10 December, 2020

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The effect of Ofgem’s Targeted Charging Review on business models

Tedd Moya gives a legal perspective on the effect of Ofgem’s Targeted Charging Review on business models.

Introduction

The scope of this brief is the link between law/regulation (mainly the Targeted Charging Review (TCR) and the Significant Charging Review (SCR)) [1] and their effect on the business models of actors in renewable energy. The brief suggests potential pathways and practical steps to lobby or mitigate any adverse effects of changes to residual network charges, from a legal perspective.

This review has considered the views of both government and industry as well as those of other leading energy law firms (to a limited extent). Leading law firms tend not to be involved at this formative level of regulation (with the exception of the rare article, short opinion pieces, or a news flash). When they are, it is contractual client work and, therefore, privileged or confidential.

Overview of the Targeted Charging Review

The main changes of the TCR are as follows:

  • Fixed Residual Charges: Introduction of fixed network charges based on agreed connection capacity in lieu of network charges linked to grid usage
  • Withdrawal of Embedded Benefits: namely: (1) Transmission Generation Residual Charges (“TGR”); an existing rebate for larger generators to the Transmission Network are withdrawn; and (2) Removal of Balancing System Use of System (“BSUoS”) charges that:
    1. paid smaller embedded generators for services that help suppliers reduce their system balancing costs; and
    2. Withdrawal of the exemption to smaller embedded generators from paying avoid paying generation BSUoS that other generators connected to the distribution and transmission networks pay.
  • Introducing Balancing Charges: based on gross demand at the Grid Supply Point.

Ofgem’s rationale and principles

Users of the transmission and distribution networks are charged for the costs they impose on the system, Ofgem seeks to remove distortions/ unintended consequence (larger generators receiving tariff reduction credits since 2017).

To assess options for residual charges, Ofgem uses a principles-driven assessment; namely: (a) Reducing distortions, (b) Fairness, and (c) Proportionality & practical considerations.[2]

However, I think the rationale by Ofgem is counter-intuitive in two ways:

    • First, it seeks to correct a market distortion but operates against a key policy objective (Fixed Residual Charges discourage further renewable energy investment).
    • Second, withdrawal of TGR from larger generators to protect smaller players then restructuring BSUoS to impose a bigger burden on smaller embedded generators militates against the policy aims as well.

How Will the TCR Negatively Impact Business Models for Renewables?

I think that the TCR will have the following diverse impacts:

  • TCR reforms will lead to lower revenues and higher costs. Thus capacity market prices will increase as assets require additional revenues to remain on the system;
  • All renewable generation, storage and flexible technology asset types are negatively affected throughout the whole merit-order to the benefit of gas generation [3];
  • It may be argued that the failure to price-in the climate costs of gas burning (say, through tax or carbon price), keeps the price of gas substantially lower and more competitive than it would be. Is a review that could make renewables less competitive an unintended regulatory support for gas generation?
  • Fixed costs will penalise large energy users that have invested to reduce their energy demand in response to government policy; incentives to invest in storage, on-site generation or demand side response will be reduced and the business case for such technologies will be less attractive;
  • Disjointed reviews of sunk costs and forward-looking charges. The different implementation timelines of the TCR and SCR creates uncertainty on their collective impact to business models, which will in turn deter investment in renewables and flexible generation. Highlights can be found here; and
  • Ofgem assumes that the changes would not fundamentally discourage investment in decarbonisation, yet the foundations of Ofgem’s assumptions are not clear.
  • Does the TCR imperil the existence and functioning of the flexibility market? If yes, what is the risk or cost to what customers will have to pay?

Challenges to consider:

  1. Different actors are affected in various ways. Thus, uniform treatment/redress/ is difficult.
    • Potential Beneficiaries: High consuming non-domestic customers without onsite generation assets;
    • Suppliers may be neutral (may charge customers more and pay embedded generators less); and
    • Embedded generators will be most negatively affected as they will have reduced benefits and lower income from suppliers.
  1. Ofgem has three compelling factors in their favour: (a) the ‘lower/fairer charges for consumers’ is politically expedient; (b) the fundamental change of circumstances (renewable energy prices are competitive and the TGR becoming negative) can be a legal justification for the proposed regulations as a corrective measure; (c) the changes are gradually implemented with long periods of notice to allow industry actors to modify their business models and operations;
  2. Complaints based on business models being negatively affected come across as being largely commercially driven. Thus, it appears to be a ‘net zero cost’ campaign (fighting against profit reduction) rather than advocating for net zero;
  3. Generally, business models for highly regulated sectors (insurance, telecoms etc.) tend to be created/supported by regulation. They are, therefore, more susceptible to legal, policy or regulation shocks. Thus, periodic changes are, arguably, foreseeable from the outset;
  4. Changes made in compliance with international obligations like EU Regulation 838/2010 (the inter-transmission system operator compensation mechanism and a common regulatory approach to transmission charging) are unlikely to be altered; and
  5. On a balance, price reduction policies to consumers (projected benefits to the order of between £3.3bn and £4.1bn by 2040) are likely to hold sway; especially when weighed against system costs (estimated by Ofgem not to exceed £300 million).

Assuming that the views against TCR are convincing yet unheeded, what would be the best course to take?

Traditional Legal Remedies:

Judicial redress (suing) is not ideal. Here are some reasons why:

  1. Public/Administrative Actions only challenge the decision-making process (not the substance), are onerous, and unlikely to succeed here without a strong legal basis. Or, in this case, presenting solid economic logic demonstrating that that the proposed rebalancing of charges is less fair as between consumers/ producers and more likely to create economic distortions.
    • Grounds for challenging the decision itself are far more convoluted and would need some rather fine/sophisticated arguments like legitimate expectation or estoppel.[4]
    • Successful cases have been based on procedural issues and natural justice (like retroactivity in the UK). See highlights here (Global arbitration review).
  1. Private Law/Contractual disputes deal with substantive issues. However, they are based on a contractual or treaty arrangement. The proceedings are private, dependent on what the parties submit for adjudication, have an assortment of other unrelated aspects, are determined on a case-to-case basis, are also usually confidential, and non-binding;
  2. Success in a legal battle does not always salvage the business or lead to instantaneous policy change. The Tempus Energy case went through Appellate processes and took years. The impact on the business was immense; and
  3. Litigation or other legal actions are expensive and disenfranchise smaller players.

Emerging/Potential Market Mechanisms:

Apart from legal action highlighted above, there may be other market-based and policy pathways for mitigating the negative effects of the regulatory changes.

Note: Market-based or contractual measures are variable and usually proprietary. This leads to different treatment/remedies for the same class of actors; perfectly legal yet grossly unfair.

    1. The rise of aggregation services or energy brokerage a laOctopus Energy may level or circumvent the negative impacts of the reversed charges;
    2. Privately regulated charging system/plans may become mainstream. Example: Octopus Energy & Tesla similar to 1 above;
    3. Renewable Energy players could establish business risk Insurance pools/products like the Nuclear Risk Insurance;
    4. With variable benefits and impacts highlighted by point A above, non-domestic consumers may negotiate with suppliers to be categorised where they would derive the most benefit and lower prices (possible but problematic);
    5. Greater involvement of legal expertise is needed. Establish an association of renewable energy lawyers (potentially in-house counsel) to formulate industry specific aims, principles, and rules? Or act as a lobby group. The IBA power group lacks this;
    6. Collaborate with law firms’ pro bono energy/power groups for thought leadership and policy development at formative stages of legal/policy/regulatory development; and
    7. Review existing contractual arrangements like power purchase agreements. Do they allow price modifications based on change in law provisions? If yes, invoke them as a shield/ mitigation measure against loss of revenue when the changes apply.

Possible Policy Proposals:

    1. Lobby for the SCR (or other regulations)[5] to introduce flexibility incentives/ compensatory mechanisms to offset any loses that would be occasioned by the TCR; especially to embedded generators;
    2. Establish a Renewable Energy Reinsurance or Government Fund from the projected system benefits (estimated by Ofgem to be up to £2.9bn until 2040) to cover business risk. e.g., FloodRe or PoolRe.[6] Would the risk or magnitude of loss be significant enough to justify a government backed fund? Or the Insurance Pool suggested as a Market mechanism?
    3. Propose closer periodic reviews and shorter/more efficient charging review durations;
    4. Harmonise, centralise and simplify legislation, regulation and definitions of technologies and assets related to grid charges; and
    5. Propose shelving of current changes until there is an overall market review of tariffs? Reduce fossil fuel subsidies, account for social costs. Harmonise regulations with national and international aims and obligations g. the Paris Agreement* and “net zero”; perhaps give tax credits/capital assistance programmes especially to embedded generators who would be most adversely affected (desirable but seems unlikely).

Notes

[1] Ofgem Publications: November 2018, ‘Targeted Charging Review: Minded to Decision and Draft Impact Assessment’; September 2019, ‘Future Charging and Access Programme-Consultation on Refined Residual Charging Banding in the Targeted Charging Review’; November 2019, ‘Targeted Charging Review: Decision and Impact Assessment’.

[2] This is extremely broad and ambiguous. What other principles should’ve been considered? Decarbonisation? Cost? Externalities? Subsidies to other competing fuels? Other government policies? Estoppel? What are the principles that are driving the objections from various actors?

[3] Query incentives to other fossil fuels especially decarbonising heat. Is TCR an indirect incentive to greater CCGT reliance?

[4] e.g., i). Legitimate expectation and estoppel. if a public body leads a private one to believe that they will receive a substantive benefit, they may be deemed to have a legal and substantive legitimate expectation (See, R v North and East Devon Health Authority, ex Parte Coughlan [2001] QB 213). This principle is controversial.

ii). One could also argue that such fundamental changes (that lead to total remodelling of businesses) are tantamount to ‘constructive/ostensible retrospectivity’ because business plans are long-term and made based on past policy. (similar to indirect expropriation).

[5] Ofgem seems receptive to introduce incentives through other regulations (see here) but appears unwilling to fundamentally change the TCR.  What would, ‘adaptations to our charging options or retail market provisions’, entail for small users?

[6]   Would the risk or magnitude of loss be significant enough to justify a government backed fund? Or the Insurance Pool suggested as a Market mechanism?

Photo by Lara Morrison on Unsplash