot also sell services to other parties (so they can combine, or ‘stack’, revenue streams). Enabling providers to stack revenue streams could support the ability of both new and existing providers to compete to provide balancing services, potentially reducing costs, but needs to be balanced against the need for the SO to have confidence in accessing sufficient resource when needed.”

“We expect the process of the SO improving the transparency and accessibility of its balancing services to begin now, as it is not dependent on the future governance arrangements.”

“We think a particular key role for the SO is to identify and propose changes to code arrangements to ensure that these new providers are able to compete on a level playing field with existing providers.”

Facilitating a whole system view – the SO should work with other network companies to ensure that there is a whole system view on network planning and operation, to deliver end-to-end system resilience and ensure that the most efficient overall solutions are taken forward.

Facilitating competition in networks – The SO should encourage greater efficiency, more innovation, and smart solutions, and should have a role in identifying the right projects for tendering and in developing projects before a tender is run.

Despite these proposed changes, Ofgem acknowledges that the independent SO question has not completely gone away:

“In the longer term, we think the SO may need to evolve further and that there may be a need to consider moving to a fully Independent System Operator (ISO).”

Financial implications

NG control roomOfgem recognises that the changes will require the RIIO price control to be divided between the SO and TO (transmission owner) parts of National Grid’s business, and further work is needed to determine how this will be done. Ofgem does not propose increasing the overall revenue allowance unless it can be demonstrated that the expansion of the SO role imposes a material increase in costs.

It does however, provide that National Grid would be able to recover some of the costs of separation.

Ofgem also intends for both the SO and TO parts of National Grid to maintain investment grade credit ratings, and plans to set appropriate financial parameters such as gearing levels and the cost of equity for NGSO as a separate entity as part of the next price control review process. Ofgem believes it is an internal matter for National Grid to determine how existing financial obligations such as debt will be split between the SO and TO functions, and that the wider NG Group will provide the financial resources necessary for the operation of the SO.

Making it work in practice

It will be interesting to see how the industry responds to the consultation, both around the principles set out by Ofgem and the practicalities of the new arrangements. National Grid has proposed that a physical separation of its SO and TO businesses can be achieved by modifying its existing offices by creating separate entrances for the staff of the different functions and having separate facilities such as cafeteria. This is in contrast to the physical separation of Centrica’s arm’s-length gas storage business which is located at a completely separate site from the rest of the Centrica organisation.

Ofgem’s approach is consistent with that taken by the telecoms regulator, Ofcom, which in November ordered BT to legally separate from Openreach, its infrastructure subsidiary, in response to criticism that BT was benefitting unfairly from the monopolistic position of its Openreach business, particularly in failing to reach remote areas and thwarting other networks’ provider planning.

Ofcom chose legal separation, rather than structural separation where BT and Openreach would become entirely separate companies, because it feared structural separation “could generate materially greater costs and risks”, not least in relation to BT’s large, underfunded pension scheme.

Both National Grid and BT are now challenged to make their new arrangements work, or pressure for full and permanent separation will become difficult to ignore.

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