Win for Ofgem: application for juducial review into embedded benefits decision rejected

On Friday, Mr Justice Lavender handed down his Judgement on the application by a number of small electricity generators for a judicial review into Ofgem’s decision last year to limit the amount of so-called “embedded benefits” available to such generators.

The Claimants had been given permission to pursue this application on two grounds: that Ofgem’s decision was contrary to the EU principle of non-discrimination; and that in making its decision, Ofgem failed to take account of material considerations and/or facts. There were two alleged breaches of the EU principle of non-discrimination: treating small embedded generators differently from providers of behind-the-meter generation and demand-side response, when they are equivalent; and/or treating small embedded generators as equivalent to transmission-connected generators, when they are materially different. The Claimants had been refused permission to seek a judicial review on the grounds that Ofgem’s decision was irrational.

The Judge has done an excellent job of distilling over 280 pages of witness statements and about 5,500 pages of exhibits into a 42-page Judgement, which sets out the background to the case in a coherent if simplified way.

As I described previously, one of the key areas of difference between the parties was around the nature of the locational component of transmission charges (“TDL”), which the Judge summarised as follows:

• Ofgem’s view is that the TDL charge reflects the marginal cost of a unit of demand either increasing or decreasing at a particular location on the transmission network, ie the long term increase or reduction in the cost of the transmission network associated with a change in demand in that location.
• The Claimants’ case was that the TDL charge did not adequately reflect the savings in the costs of the transmission network resulting from an increase in small embedded generation.

Demand locational charges

The TDL charge is calculated using the Direct Current Load Flow Investment Cost Related Pricing transport model (known as the “Transport Model”), with rates being set annually for each of 14 charging zones.  The rate charge paid by a supplier in relation to a particular zone may be positive or negative, depending on the location of the supplier’s demand relative to the location of generation on the transmission network. 

In general, suppliers pay positive TDL charges in zones in the south of Great Britain, where demand exceeds local supply, and receive the benefit of a negative TDL charge in zones in the north where local supply exceeds demand. The range can be large – in 2018/19, the TDL charge is forecast to range from a positive charge of £7.38 /kW to a negative charge of £21.22 /kW.  Overall, the positive and negative charges largely balance each other out, so that the net amount raised is small in the context of transmission charges as a whole.

The Claimants argued that the TDL charge reflects relative rather than actual costs in part because the net amount raised is close to zero. However, the Judge points out that this needs to be seen in context in general transmission-connected generators are located further away from sources of demand, while embedded generators are generally built close to demand, and in particular small peaking plant is usually not built in remote areas. While in theory, the direction of the signal could change, there is no evidence that in practice that the market is likely to change to such a degree that small embedded generators would find themselves in locations where there was no net demand for electricity.

“The Claimants’ submissions appeared at certain points to amount to an argument that the TDL charge was inappropriate for the purposes of reflecting costs because it was based on a model, but in the context of a complex market such as the electricity market the use of models is most likely inevitable, and certainly unobjectionable.  Mr Pleming [Counsel for the Claimants] did not contend that the use of a model in itself made the Decision unlawful.  Nor does it amount to an error of law for the Claimants to point out that the model, and consequently the TDL charge, could be improved.”

The Judge accepted that the TDL charge is not calculated by identifying a set of transmission network costs and dividing those costs between suppliers, but based on the Connection and Use of System Code (“CUSC”) this is not how transmission costs are designed to be recovered – the CUSC describes the locational component as being calculated with reference to potential savings (or increases) in the costs of the transmission network. 

Demand residual charges

The demand residual charge, or “TDR” is designed to recover all the costs of running the transmission system that are not recovered either from generators or from the demand locational charge. Much of these costs reflect historic infrastructure investments, and as such are “sunk” costs, however there is an element of investment in new or replacement assets. According to the Claimants, the increased use of small embedded generators would reduce the need for such investment by reducing the demands on the transmission network as a whole, and that in the long term, use of embedded generation would reduce overall transmission costs.

Historically, the TDL and TDR charges were both recovered on the basis of a supplier’s net demand, so having embedded generation in their portfolios reduces their demand and hence the amount of these charges they pay. In practice, suppliers pass on 90% or more of these savings to the embedded generators (and these are therefore seen as “embedded benefits”).

According to Ofgem, when one supplier’s net demand is reduced by the electricity generated by small embedded generators, the level of costs that must be recovered from other suppliers will increase, and these additional costs are then passed on to consumers. The Claimants’ believe that this ignores that contribution of small embedded generators in reducing transmission costs across the system as a whole.

Ofgem analysed the 25 modification proposals. All of the proposals involved moving from net to gross demand as a basis for calculating the TDR charge, however, most involved introducing a different credit in relation to the amount of electricity generated by small embedded generators during the triad.  The amount of this credit was referred to by Ofgem as “the value of “x”.  There were a range of different proposals for the value of “x”, of which the AGIC was one (see box).

Ofgem assessed each of the options against the CUSC objectives and Ofgem’s statutory duties, and concluded that avoided grid supply point (“GSP”) costs are the only benefits to the transmission system that have been robustly demonstrated to arise from the use of small embedded generators.  Therefore, a “value of x” equivalent to avoided GSP costs would reduce the TDR payment to one which reflects long run cost savings attributable to small embedded generation.

“At the heart of this case is the simple fact that the Claimants disagree with this conclusion.  However, that in itself is not a ground for judicial review.”

Breach of principle of non-discrimination

In assessing the alleged unlawful discrimination, the Judge described the electricity market as being broad, with complex charging arrangements. Ofgem’s decision impacted a subset of generators whom Ofgem deemed to be in receipt of payments that were distorting this market, significantly increasing the cost of electricity to consumers.

Comparison with DSR and behind-the-meter generation

The Claimants contended that small embedded generators are materially the same as providers of behind-the-meter generation (“ BTMG”) and demand-side-response (“DSR” – in this context excluding on-site generation which is covered under BTMG) because all three reduce a supplier’s net electricity demand. The Judge took issue with this characterisation – as he had to a certain extent during the hearing – pointing out that DSR is not a form of generation at all, but a means of assisting customers in reducing their demand for electricity, as is BTMG.  To the extent that a customer makes use of DSR or BTMG it does not buy electricity from its supplier, which reduces the supplier’s gross electricity demand. On the other hand, small embedded generators do not reduce suppliers’ demand, but help to meet that demand. 

Providers of DSR and BTMG did not receive TDR payments from suppliers (no evidence was presented as to how they are remunerated) and they will not benefit from the EET.  Moreover:

1. Because providers of DSR and BTMG supply their services to customers, they need to identify and enter into contracts with customers that can benefit from their services.
2. Because they supply electricity to suppliers rather than to customers, small electricity generators do not need to identify and enter into contracts with individual customers – suppliers make arrangements for the electricity generated by small embedded generators to be supplied to their own customers.
3. Supposing (although there was no evidence about this) that providers of DSR and BTMG are able to charge more for their electricity than small embedded generators, this may just be a function of the fact that they occupy different positions in the market – providers of BTMG supply electricity “retail” to individual customers, whereas small embedded generators supply electricity “wholesale” to suppliers for on-sale to customers.
4. Ofgem’s decision concerned charges paid by suppliers and payments made by suppliers (ie the TDR payments). Since providers of DSR and BTMG do not supply electricity to suppliers and do not receive payments from suppliers, it is difficult to see how Ofgem’s decision could be applied to them.

In addition, Ofgem has assessed that the TDR payments made to small embedded generators distorted the market and increased electricity costs for end consumers, whereas any payments made by consumers to providers of DSR or BTMG would presumably only be made if their services were reducing the electricity costs of those consumers.

Therefore the Judge concluded that the differences between small embedded generators on the one hand, and DSR and BTMG on the other are large enough to justify their different treatment by Ofgem. 

Comparison with transmission-connected generation

The Claimants also submitted that Ofgem’s decision was unlawfully discriminatory because it treated small embedded generators as if they were in a comparable situation to transmission-connected generators, when there are material differences between them.

The Judge identified a number of similarities and differences between small embedded generators and transmission-connected generators: 

1. Both generate electricity and supply that electricity to suppliers.
   1. Prior to Ofgem’s decision suppliers did not pay TNUoS charges to the extent that they satisfied their demand during the triad with electricity generated by small embedded generators; and some small embedded generators received TDR payments, whereas transmission-connected generators did not receive these payments.
   2. Following Ofgem’s decision suppliers pay TNUoS charges on all their demand during the triad, whether that demand is satisfied by transmission-connected generators, large embedded generators or small embedded generators; those small embedded generators that used to receive TDR payments will receive the EET, which includes elements designed to reflect the costs savings attributable to the fact that they are not connected directly to the transmission network.
2. Transmission-connected generators pay TNUoS Generation charges, including TNUoS local charges, whereas small embedded generators do not.
3. Both transmission-connected generators and small embedded generators pay the connection charges appropriate to the network to which they are connected. Small embedded generators pay deeper connection charges than transmission-connected generators although the difference between the two has not been quantified.  Moreover:
   1. This is the case for all embedded generators, large or small, and whether or not they used to receive TDR payments. 
   2. It does not appear that the difference has prompted any large or small embedded generators to propose amendments to, or otherwise to challenge, the distribution connection charges on the grounds of discrimination.
   3. It was not the purpose of TDR payments to compensate their recipients for this difference.
   4. It is not the case that any perceived unfairness is incapable of remedy – it could be addressed in the ongoing Targeted Charging Review.

Therefore the Judge concluded that the differences between small embedded generators on the one hand, and transmission-connected generation on the other are large enough to justify their different treatment by Ofgem. 

Alleged failure to take account of material considerations and/or facts

The Claimants’ case in this respect changed during the course of the proceedings. Initially, the Claimants focused on their allegation that Ofgem failed to consider what they considered to be the impact of small embedded generators on the long-term avoided marginal costs of the transmission network. In his Judgement, the Judge described at length the process by which Ofgem had arrived at its decision to change the way in which transmission costs are allocated to suppliers, and in particular the repeated invitations to market participants to provide evidence of the costs savings, other than avoided GSP costs, that arose due to the use of embedded generation.

“In effect, the Claimants’ case as originally pleaded asserted as a fact that small embedded generators produce larger savings in transmission network costs than are reflected in the EET, and then complained that Ofgem had failed to take that asserted fact into consideration.  But Ofgem had considered whether that asserted fact was actually true, and had decided that it was not.  That was the assessment of the expert regulator.  This court cannot simply assume the existence of asserted facts which the expert regulator has concluded are untrue.  Ofgem’s assessment could be challenged on the grounds of irrationality, but the Claimants are not bringing such a challenge.”

At the hearing, the Claimant’s primary submission was that although Ofgem had tried to address the arguments made to it by the Claimants and others, that the EET would not adequately reflect all of the savings attributable to the use of small embedded generators, it had failed to properly address them as it had not properly understood them, and therefore it had made an error of law which was amenable to judicial review.

Further arguments were that Ofgem did not adequately investigate the impact of small embedded generators on what the Claimants alleged were the long-term avoided marginal costs of the transmission network; and that the provisions of the Security and Quality of Supply Standard (“SQSS”) which sets out the criteria and methodologies to be used in planning and operating the transmission network, meant that small embedded generators placed less demand on, and therefore created opportunities for savings in the costs of the transmission network.

Ofgem’s alleged misunderstanding was summarised by the Claimants’ Counsel as follows:

1. The TDL charge is not cost reflective, but creates a relative and temporary locational signal;
2. The TDL charge, either by design or as a consequence of the model on which it is based, nets to zero; and
3. The transmission network costs saved or avoided by the use of small embedded generators are to be found in the TDR charge.

The Judge wrote that he was not persuaded that there was any such misunderstanding by Ofgem, and that Ofgem had adequately understood the points which were being made to it by the Claimants and others – it simply disagreed with them.  He also stated that there was no reason to believe that Ofgem misunderstood the nature of the TDL charge.

“More importantly, Ofgem demonstrated by including the AGIC in the EET that it was willing to adjust the use of system charging methodology in ways which went beyond the scope of the TDL charge if it considered that it was necessary to do so in order to make the charging methodology reflective of costs savings achieved by the use of small embedded generators.”

The Judge also rejected the additional arguments that Ofgem did not adequately investigate the impact of small embedded generators on transmission costs, and that the different treatment of emall embedded generation in the SQSS itself was evidence that they had a different (and potentially beneficial) impact on the transmission system.

The principle that a decision-maker can decide upon the manner and intensity of any inquiry to be undertaken into any material consideration is set out in legal precedent, and while the SQSS argument had more merit, the Judge expressed frustration that it had only been raised in the final parts of the hearing and was primarily argued in post-hearing correspondence. However, the Judge concluded that he was not persuaded these submissions demonstrated any error of law on the part of Ofgem, and that Ofgem had considered there arguments in reaching its decision.

Is this the end of the embedded benefits story?

In my previous post on this issue, I expressed some doubts that the Judge would be willing to find that Ofgem was incompetent in its decision-making, given the complexity of the market and his own lack of expertise in the sector. In fact, in his Judgement, the Judge confirmed:

“Ofgem is an expert body charged with making decisions on complex, technical issues. The Courts will be slow to interfere with the judgments of such a body on such issues.”

I was also dubious that the discrimination claim would be upheld, since requiring Ofgem to avoid any discrimination in any of its decisions would make the regulatory system very inflexible, given the complexity of the market. In fact the Judge did not even bother to address the arguments around whether some discrimination can be allowed where complex decisions are being made, and found that there was no discrimination in Ofgem’s treatment of small embedded generators in this case.

The Claimants are quoted in UtilityWeek as saying they are considering whether they should seek permission to challenge the Court’s decision to reject their application for a judicial review, saying they “continue to believe that [Ofgem] has made a fundamental error in their understanding of transmission network charging.”

I struggle to see the basis for an appeal having read the Judgement, although the Judge’s comments on the SQSS argument were significantly less detailed than the rest of the Judgement, so there may be some scope for a challenge in that area. Given that the stakes for the Claimants are high – some of them have been awarded Capacity Market contracts based on auction strategies that assumed the ongoing receipt of embedded benefits – they may be tempted to try. The new charging regime significantly reduces their income streams and threatens their business models. I would expect that any appeal would need to provide much clearer evidence of the different savings small embedded generators create in respect of transmission costs, including quantification of these potential saving, since not providing these was a major weakness in the Claimants’ case.