Ofgem published its final policy decision on the Electricity Balancing Significant Code Review on 15 May 2014. There is now clarity on the changes to be imposed, the timetable for imposing them and the methodology by which they will be imposed.

Executive summary

Balancing charges will be progressively reformed, starting this winter and ending at the end of 2018. Charging will be made ‘sharper’: more reflective of the costs incurred as a result of imbalances by the system operator and the market as a whole. Charging will be based on the marginal cost of balancing the system, not an average cost. The cost to consumers of disconnections will be charged. The cost of reserve capacity will be changed from the charging of short term operating reserve costs to a charge levied dependent upon the tightness of the market at the time (LOLP). Finally reverse cash out charges will be abolished, with (possibly) counter-intuitive benefits for smaller market participants and renewable interruptible generators.

The balancing regime

Participants in the UK power market who flow power onto the system, trade on the wholesale market or supply power to consumers are required to make a central notification of power volumes which will flow or be traded in each half hour settlement period by gate closure (one hour before the start of the settlement period). To the extent actual flows differ from those notified, that participant is ‘out of balance’ and is subject to balancing charges to compensate the system operator for the costs of balancing the system.   

Why make changes?

The broad policy motivations for the changes are to ensure that balancing charges reflect as accurately as possible the costs incurred by the system operator (National Grid Electricity Transmission plc) (SO) in balancing the system. This will properly incentivise market participants to trade to balance their positions in each half hourly settlement period and lead to:

  • more efficient (ie the cheapest possible) balancing of the system to the benefit of the ultimate funders of the system – consumers;
  • enhanced incentives for the market to develop flexible supply and demand side balancing solutions; and
  • enhanced security of supply, thereby complementing the new capacity market, to be introduced in 2018 as part of the UK Electricity Market Reform initiative.

Four key changes will be implemented:

  • marginal pricing: a phased move to balancing charges being based on the cost of the SO’s most expensive (marginal) balancing action rather than on an average cost of its balancing actions;
  • demand control charges: the imposition of charges for demand side balancing actions that the SO may take: disconnecting customers and/or reducing voltage to customers;
  • reserve scarcity pricing: a change to the method of charging for reserve capacity in the market; and
  • single cash-out charge: the removal of reverse cash-out charges where a market participant is out of balance but in the opposite direction to the market.

Each of these changes is dealt with in more detail below.  

Marginal pricing

Cash-out charges are currently based on an average of the cost to the SO of the most expensive balancing actions relating to 500 MWh of power imbalance in any half hour period. This is known as ‘price average reference (PAR) 500’. Going forward, cash-out charges will be based on the most expensive (ie marginal cost) of the SO’s balancing actions, or PAR 1, in order to send a clear signal as to the true costs incurred as a result of market imbalances.

The transition from PAR 500 to PAR 1 will be phased in over a number of years to allow market participants to adjust their trading and hedging strategies as follows:

  • move to PAR 250 by winter 14/15;
  • move to PAR 50 by winter 15/16 (coinciding with the implementation of most of the other reforms of cash-out charging); and
  • move to PAR 1 by winter 18/19.

Demand control charges

Cash-out charges do not currently reflect the cost to consumers of black-outs (disconnections) and brown-outs (reductions of voltage) imposed by the SO as a result of imbalance-induced shortages. Indeed, supplier imbalance volumes are currently reduced by demand control actions, so market participants are, again, cushioned from the full cost of imbalances to consumers. It is intended that this will be changed with effect from November 2015, when demand control event pricing will be introduced and supplier imbalance volumes will cease to be reduced by demand control events.

The charging methodology will be based on the value to the consumer of power lost as a result of the demand control event, and will equal the volume of lost load multiplied by the value to the consumer of the lost load (VoLL).

VoLL will be set initially (winter 2015/16) at £3,000 per MWh and will rise to £6,000 per MWh in winter 2018/19. These valuations of VoLL have been settled upon by Ofgem informed by a report from external consultants which established an average VoLL across the market of around £17,000 per MWh. Ofgem then adjusted the number to reflect the interaction between cash-out charges and the looming capacity market and to ensure that the number was adequate to incentivise (amongst other things) rational interconnector use and the adoption of interruptible contracts by industrial and commercial customers.

Volumes of lost load will be estimated by the SO for the purposes of the initial calculation of cash-out prices 15 minutes after delivery. The precise methodogy for this has not been determined, although the draft Business Rules, published by Ofgem alongside the Final Decision, set out various options. For later runs of cash-out price, a bottom up approach will be taken to measuring volumes of lost load: licensed distribution system operators will provide data showing what consumers would have consumed had the demand control event not occurred. Again, the precise process will be determined as part of the Balancing and Settlement Code modification process (see ‘implementation: process and timing’ below).

Reserve scarcity pricing

The SO currently runs a portfolio of short term operating reserve (STOR) contracts, under which the SO pays regular availability charges and also pays usage charges when the reserve is used. In terms of imbalance cash-out charging, STOR charges are applied to settlement periods by a weighting model which shows when STOR has traditionally been used. However this rarely applies STOR costs to those half hours when STOR is actually used. So balancing signals are again dampened, and cash-out charges, in this instance, are again unreflective of actual costs.  

With effect from November 2015, a new more cost reflective charging method will apply which will increase cash-out prices in settlement periods in which reserve capacity is in short supply. Instead of using STOR costs to impact cash-out prices, reserve scarcity will be priced by reference to its value to the system in any half hour: the cash-out price for each megawatt of imbalance in any half hour will be increased by £(VoLL x LOLP).

VoLL is explained above – see: ‘demand control charges’. Loss of load probability (LOLP) will be determined by a new LOLP calculation methodology, which will be published and consulted upon in due course and which will become part of the Balancing and Settlement Code. Generally reserve scarcity pricing will not change cash-out prices because LOLP is likely to be low most of the time. However when LOLP approaches 1, the system is very tight, supply curtailments are highly likely, and cash-out charges could rise significantly, up to VoLL. Market participants will be provided with indicative LOLP values before gate closure to enable them to adapt their trading strategies accordingly.

Single cash out charge

The final aspect of non-cost reflective imbalance cash-out charging to be changed is the dual-cash out price methodology. In any half hour settlement period, a market participant who is out of balance and long will receive system sell price (SSP) and a market participant who is out of balance and short will pay system buy price (SPB). However there is a main price and a reverse price for both SBP and SSP. If the imbalance is aggravating (ie in the same direction as the market) the main price applies. If the imbalance is reducing (ie in the opposite direction to the market) the reverse price applies. The reverse price is based on prices of trades cleared in the 12 hours prior to gate closure for the relevant settlement period – effectively a market price.

The concern is that the reverse price is not cost reflective. A reducing imbalance reduces the number of balancing actions the SO needs to take in any settlement period, but the cost of those actions remains the same should be shared by all non-balanced participants. 

With effect from November 2015, reducing imbalances will be treated in the same way as aggravating imbalances and the main price will be applied. The reverse price will no longer be used. This makes cash-out charging more cost reflective and removes complexity. It is also likely, for some market participants, to counterbalance the negative impacts of some the other changes to cash-out pricing. See “Impacts of the Changes” below.

Impact of the changes

Higher cash-out prices: will inevitably ensue, particularly when LOLP is high and reserve scarcity pricing kicks in. However prices will be more cost reflective and will drive more trading and possibly greater liquidity in the wholesale markets, more efficient balancing, flexible technologies, and consequently security of supply. More trading should also assist in ensuring logical inflows on interconnectors which have historically been known to export at times of system shortages.

Who will benefit/bear the brunt? Gas fired power stations are likely to be beneficiaries of cash-out reform due to their inherent flexibility and ability to earn more in wholesale markets at times when the system is tight. As to who will bear the brunt of the reforms, Ofgem’s modelling suggests that small suppliers and wind generators generally have the biggest imbalances and thus are likely to be most impacted by sharper cash-out prices, but that these negative impacts are likely to be cancelled out, and indeed that smaller generators should actually see a reduction in balancing charges, as a result of the single cash-out price,

Effects of the single cash-out price: Ofgem’s modelling suggests the single cash-out price has a neutralising impact for smaller suppliers and renewable generators for the following reasons. The current dual charging system inflates total imbalance charges as it provides advantageous cash-out prices to parties in reductive imbalance which are funded by parties in aggravating imbalance. This, combined with the fact that the spread between cash-out prices is likely in the future to widen in light of the increasing (wind-driven) variability of imbalance, means that small suppliers and wind generators, which have the biggest imbalances, are likely to be disproportionately significant contributors to the cash-out pot. Any reimbursement of the pot pursuant to residual cashflow reallocation cashflow payments (RCRC – the process by which surplus imbalance charges are returned to the market) will be pro-rata to size of energy accounts, rather than size of imbalance, favouring vertically integrated utilities over small suppliers and wind generators.

The single cash-out price does away with the distortions created by the dual system to the advantage of smaller suppliers and wind generators: total imbalance charges are reduced, so the share of imbalance charges funded by small suppliers and wind generators will decrease (disproportionately significantly as they generally have proportionately larger imbalances) and RCRC reimbursements to smaller suppliers and wind generators will be more significant (in proportion to the newly reduced cash-out charges paid by these parties). 

Implementation: process and timing

Ofgem will direct National Grid to raise two modifications to the Balancing and Settlement Code to introduce the reforms in accordance with the following timetable:

by November 2014 (first modification to the Balancing and Settlement Code)

  • move to PAR 250 based charges.

by November 2015 (second modification to the Balancing and Settlement Code)

  • move to PAR 50 based charges;
  • demand side charging introduced with VoLL set at £3,000 per MWh;
  • reserve scarcity pricing introduced;  and
  • single cash-out price introduced.

by November 2018 (automatically as a result of earlier modifications)

  • move to PAR 1 (marginal) based charges; and
  • VoLL moves to £6,000 per MWh.