Last week Ofgem published its “minded to” decision on electricity network charging reform as part of its Targeted Charging Review (“TCR”) into the way in which residual transmission charges are recovered from consumers, and on certain “embedded benefits”:
Charges for using the electricity network have two elements:
- Forward looking charges that are designed to ensure network users (via suppliers for many customers) receive signals reflecting the costs of how and when they use electricity, to encourage users to be flexible in their use to reduce their own electricity bills and thereby reduce overall network costs; and
- Residual charges which are designed to ensure that network costs not recovered from the forward-looking charges are fully recovered, and should be designed to minimise distortion to the forward-looking signals.
This second element, reform of residual network charging, is the focus of the current Review, and has been a subject of some controversy, following Ofgem’s decision last year to remove a portion of the benefits (“embedded benefits”) available to distribution-connected generation which was subject to a legal challenge (won by Ofgem). The Review is taking place alongside a wider examination of network charging in the Electricity Network Access project, which, in addition to considering reform of the forward-looking component of network charges, has proposed a review of balancing charges (Balancing System Use of System charges or “BSUoS”).
Residual charges are recovered from smaller users through per-unit consumption charges, and for larger users by a mix of per-unit consumption charges for distribution costs and peak demand charges for transmission costs, which are determined by the “triad” mechanism where charges are based on consumption in three half-hour periods of high demand in between November and February that are not known beforehand. This approach strongly incentivises users to reduce their electricity consumption from the grid in anticipation of these periods by load-shifting and using on-site generation and storage instead.
“Where these activities are prompted by residual charge avoidance, they will not reduce costs for the system, and in some cases may add to them. These activities will also push residual charges up for other users. We do not think this is a fair outcome – all users should contribute to the ongoing costs of the network infrastructure in exchange for the benefits it provides,”
– Ofgem
Network and system operator charges amount to around £10 billion per year, of which around £4 billion is recovered through residual charges. Ofgem was concerned that market participants were changing their behaviours in response to residual charges, and this was contrary to its belief that residual charges should not provide forward-looking signals. The quantum of residual charges and their proportion of the whole has grown over recent years, making these effects more significant.
Reform of access arrangements and forward-looking network charging may well change this, which is why Ofgem has delayed publication of its minded-to document until after the access/forward-charging consultation closed. However, Ofgem is concerned that the size of the customer detriment caused by the current approach to residual charge recovery means that it should not wait until the review of forward-looking charges is finalised before addressing the issue.
Ofgem is now consulting on a proposed reform of transmission and distribution residual network charging and on some of the remaining embedded benefits. Both of these are covered by a Significant Code Review where Ofgem is establishing the basis for detailed changes to be made by the industry.
On network charging, Ofgem considers that there are two leading options for reform:
- A Fixed Charge – where charges are set for individuals in customer segments, with these segments being based on an existing industry approach. This is Ofgem’s preferred option;
- An Agreed Capacity Charge – where for those larger users that have a specified agreed capacity, a charge would be calculated directly, while capacity for households and smaller business would be based on assumed levels.
Ofgem’s analysis of the alternatives for network charging reform
Ofgem explored a number of alternative network charging approaches before settling on its preferred reform alternatives, and believes that residual charges should be levied on final demand users only. The Fixed Charges and Agreed Capacity Charges alternatives were most consistent with Ofgem’s TCR principles since both options scored well against the reducing harmful distortions principles and the distributional impacts analysis.
The Fixed Charge option also scored well against the proportionality and practical considerations principles, whilst both the Agreed Capacity Charges and Fixed Charge option scored well against the fairness principle. The Agreed Capacity Charge scored moderately well on the proportionality and practical considerations principle. Neither option scored poorly against any of the principles or the distributional impacts analysis.
Ofgem also considered the option of mostly Agreed Capacity charges (75%) and partially net volumetric charges (25%) was attractive and had a reduced impact on lower consumption users, as well as differentiating between similar users who use different volumes of electricity. However, its was concerned this would retain a moderately significant distortion to efficient price signals as the volumetric component could be avoided by some users.
Detailed assessment of the preferred network charging options
The two leading options for reform of network charging are Fixed Charges and Agreed Capacity Charges.
Fixed Charges
The Fixed Charges Option allocates the total residual network charging pot by customer segments, based on the total net metered consumption volumes used by that segment. Ofgem believes there is a strong theoretical basis for fixed charges, as they cannot be easily avoided other than by disconnecting from the grid.
Line Loss Factor Classes (“LLFC”) have been selected as the means of segmenting users – this is an existing method in wide use which groups together similar types of consumers and is currently used for allocating network losses. For example, in a single distribution network operator (“DNO”) area, different fixed charges could be paid by all single rate domestic consumers, all Economy 7 customers and all single rate small non-domestic consumers.
The key remaining challenge with this option related to the boundary effects created by segmentation, as there are step changes in the residual charges paid for each segment, and no variation within the segment. Movement between segments would only be possible if the Line Loss Factor Class is changed for that user.
Under Fixed Charges, the domestic segment contribution to residual charges would reduce, while the other segments would see moderate increases, as large users will see charges changing from a peak capacity basis to a volume-based fixed charge basis.
Agreed Capacity Charges
Network charges would be allocated based on agreed capacity. Where this does not exist, as is the case for smaller users, a deemed capacity value would be used. For the purposes of its modelling, Ofgem has used the following indicative bands:
- 4 kVA for most domestic customers (75% of all domestic customers)
- 6 kVA for ‘higher consuming’ domestic customers (assumed to be 15% of all domestic customers)
- 8 kVA for users with electric vehicles or heat pumps (assumed to be 10% of all domestic customers)
These allow for greater differentiation between types of consumer (particularly at domestic, extra high voltage and transmission level) and so have fewer step-changes in charges for different groups. However, as they are based on capacity, there could still be some scope to take action to reduce contribution to residual charges through changes to capacity agreements. In particular, new users may opt for agreed capacity levels that could result in charges being shifted on to other users. Having deemed capacity bands also means step changes between user groups for smaller users.
Under Agreed Capacity Charging, domestic users would also see their share of overall charges fall, but by a smaller amount than for Fixed Charging, since relatively low amounts of capacity are assumed for domestic users. At the same time larger users connected to the high voltage and extra-high voltage levels of the distribution networks and those users directly connected to the transmission network would see their contributions to residual charges fall as these users hold relatively small amounts of agreed capacity compared to the other users on the system. The bulk of the charges would be faced by low-voltage non-domestic users.
Where Agreed Capacity Charges will vary with the size of the user (through deemed band or agreed capacity) Fixed Charges will not, with the same charge applying to all users in an LLFC group. As extra high voltage and transmission sites covering a significant range of size, this standardisation of charge may lead to increases or decreases in capacity agreed.
Ofgem’s modelling of the proposed reform of network charging assumes that for Fixed Charges, the same charge would be paid for a given Line Loss Factor Class regardless of the size of the plant, unless additional bands were added (for example to split out smaller and larger users within a band). Agreed Capacity Charges would increase proportionally with the size of the user’s connections. For smaller sites, no smaller fixed charge would be payable, while capacity based charges would scale down accordingly. For example, a 2 MW extra-high voltage site might pay around £25k per annum, while a 200 MW site would pay closer to £2.5 million per annum.
The degree of change seen by extra-high voltage sites depends on their current charge, in which there is significant variation due to location and whether the user manages their exposure to triad charges. For users that do not engage in triad management, both charging options may lead to significant cost reductions.
For transmission-connected users in Ofgem’s example, network charging would remain roughly the same after the reform, where no triad management is in place, but large increases would occur for those who practice use triad-avoidance. Ofgem thinks this is fair outcome, since taking such action results in lower residual charges for the user, but does reduce overall system costs.
“Users paying the same charges reflects the fact that the costs of the existing infrastructure do not change. This is a significant difference from the baseline and one that is more consistent with the TCR’s objectives of improving fairness and reduced distortions (in this case competition between customer sites),”
– Ofgem
The example user groups consider extra high voltage sites with 10 MW connections consuming c.50 GWh per annum and transmission-connected sites with 20 MW connections consuming c.100 GWh per annum.
Ofgem believes that incentives for large users to disconnect are highly site-specific and not based solely on electricity use. Both leading reform options have the potential to increase network charging for large users who practice triad avoidance, because of the need to recover costs which do not change with use. However, residual charges would become more predictable, which is likely to be positive for most users.
While the proposed reform of residual network charging may increase the likelihood of disconnection due to higher costs, Ofgem expects that for most users the overall likelihood is low. For the largest users, the Fixed Charges option may reflect a relatively small annual cost in terms of overall expenditure, but they are likely to represent a proportionately very large cost for smaller users. Ofgem is seeking views on whether single fixed charges for each voltage level for the largest users is appropriate, or if further division is needed.
At the other end of the user spectrum, the proposed refom of network charging would have a variety of impacts. All SMEs in the same LLFC will receive the same charge under the Fixed Charges option, meaning that larger users will see reductions in network charging and some smaller users will see moderate increases. Users with on-site generation will pay the same charge as those without.
The smallest microbusiness users may see some significant increases in charges under the Fixed Charges option, and very significant increases under Agreed Capacity options. This is because they would move from being charged on a volumetric basis on their own consumption, which may be similar to that of a household, to a Fixed Charge which reflects the average consumption within an SME Line Loss Factor Class, which is much higher. The Agreed Capacity Charge option would also see an increase, as these users would have a deemed capacity set at the non-domestic deemed level, unless other arrangements were made for microbusinesses.
A large SME site could pay a Fixed Charge of £236 in one LLFC, or £1,099 in another. The different LLFCs are indicated in the chart as (1) or (2). Under an Agreed Capacity Charge option, sites of this type would pay £883, representing significant increases for many. Where users have agreed capacities, these charges would differ, and are expected to be higher as such sites would typically hold higher levels of capacity than the deemed values used in the example. Ofgem is interested in views on whether and how particular users, such as microbusinesses, might be treated differently.
The chart above illustrates the potential impact of the proposed network charging reform on a typical DNO (Northeast) domestic consumer. Both options lead to annual reductions in residual charges for the median user, while higher consuming users would see reductions in their charges, and low consuming users would see increases.
Users with Economy 7 meters using 7,100 kWh, reflective of the upper quartile of such users, would see large reductions in their charges (£60 less under the Fixed Charge option and £67 less under the Agreed Capacity Charges option). Both options lead to increases in charges for low users of around £20 per year.
Ofgem is particularly interested in views on whether the Agreed Capacity bandings set for domestic users are appropriate, including whether the use of volumetric consumption to generate domestic deemed capacity bands is distortive.
Where domestic consumers are using low-carbon technologies such as solar PV and solar PV with storage, the reform to network charging will mean users are exposed to increased charges in all cases. This is because the use of these technologies currently reduces their contributions to residual charges by a significant amount. The benefit of lower use of the networks is already reflected in reductions in the cost-reflective element of charges.
The Fixed Charges option will lead to reductions in residual charges for larger domestic consumers such as electric vehicle and heat pump users, as all single rate users have the same Fixed Charge based on their Line Loss Factor Class. Under the Agreed Capacity option such users would see higher charges.
Under both reform options, Ofgem’s intention is that residual network charging would be based on the voltage level at which users are connected. Distribution-connected network users would also pay transmission residual charges, in line with current practice. Transmission-connected network users do not pay distribution residual charges and, so far Ofgem sees no strong case for moving away from this approach. However, it is seeking stakeholder views on whether this aspect of the current arrangements remains appropriate.
Issues related to on-site generation and generation sites with significant demand
Ofgem’s current proposal is to levy residual charges on final demand users, and not charge them to generation, so where a demand load co-locates with a generation site or is connected through the use of a private wire, the demand load not reduce the residual charges that would otherwise be payable.
For co-located or private wire sites with both generation and demand, similar issues are being considered by Elexon in its consultation on how to align Balancing & Settlements Code reporting with Electricity Market Reform regulations, specifically in regard what is considered “final demand” when charging Final Consumption Levies.
Elexon’s consultation sets out a possible solution on how to determine, and report, the imports used by generation and demand at co-located sites. The solution could be used to separate out the import at these sites for the purpose of residual charging. Ofgem believes the approach currently used by the Low Carbon Contracts Company when estimating charges to a Contracts for Difference generator may be sensible. This involves not charging licensed generators for imports to:
- their generating units; and
- any auxiliary equipment required to operate the generating units for a sustained period of time safely and efficiently at the maximum capacity possible and without causing damage to it.
Further reform to embedded benefits
Ofgem is considering reform to three remaining significant embedded benefits which it believes are responsible for significant market distortions, one of which relates to the Transmission Generation Residual (“TGR”), and two relate to Balancing Services Use of System charges:
- Transmission Generation Residual payments: smaller embedded generation is not subject to transmission generation residual payments, which are currently negative. A negative TGR directly increases costs for consumers, as it results in an increased Transmission Demand Residual paid by consumers. It also makes transmission-connected generators more competitive relative to other generators, for example in the Capacity Market where this additional revenue can distort bids, making this generator more likely to clear in the auction, at the expense of capacity which is actually more cost-effective.
- BSUoS charges – payments: smaller embedded generators can generate income by helping suppliers reduce their contribution system balancing costs. Suppliers pass on most of these savings to smaller embedded generators through contractual arrangements and then recover the cost of these payments from other customers, meaning the payments directly increase costs to consumers.
- BSUoS charges – avoided charges: smaller embedded generators also avoid paying generation BSUoS charges, which all other generators connected to transmission and distribution networks are required to pay. Larger generators therefore pay higher balancing charges, which may be passed on the consumers through higher wholesale electricity prices.
Each of these embedded benefits represents a difference between the revenues or costs of small embedded generation and larger generation, which does not reflect a difference in the value provided or cost imposed on the system.
Ofgem believes these distortions also lead to higher consumer costs as they result in inefficient investment in generation connected to either the transmission or distribution networks potentially requiring higher network costs.
Ofgem has asked National Grid to set up a BSUoS charges task force to examine the potential for making some elements of BSUoS more cost-reflective and hence provide stronger forward-looking signals. This is due to report its findings in Spring 2019. Ofgem is therefore limiting its consideration to options which remove the BSUoS Embedded Benefits without changing the overall structure of these charges.
Ofgem has considered two reform options for these embedded benefits:
- Setting the TGR to zero & partial BSUoS reform: TGR reform and removing the ability of smaller embedded generators to receive payments from reducing suppliers’ contributions to BSUoS charges.
- Setting the TGR to zero & full BSUoS reform: TGR reform, removing the BSUoS payments, and requiring smaller embedded generators to pay BSUoS charges.
Removal of the BSUoS Embedded Benefits would tend to reduce revenues and increase costs for smaller embedded generators, and reforming the TGR would reduce revenues for larger generators.
Ofgem’s analysis shows that both options for reform have only modest impacts on system costs due to limited changes in the investment in generation capacity, and the operation of this capacity. Both options reduce consumer costs (by £4.5 – £6.0 billion for TGR & Full BSUoS reform, and by £3.3 – £4.1 billionn for TGR & Partial BSUoS reform).
These are partially offset by increases in Capacity Market clearing prices and payments to generators support by Contracts for Difference as generators in these markets would increase bids to offset the loss in revenue or increase in costs as a result of the reforms. The majority of the reduction in generator revenues would fall on existing renewables supported under the Renewables Obligation (“RO”). Larger RO-supported generation would see an increase in transmission charges, whereas smaller RO-supported generation would see the end of both elements of the BSUoS Embedded Benefit.
The proposed reform of residual network charging and the removal of the TGR Embedded Benefit would eliminate the differential treatment of on-site generation compared to other generation since no forms of generation would pay transmission generation residual charges and no forms of generation would receive payments/benefits from transmission demand charges.
However, the proposed reforms for BSUoS would leave some potential benefits for non-exporting on-site generation compared to other forms of generation since:
- Non-exporting on-site generation would continue to benefit from avoiding paying generation BSUoS, alongside avoidance of network and policy costs in general; and
- Non-exporting on-site generation would continue to receive benefits from helping to reduce demand BSUoS for the site on which it is located.
Ofgem’s preferred approach is TGR & Full BSUoS reform, but it is consulting on both options, and will consider the findings of the BSUoS charges task force.
What next?
There has been a mixed reaction to Ofgem’s position on network chargaing reform and the removal of embedded benefits, with consumer groups predictably supporting it, while others, particularly renewable and decentralised generators, being more doubtful. The Association for Decentralised Energy, which represents providers of decentralised energy systems amongst other groups, warned the proposals could damage industrial competitiveness with businesses deciding that it is not worth providing flexibility to the grid.
“Under this option the hardest-hit sector will be the thousands of forward-thinking businesses across Britain who invest in storage and on-site generation. We are concerned the regulator is taking a short-sighted approach and that the tremendous whole system value of flexible, low-carbon, on-site energy generation is not yet being reflected back to our innovators and risk-takers,”
– Chris Hewett, chief executive of the Solar Trade Association
There are also concerns that a fixed charge framework would benefit “profligate energy users” at the expense of those who have actively engaged with efficiency and load reduction strategies, however, there are many other components of energy charging that are volumetric in nature, so it is not given that fixing a portion of network charges would encourage profligate electricity consumption.
Without doubt, the economics of small distribution-connected generators will be significantly impacted by the proposed removal of embedded benefits. The main losers from the reform of network charging will be some categories of low voltage SMEs, with those that have invested on in-site generation and/or storage no longer seeing a benefit from these in terms of reduced residual network costs. Such SMEs that also provide demand reduction services to suppliers and therefore receive embedded benefits will see the most adverse impact from these changes.
“All this seems a bit odd when we are supposed to be encouraging smart flexible energy use and renewable generation. It could be the review of forward-looking charges will balance things up again – but on this evidence Ofgem still yearns for the days of a few big generators before energy users started doing dastardly things like generating their own power,”
– Regen
Ofgem is consulting on both implementation in 2021 and a phased implementation from 2021 to 2023 for the reform of transmission and distribution residual network charging, and 2020 and 2021 implementation for the reforms to embedded benefits.
It may be the case that some affected parties may seek to challenge Ofgem’s position in the courts if the minded-to position is adopted following the consultation, however the defeat of the earlier challenge by a group of embedded generators may act as a deterrent.
Ofgem can also legitimately make the point that the distorting nature of current arrangements has been known for some time, as have Ofgem’s concerns about them, so investment decisions that did not take into account the possibility of adverse change could be criticised. Most projects that began before these issues came to light should have achieved payback before the planned implementation dates, assuming normal investment horizons.
However, the extent of these proposed changes and the expectation of further network charging reform under the Electricity Network Access project, adds to the picture of a rapidly changing regulatory environment, where some changes such as the retail price cap have been implemented over very short time periods. This is likely to contribute to the wider sense of investor uncertainty in the sector.
Many businesses will now be evaluating the impact of these proposals, and deciding whether to continue with existing strategies and planned investments.
Ofgem’s consultation on its minded to decision for network charging and embedded benefits reform closes on 4 February 2019. Alongside this consultation, Ofgem will hold a stakeholder event (the Charging Futures Forum) in January to discuss the TCR and the Electricity Network Access Project. The Forum is intended to make accessing information on the TCR and providing feedback on the proposed changes. Ofgem expects to make a final decision on this Review in mid-2019.
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