'Unsustainable' embedded benefits still cause for concern, says Ofgem

The energy market regulator has resisted calls to carry out a full review of network charging arrangements more widely, on the grounds that without immediate action the current "market distortion" would "escalate further, introducing significant market/investor uncertainty for a considerable period of time", according to an open letter to the industry.

Ofgem began seeking industry views on the treatment of so-called 'embedded benefits' in July. The term refers to the payments that small generators receive in return for connecting to the distribution network, as well as the charges that these generators avoid paying.

The regulator is particularly concerned about the Transmission Network Use of System (TNUoS) demand residual payments that these generators receive from suppliers to help them reduce the biggest element of the electricity transmission charges they face at peak times. These payments are made on top of the price that these generators get for selling their electricity in the first place.

Ofgem's view is that there are two problems with the current system. The first is that there are far more small generators using diesel, gas and combined heat and power connecting to the distribution networks than when the arrangements were first entered into, meaning that the cost to the regulator of providing these payments has increased significantly. In addition, the payments could be providing incentives to small generators that could affect plans to build or close much-needed large generating plant.

"In light of the evidence received since our July open letter, we still consider the TNUoS demand residual payments to [embedded generation] to be a major concern," Ofgem said in its latest letter. "We think they are larger than distortions from the other types of [embedded benefits] and increasing."

"We remain concerned that this distortion is having an impact on the capacity and wholesale markets, driving up costs to consumers. Our current view is that taking early action to address rising demand residual payments is likely to be in consumers' interests," it said.

Two proposed modifications to the industry's Connection Use of System Code (COSC) have been raised which would enable Ofgem to take immediate action to address the rising cost of the TNUoS demand residual payments. CMP264 aims to stop any new embedded generation connected after 30 June 2017 from receiving the payments, while CMP265 would prevent any embedded generation with capacity market agreements from receiving any demand residual payments from 1 April 2020 onwards.

Ofgem expects to be able to make a decision on these modification proposals in the first half of next year, following consultation on a 'minded-to' decision and draft impact assessment that it intends to publish early in the new year, according to its latest letter. Any changes would then be implemented by April 2018, it said.

The regulator will also set out its "proposed way forward" on network charging, including on the issues it identified in its July letter, early in the new year.

Energy law expert Jeremy Chang of Pinsent Masons, the law firm behind Out-Law.com, said that Ofgem's review of embedded benefits "continues to be a hotly-debated topic – as evidenced through the large number of respondents to its open letter".

"Ofgem's approach to addressing the escalating level of embedded benefits is through its decision on the code modifications before it, despite concerns that a piecemeal approach may result in undesirable and unintended consequences," he said.

"However, it is perhaps a cause for caution optimism that Ofgem has confirmed that it fully intends to carry out a review of the regulatory and market arrangements governing the energy system. Together with its recent call for evidence on a smart, flexible energy system, this confirmation leaves the door open for any subsequent review to supersede the arrangements put in place by the current code modifications," he said.

The UK government is currently consulting on technical changes to the capacity market auction process, which would remove the potential for small-scale diesel generators to receive both capacity market payments and demand residual payments. The consultation closes on 23 December.