Embedded benefits are savings or payments available to generating stations that are directly connected to distribution networks (commonly referred to as embedded generation or distributed generation). They come in a variety of forms, and, in part, are intended to reflect the fact that the generation is located closer to the demand, thereby reducing the required levels of network investment (transmission and distribution) and electrical line losses.

Embedded generators typically realise, and share the financial value of, embedded benefits under the power purchase agreement under which they sell the electrical output from their generating station. Embedded benefits can therefore be a valuable income stream for those generators.

First gaining widespread attention due to Government concerns in respect of the Capacity Mechanism, and also the subject of an ongoing Ofgem review, there are now a number of industry code modification proposals that seek to limit and exclude the availability of certain embedded benefits. The outcome of these proposals will be of real concern to those developing and operating embedded generation projects, as well as their funders.

The Context

Embedded benefits have been reviewed on numerous occasions over the years, but have nevertheless remained an integral part of the industry charging arrangements.

However, in Ofgem's 2016/17 Forward Work Programme, it noted that it would be reviewing the transmission network charging arrangements for embedded generation again, in light of concerns that those arrangements could be over-rewarding embedded generation, thereby distorting investment decisions.

These concerns were then expressed again by the (then) Department for Energy and Climate Change (DECC), in the context of the potential distorting effect of embedded benefits on the Capacity Market - DECC noting in its March 2016 response on reforms to the Capacity Market that "Ofgem is ... reviewing whether it would be in consumers' interest to change the charging arrangements for distribution- connected generators".

On 29 July 2016, Ofgem issued an open letter on its review of the charging arrangements setting out its thoughts on the key issues. Ofgem stated that its main concerns related to the regime for transmission network use of system (TNUoS) charges, the mechanism for which is contained in the Connection and Use of System Code (CUSC).

In the period between the DECC statement and the Ofgem open letter, two CUSC modification proposals (CMPs) were raised - CMP264 and CMP265 - by Scottish Power and EDF Energy, respectively. These proposals seek to change the TNUoS charging mechanism. The content of these proposals is outlined in more detail below.

In light of the CUSC modification proposals, Ofgem intends to deal with any changes to TNUoS via the industry code modification process, rather than launching a separate Significant Code Review process - its view being that the delay incumbent in going down the Significant Code Review route is likely to be to the detriment of consumers.

Ofgem intends to consider embedded benefits other than in respect of TNUoS separately and notes the need for a co-ordinated approach in relation to a number of issues, including electricity storage (which we highlighted in our note on electricity storage earlier this year). It plans to set out its further thinking in the Autumn.

TNUoS charges and their application to embedded generation

TNUoS charges are the charges levied by National Grid to recover the costs of providing and maintaining the transmission network. They are levied partly on generation and partly on demand. They include a locational element - a locational signal that should broadly reflect the transmission system-related costs in different locations - and a residual element to recover the remaining costs of the transmission network.

Demand-side TNUoS charges are currently charged to licensed suppliers by reference to their average net demand over the three so-called "triad periods" - the three half-hour periods of highest system net demand in the period November to February separated by at least 10 days.

Currently, the output from licence exemptible embedded generation can be registered by suppliers under the industry codes as negative demand. Generation by licence exemptible embedded generators therefore reduces the TNUoS demand charges for which suppliers are liable. This is known colloquially as the "Triad Benefit". Ofgem's open letter suggests that the current value of the "avoided" charges is circa £45/kW (estimated to rise to £72/kW over the next four years). Suppliers will typically share a proportion (often a large proportion) of that financial benefit with the embedded generator.

Ofgem suggests that the level of this income to embedded generators could be distorting the market in a number of ways, including leading to an inefficient mix of generation by encouraging smaller embedded generation over more efficient larger embedded generation or transmission-connected generation. This could lead to transmission-connected generation exiting the market as it is unable to compete, and distorting the outcome of the Capacity Market by depressing prices (as smaller embedded generation can bid in at lower prices than transmission connected/large embedded generation).

CUSC modification proposals

The Ofgem open letter identifies that any changes to the charging arrangements will require changes to the CUSC. There are already two modification proposals going through the CUSC modification process.

CMP264 - Embedded benefit triad avoidance standstill

This modification proposal (raised by Scottish Power) would change the rules for new licence exemptible embedded generation (being generation commissioned after 30 June 2017).

The generation output from these new embedded generators would no longer be treated as negative demand for the purpose of establishing a licensed supplier's TNUoS charges. Suppliers would therefore not have a financial saving that could be shared with new embedded generators. The proposal does not envisage changing the position for generators commissioning before 30 June 2017.

The proposal is described as a short-term mitigation to the distorting effect described above until Ofgem's consideration of the charging arrangements has been completed and any changes fully implemented.

CMP 265 - Gross charging of TNUoS for HH demand where embedded generation is in the Capacity Market

CMP265 has been raised by EDF Energy. It is aimed at what EDF Energy describes as the "pressing issue" in relation to the next Capacity Market auction (in December 2016). The intent is that the proposal can be considered and determined in advance of the auction - acknowledging that further important changes may be needed to the TNUoS arrangements going forward.

The proposal would affect only the output from embedded generation that has a capacity agreement under the Capacity Market. It would apply to both existing and new generation, but would only apply from April 2020. The proposal would prevent the output from such embedded generation being counted as negative demand.

CUSC Modification Process

Having completed their consultation with industry, the CUSC working group established to consider CMPs 264 and 265 (and any alternatives developed during the process) is currently expected to submit its proposals to the CUSC Modifications Panel by the end of September (although a further extension to the timetable may be sought).

The Modification panel would then vote on the proposals in October, with an Ofgem determination on them expected in November.

As is the case for all industry codes, there is a merits-based appeals mechanism, which allows interested persons to appeal certain Ofgem modification proposal decisions to the Competition and Markets Authority. However, if both the CUSC Modification Panel and Ofgem approve the proposed modification, there will no right to bring such an appeal.

Conclusion

The embedded benefit matrix in the electricity industry is complex, but is a very important component of an embedded generator's revenues. Any change could have significant (and potentially unintended) consequences for embedded generators, funders, the wider industry and consumers including in terms of current revenue streams and appetite for further investment in embedded generation.

It is clear that the regime, and in particular the Triad Benefit, is under scrutiny. It will be essential that Ofgem undertakes a thorough analysis both when considering the current CUSC modification proposals and when looking at the embedded benefit regime generally. That analysis should include a consideration of the significant value that embedded generation provides to the electricity system in Great Britain.

Generators should ensure that their voices are heard, and that the impact on them is taken into account as part of the analysis. Generators have an opportunity to do that, by responding to Ofgem's open letter. They will need to do so swiftly - responses are required by Friday 23 September 2016. They should also continue to engage in Ofgem's wider process as it develops.