Briefing: behind the embedded benefits discussion

Regulator Ofgem has announced it is ‘minded to’ reduce the earnings embedded plant can harness from so-called embedded benefits.  Janet Wood sets out the background to its document


What are embedded benefits?

Embedded generation charging is complex, such plant can accrue several types of financial benefit – bit also has costs to bear. On balance they have largely cancelled each other out in the past.

The benefit that Ofgem is addressing with its current ‘minded to’ statement arises because of the way customers are charged for the transmission system. In fact, even that charging scheme has several components, but one (the residual cost or TDR) is growing dramatically and this is the component Ofgem wants to tackle.


What are we paying for?

We are paying transmission network owners – National Grid in England and Wales, subsidiaries of Scottish Power and SSE in Scotland – who are recovering the cost of building and running their networks from customer bills.


Why is the cost rising?

The network is being expanded to connect new facilities like offshore wind and large new nuclear plant, and to make it operate better – for example installing ‘bootstrap’ high voltage links to transmit power between Scotland and the rest of GB. In future years, new expansion will be determined by the System Operator’s Network Options Assessment, and more expansion is likely. But in any case customers will be paying the ‘mortgage’ on already-built network for many years.


How is it paid?

To recoup their investment cost, transmission operators are allowed to collect a certain amount of revenue from customers each year. The amount has been set over eight years (2013-21) by the RIIO price review, which also allows for relatively small variations (eg this year Ofgem agreed that National Grid could be reimbursed an extra £150 million for installing so-called shunt reactors to help manage the system).

The costs are charged to parties that use the transmission system, both generators and demand customers (ie suppliers).

How those costs are allocated is determined by the Connection and Use of System Code (CUSC). Users that connect to the system can suggest modifications to the charging codes at any time. The modifications are considered by a Code Panel, which has to consider whether they meet the CUSC objectives, and by Ofgem, which has to decide whether the change would benefit customers as a whole (not just one group).

The Code Panel comprises companies who are connected to the transmission system, so embedded generators do not get a say. The panel members are supposed to act ‘independently’, not as company representatives, and to assess whether modifications meet CUSC objectives as set out – not whether they are generally ‘a good thing’. Embedded generators argue that these panel members will have an underlying bias even when they try to act independently.

There is a route by which parties who aren’t connected to the transmission network (ie embedded generators) can suggest variations to proposed modifications, which again are decided by the Code Panel and Ofgem.


Who is paying?

Allocation of the total cost has changed. EU rules have capped (at €2.50/MW) how much of the charges generators can bear, to maintain consistency between countries and allow them to trade power easily across country boundaries.

That means most of the payments fall on demand customers (ie, suppliers).


So where is the embedded benefit?

The part of the bill Ofgem is addressing (TDR) is shared between suppliers. They pay in proportion to how much power they are drawing from Supply Points (where power is passed from transmission to local distribution networks) on the three highest-demand days in winter (so-called Triad days). The less they draw, the smaller proportion they pay.

If they have embedded generation connected it reduces the amount of power they are taking and they bear less of the cost.


Who will be left with the bill?

However, all the suppliers are doing the same. Because they are sharing a fixed pot of costs they are in a contest to avoid being landed with too much of the bill – like the last diner in a restaurant.

To avoid getting stuck with too much of the transmission bill, suppliers effectively pay embedded generators to start up, or demand side response providers to react, to reduce their usage on Triad days. But all it does is change how the transmission bill is shared – it still has to be paid.

Ofgem argues although some suppliers will succeed in reduce their own share, other suppliers (and their customers) have to take up the slack. Overall, the ‘embedded benefit’ payments are simply a cost to customers with no benefit.


How much is involved?

Ofgem says between now and 2034, £7.2 billion will be paid in embedded benefits to avoid the transmission bill. But the bill will still have to be paid, so for customers as a whole that’s a waste of money. Ofgem also thinks starting up those small plant also has system costs – over £2 billion to 2034. Embedded plant owners dispute that – in fact, they say they are more efficient and flexible than the large plant they displace.


What about security of supply?

Ofgem says that removing the benefits will relieve customers of that £7 billion bill. It also thinks it will reduce the number of small plants built, which will mean large CCGTs are built instead.

The small plant developers agree that they will cancel projects. But it says the result will be that security of supply will be affected (it warns 2GW could be cancelled) and that instead of new, efficient and flexible CCGTs being built, the Capacity Market will keep in service dirty coal plant and old, inflexible gas plant.


What about grandfathering?

The UK has a tradition of ‘grandfathering’ existing arrangements so that investors don’t have the rug pulled from under them when the rules change. Ofgem argues that should not happen in this case. Investors should not have built a business case on a benefit they should have seen was not sustainable, and in any case they were warned 18 months ago that there would be changes to the regime. It also thinks continuing to pay companies at high levels, perhaps for 15 years, will stifle innovation.

Embedded generators say they should be able to rely on some level of benefit, possibly at the current level, as they have invested on that basis.


What about other embedded benefits?

Many companies argue that Ofgem should not be addressing just one issue. Ofgem plans to change only one aspect of the transmission charging regime, the so-called TDR, because it is rising so fast. It is not, for example, addressing the scale of payments to transmission operators (that is for the RIIO price review) or other parts of the scheme such as whether to depart from the EU’s €2.50 cap on connected generators. There are a large number of other charging schemes, such as the cost of using the distribution network, that are also untouched.

The companies have called for Ofgem to carry out a so-called Significant Code Review, which could break open all these charges and rebuild the charging system – making it, they argue, fit for purpose for a changing industry.

That may happen: Ofgem has announced plans for a wide-ranging Transmission Charging Review, and will start a consultation shortly. That may take the form of an SCR.

Small generators say it is more sensible to wait until a broader review has been carried out before addressing the TDR. But the regulator says the review will take at least two years, plus implementation time – in which period customers will be paying embedded benefits that distort the market but do not defray the transmission bill.


Are the benefits real?

The charging issue goes to the heart of a debate in the industry. Because it is about sharing a bill, the question is whether the cost falls onto large or small generators. The fault line splits the industry. It puts incumbents with large plant – and, it should be said, large regulation departments and places on industry bodies like the Code Panels – on one side and new entrants with small plant – and little industry influence – on the other.

On the face of it, it seems logical that small generators should be relieved of the burden of paying for transmission systems. Local plant, supplying users nearby, must mean less transmission network is required.

But in its analysis Ofgem questions that assumption.

First, it says the transmission network is still available to an onsite generator, even if it is only used occasionally as ‘insurance’. There are some interesting developments in the electricity industry – like peer-to-peer trading and virtual networks – but they too only work if there is a grid across which electrons can flow.

And second, in its analysis Ofgem highlights arguments that say there are often physical effects on the transmission network of installing and using embedded generation. These suggest that the assumption that you can simply ‘net off’ the total at the grid supply point is wrong. Others say those effects are tiny.


There are some fundamental questions here for how the electricity network develops in future – and who pays. The Transmission Charging Review may go some way towards answering those questions. The ‘minded to’ position on TDR charging is unlikely to go unchallenged.