Squeezing out the value of embedded benefits for power generators

Published on 17th January, 2017

A key factor informing any investment decision in virtually every market sector is the presence of a stable and predictable legal and regulatory framework.

This is especially true of the power sector, where the investment climate has been clouded by the major changes that come under the umbrella of Electricity Market Reform (EMR), most notably Contracts for Differences (CfDs) and the introduction of a Capacity Market.

The EMR is the central plank of the Government’s energy policy, set to incentivise investment in low-carbon electricity, to improve the security of Great Britain’s electricity supply, and improve affordability for consumers. CfDs are legal contracts between low carbon electricity generators and the Low Carbon Contracts Company (LCCC), a government-owned company. A generator party to a CfD is paid the difference between the ‘strike price’ – a price for electricity reflecting the cost of investing in a particular low carbon technology – and the ‘reference price’– a measure of the average market price for electricity in the GB market.

CfDs, and particular the ‘strike price’, are therefore used as the sweeteners to encourage investment in power generation. They provide investors with some peace of mind by offering a degree of stability to electricity generator revenues by reducing their exposure to volatile wholesale prices. As such, they are central to the Capacity Market, which seeks to incentivise investment in further sustainable electricity generation opportunities and so build the capacity the Government believes is needed to help secure electricity
supplies for the future.

However this situation is further complicated because following the recent introduction of EMR via the Energy Act of 2013, further new discussions are already under way which are likely to lead to yet more changes to the regulatory regime and which could have a major impact on the returns that can be achieved by power generators.

As the costs of renewable technologies come down, there is an increasing recognition of the important role to be played by smaller, renewable technology generators in the development of a decentralised, “smarter” electricity system. The returns earned by such generators, which are invariably “embedded” within the lower voltage distribution networks, consist in part of a financial payment made as a reward for their contribution to the saving on the costs of using the higher voltage transmission system and these have become increasingly important over time.

Under current arrangements, Suppliers principally pay so-called Transmission Network Use of System (TNUoS) charges on the basis of how much demand their customers place on the system at the times of highest overall demand – known as the Triad periods, these are the three half-hour settlement periods with highest system demand.
Consequently, embedded generators can reduce this demand by producing power which then offsets the overall Supplier exposure to these TNUoS charges – a service for which they are compensated in direct proportion to the savings realised.

However, over time payments of these so-called “embedded benefits” have increased significantly as the volume of local generation has grown. Moreover, using the Triad periods as a basis for paying these benefits has become less meaningful as the Triad periods themselves are now harder to identify. Suppliers have increased their ability to reduce the financial burden of TNUoS by adopting measures to avoid customer demand during the Triad periods and at the same time generators have become better able to “chase” the Triad periods in order to maximise their payments. These trends, reinforced by a growing number of companies offering specialised advice in this area, have had the effect of flattening out the demand curve at time of peak demand and leading to questions about the long-term viability of the whole Triad-based approach.

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The National Grid expressed concern in an informal review in April 2013 that the current system is unsustainable and distorting proper incentives for investment in generation. Various proposals have been made to amend the Connection and Use of System Code (CUSC), in particular Code Modifications 264 and 265. CUSC is the contractual
framework for connection to, and use of, the National Electricity Transmission System (NETS). The National Grid is the Code Administrator for the CUSC and maintains the Code. All changes are subject to industry consultation and approval by either Ofgem or the CUSC Modifications Panel.

Modification CM 264 proposes to stop any new embedded generation connecting after June 2017 from getting any TNUoS benefits, while CM 265 would remove the eligibility for TNUoS benefit payments from all embedded generation with Capacity Market contracts. There are various other variations to these proposals also under active discussion. The industry regulator, Ofgem, initiated a review of transmission charging arrangements for embedded generators in January 2016. The issue of how any changes are implemented, including possible transitional arrangements, will be an important factor in deciding how to move forward. Ofgem is expected to announce its proposals to replace the existing arrangements very soon.

As things stand, generators face the tricky problem of how to ensure that they maximise their revenues by generating in the Triad periods, given that it is increasingly difficult to predict when the Triad will actually happen. Looking at the winter period as a whole, generators need to find a way of ensuring that continuous generation is financially viable over all of the key likely Triad periods.

This can be achieved by looking at other sources of revenue (e.g. the so-called “superred DUoS” payments) and comparing these with generation costs. EnDCo’s understanding of the energy market and its approach to realising the value from embedded benefits can help generators achieve this outcome, ensuring that financial returns are positive whatever the circumstances and in effect taking the TNUoS payments as a “bonus” on top of normal, guaranteed returns.

This is a pragmatic approach and one which can help embedded generators chart a financially more secure course through the choppy waters about to be experienced as more changes affect the regulatory regime in the energy sector.

For further information, please email me at: les.abbie@endco.co.uk

Les Abbie, CEO, EnDCo