Two recent publications (an open letter from Ofgem and a note from Defra) may spell bad news for operators of small diesel generation facilities.

In recent years, and contrary to the Government's stated 'green' ambitions, the electricity market has unintentionally favoured small diesel generators. In last year's Capacity Market 2015 auction, operators of new build diesel generators successfully bid for subsidies of £176m out of total £1.1bn. This means that at times of peak demand, diesel generators are being paid to provide the UK with the extra power needed.

Embedded benefits

Diesel generators, and other small generators of less than 100MW, get another advantage (in addition to capacity market payments) by being connected to the distribution rather than the transmission network. Such generators are known as "embedded generators" and the benefits they get are known as "embedded benefits". In simple terms these benefits include the following:

• Since the generators are not connected to the high-voltage transmission network they do not have to pay NGET any Transmission Network Use of System (TNUoS) charges
• Electricity suppliers have to pay NGET TNUoS demand charges on the basis of their average net demand over the 'triad periods' (the three half hour periods of highest system net demand during November-February). If suppliers have an arrangement with an embedded generator, they can ask that embedded generator to generate electricity at those times. If they generate enough, it will flow the other way, from the distribution network to the transmission network, and in effect net off the supplier's demand. This means the electricity supplier pays a lower TNUoS demand charge and will share a significant part of this saving with the embedded generator. This is sometimes known as 'triad avoidance'.

The value of the current triad avoidance benefit is £45/kW which is over double the 2015 Capacity Market clearing price and is forecast to increase in four years to £72/kW.

The main beneficiaries of triad avoidance payments are small power plants that can generate at times of peak demand – so not solar (as the triad periods are all winter evenings) and not always wind (as it will depends if it is windy during a triad period) - but usually diesel, gas, CHP, AD and some storage.

Market distortion

The issue is that because overall TNUoS charges have increased and the volume of embedded generation has grown rapidly, both the size and number of triad avoidance payments has grown and could now be distorting the market, leading to an inefficient mix of generation by encouraging investment in smaller embedded generation over potentially more efficient larger transmission-connected generators and distorting the outcome of the Capacity Market by holding down prices – see further on this below.
Ofgem and National Grid have had this issue on their radar for a long time but have put the onus back on the industry to suggest solutions by way of proposing modifications to the industry's Connection and Use of System Code (CUSC). There are two proposals that Ofgem will be considering in the Autumn and the aim is to implement one of these (perhaps modified/adapted) by 2019/20. The two proposals are:

• CMP264 from Scottish Power to stop any new embedded generation, connecting after June 2017, from getting triad avoidance benefit.
• CMP265 from EDF to remove the ability to get TNUoS avoidance payments from all embedded generation with Capacity Market contracts, to be implemented in 2020.

In light of the upcoming CUSC modification proposals, Ofgem have issued an open letter to the industry asking for views on embedded benefits, in particular the triad avoidance payments, by 23 September 2016. Ofgem are aware that changing the embedded benefits regime might mean that generators instead choose to locate behind the meter or on private wires. They will issue a further consultation on other elements of embedded benefit and storage/behind the meter costs in the Autumn.

Capacity Market

Prequalification for the three capacity market auctions that will be held at the end of 2016 and early 2017 (the third 'T-4' auction for delivery in 2020/21; the 'early' auction for delivery in 2017/18; and the second ‘transitional arrangements’ auction for DSR, for delivery in 2017/18) opened on 1 August 2016.

See our previous article Capacity Market Auction Brought Forward for more background

Embedded generators can also enter the Capacity Market and get capacity payments for generating at times of peak demand, but because they get embedded benefits as well, they can put in a lower bid, which distorts the Capacity Market. This is why CM265 proposes removing embedded benefits from embedded generators who participate in the Capacity Market.

The Capacity Market is paid for by a levy on suppliers but this is based on their net demand, i.e. suppliers can contract with an embedded generator and therefore net off their demand and pay a lower levy - another benefit that embedded generators will share in.

Ofgem will be consulting on changing the supplier levy so that it is calculated on the basis of gross rather than net demand. This consultation will be carried out in time for any consequential regulatory changes to be made in advance of the levy being collected for the new Capacity Market auction in October 2017, and would apply for Capacity Market revenues recovered in respect of all delivery years from that point forward (see paragraph 4.16 of the Government response to the March 2016 Capacity Market consultation).

So whilst this will not affect the three upcoming capacity market auctions, it will, if brought in, affect capacity market auctions from October 2017 onwards.

Defra's proposals to regulate generators with high NOx emissions

The other bad news for diesel embedded generation is that Defra intends to consult later in 2016 on options including legislation that would set binding emission limit values on relevant air pollution limits from diesel engines, with a view to having legislation in place no later than January 2019 and possibly sooner.

The proposals are likely to require emissions limit values for NOx to be achieved within 5 minutes of plant operation where secondary abatement is needed to meet the limit. This will primarily affect diesel engines. It will directly impact installations with a thermal input less than 50MW that become operational after the proposals are published – so after this Autumn.

Investors bidding into the Capacity Market auctions in 2016 will need to take this into account.