Ofgem minded to cut embedded benefits

Ofgem is 'minded to' accept a proposal to cut the triad avoidance payment for embedded generators by 95% over three years.

Background: embedded benefits

Let's go back a step and explain the background, before looking at what this means and why it is important.

Small generators of less than 100MW that are connected to the electricity distribution network rather than the transmission network are known as "embedded generators". By not being directly connected to the transmission network they avoid paying certain charges and even get paid by electricity suppliers to generate electricity at times of peak demand. These benefits are known as "embedded benefits". In simple terms they include:

Not having to pay National Grid any Transmission Network Use of System (TNUoS) charges, since the generators are not connected to the high-voltage transmission network.
'Triad avoidance' payments. 'Triad periods' are the three half hour periods of highest system net demand during November-February (this is worked out afterwards so no one knows in advance when a triad period will be). Electricity suppliers have to pay TNUoS demand charges on the basis of their average net demand over those triad periods. If suppliers have an arrangement with an embedded generator, they can ask that embedded generator to generate electricity at times of (likely) highest demand (hoping that three of those will end up being a triad period) 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.

The value of the current triad avoidance benefit is £45/kW (which to put it in context is over double the latest 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.

The issue: market distortion

Embedded benefits are becoming a problem for Ofgem. More and more generators are choosing to connect to the distribution network rather than the transmission network, which leaves fewer transmission-connected generators to pay the TNUoS charges. The TNUoS charges go up, so suppliers pay embedded generators more to generate at triad periods (to reduce their TNUoS demand charges), which increases the triad avoidance payments and encourages yet more generators to connect to the distribution network – a feedback loop that (as mentioned above) means in four years' time the triad voidance benefit is forecast to be £72/kW.

Ofgem believe that this has led to these market distortions:

Dispatch – Smaller embedded generators generate 'out of merit' (i.e. instead of the cheapest and most cost-effective generators running first, embedded generators run when normally, if it weren't for the embedded benefits, it would not be as cost-effective for them to generate first).
Wholesale price – by running 'out of merit', the wholesale market price is distorted and artificially damped at peak times.
Capacity Market – embedded benefits give smaller generators a competitive advantage so they can bid into the Capacity Market at a lower price, potentially pushing out more expensive, but ultimately more efficient, plant.
Inefficient investment in generation capacity – although it might be more efficient to locate on the transmission system, generators choose the distribution system instead so that they can get embedded benefits.

This ultimately leads to higher costs for consumers, as suppliers recover the cost of paying embedded generators by putting it onto customers' bills.

Why now?

Ofgem has been accused by the Association for Decentralised Energy (ADE) and others of rushing the embedded benefits review, but both Ofgem and National Grid have had this issue on their radar for a long time (the consultation points to discussions going back to 2007). Ofgem have issued various open letters to the industry, in July 2016 and December 2016, asking for views. Instead of launching a full-scale review of charges, Ofgem put the onus back on the industry to suggest solutions by proposing modifications to the industry's Connection and Use of System Code (CUSC). The industry duly put forward two proposals that Ofgem have been considering, and they have decided to implement a modified version of one of them. This would see the level of triad avoidance payment reduced to the level of avoided Grid Supply Point costs. Grid Supply Point costs are the cost of reinforcing the point where the distribution network connects to the transmission network. Generation connected to the distribution network takes demand off the transmission network, so offsets the need for reinforcement. The value of this avoided reinforcement cost is approximately £2/kW.

Reducing the level of triad avoidance payment to the avoided Grid Supply Point costs would take place gradually over three years from 2018 to 2020. In practice, this means a reduction from £45/kW (which was rising each year) to only £2/kW.

Is it such a problem?

Former Energy Secretary Sir Ed Davey has warned that Britain risks "sleepwalking into brownouts and blackouts" as the reduction in embedded benefits could cause many smaller plants to close early and to renege on their Capacity Market contracts. There is a view amongst the smaller generators that the CUSC panel (mainly made up of larger generators) are targeting this one area rather than looking at network charges as a whole, and that this itself could cause distortion in the market to the detriment of smaller generators.

Ofgem's view is that "the proposed reforms would not have a material impact on security of supply" but could potentially save consumers up to £20 per household per year by 2034 and make the energy system more efficient overall.

What does it mean for embedded generators?

Chapter 5 of the consultation looks at the likely effects of the modifications on specific types of generators and is worth a closer look. In summary:

Thermal generation, including energy consumers with on-site generation (such as hospitals) are likely to see a reduction in revenues if they currently export part of their generated energy. In some cases triad avoidance payments can form up to half of their anticipated revenues and operations. Ofgem "recognise that in some cases, this could lead to a significant challenge to business models or the perceived stranding of assets".
DSR and storage – reducing the triad avoidance payments may incentivise generation to move 'behind the meter'. This means moving generation beyond the point where electricity consumption is measured (such as a backup generator at a factory) to net off the customer's metered consumption and so reduce their demand charges. Ofgem are considering this as a priority area for the Targeted Charging Review (see below). Some electricity storage projects at distribution level may be reliant on triad avoidance
payments to be economic. Ofgem don't go into detail as to what this might mean but I think we can read between the lines that it is not good news for storage, and it will be interesting to see the industry responses.
Renewables will be impacted less than dispatchable generation, as they cannot guarantee to generate at triad periods, but anaerobic digestion (AD) plants that prioritise electricity generation over gas production may be particularly impacted, and might prompt them to switch to biogas production, or to export electricity over private wires rather than the distribution network.

Ofgem end Chapter 5 with their provisional view that the network charging regime is not the correct place for supporting emerging technologies and that if they need support it should be through direct explicit subsidy to meet a policy aim, rather than through potentially distortive charging arrangements. We are not holding our breath for a new subsidy.

Targeted charging review

Ofgem also promised to issue a Targeted Charging Review to look at the other embedded benefits and they published it on 13 March. They are consulting on whether to issue a Significant Code Review that will look at changes to the TNUoS and DNUoS residual charges plus changes to embedded benefits (other than the triad
avoidance payments).

There is some good news for storage in this. Part of the Targeting Charging Review is looking at how storage is charged and trying to put it on a level playing field with generation, removing the element of double charging that up to now has placed storage at a disadvantage. Ofgem are proposing that this is done via the normal code
modification process rather than as part of the Significant Code Review, so that the reforms can be brought about more quickly. See our article Battery Storage: a SWOT analysis for more context on storage.

Next steps

The embedded benefits 'minded to' decision is open for consultation until 9.00am on Wednesday 18 April (an extension from the original closing date of 10 April but over the Easter weekend so not as helpful as may first appear). Ofgem will decide in May whether to proceed with this, or to accept one of the other modifications proposed, or even to reject all the modifications and consider triad avoidance as part of the Targeted Charging Review process instead.

If Ofgem proceed with their decision, triad avoidance charges will start to reduce in April 2018 by a third each year, until by April 2020 they are down to £2/kW.

The Targeted Charging Review consultation is open until 5 May. If Ofgem decide to launch a Significant Code Review, this will take at least 18 months to conclude, then implementation will be after that. That is why Ofgem want the storage charges to be reviewed using the code modification process, which is quicker.