Call for Input on options to address high balancing costs (the TCLC strikes back)
In its open letter of 15 July 2022, Ofgem put forward a range of intervention options to reduce the balancing costs incurred by NGESO and, consequently, reduce these costs which are ultimately borne by consumers.
Ofgem has now published a Call for Input that provides more detail on the proposals set out in its July open letter and seeks feedback on Ofgem’s preferred option. Ofgem’s preference is to introduce a licence condition for generators which is largely based on the Transmission Constraint Licence Condition (“TCLC”).
Generators will be familiar with the TCLC and the difficulties and uncertainties this licence condition has created for licensees, and who may now wish to engage closely with Ofgem in a timely manner to ensure that this latest proposed intervention creates a more targeted, workable, and predictable regime than under the TCLC.
The deadline for responses is 5 December 2022.
Background
National Grid Electricity System Operator (“NGESO”) balances the supply and demand for electricity in real time. NGESO does this by predicting discrepancies in electricity production and demand and relies on market participants to signal to NGESO the costs they are willing to pay or be paid to adjust their electricity output or consumption in each given 30-minute settlement period. Electricity generators will submit ‘bids’ when decreasing electricity output and ‘offers’ when increasing electricity output. NGESO will then take action based on the most competitively priced bids and offers, though specific network issues may result in the requirement for more expensive bids and offers being accepted.
The costs incurred by NGESO throughout this process are recovered through the Balancing Services Use of System (“BSUoS”) charges from generators and suppliers but are ultimately passed through to consumers, typically contributing to 1-2% of consumer’s electricity bills. It should be noted that from April 2023, generators will no longer be liable to pay BSUoS charges.
Between 2017 and 2020 balancing costs for the winter months (November to February) averaged at just under £500 million. For winter 2021/22 costs rose to over £1.5 billion. The reason for this sharp increase in costs has been attributed in part to the volatility and uncertainty of the energy markets and the geopolitical landscape over the past year, resulting in periods of tight margins and high fuel and emissions costs.
Ofgem’s stated rationale for intervention
In carrying out an investigation into these costs, Ofgem found that in some instances the behaviour of some generators was not aligned with the interests of consumers.
Specifically, there were instances of generators initially signalling their intention to generate during a settlement period but then reducing physical notifications to zero, signalling to NGESO that the generation unit intended to cease generating, with very little time before the cut off time (“Gate Closure”). NGESO can take action through the Balancing Mechanism to ensure that the unit continues to generate electricity by accepting the generator’s offers to do so. However, in some cases, generators were notifying NGESO of the intention to cease generating before significantly increasing the price of such offers. The combination of high offer prices, lengthy minimum zero times and limited spare generation capacity, meant NGESO often had limited options and incurred higher costs when ‘balancing’ the system.
Proposed options
| Option | Description | Ofgem’s comments on the option |
| Price cap in the Balancing Mechanism | Implemented as either:
| These changes would be implemented via amendments to the Balancing & Settlement Code. This option would lower costs for consumers while also giving certainty to market participants about the price level of offers that is deemed acceptable. However, this option is likely to dampen price signals, which could impact security of supply. |
| Changes to the Balancing Mechanism bid/offer structure | Rather than simply submitting the price per MWh, the structure of bids could be varied to include, for example, variable prices depending on whether the generation unit was already running or not. Equally, the structure could include a requirement to include information relating to the generation unit’s technical parameters. If this information was not included, NGESO would be free to select the required balancing actions based solely on cost with generators “internalising” the implications of their own technical characteristics. | This option could increase the flexibility on the basis with which market participants submit bids and offers. However, it may reduce costs for consumers but does not directly address the behaviour Ofgem is seeking to curb. There is also a risk that including more dynamic parameters may negatively impact smaller generators. The main issue raised in Ofgem’s discussion with stakeholder was that this option may not be compatible with NGESO’s IT systems and, therefore, may not be implemented for several years. |
| New NGESO balancing service to procure firm reserve | NGESO would be able to lock in reserve capacity in advance. This means that those generators that chose to enter into this service would be prevented from reducing their physical notifications to zero MW. | There is uncertainty over the cost and potential volume this service could attract if participation was voluntary. The product also may itself incur costs in preventing participants from behaving in a way that was not consistent with consumer interests. Further, it would be important to consider how this product would interact with other NGESO products. |
| A new licence condition | A new licence condition would prohibit generators from gaining excessive benefit after they have reduced their physical notifications to zero. Where Ofgem suspected that a market participant was seeking to gain excessive benefit after submitting their zero MW physical notification, the market participant would be asked to objectively justify why their relevant offer prices were not excessive. A draft licence condition is set out in the Annex of Ofgem’s Call for Input document. | This is Ofgem’s preferred option and is seen to target the behaviour that has led to increased costs without impeding price signals. Concerns about this option included whether market participants would be given sufficient clarity on how “excessive benefit” would be defined. |
| Restrictions on amending physical notifications close to real time | Physical notifications would be considered final at an earlier point than at Gate Closure, e.g. at the day ahead stage. A limited number of changes could be made to the physical notifications but only for justified reasons. | This option would prevent generators from revising their physical notifications at short notice. However, this option is seen as a significant departure from current market arrangements, reducing flexibility and creating unintended barriers for intermittent generators. |
| Clarifying “good industry practice” in the Grid Code | This would revise “Good Industry Practice” in respect in respect of the submission of physical notifications, clarifying Ofgem’s expectations. The new definition could state that submitting zero MW physical notifications when margins are tight would not constitute good industry practice. | While industry responses welcomed the clarification of the term, it is questionable the extent to which such a definition could be relied upon to produce the desired result, given the scope for interpretation. |
Comments and next steps
Generators are already subject to complex regulations governing their pricing (i.e. a form of price control by stealth) under the REMIT regime and the Transmission Constraint Licence Condition (“TCLC”). Direct market interventions and restrictions, such as those proposed, can be onerous in nature and (unless very well designed, calibrated and understood) can lead to myriad unintended consequences, particularly in an otherwise fully liberalised electricity generation market.
Ofgem is now proposing to introduce yet another form of price control by stealth for generators, i.e. its preferred option of creating a licence condition that prevents generators obtaining an “excessive benefit” in the Balancing Mechanism in certain circumstances. The quoted language is identical to that used in the TCLC and it is striking that the Call for Input makes no mention of this similar existing regime, let alone acknowledge the considerable uncertainty regarding the TCLC’s interpretation.
It is of course legitimate (and indeed required under the Electricity Act 1989) for Ofgem to seek increased competition in the generation market. Nevertheless, it is reasonable to expect that any intervention aiming to improve competition would be based on wide-ranging consultation and supported by robust evidence.
On its face, the Call for Input does purport to balance several valid considerations and references an investigation which identified certain behaviours that the proposed licence condition aims to prevent going forward. Nevertheless, there is little evidence that these behaviours are so endemic and systemic as to require intrusive blanket intervention in generators’ ability to price their output in the Balancing Mechanism. Likewise, the single “industry workshop” held by Ofgem on the options would not seem sufficient industry consultation given the level of intervention now proposed.
Ofgem notably acknowledges that its investigation into high balancing costs seen last winter found no “conclusive evidence” of REMIT or licence breaches, and instead refers vaguely to “sharp” behaviours that are not “aligned with” consumers’ interests. As Ofgem cannot precisely define the problem and explain in any detail why its current toolbox is insufficient, it is therefore very difficult to see how introducing further behavioural pricing restrictions (which require monitoring and enforcement) will improve the regulatory framework.
As mentioned, the preferred option would largely replicate provisions found in the TCLC. However, generators will know that the TCLC concept of “excessive benefit” is ambiguous, poorly defined, and can therefore give rise to excessively subjective interpretations. While Ofgem confirms that it will issue guidance on the interpretation/application of the proposed licence condition, similar guidance on the TCLC has done little to improve the transparency for market participants.
If Ofgem’s preferred option is ultimately implemented, market participants will no doubt welcome detailed guidance on its interpretation/application (similar to REMIT), and an appeal route that is more extensive and focused on the merits than is currently available for licence enforcement actions.
While all generators will in some way be affected by the implementation of any of the options, the proposed changes will have a significant effect on flexible generation, in whose revenue stack balancing services can comprise a significant proportion.
Whilst it is in line with its principal objective for Ofgem to intervene to lower prices for consumers, blunt instruments which are adopted under pressure (and in haste) rarely lead to optimal outcomes over the long term. If there is a pressing issue, Ofgem’s commentary on the available options seems to suggest that the ‘NGESO new balancing service’ route is perhaps the most appropriate (such that it achieves the desired outcome and mitigates unintended consequences).
