Opinion: What’s all the fuss about embedded benefits?

Filippo Gaddo (Head of energy economics, Arup) and  Marina Charalambous (Economist, Arup) discuss why embedded benefits are important and how the relevant decision bodies should address them

 

The concern that has brought embedded benefits into the spotlight stems from the distortive effect of these benefits on the wholesale power market and in particular on the Capacity Market (CM). The technology-agnostic intention of the CM is seen to have been distorted, because embedded benefits have artificially increased the competitiveness of sub-100MW generation relative to large scale gas-ired capacity, which some argue is more efficient.
The next CM auction is in December 2016 (for winter 2020/21) and this is the main reason Ofgem has decided to use a Connection and Use of System Code (Cusc) code modification process to address the issue, rather than opening a much broader Significant Code Review (SCR).
Industry made four Cusc modification proposals between May and August and one  sought an accelerated timetable, claiming urgency. This was denied, because of the complex nature of the issue.
Our view is that an SCR is the appropriate framework to address embedded benefits. They can be considered holistically, alongside all the parameters it would affect and that would affect it. Our premise is that the charging arrangements should be updated to promote the most efficient use of the system and not as a vehicle to address concerns relating to the generation landscape.

What is National Grid doing?
National Grid, as the Cusc Code administrator, is consulting on two of the first code modification  proposals raised in May (CMP264 and CMP265). A common working group of 22 industry representatives, set up to consider these two CMPs together, is now faced with over 40 alternative options to consider. (Two others, CMP271 and CMP 274, are still at the initial proposal stage.)
The live consultation, which closed on 4 November, shows there is not much consensus within the Working Group. The final Modification report has won a timetable extension and the deadline is now 28 November. This means that no decision can be made before the next CM auction, but it does not necessarily mean that bidders will not change their strategies. A signal has been given to the market that embedded benefits may change. By how much, remains to be seen.

What is industry proposing?
CMP264 and CMP265 are both proposals to remove the embedded benefit completely for certain generators. One embedded benefit arises because the transmission component of the bill is charged on a ‘net usage’ basis – which reduces cost for those with embedded generation, a saving that can be passed on to the generator. Under the change proposals charging would be by gross demand.
The difference between them is who would be affected. CMP264 would affect all new generation after June 2017, whereas CMP265 would affect all units with a CM contract effective from April 2020. CMP264 is intended as a stopgap modification and would expire when Ofgem completes its review of embedded benefits. CMP265 will affect a bigger proportion of embedded capacity in the short to medium term.
The other proposed modifications, CMP271 and CMP274, represent a much bigger departure from the status quo and would be very complex to implement within the time allowed by the Cusc modification process. They may become redundant once a decision is made on CMP264 and CMP265.
CMP264 and CMP265 are being addressed by a single working group. The 40 alternative options raised are all on a spectrum of variations across three main questions:

  • Will the modification be temporary or an enduring change in the charging framework?
  • Who will be affected? Is it all embedded generation, those that are new from 2017 or 2018, or only those with CM or CfD contracts? Will there be grandfathering and for how long?
  • How will we set the embedded benefit the small generator recovers? This may include, for example, avoiding the cost of reinforcing a grid supply point, or other transmission reinforcement; the generation residual; a four-year average of the demand residual; maintaining the current level or a combination.

Our view
We are of the view that embedded benefits should be considered within an SCR and that piecemeal attempts to address them could have unanticipated consequences. For example, more and more generation could connect ‘behind the meter’ in order to avoid new restrictions, or there could be cross effects on the Balancing System Use of System (BSUoS) generation charge.
The benefits of local balancing and flexibility have to be considered, something that Ofgem itself has already signalled, and perhaps even the possibility of nodal charging. Moreover, Defra’s planned review on the level of NOx emissions from small scale generation could, on its own, achieve a big part of the objectives behind the current modifications.
In the absence of an SCR, and in the face of a decision to be made in relation to CMP264 and CMP265 in the coming months, this is our view on actions that could be taken temporarily, and in the short term.
We believe that the charging arrangements reflect the relative costs and benefits of demand and generation at different locations on the network. Therefore we believe that the avoided GSP and transmission network reinforcement brought about by the existence of embedded generation should be reflected in its charges (or payments). CMP264 is closer to this objective than CMP265: at least it maintains this benefit for existing generation.
Embedded generators are crucial in managing the winter peak and their charging framework provides an incentive to target their output to times of tight margin. This happens via so-called ‘Triad’, which relates costs to usage in three winter periods when demand is highest. This has led to so-called ‘Triad chasing’, which has also led to market distortion because power plants generate despite having negative spreads to make sure they have low demand at Triad times. However, removing the Triad signal removes the incentive for embedded generation to operate at times of system stress.
In terms of the distortion to the outcomes of the CM, CMP265 is clearly more targeted and would affect all embedded generation that chooses to bid in the CM. There is a risk that plant already contracted in the CM would withdraw in the event their benefits change.
The last three considerations are interrelated. A dramatic departure from the existing framework is harder to implement and it raises the question of whether a significant change from the status quo is appropriate under a CUSC modification process. We view CMP264 as a smaller departure from the status quo, which in our view would mean fewer unanticipated consequences.
Finally, the extent to which any changes affect the viability of past investment decisions, especially against a background of recent government policy changes with respect to renewables, is an important consideration and affects general investor confidence. By this measure CMP264 is preferable, as it limits effects to existing plant.

Conclusion
We believe that, on balance, CMP264 is a better option than CMP265. An even better option would be a variation of CMP264 that allows for some of the benefits to be retained, to better reflect the cost reflectivity objective above. Finally, an important advantage of CMP264 is that it is a clearly temporary modification, which would expire once Ofgem completes its review of embedded benefits.
We expect that there will be concerns, and rightly so, over the lack of analysis done by the working group itself and any mention of previously unidentified unanticipated consequences from respondents. We would like to see the industry engaging in a fruitful discussion, which will lead to a targeted, balanced and temporary change and hope that our contribution facilitates this.
We also hope that such a discussion will highlight the reason why the issue of embedded benefits is crucial in the design of appropriate charging arrangements for a system under unprecedented change – which will pave the way for a fundamental review by Ofgem.

Further reading:

A Guide to Embedded Benefits

Beware an embedded benefits review by stealth

Login to read: Review of embedded benefits opens fault lines among industry players

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