Earlier this month, the House of Lords Economic Affairs Committee issued a report which said that constant intervention by successive governments in the electricity sector has led to an opaque, complicated, and uncompetitive market. A damning report maybe, but it would be difficult for anyone to argue against the fact that the UK’s electricity market is overly complicated and difficult to navigate.
A week later, OFGEM launched its consultation on a targeted charging review (68 pages if you’ve got the time). This follows its ‘minded to’ position announcement last week in relation to embedded benefit payments relating to TRIADs (another 118 pages). Both documents have the potential to be hugely impactful on energy investment decisions in the future.
The focus on the latest consultation is the best approach for charging ‘residual’ system costs. Several options are laid out in the consultation and the principles against which the options are to be assessed are defined as:
- Reducing distortions
- Proportionality and practical considerations
I would like to propose the addition of three further principles, picking up on the theme from the House of Lords report:
- Keep it simple
- Apply a test of common sense.
- Make it quick
1. Keep it simple
What Ofgem are talking about here, is the best way to recover the regulated costs of delivering electricity to our homes and businesses and the costs associated with maintaining the physical balance of supply and demand. The total costs recoverable are regulated by Ofgem ie defined, and are either ‘forward looking’ which are linked to volumes consumed or generated at a point in time, or ‘residual’ which is the balancing figure to come back to the total regulated allowable cost. The Ofgem consultation is focused on the ‘residual’ costs.
For whatever reason, when the market was originally designed, the methodologies for recovering transmission costs (ie TNUOS) and distribution costs (DUOS) were designed fundamentally differently. Both methodologies are complex and data heavy, with multiple regional and voltage tariffs. It is therefore almost impossible for investors, developers and the man on the Clapham omnibus to really understand what costs they are in for without complex modelling, broad averaging, or help interpreting the methodologies.
Worse, the governance structure allows for constant change to the methodologies, which can have a profound impact on the economics of a project or size of a consumer’s bill. Currently there are 30 live modification proposals relating to transmission costs and 27 relating to distribution costs. Good luck to anyone trying to keep up.
Simplifying it, all we are trying to do is find an equitable way of recovering UK system costs. What can be absolutely guaranteed is that there is no right answer. Therefore, I’d hazard a guess that the vast majority of people at home and in business would vote for an answer that is simple to understand and work with rather than one that is super clever but unintelligible.
2. Apply a test of common sense
Many times as the market has evolved, there has been a tendency to focus on academic rigour and economic theory rather then apply a test of plain old common sense.
Relatively recently I shared a platform with an economist whose intellect left me standing. We were discussing charging methodologies and his report that had recently been prepared for the government. The thesis, linked to much talked of ‘cost reflectivity’, was that new generation should be built near demand in order to reduce total system costs. This makes perfect sense, until you extend the logic which goes along the lines of demand is heaviest in the south so we should incentivise all new generation to be built here. Common sense says that if we are genuinely looking to break the North-South divide and incentivise business outside the M25 corridor, then sending economic messages to investors that ‘South good/North bad’ cannot be the right thing.
Too often unintended consequences have resulted in the market from trying to be too clever. Self interested, but smart, market modifications are raised, which are suitably opaque and complex so that the vast majority of market participants either don’t engage with them or lose the will to live in trying to keep up. In the market we’re in now, where there are many varied participants and stakeholders, we need to ensure that change is accessible and makes sense in a practical world.
3. Make it quick
Due to the self imposed complexity and optioneering related to most proposed changes, it invariably takes months if not years to come up with an answer (which is never the perfect answer). The recent ‘minded to’ position from OFGEM relating to embedded benefits, came more than 12 months after the spectre of change was first raised which is not atypical.
With the pace of change in the market now, and particularly the soon to be transformational impact of flexibility through storage and demand side response, the market has to become more agile. As the EY investment attractiveness index shows, the UK is slipping down the league, with uncertainty being one of the biggest drivers for investment going elsewhere.
Ultimately there is no right answer for charging methodologies that will be acceptable to everyone. Therefore, better to make an equitable decision quickly then consult and navel gaze for months, by which time the market will have moved on. This requires a huge cultural and probably governance change across the industry, but I suspect a change that would be welcomed by the majority of people trying to operate in the market.
The UK energy market is going through its biggest transformational phase since it opened to competition. Market change processes need to transform too with simple, timely and common sense principles applied at all times.