External Review of Ofgem s Gas Security of Supply Further Interventions

Transcription

1 External Review of Ofgem s Gas Security of Supply Further Interventions A REPORT PREPARED FOR CENTRICA October 2012 Frontier Economics Ltd, London.

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3 October 2012 Frontier Economics i External Review of Ofgem s Gas Security of Supply Further Interventions Executive summary 1 1 Introduction 7 2 Rationale for further intervention Weak price signals for shippers under current cash-out arrangements Ofgem s proposed cash-out reforms Definition of options for further intervention Technology non-specific Technology-specific Demand-side Assessment criteria Effectiveness of improving security of supply Cost Impact on wholesale market Speed and ease of implementation Risk of unintended consequences Evaluation of options against assessment criteria Technology non-specific options Technology-specific options Demand side options Annexe A: Costs and impact on wholesale market prices 67 Annexe B: Eclipse Energy s market analysis 71 Contents

4 2 Frontier Economics October 2012 External Review of Ofgem s Gas Security of Supply Further Interventions Figure 1. Range of options for storage intervention 4 Figure 2. Options under consideration 14 Figure 3. Range of technology-specific options 45 Figure 4. Trade-off with allowing strategic stock to interact with market 59 Figure 5. Costs and impact on wholesale market 69 Executive summary

5 October 2012 Frontier Economics 1 Executive summary Over the two decades since privatisation and liberalisation, the gas market in Great Britain has delivered secure supplies and substantial investment in the sector. Historically, most UK demand has been met by local supplies of gas from the UK continental shelf (UKCS). With the decline of this indigenous production, since 2004 the UK has become a net importer of gas. In future, it seems that the UK will become increasing reliant on gas imports from distant sources of gas supply. The prospects for shale gas create a degree of uncertainty around this view although even under the most optimistic scenarios there has been no suggestion that this could realistically offset the decline in the production of the UKCS. Dependence on more distant gas supplies has raised two concerns with the regulatory authorities 1 : the UK is less able to exert control over distant gas supplies during times of system stress, which has raised concerns that gas flows might not respond to market signals; and reliance on longer supply chains could increase risk of supply failure. In addition, because GB has historically relied on gas sourced locally from the UKCS, there has been less need for investment in gas storage facilities. This means that, compared to other European countries, the UK s gas storage facilities are relatively limited. Indeed, while there has been some investment in smaller gas storage projects in the last two decades, the only large scale gas storage facility in GB was commissioned in 1985 prior to the liberalisation of the market. These concerns prompted the cash out reforms, which were set out in Ofgem s gas security of supply code review draft policy decision of November 2011 and confirmed in their proposed final decision document of 31 July Ofgem considered that even if the cash out reforms were introduced, further intervention could be needed to secure gas supplies. Ofgem is now considering a range of different options for further intervention in the gas market to ensure security of gas supplies. Ofgem s recent report has shed further light on the possible reasons for a further intervention in the market. Having revised its analysis, Ofgem has concluded 1 Ofgem (2011), Gas Security of Supply Significant Code Review Draft Policy Decision, November; Ofgem (2012), Gas Security of Supply Significant Code Review Proposed Final Decision, July Executive summary

6 2 Frontier Economics October 2012 that, following its reforms of the cash out regime, the supply of gas to GB is actually very secure: by its own estimates an involuntary supply side interruption of non-daily metered customers is likely to occur only one year in every onehundred and sixty seven. Even under more conservative assumptions, gas supply to domestic customers is likely to fail only one year in sixty. This would suggest that any intervention in the market cannot be motivated by security of supply concerns per se. Instead it seems more likely that policy makers may wish to guard against sustained prices rises. Given the increasingly distant sources of gas, policy makers might have concerns that at times of system stress the price of gas may increase for a sustained period. That is to say that any intervention in the market is designed to ensure that customers are not exposed to the risk of very high gas prices. In light of this possible regulatory intervention in the market, Centrica has commissioned Frontier Economics to undertake an independent review of the options being considered by Ofgem. This report presents our findings. The report is intended to help inform the decision by the Department of Energy and Climate Change (DECC) on what form of intervention is likely to be most effective in helping to secure medium to long term gas supplies. We should note that, in this report, we do not discuss the merits of the case for different degrees of intervention to support security of supply (or, more strictly, the security of the price of gas supply). Rather, we assess how best to intervene if that is what policy makers wish to do. At a high level, the approaches to further intervention set out by Ofgem can be categorised as being less or more interventionist. The less interventionist approaches are intended to facilitate the market to provide improved security of supply through the supply or demand side. We have considered two forms of less interventionist approaches in more detail in this report: An information requirement whereby market participants are obliged to provide information to the regulatory authorities on their supply and demand side positions; and Two possible demand side measures whereby: a standardised form of interruptible contract is developed; or a centralised (voluntary) auction is held for demand side response by large industrial customers. These approaches tend to align well with the grain of the market and are fast to implement (although the response from the market in terms of developing any physical response may take longer). While they are unlikely to be very effective Executive summary

7 October 2012 Frontier Economics 3 in terms of delivering increased physical security of supply or price security, they are also unlikely to be costly to implement. Therefore, if the case for intervention is thought to be weaker, these may be an appropriate initial response, with minimal regrets. If the case for intervention is stronger, one of the more interventionist approaches may be appropriate. We have considered two broad types of more interventionist approaches in more detail in this report: A license condition which places an obligation on market participants such as an obligation to meet customers demand under certain conditions or an obligation to show that customers demand can be met under certain conditions. A storage specific intervention that would trigger the development of new gas storage. The license condition is intended to be technology neutral, which would have the advantage that parties can decide how best to meet the obligation, e.g. through a demand or various types of supply side response. However, from a security perspective, this apparently laissez-faire approach is also its most significant drawback: market participants would be free to choose how to meet the licence condition and policy makers would, in the first instance, have limited control as to where gas is sourced. It therefore may mean, for example, that participants choose simply to buy more gas at NBP - which would have an uncertain and likely limited effect on security of supply or security of price. This likely ineffectiveness of a strictly technology neutral approach in meeting policy makers security concerns means that we see a very significant risk that the obligation is adapted over time to become increasingly intrusive. To achieve the objectives desired it could eventually be used by politicians and regulators to micro-manage the industry. Our concern is that this regulatory slippage would mean any action by market participants would be made purely in response to the obligation and the impact of prices (signalling different costs for different sources of gas) would be increasingly reduced. This could, potentially, be very costly for the GB customer as the regulatory authorities, rather than the market, start to take an increasingly large role in where and how gas should be sourced. The other more interventionist approach is to develop a mechanism that triggers the development of additional storage. Any storage specific intervention would have a lead time of several years in terms of an investment response by the market. Executive summary

8 4 Frontier Economics October 2012 Figure 1. Range of options for storage intervention Market based Regulation based Storage obligation Semi-regulated storage Regulated strategic storage Source: Frontier As indicated in Figure 1 above, there is a range of possible approaches for intervention in storage. At one extreme, the mechanism could indirectly support new storage build through a market based storage obligation, perhaps placed on suppliers, similar in spirit to the existing Renewable Obligation or the capacity mechanism currently being developed as part of the Electricity Market Reform (EMR). In response to the increased demand for storage, developers would decide what type of storage to build and when to build it. The storage would operate in the market as normal although there may be certain restrictions regarding the amount of gas that must be held in storage at different times of the year. A benefit of the storage obligation is that market participants would be free to choose when and where to build storage. The storage would be used in the market, bringing the benefit of reduced summer-winter price spreads, which in turn reduces the price end consumers pay for gas. Ultimately end users would bear the cost of the new storage facility and the increased revenue received by existing storage facilities (assuming the storage obligation applied to new and existing storage). A notable downside with this approach is that developers may choose not to invest if they thought the payment flows associated with the obligation mechanism lacked long term regulatory credibility or they may invest only in small storage facilities with relatively short lead times, raising the unit cost of storage and in turn, the overall cost to customers. At the other extreme, the new storage facility would be fully regulated strategic storage. Under the approach, the storage facility would be held outside of the market and would only be used, in extremis, for example, during periods of system stress when no other market based options for meeting gas demand were available. The storage might be procured through a central tender and would be remunerated on a regulated revenue basis. With the fully regulated approach policy makers will be able to ensure that developers build the most cost effective form of storage. However, of the storage interventions considered, this is very likely to be the most costly since the facility would not operate in the market, there would be no (or little) benefit to Executive summary

9 October 2012 Frontier Economics 5 consumers from reduced gas prices. The flip side benefit is that, because the facility is kept outside of the market and only used in extremis, the gas market would continue to operate as normal and market participants should continue to make investment decisions in response to market determined price signals. Therefore, if security of price is considered to be the main policy concern, strategic stock may not be a viable option for further intervention. In other words, while the fully regulated approach would facilitate an improvement in physical security, a security of price risk would still remain. Finally, a semi-regulated option sits in the middle. Here, the storage facility would operate in the market as normal but it would receive financial support, for example, in the form of a top up payment whenever summer-winter price spreads fell below a certain threshold. With the semi-regulated approach, developers are more likely to invest in the type of storage preferred by policy makers than with the unregulated approach. Policy makers would be able to define the type of storage facility eligible for support and they could reduce regulatory risk by pre-defining the level of support through a long term contract. As with the unregulated approach, the facility would be used in the market, bringing the benefit of reduced summer-winter price spreads, reducing the price end consumers pay for gas. However, the intervention risks undermining the rest of the market. The revenue received by existing storage facilities would decline (due to the reduced summer-winter spreads) which might deter material maintenance expenditure the mechanism would probably therefore need to be extended to include major life extension replacement expenditure. In addition, investment in new storage facilities, particularly in seasonal storage, is unlikely to occur unless it is also part of this mechanism. In short, the approach is likely to trigger what is termed a slippery slope of intervention by the authorities in the storage market. Overall our conclusions are that, if a more interventionist approach is believed to be required to ensure security of supply in GB, a licence condition runs the risk of either not being effective in terms of meeting policy makers objectives or of becoming increasingly intrusive in the market over time, potentially to the detriment of the entire GB gas market (although this would depend on the specific design of the condition). If a greater degree of intervention is required, it therefore would, in our view, be preferable to adopt a specific storage intervention. Even here, however, all of the approaches on the table have drawbacks. The storage options either are very costly to the GB customer (the fully regulated approach), risk encroaching on the normal operation of the GB gas market and impacting on the price signals coming from that market (the semi-regulated approach) or rely on regulatory tools that might not be sufficiently credible to induce the investment required (the fully market-based approach). Executive summary

10 6 Frontier Economics October 2012 Of the three approaches, it seems to us that, if the case for a more interventionist approach were made, the semi-regulated approach is the best: it guarantees new investment, thereby meeting policy makers objectives, and at the lowest cost to customers. The major drawback we have identified with the approach - that it is likely to impact on the rest of the gas storage market at least has the advantage that it is confined to the storage market and is less likely to impact on the wider gas market, may be the price policy makers are willing to pay for the increased security it delivers. Executive summary

11 October 2012 Frontier Economics 7 1 Introduction This report by Frontier Economics has been commissioned by Centrica. It provides an independent assessment of the range of further interventions raised by Ofgem as possible ways to improve security of gas supply. 2 The aim is to inform the decision by the Department of Energy and Climate Change (DECC) on what form of intervention is likely to be most effective to ensuring the security of medium to long term gas supplies, if further action is needed. Over the two decades since privatisation and liberalisation, the gas and electricity markets in Great Britain have delivered secure supplies and substantial investment. The introduction of the Gas Act initiated a staged liberalisation of the entire UK gas market. These reforms, which extended competition to domestic retail supply in the late 1990s, were generally regarded as successful and have led to the creation of reasonably liquid spot and forwards markets. Until 2004, the UK was self-sufficient in the production of gas to meet its national demand. Indeed, from 1998, when the Bacton-Zeebrugge interconnector (IUK) was commissioned, until 2003/04, the UK was a net gas exporter to Europe. However, liberalisation and the lifting of the prohibition on the use of gas in power generation led to a rapid rise in gas demand. Over the past two decades, gas consumption has risen to account for 41% of UK primary energy demand. 3 Furthermore, UK continental shelf (UKCS) production has been on the decline, and since 2004, the UK has become a net importer of gas. The UK will become increasing reliant on gas imports from distant sources of gas supply with the ongoing decline of UKCS production. For a number of years, Ofgem has expressed concerns with the ability of the current market arrangements to deliver secure gas supplies over the longer term. 4 Dependence on more distant gas supplies has raised two concerns with policy makers: the UK is less able to exert control over distant gas supplies during times of system stress, which has raised concerns that gas flows might not respond to market signals, i.e. gas might not flow (internationally) according to where the price is highest; and reliance on longer supply chains could increase risk of supply failure. 2 Ofgem set out eight options in its 2011 report, Gas Security of Supply Significant Code Review Draft Policy Decision. It described those and four additional options in an to industry participants dated March DECC, Energy flow chart Ofgem (2011), Gas Security of Supply Significant Code Review Draft Policy Decision, November. Ofgem (2012), Gas Security of Supply Significant Code Review Proposed Final Decision, July Introduction

12 8 Frontier Economics October 2012 In addition, the UK has little gas storage and no new seasonal storage has been commissioned since Total storage capacity (excluding storage at LNG import terminals) is about 4.4 bcm with another 0.8 bcm of storage under construction. 5 This represents about 5% of 2010 annual gas demand. In comparison, France has about 12 bcm of storage working gas volume 6, which is sufficient storage to cover about 28% of annual gas demand. 7 Germany has about 21 bcm of storage working gas volume, which is about 26% of annual gas demand. These concerns prompted the cash out reforms, which were set out in Ofgem s draft policy decision of November 2011 and confirmed in their proposed final decision document of 31 July They also prompted DECC s request for Ofgem to assess whether further action is needed to ensure the security of medium to long term gas supplies. Ofgem is considering 12 different options for further intervention. This report provides an independent assessment of the viability of each of these options. We have divided this report into four further chapters: In Chapter 2, we discuss the weaknesses of current cash-out arrangements, define Ofgem s proposed cash-out reforms, and outline the rationale for further intervention. In Chapter 3, we define Ogem s twelve options for intervention, provide a high-level assessment of each, and short-list seven options that we consider to be the most viable. We then assess the options in further detail in Chapter 5. In Chapter 4, we develop five criteria against which we assess the viability of each of the seven options that we shortlisted in chapter 3. The criteria are effectiveness, cost, impact on wholesale market prices, implementation, and unintended consequences. In Chapter 5, we assess each of seven options shortlisted in Chapter 3 against the criteria outlined in Chapter 4. In the Annexe we summarise the costs and benefits of the shortlisted technology specific interventions and describe gas market analysis undertaken by Eclipse Energy for Centrica to help understand the effect on price and security of supply of new investment in underground gas storage. 5 National Grid. Gas Ten Year Statement, GSE, MEDDTL (2011); See 7 CRE. Rapport transmis à la DG ENER. July Introduction

13 October 2012 Frontier Economics 9 2 Rationale for further intervention Historically, GB has relied on domestic gas supplies to meet its entire demand. However, domestic sources are declining and GB increasingly relies on international supplies from Norway, continental Europe and global liquefied natural gas (LNG) markets. At the same time, Europe is becoming more reliant on Russian and LNG supply sources. There is a general consensus (supported by Redpoint s updated analysis on behalf of Ofgem) that the GB gas market should be well supplied in the near term under the current market arrangements. However, there have been concerns regarding security of supply in the longer term, and that price signals are not sufficiently strong to prevent a gas deficit emergency under current cash-out arrangements. Ofgem has proposed cash-out reforms to increase resilience to a range of future gas market scenarios given GB s increased dependence on international supplies and the risks associated with low probability, high impact events that would impose a stress on the gas market, creating a security of price risk and a security of supply risk. In the sub-sections below we therefore provide the context for possible interventions and outline: why the current market arrangements are thought to give weak price signals to shippers during a gas deficit emergency; and the proposed cash-out reforms, which are aimed at addressing the issue of weak price signals, and why, in spite of this, further interventions beyond cash-out reforms may be needed. The options for further intervention discussed in chapters 3-5 of this report are then compared with the arrangements under Ofgem s preferred cash-out reform option with no additional interventions in the market. 2.1 Weak price signals for shippers under current cash-out arrangements In GB, gas shippers are incentivised to balance their gas supply and demand under the current market arrangements through imbalance (or cash-out ) charges where: Short shippers, or those that have not put as much gas onto the system as their customers are taking off, are required to pay the System Marginal Buy Price for the volume of gas for which they are short. This is usually higher than the price they would have likely paid for buying the gas in the market. Rationale for further intervention

14 10 Frontier Economics October 2012 Long shippers, or those that have put more gas onto the system than their customers are taking off, are paid the System Marginal Sell Price for any additional gas they flow onto the system. This is usually lower than the price they would have likely been paid for selling the gas in the market. The potential exposure to high cash-out charges incentivises shippers to take measures to ensure gas security of supply, for example, through procurement of storage rights, entry into long-term contracts to buy gas or procurement of demand side response (DSR) measures. However, when non-daily metered (NDM) customers are disconnected their load reduction reduces the balance position of shippers. Since shippers are not obliged to compensate their customers for the load reduction, this reduces the incentive for shippers to secure sufficient gas for their customers. Furthermore, under current market arrangements, the cash-out price is frozen upon entering into a gas deficit emergency (GDE). For shippers with a short position, the cash-out price is frozen at the price of the most expensive trade conducted by National Grid gas (NGG, which is the GB gas system operator or SO) on the day. This has two main drawbacks: First, price signals for shippers are weakened at the very time when they are needed to attract more gas. This means that shippers do not face sufficient incentives to take appropriate action to prevent a GDE occurring. Second, the event of an emergency may be unduly prolonged if the cash-out price is frozen below the level required to attract additional gas into GB. In order to overcome these drawbacks, Ofgem has proposed to reform its cashout arrangements. 2.2 Ofgem s proposed cash-out reforms Ofgem has proposed to reform the emergency cash-out arrangements to improve incentives for shippers, with a target implementation date ahead of Winter 2013: 8 Cash-out price. The cash-out price would not be frozen before firm load shedding but would continue to be set by balancing actions taken by NGG. Once firm load is shed (where individual large consumers are required to reduce their gas demand), shippers would still be able to carry out bilateral trades to resolve their imbalances. NGG would stop taking balancing 8 Ofgem (2012). Gas Security of Supply Significant Code Review Proposed Final Decision. July Rationale for further intervention

15 October 2012 Frontier Economics 11 actions on the On the day Commodity market (OCM), and the cash-out price would be set at the value of lost load (VoLL) of domestic gas customers (which is estimated to be 20 per therm). If the emergency moved to stage 3, implying parts of the network become isolated, on the first day of firm non-daily metered (NDM) customer interruption, the cash out price would also be set equal to domestic VoLL. Customer compensation. Imbalance payments would be used to fund payments to those customers whose gas supply in involuntarily disconnected. Imbalance volumes. A process would be introduced to adjust shippers imbalance volumes so that they do not benefit from the emergency curtailment of customers. Ofgem considered allowing the cash-out price to rise above domestic VoLL. However it rejected this option as it believes that there are a number of drawbacks associated with having very high cash-out charges. These include: the extreme financial liability faced by short shippers in a GDE leads to financial distress and adverse impacts on competition; market participants cannot accurately determine the probability of a GDE appropriately due to difficulties of assessing low probability events; international gas might not flow into GB (even if there are high prices in GB) if arrangements in other countries take precedent; and market participants believe that they may not have to face the full consequences of a GDE because there might be a perception that some form of support would be given to ensure that the market continues to function (moral hazard). While this cash-out reform is designed to improve price signals for shippers, Ofgem s analysis suggests that, even if the cash out reforms were introduced, there could remain a gap in the arrangements that could be filled through further interventions. Gas security of supply as a policy objective would typically incorporate both physical security (i.e. avoiding involuntary interruptions of supply) and price security (i.e. providing energy at reasonable prices to consumers). Redpoint s updated analysis for Ofgem 9 now suggests that under current cash-out arrangements: 9 See Ofgem Gas Security of Supply Significant Code Review Impact Assessment for the Proposed Final Decision July Rationale for further intervention

16 12 Frontier Economics October 2012 Physical security from retail (NDM) customers is already high, with NDM interruptions occurring only once every 167 years. It would seem, therefore, that price security would be the main concern for NDM customers under current market arrangements, which could potentially be improved through Ofgem s further interventions. Involuntary firm DM interruptions are now estimated to occur somewhat more frequently, once every 55 years, under current cash-out arrangements. Physical supply security, is therefore more of a concern for DM customers, relative to NDM customers, under current market arrangements. However, it would seem that price security is the bigger risk for both DM and NDM customers, which could possibly be improved through Ofgem s further interventions. The updated Redpoint analysis now suggests that the proposed Emergency Cash Out Reforms will improve physical security to once every 128 years, which remains to be seen. Ofgem s proposed final decision on SCR is to set cash-out at 20 per therm (an estimate of domestic customers value of lost load or VoLL) in a GDE once gas supplies to firm customers are curtailed. The options for further interventions to enhance security of supply discussed in the remainder of this report are investigated as though they would be implemented alongside Ofgem s proposed cash-out reform. Rationale for further intervention

17 October 2012 Frontier Economics 13 3 Definition of options for further intervention As discussed in Chapter 2, while there is a general consensus that the GB gas market should be well supplied in the near term under the current market arrangements, there have been concerns around security of gas supply in GB in the longer term. It has been argued that incentives under current cash-out arrangements for shippers to take measures to ensure gas security of supply, for example, through procurement of storage, long-term contracts or demand side response (DSR) measures, are weak. While Ofgem has proposed to reform its cash-out arrangements to improve incentives for shippers, there still remains a potential gap in the arrangements that could be filled through further interventions. Ofgem proposes 12 different options for further intervention. As illustrated in Figure 2, these can broadly be categorised into three groups: Technology non-specific interventions are designed to incentivise the availability of capacity (i.e. capacity to increase deliverability of gas or a demand reduction), without explicitly favouring any particular source of demand or supply flexibility over others. Technology-specific interventions (or storage interventions) are designed to incentivise investment in storage in particular. Demand side interventions are designed to facilitate the uptake of DSR from large daily metered (DM) customers. Definition of options for further intervention

18 14 Frontier Economics October 2012 Figure 2. Options under consideration a b c Technology nonspecific Technology specific Demand-side options 1 Information requirement 5 Regulated/semi-regulated returns on infrastructure 10 Standard contracts 2 Non-specific service obligation 6 Storage obligation 11 DSR auction (or tender) 3 Reliability options (financial) 7 Reliability options (physically backed) 12 Distillate back-up requirements 4 Risk capital provision 8 Emergency stock (inc LNG requirements) 9 Strategic swap (or long-term emergency option contracts with LNG suppliers), SO or Govt Source: Ofgem to industry dated March 2012 These options, as set out in Ofgem s gas security of supply code review draft policy decision of November 2011 and in its March to industry participants, are not well-specified. The viability of these options would depend, to a large extent, on how they would be implemented in practice. In this chapter, we outline Ofgem s description of the 12 options, and provide a high-level assessment of each. We then short-list seven options that we consider to be the most viable. We have developed straw-men to flesh out the design options for our seven short-listed options so as to able to assess them in further detail in Chapter 5. We do not consider these options to be mutually exclusive. Some of these options could be implemented alongside each other, or multiple options could be introduced incrementally over time. In summary: We believe that while Ofgem s technology non-specific options are unlikely to be sufficient on their own to ensure security of supply, some might be beneficial. We short-list two of these (information requirements and nonspecific service obligations) for further consideration. Ofgem s technology-specific options are likely to be more effective in meeting its requirements. However, the extent of the effectiveness of these options will depend on their detailed design. We short-list three of these options (storage obligation, emergency stock, and semi-regulated returns on Definition of options for further intervention

19 October 2012 Frontier Economics 15 infrastructure) for further consideration, and explore potential design options. Finally, we believe that the demand-side options are unlikely to be the favoured options on their own, since they are unlikely to be able to provide sufficient cost effective response during a period of extreme gas market stress that lasts for more than a few weeks. However, they may well be a useful complement to other mechanisms. We short-list two of these options (standard contracts and DSR auctions) for further consideration. In this chapter, we outline all 12 of Ofgem s options for further intervention, and provide a high-level assessment of each. We then assess the seven short-listed options in further detail in Chapter Technology non-specific Technology non-specific interventions are designed to incentivise the availability of capacity, without explicitly favouring any particular source of demand or supply flexibility over others. Ofgem considers four types of technology nonspecific options, as follows: Option 1: Information requirements would create a statutory obligation on suppliers and/or shippers to provide information to Ofgem and/or NGG on their supply-demand portfolio under various scenarios. Option 2: Non-specific service obligations would create a statutory obligation on suppliers to contract for sufficient capacity to meet their customers demand under a pre-set level of supply standards. Option 3: Reliability options (financial) would create a financial incentive, such as a financial call option, to incentivise availability, and provide penalties for unavailability. Option 4: Risk capital provision would create a requirement for companies to prove that they have enough capital to enable them to buy sufficient quantities of gas during periods of extreme market tightness. Below, we outline these options in further detail, and provide our high level assessment of each. Information requirements and non-specific service obligations are potentially the most viable of the options and we short-list them for further consideration. We assess these two options in further detail in Chapter 5. Definition of options for further intervention

20 16 Frontier Economics October Option 1: Information requirement High-level outline An explicit statutory information obligation would require suppliers and/or shippers to provide information to Ofgem and/or NGG on their supply-demand portfolio. Requested information could include: the anticipated supply portfolio, including the source of contracted supply (e.g. National Balancing Point, LNG imports, pipeline imports, beach supplies and gas storage); and demand information, including the volume of interruptible contracts and the volume of demand that is not yet met by existing supply contracts. The supply-demand portfolio information could be requested for various scenarios, such as: seasonal normal demand in winter; seasonal normal demand on the peak day; 1 in 20 peak day demand; and 1 in 50 winter demand. This could be requested for the entire winter as a whole or for different periods in winter (e.g. September to November and December to February). Further, this could be requested for all customers, or a group of customers (for example, NDM customers only, or all firm customers). In the past, Ofgem requested information from the 15 biggest gas suppliers in the country on their demand and supply portfolio for winter 2009/10 and 2010/11. The information was not requested for winter 2011/12. In the most recent request, the information was requested twice, once before winter and once during winter. A statutory information requirement could build on these voluntary winter information requests, by making these mandatory and improving the quality, consistency, and type of information requested. Such an information requirement is intended to assist Ofgem in assessing the security of supply situation, and help the system operator to balance the system. Our view It is unclear what Ofgem will do with the information that it requests from suppliers and/or shippers. Furthermore, it is unclear why Ofgem discontinued its information request from the biggest gas suppliers for winter 2011/12. While a statutory information obligation could be useful for monitoring purposes, it would not guarantee availability of capacity in an emergency. However, given Definition of options for further intervention

21 October 2012 Frontier Economics 17 that the cost of such an information obligation is probably low, it may be worth implementing in combination with other mechanisms. We therefore short-list this option for further consideration, specify a straw-man, and assess its viability in further detail in Chapter Option 2: Non-specific service obligation High level outline Through a non-specific service obligation, Ofgem would create a statutory obligation on suppliers to meet their customers demand under a set level of supply standards. Ofgem is considering two types of license conditions, through which it can impose such a service obligation on suppliers. Under both these types of licence conditions, Ofgem would pre-determine a set of supply standards for any supplier wishing to acquire a licence to enter the market, and then impose a penalty for breach of the license. The two types of licence conditions are as follows: Ex-ante license condition. An ex-ante licence condition could require suppliers to prove, by contracting for deliverability of gas (e.g. by booking underground storage or interconnector capacity, contracting for delivery at the beach etc.), before or throughout winter, that they can meet demand under the specified security of supply standard pre-determined by Ofgem. If companies fail to prove compliance with these standards, this would constitute a licence breach. Ex-post license condition. A licence condition could be ex-post in nature by requiring suppliers to meet demand under the specified security of supply standard pre-determined by Ofgem, or by requiring suppliers to use best endeavours to ensure they meet their customers gas demands under all but exceptional circumstances. Suppliers failing to meet these standards during a GDE would be in breach of their licence. It would therefore constitute a threat of sanction, over and above the cash-out price. Under both types of license condition, Ofgem could fine suppliers in breach of their licence any amount up to ten percent of the turnover of the licence holder. Further, if the licensee failed to comply with a final order or with a provisional order of the Authority or to pay any financial penalty by the due date, Ofgem could potentially revoke the company s licence. Our view We believe that licence conditions are likely to be more effective than information requirements alone at improving the resilience of the system, as suppliers would need to comply with a set level of supply standards as a prerequisite to operate in the market. An ex-ante licence condition may be more Definition of options for further intervention

22 18 Frontier Economics October 2012 effective than the information request or an ex-post licence condition for the following reasons: First, by pre-determining a set of supply standards, Ofgem would create an obligation on suppliers not only to provide information to Ofgem on their supply-demand portfolio, but also to create a requirement for this information to prove, by contracting for deliverability of gas through various potential sources, that they can meet demand under the specified security of supply standards. We therefore believe that an ex-ante license condition is likely to be more effective in ensuring security of supply, by bringing about a behavioural change, as a result of some sort of physical or contractual response by shippers than information requirements alone. Second, as suppliers already face a strong financial incentive to meet customer demand under the counterfactual cash-out arrangements, it is unclear that an incremental penalty through an ex-post license condition, over and above the cash-out price, would induce any change of behaviour. Under current market arrangements, on the first day of firm non-daily metered (NDM) customer interruptions, the cash out price could rise to the VoLL of domestic gas customers (which is estimated to be as high as 20 per therm). If such a high emergency cash-out price does not provide sufficient incentives, it is unclear that an additional financial incentive would be effective a supplier that failed to deliver during a GDE would incur a serious financial penalty through cash-out and the threat of an additional severe penalty for a breach of licence may therefore be ineffective. In addition, suppliers may still tend to underestimate the likelihood of a GDE. Third, an ex-ante licence condition would implicitly encompass an ex-post license condition, while also creating an additional obligation on suppliers to prove ex-ante that they are able to meet the pre-determined set of supply standards outlined in the license. If the shipper were unable to meet its customers demand during a GDE, following the event Ofgem would scrutinise the ex-ante proof provided by the shipper of its ability to meet demand. Fourth, Ofgem would be able to reject the proof of a supplier s or shipper s ability to meet demand under the set security standards, and require that action be taken to procure rights over additional gas sources thereby avoiding a GDE. In theory, ex-ante license conditions have the benefit of being technology nonspecific, and not favouring any particular source of demand or supply flexibility above others. However, in practice the effectiveness of this option would depend on how the licence condition is designed. For example, if the licence condition applies to the demand of NDM customers only, it may not be very Definition of options for further intervention

23 October 2012 Frontier Economics 19 effective, as supply security for NDM customers is already high under current market arrangements, with NDM interruptions occurring only once every 122 years. 10 However, we short-list this option for further consideration, and assess its viability in further detail in Chapter Option 3: Reliability options (financial) High level outline Under financial reliability options, a financial incentive, such as a financial call option, is put in place to incentivise availability, and provide penalties for unavailability. Under this approach, a central body would first establish the level of gas to be procured based on a particular security of supply threshold. Suppliers would then be required to procure an appropriate level of reliability option contracts (from shippers and/or storage operators) in proportion to their customers gas demand. The reliability options would work as follows: Suppliers would purchase a reliability contract from shippers and/or storage operators, which would provide them with a hedge, enabling them to purchase gas at no more than the strike price (or, if gas is not available, to be compensated). In return for the hedge, the shippers and/or storage operators would receive a payment (an option premium ) which would provide a more reliable source of income on which to base investment decisions. Shippers would be obliged, if called, to make a payment (the difference between the short-term wholesale market price of gas and a pre-agreed strike price) to the supplier for a given volume of gas. Reliability options would expose shippers to price spikes, thereby incentivising them to take appropriate action to insure against these price spikes, and therefore potentially to enhance security of supply. Furthermore, regular option payments also would provide greater certainty to support long term investment in infrastructure. Our view A reliability market was considered as a potential capacity mechanism option as part of the electricity market reform (EMR) debate. This approach has the following benefits: 10 See Redpoint (2011), Gas Security of Supply Significant Code Review: Economics Modelling, November. Definition of options for further intervention

24 20 Frontier Economics October 2012 First, as this approach is technology non-specific, it does not favour any particular source of demand or supply flexibility above others. By setting a target for gas volumes without favouring a particular approach, it enables shippers to use innovative methods to enhance security of supply. Second, by creating a price cap (the strike price ) for the volumes covered under the obligation, this approach would shield both suppliers and final customers from price spikes (while potentially increasing the average price due to the option fee). Third, by creating a stable revenue stream for shippers and/or storage operators (through the option premium ), it would provide them with greater certainty to support long term investment in infrastructure. However, this option was discarded in the EMR debate for the following reasons: First, reliability options were initially considered to have the advantage of requiring minimal centralised monitoring and administration, as they rely on financial incentives instead. However, further analysis of the case studies in which a reliability market has been in operation (PJM and Columbia) revealed that this is not, in fact, the case. If reliability contracts are merely financial instruments, in the absence of physical back-up requirements, it might be more profitable for speculative investors to sell option contracts without investing in the necessary capacity. This approach may lack the certainty that gas will actually be available during periods of scarcity. To encourage investment in the necessary capacity, reliability options would need to be implemented with physical back-up requirements. However, this design option would require a significant amount of centralised monitoring. Second, the electricity market is dominated by six large vertically integrated players. For these players the option payment would simply be a transfer of money within the company, therefore diluting the incentives that a reliability option would create for a vertically separated supplier and generator. There would be similar challenges in the gas market, to the extent that it is vertically integrated. An alternative way to consider the issue of vertical integration is that a vertically integrated company already has the incentive to invest in security of supply that would be provided by the reliability option. If the incentive on a vertically integrated company were thought insufficient to induce sufficient security of supply, there must also be doubts as to whether the reliability option would be effective. Definition of options for further intervention

25 October 2012 Frontier Economics 21 Due to the high monitoring costs associated with reliability options, we do not short list this intervention for further consideration in Chapter 5. However, it may be that market participants will choose to voluntarily enter into such reliability contracts as a response to Ofgem s proposed cash-out reforms Option 4: Risk capital provision High level outline Under this option, companies (suppliers/shippers?) are required to prove they have enough capital to enable them to buy sufficient quantities of gas during periods of extreme market tightness. Our view As this is a financial option with no physical backing, this approach lacks the certainty that gas will actually be available during periods of scarcity. Furthermore, creating a high level of credit requirements could create barriers to entry and reduce competition. For these reasons, we do not short list this option for further consideration in Chapter Technology-specific Technology-specific or storage-specific obligations are designed to incentivise investment in storage capacity. Ofgem has proposed five types of technology specific options. These include the following: Option 5: Semi-regulated returns on infrastructure whereby revenues for new storage operators would be topped-up when summer-winter spreads fall below a pre-determined floor price. Option 6: A storage obligation would be imposed on each gas supplier/shipper or the SO to hold sufficient supplies of gas in storage to cover a certain level or proportion of firm supply. Option 7: Reliability option (physically backed) whereby, we suppose, an obligation would be imposed on suppliers to enter into a physical call option with shippers or storage operators to cover a proportion of their customers demand. Option 8: Emergency stock whereby storage capacity is centrally procured or under-written and is held outside the gas market. Definition of options for further intervention

26 22 Frontier Economics October 2012 Option 9: Strategic swap whereby the UK government enters into a treaty or emergency supply contract guaranteeing delivery of gas in emergency conditions. Below, we outline these options in further detail, and provide our high level assessment of each. We short-list three of these options (storage obligation, emergency stock, and semi-regulated returns on infrastructure) for further consideration, and explore potential design options. The short-listed options are also assessed in further detail in Chapter Option 5: Regulated/semi-regulated returns on infrastructure High level outline Ofgem could consider a model with a semi-regulated return on infrastructure, with a floor on summer-winter spreads, for example, whereby revenues for new storage operators would be topped-up when the spreads fall below the floor. In other respects, the storage facility would operate in the market as though it were unregulated. Direct intervention, through such a semi-regulated return, for example, is intended to trigger a sufficient volume of storage to be developed. Our view A semi-regulated return would help to ensure that new storage capacity is delivered to the market by providing greater assurance that investors will generate an economic return from their investment. A key consideration with this option for intervention is the level at which the floor is set the higher the floor, the higher the cost of funding such a mechanism. However, it can be argued that the high costs associated with this option can be offset by lower summer winter spreads (as a result of the increased quantity of storage), and therefor lower average wholesale market prices for customers. 11 Nevertheless, a drawback associated with the lower summer winter-spreads is that they would lower the revenue for incumbent storage facilities. As a result of this effect, if being in the mechanism and receiving a top-up is more attractive than remaining wholly in the gas market, it could lead to a lack of investment outside of the mechanism, meaning that the central body has to procure ever more storage capacity. Ofgem refers to this type of distortion as the slippery slope effect 12, whereby the value of new storage is increased at the cost of reducing the value of incumbent storage facilities and of investing in new storage 11 It is generally the case that using underground gas storage reduces average prices throughout the year winter prices fall by more than summer prices increase when using storage. 12 Ofgem (2010), Electricity Market Reform Consultation Document, December, Page 94. Definition of options for further intervention

27 October 2012 Frontier Economics 23 outside the mechanism. This may be considered a lesser concern given that no new large scale storage has been commissioned for 27 years. Overall, since this intervention option may be effective in incentivising new investments, we consider it in further detail in Chapter Option 6: Storage obligation High level overview This policy option would place an obligation on each gas supplier/shipper or the SO to hold sufficient supplies of gas in storage to cover a certain level or proportion of firm supply. Any such obligation would need to be carefully designed to avoid unintended consequences. Ofgem is considering the following design options: Target group: A storage obligation could apply to suppliers, shippers or the system operator (or even government or a separate publically funded agency). A possible benefit of having a supplier obligation is that suppliers are ultimately responsible for purchasing sufficient capacity for their customers, and may therefore be best placed to manage the obligation. We assume that, in this case, Ofgem would place the obligation on suppliers, rather than shippers or the SO. Type of Storage: There are different types of storage and different benefits associated with each. Assuming that the obligation would provide financial incentives for storage capacity, it would increase the value of all storages that are included in the obligation, relative to the value of those that are excluded from the obligation. For this reason, we would expect that all types of storages be included in the obligation (including long-range, short-range, new and existing). Such a design option would avoid the slippery slope effect associated with the previous option, whereby storages included within the obligation may potentially displace investments in storages that are excluded from the obligation. However, some may argue for a design variant whereby third party access (TPA) exempt storage facilities are excluded from the scope of the storage obligation. Location: In theory, stocks could be held locally in storage within GB, in LNG tanks, or potentially in facilities located in continental Europe or beyond. There are key potential risks associated with extending the obligation to storages that are outside GB, around reliability of delivery in the event of an emergency. For example, with continental stocks, it would potentially take time for the physical gas to be delivered in an emergency. Furthermore, there may be concerns around its availability if an interconnector outage occurred or the SO was not physically able to call Definition of options for further intervention

28 24 Frontier Economics October 2012 upon the stocks. To mitigate this security of supply risk, it would seem sensible that the obligation includes only storages within GB (subject to complying with EU law such as restrictions on state aid). Storage volume: When calculating an appropriate volume of storage, consideration needs to be given to a range of factors. These include the availability of non-storage supplies and demand in extreme circumstances. We assume that the storage volume, or the overall size of the obligation, would be determined centrally based on a pre-determined level of supply standards. Design: When designing a storage obligation, there would need to be a penalty for not meeting the supply standards within the obligation. Also, we consider the option of implementing the storage obligation with storage obligation certificates, as these could then be traded between suppliers throughout the year. This would increase flexibility and make it easier for small companies to comply with the obligation. Our view As outlined above, there are a number of considerations that would need to be accounted for when designing a storage obligation. The effectiveness of this option would be highly dependent on how the obligation is implemented in practice. However, all else being equal, a storage obligation would increase the value of storage eligible for the obligation. A storage obligation would also reduce summer-winter spreads, assuming that it would be effective in incentivising more storage to operate in the market. We assume that storage facilities would be more than compensated for the loss of revenue through the wholesale market by revenues from the sale of storage obligation certificates (SOCs). We consider this option in further detail in Chapter 5, where we outline a strawman design of how we assume the obligation would work in practice Option 7: Reliability options (physically backed) High level outline Ofgem has not provided details as to the design of a physically backed reliability option. We suppose that, as with the financial reliability option, a central body would place an obligation on suppliers to purchase call options from shippers to cover a portion of their customers demand. In return for an option fee, the shipper would promise to either deliver gas to the supplier when prices rose above the strike price or pay the supplier the difference between the cash out price and the strike price. In the case of financial Definition of options for further intervention

29 October 2012 Frontier Economics 25 compensation, the shipper would be obliged to be able to access physical gas stocks equivalent to the options that it has sold. Our view We discard this form of intervention for the same reasons that we discarded the financial reliability options, i.e. due to its potentially high monitoring costs Option 8: Emergency stock (strategic storage) High level outline Investment in storage could also be incentivised by providing a fully regulated return for new storage investments. This could be done through the option of strategic storage or (emergency stock), under which a pre-defined level of new storage would be centrally procured and held outside the gas market and dispatched only in response to very low probability extreme events. Our view By providing a guaranteed regulated return to the strategic stock, this option would create strong investment incentives. Furthermore, a benefit of holding the new storage capacity outside the market (barring extreme circumstances) is that it would not lower the value of incumbent storage through a fall in summer-winter spreads (and would therefore mitigate the risk of a slippery-slope that may be associated with the semi-regulated option discussed in section 3.2.1). However, the main drawback of holding the new storage capacity outside the market is that the high costs associated with the new storage capacity would not be offset by lower costs to customers in the form of lower summer-winter spreads. We short-list this option for further consideration in Chapter Option 9: Strategic swap High level outline With this option, the UK government would enter into a treaty or emergency supply contract guaranteeing delivery of gas in emergency situations. Our view This option may not be beneficial in enhancing security of supply for several reasons: it would be difficult or impossible for the government to design a contract that provided an absolute guarantee that gas would be provided to GB in the case of an emergency in particular in the case of a gas emergency that encompassed the country with which the contract was agreed; Definition of options for further intervention

30 26 Frontier Economics October 2012 by definition, the gas to be provided in the event of an emergency would be sourced from abroad, creating concerns as to the speed of response during an emergency and as to the ability of the emergency supply contract to mitigate the risk of security events such as the failure of gas import infrastructure; it is unclear why the government would outperform market participants in the ability to agree an emergency supply contract on favourable terms; and other governments may compete with the UK to ensure that they were the preferred recipient of gas during a wider gas emergency. We therefore do not consider this option further. 3.3 Demand-side The demand side response options are intended to encourage daily metered (DM) customers connected to the national transmission system (NTS) or local distribution zones (LDZs) to voluntarily curtail demand in the period before or during a gas emergency. Ofgem sets out three demand side response options: Option 10: Standard contracts, whereby standard terms are introduced for contracts for interruptibility between suppliers and customers. Option 11: Demand side response auction, whereby a central body would hold an auction for interruptible capacity. Option 12: Distillate back-up requirements, whereby some or all CCGTs would be required to hold back-up stocks of distillate to allow them to switch to generating electricity from distillate during a tight gas market. It is likely that none of the demand side options would be sufficient on their own to meet Ofgem s requirements. However, the demand side should not be ignored because it is potentially a low cost way to help balance the system in the case of an emergency. Therefore, we short-list two of these options (standard contracts and demand side response auction) for further consideration in Chapter Option 10: Standard contracts High level outline Standard terms could be introduced for contracts for interruptibility between suppliers and customers. In its most basic form, a standard contract could Definition of options for further intervention

31 October 2012 Frontier Economics 27 simply formalise existing market processes, creating a more structured framework for the bilateral agreement of contracts. The standard contract could act as a template format for interruptible contracts, with customers and suppliers being free to decide all of the terms. It could provide space to define the volume of supply offered, the option/exercise price, the trigger for interruption, and any other relevant conditions. Our view We suppose that the rationale for applying a standard contract is twofold: Firstly, it may help to reduce the administrative burden on customers and suppliers when entering into interruptible contracts. This is particularly important for customers whose focus is industrial production and not gas market trading. Secondly, if greater price reporting is developed alongside the use of standard contracts, it may help to establish market prices for interruption. This would help industrial customers to decide whether or not to participate in future demand side response (DSR) auctions, including deciding whether or not to invest in DSR capability. 13 Given that existing market arrangements already provide flexibility, it may be unlikely that the development of standard contracts for DSR would bring significant benefits. However, it is a very low cost option that at least has some chance of being beneficial and for this reason we consider it further in Chapter Option 11: DSR auction (or tender) High level outline A number of stakeholders have suggested that an auction for interruptible capacity would effectively alleviate current barriers to agreeing these contracts for use in an emergency. Stakeholders have suggested that an auction, run by NGG, government, or an independent body, would be a solution to the lack of demand for interruptible contracts from suppliers. This may also address the concerns among some customers with shipper nominated interruption and the lack of transparency within contracts. Ofgem considers a range of ways in which an auction for DM customers could work, and believes that the following arrangements would be the most effective starting point for any auction design: 13 Price reporting may even be more effective than standard contracts themselves in helping to develop a market for interruptible demand. However, a pre-requisite for price reporting is a standardised product. Definition of options for further intervention

32 28 Frontier Economics October 2012 Governance: In response to concerns about customer mistrust of supplier nominated interruption there could be a benefit in NGG running the auction. However, due to a prohibition in the Gas Act 1986 against NGG contracting directly with customers, suppliers would need to submit bids on behalf of their customers. NGG would then need to hold a contract with suppliers whose bids had been accepted. These suppliers would then hold a contract directly with their customers. Timing and frequency: Ofgem believes that the timing of any auction would have to fulfil two criteria: to allow demand to be brought off in an organised and timely manner; and to capture as closely as possible the VoLL for customers at the time of interruption. Hence, an auction could be held annually pre-winter and contracts agreed in the auction could be exercised in an early stage of an emergency in the order of the bids. Participants: Any participants bidding into the auction would need to be isolatable DM customers who can demonstrate that they meet the appropriate safety requirements. Ofgem suggests that the auction only be open to customers that can safely turn down specified volumes in a short time frame. One of the main benefits of an auction run by NGG is that the price of interruption could be fed into the cash-out price, allowing costs to be targeted appropriately at those who are responsible for causing the supply shortage. Where bids are accepted in the auction, the price of the bid is equivalent to the interruptibility payment offered to that customer. To allow bids to be passed through cash-out, an auction with only an exercise price is Ofgem s preferred option. It considers that where bids are offered on an option and exercise basis, there is no clear way of ordering the bids, and of feeding an appropriate proportion of the option price into cash-out. Ofgem believes that some form of volume cap on accepted bids would be necessary to drive down the price of bids to VoLL and ensure efficiency. A critical issue, given this volume cap, is the question of what eligible customers would receive if they are unsuccessful in the auction, or if they choose not to bid. If the auction is fully combined with the proposed cash-out arrangements, all DM customers would have the opportunity to receive a payment for involuntary DSR. Definition of options for further intervention

33 October 2012 Frontier Economics 29 For these reasons Ofgem considers that eligible DM customers that do not bid into the auction or are unsuccessful would not receive a payment for the involuntary DSR services they provided to suppliers. Those that are successful would receive the exercise price (i.e. payment for voluntary DSR services) according to their bid. Our view A centrally run demand-side auction could be effective in helping to balance the system in the case of an emergency, even though it may not provide sufficient response to fully meet Ofgem s requirements. We don t necessarily agree with Ofgem s position that the auction should be in the form of a single energy price. Other tenders and auctions in both the gas sector (e.g. the operating margin tender) and power sector (e.g. the short term operating reserve tender which has an availability price in /MW/h and an energy utilisation price in /MWh) include an option fee and an exercise price. Although two part pricing would make selection more difficult than one part pricing, the operator of the auction should be capable of developing a sensible set of selection rules. For example, it could assign a probability of being called for the purposes of selection. Ofgem does not need to prescribe the auction selection process if the operator of the auction is appropriately incentivised to procure interruption cost effectively. Our main concern with an energy only price is that it may deter participation because it does not reflect the costs of the providers. A DM customer that thought there to be a low probability of being called but incurred a fixed cost in providing the capability to be interrupted may be reluctant to participate in the auction. Furthermore, an auction that allows an option fee and an exercise price may help to halt the decline in demand side interruption that we believe may be occurring Option 12: Distillate back-up requirements High level outline A number of CCGTs, which run primarily on gas, are technically capable of burning distillate (oil). A potential future policy option is to require some or all CCGTs to hold back-up stocks of distillate, so that they would be able to switch to generating electricity from distillate during a tight gas market. This policy option is based around a mandate that CCGTs must hold specific levels of distillate at a particular point in time to provide some assurance that there is some short-term flexibility available for a period following that point in time. This provides additional, relatively short-lived, support to cover shorterterm events and potentially provides a degree of longer-term security if distillate stocks can be replenished. It is a policy that has been adopted in countries that Definition of options for further intervention

34 30 Frontier Economics October 2012 do not have much gas storage, such as Croatia and even New Zealand, as it is relatively small scale and short duration. Our view Poyry s analysis suggests that in 2010 there was a total capacity of distillate backup at CCGTs in GB of 39 mcm/day. 14 However, the older CCGTs that do have backup will be coming to the end of their lives in the next ten years or so. Those plants under construction do not have distillate backup. Retrofitting plants with distillate back-up would be very expensive, time consuming and in some cases impossible (due to limited space, environmental considerations and planning permission issues). Therefore, any mandate on distillate back-up would need to apply only to existing sites, which would decline over time. Therefore, we reject compulsory distillate back up as an option for further consideration. However, we note that a power station that had distillate back up or thought that it would be able to provide distillate back up cost effectively would be able to participate in the DSR auction (see the discussion of the previous option for intervention, above). 14 Poyry (2010), GB gas security of supply and options for improvement a report to the Department of Energy and Climate Change, March. Definition of options for further intervention

35 October 2012 Frontier Economics 31 4 Assessment criteria Having defined Ofgem s 12 options for intervention and shortlisted seven for further assessment, we now develop five criteria against which we assess the viability of these options. These are: effectiveness of improving security of supply; cost; impact on wholesale market prices; speed and ease of implementation; and risk of unintended consequences. We outline these criteria below. 4.1 Effectiveness of improving security of supply The EU Gas Security of Supply Regulation (Regulation (EU) No 994/2010) prescribes a minimum level of security of supply which Member States, including the United Kingdom, must achieve. Provided that Great Britain (GB) complies with this standard, there is a number of other security of supply standards which Ofgem may wish to consider in determining an appropriate security of supply standard. When we apply this criterion, we consider what each further intervention option would achieve in terms of additional security for the gas network. In order to be effective, the options would need to bring about a structural (e.g. physical) and/or behavioural change from market participants. We describe the effectiveness of the market response (e.g. investment in storage, uptake of demand side response etc.) in terms of a number of factors: The scale of uptake, in terms of MW of backup capacity available. For example, demand-side response may be limited in terms of the scale of backup capacity it can provide. The duration of uptake, in terms of MWh of backup energy available. For example, distillate back-up may be limited in terms of the duration for which the back-up can be used. The location/deliverability of uptake, in terms of speed and reliability of response to an emergency. For example, continental storage may be slower to respond to an emergency, is subject to the risk of interconnector outage and is not directly within the control of the GB SO. Assessment criteria

36 32 Frontier Economics October Cost We consider the combination of the scale and duration of uptake, which could potentially need to cope with a security event that lasts for a month or more, to be the main security of supply concern in GB. We consider three elements of the cost of each option: First is a ballpark estimate of the actual cost of each option (that we short-list for further consideration), in terms of the cost of the new assets that are built as a result of the regime. This is done in two stages. First, we estimate the volume of investment that each option would bring forward. Next, we estimate the m cost of this investment. Our methodology for determining the size of the investment differs with the type of intervention: We draw on Centrica s security of supply modelling (details of which are outlined in Annexe B) to estimate the potential costs of our short-listed storage-specific interventions. Centrica estimates the price effect between 2020 and 2025 due to an investment in a given volume of additional storage capacity for a base case and two cases of system stress. As its storage investment, Centrica considers storage capacity of the size of Baird 15 (3bcm). The capital cost of this storage is estimated to be 1.4b (including 0.3b for cushion gas), with estimated operating costs of 45m per year. Of the technology non-specific interventions that we short-list, we assume that information requirements will not bring about any new investments. The costs of new investments under a non-specific service obligation, on the other hand, would depend on the details of its design. We envisage the upper bound of the cost of investments under a license condition to be our estimated cost of Ofgem s storage-specific interventions, since by definition, market parties would have the freedom to develop cheaper options than storage. Incentivising participation in demand-side management is cheaper than contracting for new investments. The cost of new infrastructure built under this approach is relatively low, although some users may need to install equipment, while the cost of calling an interruption are potentially high. However, for the purposes of our analysis, we do not estimate the costs of these new investments that may take place as a result of the short-listed demand-side interventions. The main cost of implementing 15 The Baird Gas Storage Project is a joint venture between Centrica Storage (CSL) and Perenco UK, which has been granted onshore planning permission by North Norfolk District Council. At 3bcm, Baird would be the second largest gas storage facility in the UK after Rough another of CSL's storage facilities. Assessment criteria

37 October 2012 Frontier Economics 33 such an auction would be the option payments made to DM customers in exchange for their offer to self-interrupt and the exercise payments for being interrupted. Second is an assessment of the transfer between stakeholders and how the costs of the option would flow through the value chain to the end consumer. Finally, we also estimate the size of other costs associated with each option, including monitoring and administration costs, and any up-front cost of setting up the intervention. The costs of each of our short-listed storagespecific options are compared in Annexe A. 4.3 Impact on wholesale market We assess the impact of each option on wholesale market prices. This is done at two levels: First, we provide a high-level indication of whether wholesale market summer-winter spreads are likely to reduce as a result of the intervention. Second, we consider how the option would affect both the level and shape of wholesale prices, in part drawing on the results of the analysis that Centrica has commissioned. The impact on the wholesale market of each of our short-listed storage-specific options is compared in Annexe A. 4.4 Speed and ease of implementation We assess the ease with which each option can be implemented in terms timescale and complexity: Timescale. The timescale for implementation is important when considering how well each of the interventions meets Ofgem s requirements. It takes many years to develop underground storage whereas other options such as DSR could be implemented relatively quickly. Complexity. Some types of interventions are more complex to design than others, for example, there are several design options that can be considered when implementing a storage obligation, some of which may be less effective in incentivising new investments. On the other hand, it is simpler to incentivise investments through a strategic storage option. We consider the regulatory risk that investments may not be triggered if the regime is too complex or lacks credibility with investors. Assessment criteria

38 34 Frontier Economics October Risk of unintended consequences Ofgem s interventions may also have some unintended consequences. These could include: Impact on the value of storage. We would consider how the mechanisms affected the value of storage for both incumbents and new entrants: Some mechanisms by increasing the overall demand for storage may increase the value of both new and existing storage. Other mechanisms may increase the value only of new storage (for example a targeted mechanism) and actually reduce the value of existing storage. This has an impact on incentives to maintain existing assets, which need significant replacement expenditure. As a result of this effect, if being in the mechanism is more attractive than remaining wholly in the gas market, it could lead to a lack of investment outside of the mechanism. Ofgem refers to this type of distortion as the slippery slope effect. Further mechanisms could decrease the value of both existing and new storage (for example, DSR). Impact on competition and new entry. Some interventions, like risk capital provision, for example, by creating high capital requirements for market participants, may reduce competition and new entry from small players. Other interventions, like strategic swaps, may reduce the likelihood of gas coming from countries without a treaty or agreement in place. Furthermore, some mechanisms, like strategic storage, may lead to the crowding out of commercial storage projects, given the limited number of suitable gas storage sites that can be developed into seasonal storage at an acceptable cost. Investor certainty. Regulatory uncertainty creates a risk for investors: Uncertainty of reforms. Uncertainty about the interventions intended to incentive the market to increase security of supply may have the effect of discouraging investment. For example, during the current period where mechanisms to support storage investment are being discussed, investors may want to wait until the reforms have been decided upon before making an investment decision. In addition, uncertainty about possible future changes to the design of the interventions could result in further delays to investment. Assessment criteria

39 October 2012 Frontier Economics 35 Missing money. The expectation of price caps in energy markets could lead to missing money. 16 At times of system tightness, storage facilities should be able to raise their prices to the point where they can cover their long-run marginal costs, and ultimately to the VoLL. However, storage facilities may not be able to realise the necessary prices and hence cover their long-run costs. In particular, investors are likely to worry that periods of high prices will lead to regulatory intervention in the form of price caps, and this worry (even if it never materialises) will reduce incentives to invest. Impact on the electricity market. Given that CCGTs form a significant part of GB s electricity generation mix any demand side response in the gas market from CCGTs that did not have distillate back up could simply lead to the need for an alternative CCGT to increase generation. The net effect would be not to reduce gas demand. In Chapter 5 below, we assess the seven options short-listed in Chapter 3 against the five criteria that we have outlined in this chapter. 16 Ofgem (2010), Electricity Market Reform White Paper Consultation: Annexe C. Assessment criteria

40

41 October 2012 Frontier Economics 37 5 Evaluation of options against assessment criteria In Chapter 3, we outlined Ofgem s 12 options for intervention, and short-listed the seven options that we considered to be the most viable. These are: Two technology nonspecific options: information requirements; and non-specific service obligations. Three technology-specific options: the fully regulated option (strategic storage or emergency stock); semi-regulated returns on infrastructure; and the fully-market-based option (storage obligations). Two demand-side options: standard contracts; and DSR auctions. While Ofgem has briefly outlined these options in its gas security of supply code review draft policy decision of November 2011 or in its to industry of March 2012, a significant degree of uncertainty remains about how each of these options would be designed and implemented in practice. The viability of each option is largely dependent on the details of its design. In this chapter, we: Create a straw-man design of each of these seven options, outlining the assumptions we make for the option to work in practice. We then assess each of the options against the criteria outlined in Chapter Technology non-specific options We have short-listed two of Ofgem s technology non-specific options: Information requirements would create a statutory obligation on suppliers and/or shippers to provide information to Ofgem and/or NGG on their supply-demand portfolio under various scenarios. Evaluation of options against assessment criteria

42 38 Frontier Economics October 2012 Non-specific service obligations would create a statutory obligation on suppliers to meet their customers demand under a set level of supply standards. As we describe further below, our view is that Ofgem s technology non-specific options are unlikely to be sufficient on their own to ensure security of supply, although some might be beneficial. Furthermore, we do not consider these options to be mutually exclusive, and envisage that both these options could be implemented alongside one of Ofgem s storage interventions and/or demand side interventions Information requirement Straw man design Ofgem would create a statutory obligation for suppliers and/or shippers to provide demand and supply information to NGG and/or to Ofgem under various scenarios, e.g. 1/50 winter, and/or 1/20 peak day. The aim of this information requirement is to help the SO and Ofgem to assess the security of supply situation, and to help the SO to balance the system. In addition to the details of Ofgem s proposed design that we discussed in section 3.1.1, an information requirement would need to consider the following: It is unclear whether shippers will be included in Ofgem s information requirement. It would seem to be useful to include both suppliers and shippers in the survey to understand whether long and short NBP positions are netted out. Such an information requirement could also be extended to DM finalcustomers. In order to guarantee that the information provided is timely, accurate, and in keeping with specified standards, Ofgem would need to define the requirements, place a licence obligation on suppliers and/or shippers to comply and impose a fine for breach of license. Ofgem would probably also need to create a template and guidance notes to ensure that the suppliers and shippers understand the information requirements correctly, provide the information in a consistent format, and provide information relating to consistent timescales. Ofgem could also consider publishing this information at an aggregate level to improve market signals for market participants. Evaluation of options against assessment criteria

43 October 2012 Frontier Economics 39 Assessment against criteria Effectiveness It is unclear what Ofgem will do with the information that it requests from suppliers and/or shippers. Previously, Ofgem requested information from the 15 biggest gas suppliers in the country about their demand and supply portfolio for winter 2009/10 and 2010/11. The information request was discontinued. Although it is unclear as to why, this may indicate that in its previous form the information provided was not useful. Although a statutory information obligation could be useful for monitoring purposes, it would not guarantee availability of capacity in an emergency. While Ofgem could create a template and guidance notes to facilitate consistency of information, it cannot guarantee its accuracy. Importantly, information goes out of date quickly, and may not accurately reflect market conditions on the day far ahead of the date at which it is reported. However, given that the cost of such an information obligation is likely to be relatively low, we believe that it may be worth implementing in combination with other mechanisms. Cost We suppose that the cost of implementing such an information obligation to be low. At a very high-level, we assume that: the cost of providing this information is, say, 10k per shipper and supplier, which adds up to a total cost of c. 3m 17 per year; and Ofgem s cost of processing information is c. 0.5m per year. Therefore, the total cost of such an information requirement may be c. 3.5m per year. Impact on wholesale market As we do not envisage an information requirement alone to bring about any behavioural change, and therefore we do not think that it would have any impact on wholesale market prices. Implementation Ofgem has previously requested information from the 15 biggest gas suppliers on their winter portfolio. Hence an explicit information obligation may not be difficult to implement. 17 Assuming c. 200 unique shippers and c.100 unique suppliers. See Ofgem (2012), All Gas Licensee s Registered Addresses, July Evaluation of options against assessment criteria

44 40 Frontier Economics October 2012 Unintended consequences As we do not envisage an information requirement alone (as defined here) would bring about any behavioural change, we do not think it is likely to have any unintended consequences Non-specific service obligation Through a non-specific service obligation, Ofgem would create a statutory obligation on suppliers to meet their customers demand under a set level of supply standards. As outlined in section 3.1.2, Ofgem is considering two types of license conditions (ex-ante and ex-post), through which it can impose such a service obligation on suppliers. Under both types of license condition, Ofgem could fine suppliers in breach of their licence any amount up to ten percent of the turnover of the licence holder. Further, if the licensee failed to comply with a final order, or with a provisional order to pay any financial penalty by the due date, Ofgem could potentially revoke the company s licence. As also discussed in section 3.1.2, an ex-ante type of licence condition is likely to be more effective than an ex-post license condition. For the purposes of this assessment, we assume that such a license condition, if introduced in GB, could be modelled on the French example. A straw-man design of this approach is outlined below. Straw-man design modelled on the French approach Two decrees apply to all gas suppliers and traders wishing to enter the French market: first, a gas supply licence is required to supply French customers; and second, a public service obligation (PSO) is placed on all suppliers. The gas supply license sets out: The gas procurement information required to be provided annually by all suppliers, including: a forward-looking gas procurement plan for the next 5 years and 10 years, and evidence that the applicant has the capacity (in terms of gas volumes, transportation and maximum hourly output availability) to provide gas to customers; information on measures taken to ensure continuity of supply (e.g., reinsurance agreements in case of non-performance by the gas procurement sources, additional purchase of gas from other sources and gas storage); and other customer, market and resource information. Evaluation of options against assessment criteria

45 October 2012 Frontier Economics 41 Conditions for withdrawal, suspension, and annulment of the licence, in case of failure to: comply with the conditions of the license; provide requested information updates; or comply with the PSO. The PSO on all suppliers wishing to operate in the market sets out obligations relating to the following: Access to gas procurement sources and network connections, including access to: several geographically diversified and sufficient gas procurement sources; at least two entry points on the national transport network for the suppliers who supply more than 5% of the national market; and at least three entry points on the national transport network for the suppliers who supply more than 10% of the national market. (Where an entry point could be cross-border interconnections, a national production site, or LNG imports). Uninterrupted supply of gas to all firm end-customers under all of the following scenarios: in case of disruption to the major supply source during six months under normal weather conditions; during a cold weather statistically occurring once every 50 years; and when facing extreme temperatures during a three day peak spell period statistically occurring once every 50 years. Alternative arrangements to provide uninterrupted supply in case the supplier cannot secure the gas, including: interruption or reduction of the gas supply to some customers, when it is provided for in their contracts; additional purchase of gas derived from other procurement sources (short term gas or liquefied natural gas contracts); and storage of gas. Evaluation of options against assessment criteria

46 42 Frontier Economics October 2012 When suppliers are not able to supply clients, an obligation on the TSO, during the 5 first days of non-supply, to secure supply to final consumers. During these days, consumers can try and source their gas with other suppliers. After the five days, if the situation is not back to normal, consumers who have not contracted with another supplier can be allocated a supplier of last-resort. Gas quality (including upper calorific value and purity). Such an ex-ante license condition, if modelled on the French case-study, would therefore implicitly include an information requirement, as well as an obligation to meet pre-defined supply standards. For the purposes of our quantitative analysis, we assume that these minimum supply standards would be an obligation to supply gas on an uninterrupted basis during the demand and supply shock events modelled by Centrica (see Annexe). We use these two stress cases to consider the costs of our strawman license condition, and its impact on wholesale market prices. In reality, however, an ex-ante license condition in GB could place a number of different obligations on different parties (regarding geographic diversity, alternative supply arrangements, quality, as well as placing an obligation on the SO, for example), as is the case in France. We do not attempt to attribute a cost or benefit to these other obligations. Assessment against criteria Effectivenesss The type of licence condition described above has been implemented in the French market, with no precedent of a licence breach by any suppliers. However, it is important to note that there are a number of differences between the French and GB markets. Currently, there is surplus storage capacity in France. 140 TWh of gas can be stored in the existing facilities in France, which represents 28 % of the country s annual gas demand, significantly more gas than can be stored in GB. In 2011/12 about 15% of Storengy s (the operator of gas storage located in the GRTgaz network) gas storage was unsold due to lower spreads between winter and summer gas prices. The imposition of a licence condition and the risk of financial penalties on suppliers for non-compliance may not create adequate incentives to induce a sufficient amount of change in behaviour to improve sufficiently security of supply. Alternatively, the change to behaviour may induce a physical response that does not alleviate risks. For example, under an ex-ante license condition: Evaluation of options against assessment criteria

47 October 2012 Frontier Economics 43 Suppliers would most likely sign a large number of long-term futures contracts, firm at the NBP, rather than contracting for new investments in underground gas storage. This is likely to be the least cost response to a license condition in a fully liberalised market. However, under this approach, it would be difficult to ensure physical gas supply security in GB. Alternatively, suppliers may be incentivised to enter into long-term LNG contracts. The issue is that it may take several weeks for an LNG shipment to arrive, whereas gas can be withdrawn from storage almost instantaneously. Long-term oil-indexed LNG imports are also likely to be relatively costly under current market conditions. Another possible supplier response may be to prove compliance with their license ex-ante through partial reliance on continental gas stocks. However, it would potentially take time for this physical gas to be delivered in the event of an emergency, and there may be concerns around its availability in case of an interconnector outage and the ability for the SO to physically ensure that the gas is delivered to GB. A response would not be guaranteed in tight GB gas market conditions under this approach or, even worse, the event that caused extreme market tightness may also prevent gas being delivered from the continent to GB. If the market s responses to the obligation do not align with the regulator s understanding of actions that would enhance security of supply, the regulator may adapt the obligation to achieve its specific desired outcome. The danger is that having established the instrument by which an obligation may be placed on suppliers, the regulator uses the instrument to micro-manage the delivery of security of supply by the industry in light of how it, rather than the market, perceives gas should be best delivered to the market. In turn this risks raising the costs material the costs of meeting the country s demand for gas. A second concern is that market participants would need to be absolutely sure that the licence conditions will not be revoked in future in order to develop physical assets that required significant investments. This is because the value of the assets would rely upon the licence condition. The increased (perception of) regulatory risk may reduce the effectiveness of the obligation. A license condition, as currently applied in France, may therefore not be effective on its own in incentivising sufficient new investments in the right kind of supply source in GB. In reality, the French PSO relies on a somewhat dirigiste allocation of already plentiful gas storage, rather than on a combination of market incentives and regulatory monitoring. The situation in GB, with a more liberalised gas market and a limited amount of existing gas storage, is markedly Evaluation of options against assessment criteria

48 44 Frontier Economics October 2012 different. In addition, the apparent complexity of the licence condition may create a barrier to entry to the supply market. 18 Implementation An ex-ante licence condition has the attraction of being fairly quick to design and implement, although the market s response may take longer. The rapid nature by which some sort of intervention can be achieved may be attractive to policy makers. As discussed earlier, we do not consider Ofgem s options for further intervention to be mutually exclusive, and envisage that some of these options can be implemented alongside each other, or multiple options could be introduced incrementally over time. It might be that Ofgem could consider implementing a less- prescriptive licence condition in GB immediately, before designing other storage-specific and demand-side interventions which we consider as being more effective, but which would take longer to implement. However, such a license condition would need to be designed such that it would overlay, rather than counteract any subsequent interventions that might be introduced. In addition, as discussed below, to avoid the threat of regulatory creep the license condition would need to be limited somehow. It could also include a sunset clause such that the obligation automatically fell away when another intervention is put in place. Unintended consequences In theory, a technology non-specific licence condition benefits (by definition) from not favouring a particular source of demand or supply flexibility above others. However, as recognised by Ofgem, supply solutions do implicitly deliver different types of flexibility in terms of response time and certainty of delivery. This might need to be taken into account when designing an ex-ante licence condition. For example, an ex-ante license condition may increase the number of long-term supply contracts, as a means of demonstrating compliance with the obligation, which could potentially dampen market competition. Alternatively, licensees may respond to the obligation by all developing the cheapest source of gas to comply with the obligation. Unless the obligation specified a portfolio of sources (e.g. LNG, underground storage, DSR and pipeline imports) the market response may leave GB vulnerable to a range of security events. In effect, when measured against the goal of physical supply security, the licence obligation may induce the market to over supply, say, LNG import capacity and to under supply, say, underground storage. It is possible that 18 We understand that arrangements have been put in place in France to allow gas in storage to be traded between suppliers when customers switch supplier. In effect this means that the gas in storage follows the customer and a supplier cannot block an entrant to the supply market by preventing access to storage. Evaluation of options against assessment criteria

49 October 2012 Frontier Economics 45 the market response has no effect on security of price or supply if the response from downstream shippers were to buy more gas firm at the NBP. The license condition could be designed with rigid requirements to mitigate such risks. However, it could be argued that such an approach would be undesirably interventionist, and rely heavily on the judgement of a monitoring agency. Such a temptation to micro-manage supply could create a large amount of regulatory risk, i.e. the risk of increasing prescription in terms of which measures can and can t be counted towards meeting the supply security standard. Furthermore, by introducing very rigid requirements in its supply license condition (as in France, for example), Ofgem may create barriers to entry from new suppliers. This risk can be mitigated by designing a license with less specific conditions in combination with other storage-specific and demand-side interventions. Nevertheless, there would still be the risk of further intervention under this approach by the regulator, if the license condition does not induce the response by market participants that was envisaged by the policy makers. 5.2 Technology-specific options Technology-specific, or storage-specific obligations are designed to incentivise investment in storage capacity. We short-list three of Ofgem s technologyspecific options, which range from fully market-based to fully regulation-based, as illustrated in Figure 3. Figure 3. Range of technology-specific options Market based Storage obligation Semi-regulated storage Regulated strategic storage Regulation based Source: Frontier Economics The range of options include the following: The fully market-based option. A Storage obligation could be designed to incentivise market-based uptake of storage capacity to meet an obligation set by the regulator. An obligation could be created, for instance, on each gas supplier/shipper or the TSO to hold sufficient supplies of gas in storage to cover a certain level or proportion of firm supply. One of the benefits of Evaluation of options against assessment criteria

50 46 Frontier Economics October 2012 this approach is that it relies entirely on the market to deliver capacity, without any direct regulatory funding to cover the costs of the storage. The semi-regulated option. Ofgem could consider a model with a semiregulated return on infrastructure, with a floor on summer-winter spreads, for example, whereby revenues for new storage operators would be toppedup when the spreads fall below the floor. If implemented through a longterm contract that insures potential new investors against a fall in spreads, it would provide them with greater certainty and stronger investment incentives. The fully regulation-based option. Investment in storage could also be incentivised by providing a fully regulated return for new storage investments. This could be done through the option of strategic storage (emergency stock), under which a pre-defined level of new storage would be centrally procured and held outside the gas market and be dispatched only in response to very low probability security events. By providing a guaranteed regulated return to the strategic stock, it would create strong investment incentives. There are likely to be trade-offs associated with all of these options that we have short-listed. Furthermore, the extent of effectiveness of these options will depend on their detailed design. Below, we outline a straw-man design for each of these options, and assess them against the criteria outlined in Chapter The fully market-based option (storage obligation) This policy option would place an obligation on each gas supplier, shipper or the SO to hold sufficient supplies of gas in storage to cover a certain level or proportion of firm supply. Ofgem is considering a number of design options, and considerable ambiguity remains regarding how such a storage obligation would be implemented in practice. Below, we analyse the pros and cons of the options that Ofgem proposes to consider, and create a straw-man design of a possible approach. In contrast to the TSO obligation approach in the electricity sector, we assume that the storage obligation in the gas sector would be on suppliers, who would be required to demonstrate that they have access to sufficient levels of gas in storage to meet the size of the obligation, which would be centrally pre-determined. The storage obligation could be implemented in the form of storage obligation certificates (SOCs) 19, whereby suppliers have an obligation to present a certain 19 This would be designed to facilitate new storage capacity investment in a similar way to the Renewable Obligation Certificate (ROC) mechanism, which was introduced to provide renewable energy developers with the appropriate level of support necessary to investment in renewable generation. Evaluation of options against assessment criteria

51 October 2012 Frontier Economics 47 number of SOCs in proportion to their customers demand at certain times of the year (e.g. 1 Nov and 1 Jan). Failure to comply would result in a financial penalty. The certificates would be created by storage operators (new and existing) in accordance with their physical storage capacity. All storage facilities could be eligible to create SOCs, i.e. facilities offering regulated third party access and those that did not since both types of facility contribute to security of GB gas supply. The penalties could be redistributed to suppliers that had presented SOCs in order to boost the value of storage when the market was short and to reduce the value of storage when the market was long. Straw man design Any such obligation would need to be carefully designed to avoid unintended consequences. We have assumed the following design criteria: Target group: We assume that the storage obligation in the gas sector would be on suppliers. Other options are available, e.g. a storage obligation could apply to suppliers, shippers or the system operator (or even a separate publically funded agency). Suppliers might be best placed to manage an obligation as they are ultimately responsible for purchasing sufficient capacity for their customers and are likely to understand the demand of their customers better than others. Type of Storage: There are different types of storage technologies and different benefits associated with each: Long vs short-range: The obligation could be designed to incentivise long-range and/or short-range facilities. Long-range storage facilities are those that could deliver gas from their maximum stock at full capacity for at least two months. Short range storage facilities, on the other hand, are able to deliver gas quickly relative to their stock levels, but usually for a few days at maximum capacity. An obligation could therefore define both, volume and deliverability of storage. New vs existing: An obligation could be placed on new storage investments alone, or could also include existing storage facilities. Assuming that the obligation created demand for storage over and above existing demand and that this induced investment in storage, the value of all storage that is part of the obligation must rise (at least in the long term) even though the investment in new storage would result in lower summer winter spreads. This may create the risk of windfall gains for incumbents, if their total revenue, as a result the SOC subsidy, exceeds the revenue they Evaluation of options against assessment criteria

52 48 Frontier Economics October 2012 would have received in the market in the absence of the SOC subsidy. However, including all types of storages in the obligation would mitigate the slippery slope problem, whereby the obligation may potentially displace investments in storages that are excluded from the obligation. Location: Stocks could potentially be held locally in storage within GB, in LNG tanks, or potentially in storage facilities located in continental Europe or beyond. There are key potential risks associated with extending the obligation to storages that are outside GB, around reliability of delivery in the event of an emergency. For example, with continental stocks, it would potentially take time for the physical gas to be delivered in an emergency, there may be concerns around its availability if interconnector outages occurred, and the SO may not have the ability to physically call upon stocks when required. To mitigate this security of supply risk, the obligation could be designed to include only storages within GB (provided that this is allowed for under EU legislation). Storage volume: When calculating an appropriate volume of storage, consideration needs to be given to a range of factors. These include the availability of non-storage supplies and demand in extreme circumstances. We assume that the storage volume, or the overall size of the obligation, would be determined centrally based on pre-determined supply standards. Every supplier would have an obligation to contract for enough gas storage to meet the prescribed standards. For example, suppliers may need to contract for sufficient storage to meet: 30 days of customers demand on 1 November; 20 days of customers demand on 1 January; and 10 days of customers demand on 1 March. We also assume that the obligation level would be ratcheted up over time, to reflect the increase in reliance of the GB system on gas imports over the years, and to allow for lead time in investments. The obligation may also need to specify a minimum ratio of send out capacity to storage volume. Design. When designing a storage obligation, there would need to be a penalty for not meeting the supply standards within the obligation. We assume that the storage obligation would be administered through tickets called storage obligation certificates (SOCs), where one SOC would have the value of 100 therms of storage, for example. Suppliers would then need to buy a sufficient number of certificates to meet their obligation, or pay a buyout price. The penalty would need to be sufficiently high such that the expected revenue obtained from the sale of SOCs (plus recycled penalties) and the use of the storage in the market was sufficient to cover the cost of Evaluation of options against assessment criteria

53 October 2012 Frontier Economics 49 new entry. An alternative option might be to impose a fine on suppliers who fail to comply with their obligation, as discussed under the non-specific service obligation, where suppliers in breach of their licence could be fined any amount up to ten percent of their turnover. We assume that the SOCs approach is preferable due to its added flexibility, which may make it easier for small companies to comply with the obligation. As noted above, SOC penalties could be redistributed to suppliers who hold certificates, thus raising the value of storage when the market was short of the obligation. Assessment against criteria Effectiveness A storage obligation on suppliers would provide indirect financial support to storage capacity providers. The SOC price, which would be paid on top of seasonal spreads, would increase the incentives to build new storage and help to manage the impact of forward price volatility. By allowing all storage operators to participate in the obligation, such an intervention would allow all participants to operate in the market as they would on a commercial basis. A material risk, however, is that the strength of signal to investors would rely on the credibility of the overall regime. If potential investors had concerns of a risk that the regime would not be maintained over the entire life of the asset, then it would not be effective in triggering the required level of investment. Hence, there would need to be a very long term and strong regulatory and political commitment to the regime for it to be effective. Whether this could be achieved in practice is debateable. Indeed, given that investments represent a sunk cost it might be very difficult to build a regime that is credible: political and regulatory authorities of the future would have an incentive, once the investment is in place to rescind or adapt the arrangements to make it less costly for customers. The existence of this incentive on policy makers may well be significantly large to deter sufficient investment in the first place. Cost We draw on Centrica s security of supply modelling (details of which are outlined in Annexe B) to estimate the potential costs of a storage-obligation. Centrica estimates the capital cost of new storage under an illustrative 3 bcm storage obligation to be 1.4b (including the cost of cushion gas) and the operating cost to be 45m per year (the operating cost has a PV of 500m for a 20 year life with 6.5% real discount rate). A storage obligation, under our proposed straw-man design, would increase the value of all storage, new and existing. Therefore, under a storage obligation, Evaluation of options against assessment criteria

54 50 Frontier Economics October 2012 there would be a cost of 1.9b ( 1.4b plus 0.5b), which customers would eventually incur, as well as an additional transfer to operators of incumbent storage facilities that participate in the obligation. If the transfer to all existing storage facilities and those currently under construction were the equivalent of the supplementary payments per unit of working gas volume that Centrica estimated would be required under the semi-regulated returns, this implies a transfer of approximately 39m p.a., or 430m over 20 years at a 6.5% real discount rate. The cost of the storage obligation above assumes that a single large storage facility (3 bcm) is developed to meet the obligation. If a series of smaller short range storage facilities were developed instead, the capital and operating costs would be higher. For example, the capital cost (including the cost of cushion gas) of smaller short range storage may be as much as three to four times greater per unit of working gas volume than that of long range storage. Annexe A outlines how these costs compare with the costs of the other storagespecific options that we short-list. Impact on wholesale market We draw on Centrica s security of supply modelling (details of which are outlined in Annexe B) to estimate the impact of a storage-obligation on wholesale market prices. As the new storage procured under a storage obligation would be allowed to operate in the gas market during the course of a normal winter, it would lower summer-winter spreads as a result of investments in new storage. Centrica s analysis shows that a storage facility the size of Baird would reduce gas prices in a typical year by an average of 113m and in the case of a system stress event by as much as 1.2b (for the demand stress case modelled) or 1.6b (for the supply stress case modelled). Assuming the demand stress case occurs on average once in every 20 years, the average annual reduction in gas costs for end consumers would be 166m (or 1.8b over 20 years with a 6.5% real discount rate). 20 Annexe A outlines how these benefits compare with the benefits of the other storage-specific options that we short-list. Implementation The inherently lumpy nature of storage investments may create the risk of a binary storage market, when the market is in under-supply or over-supply. Because storage capacity is added in large increments, it is difficult for the investment decision to be assessed against any target storage level, and it is 20 The actual cost saving may well be higher than this since Centrica has applied the price saving to only 50% of demand volumes and the calculation above does not consider the effect of the supply stress case. Evaluation of options against assessment criteria

55 October 2012 Frontier Economics 51 challenging to set the right penalty for not presenting a SOC. The lumpiness of storage investments means that storage capacity can move very quickly from an (expected) undershoot to overshoot, relative to targets, or vice versa. When the market is in under supply, SOC prices could rise very quickly to the buy-out price (or even higher if any revenue from penalties was passed on to those that had presented SOCs). Similarly, when the market is in over supply, SOC prices could fall to the short run marginal cost (SRMC) of operating the existing storage facilities. From the perspective of a storage operator, this creates the risk of severe undercompensation when the market is over-supplied. From the perspective of the policymaker there is a risk that an agreed SOC price, paid on top of seasonal spreads actually achievable in the market, may turn out to be too generous in a world where future spreads move back up into the higher range again. Policymakers may therefore be reluctant to commit to a SOC price which would be sufficient to protect storage developers in a world where spreads remain at their current depressed level. These risks may mean that the regime may lack credibility with potential investors. Unintended consequences A storage obligation may have several types of unintended consequences: As with other storage-specific interventions, a storage obligation would undermine the value of other types of flexibility including demand-side response. By reducing summer-winter spreads, a storage obligation would mute price signals, and therefore reduce incentives for customers to choose to be paid to self-interrupt, and for shippers to pay for this service. This same effect may deter investment in other capacity such as LNG import capacity, pipeline import capacity and even UKCS production. The inherent risk of a binary outcome in a SOC regime may create adverse incentives for large investments, leading to an outcome of the take-up of a large number of short-range storage facilities, and no long-range facilities. This would be significantly more costly to customers Regulated/semi-regulated returns on infrastructure One of the risks associated with a fully market-based solution is that it may not trigger sufficient new investment in storage. Given the implementation risk associated with the fully market-based option, a semi-regulated approach could potentially be more viable. Ofgem could consider a model with a semi-regulated return on infrastructure, with a floor on summer-winter spreads, for example, whereby revenues for new storage operators would be topped-up when the spreads fall below the floor. Evaluation of options against assessment criteria

56 52 Frontier Economics October 2012 Straw-man design The main driver of seasonal storage value is the forward winter summer spread, and the main risk to storage investments is therefore a collapse in this spread. A floor on this spread with storage revenue top-up (when spreads are below this floor) would provide direct financial support to new storage capacity providers. This would, in effect, put a floor on the level of return, therefore reducing the risk to storage investments. Key elements of this approach include the following: Setting the floor. A simple tender process could be employed to identify the least cost option (which may also need to consider how to compare different technical solutions in an auction). Providers of capacity could bid in the minimum floor level required to support their projects. Ofgem could then select the most economic bid/bids that would deliver the policy requirements, and long term contracts could be agreed (including penalty clauses for late delivery or non-delivery). 21 Calculating the average winter summer spread. Once the price floor is set, the average forward winter summer spread for the entire year would need to be calculated. Based on an agreed price reference 22, for each trading date between 1st October and 31st December (the period when the majority of storage capacity sales traditionally take place) this could be calculated as the difference between the summer price for the next year and the Q1 price for 2 years ahead. Providing a top-up. If the average spread for the year is greater than the agreed floor (16.4 p/th, in the example modelled by Centrica), no payment would be made. If the average spread is less than the agreed floor, a revenue top-up would be made based on the facility s storage capacity. The process would then be repeated for each year of the agreed contract length, which could be referenced to the lifetime of the project. Passing on costs. The costs associated with this top-up mechanism would be passed on to end consumers through a levy on transmission charges. The extent to which this option is relatively market-based or regulation-based would depend on the level at which the floor is set. The higher the floor, the higher the regulatory revenue support provided by such an intervention. Since 21 Centrica s modelling suggests that for an investment the size of Baird, the floor would need to be set at 16.4 p/th to target an IRR of 8.5% (nominal) on the investment. 22 This could be an individual or basket of trade publications e.g. Argus, Heren or Platts. Evaluation of options against assessment criteria

57 October 2012 Frontier Economics 53 the floor is difficult to estimate, an approach is to set it using a tender if there were sufficient competing storage projects. Assessment against criteria Effectiveness By creating a floor on summer-winter spreads and insuring new storage investments against revenue shortfalls when spreads fall below the floor, such a top-up mechanism would inherently create a floor to the level of return that can be earned on these investments. Such a mechanism is therefore likely to effectively trigger new storage investments. If the mechanism were set out in the form of a contract, it may help to reduce the perception of regulatory risk for the investor. Cost The cost of a top-up mechanism would depend on the level at which the floor is set. The higher the floor, the higher the level of subsidy, and the lower the investment risk for new investors. We again draw on Centrica s security of supply modelling (details of which are outlined in Annexe B) to estimate the potential costs of a top-up mechanism. As before, Centrica estimates the total cost (i.e. capex, cushion gas and opex) of new storage with 3bcm of capacity to be about 1.9b. Centrica s modelling suggests that for an investment of the size and cost, the floor would need to be set at 16.4 p/th to provide an expected IRR of 8.5% (nominal) on the investment. If the average spread for the year is greater than the agreed floor (16.4 p/th, in this case) no payment would be made, if the average is less than the agreed floor a revenue top-up would be made based on the facility s capacity. Based on summer winter spreads for the period 2004/05 to 2012/13 a floor of 16.4 p/th would have resulted in supplementary payments of 21m p.a., or 230m over 20 years at a 6.5% real discount rate. A semi-regulated return, under our proposed straw-man design, would increase the value only the new storage operators that successfully selected in the tender for a top-up. Under such an intervention, there would be the cost of the storage facility of 1.9b, as before. In this case there would be no transfer to incumbent storage operators since they would not be funded as part of the mechanism. Annexe A outlines how these costs and transfers compare with the costs and transfers under the other storage-specific options that we short-list. Impact on wholesale market The impact on the wholesale market would depend on the level of new storage investments that the intervention is likely trigger. The greater the level of new storage capacity triggered by the mechanism, the lower the summer-winter spreads in the gas market. This is because the new storage capacity triggered by Evaluation of options against assessment criteria

58 54 Frontier Economics October 2012 the mechanism would operate in the gas market as normal, reducing the stress on winter gas prices, and therefore reducing summer-winter spreads. Assuming a single 3bcm storage facility is built, the effect on the gas price paid by end users would be the same as for the storage obligation, i.e. customer bills would fall by 166m per year (or 1.8b over 20 years with a 6.5% real discount rate). The reduction in winter summer spreads would reduce the value of incumbent storage facilities and this would not be offset by the mechanism since it would not apply to incumbents. Annex A outlines how these benefits compare with the benefits of the other storage-specific options that we short-list. Implementation We envisage that such a top-up mechanism would be fairly quick to implement although a storage facility may take many years to design and construct. The main complexity under this approach would be in designing an auction that facilitates genuinely competitive bidding amongst a few developers and allows storage facilities with different technical characteristics to be compared. Once this is designed, however, a storage revenue top-up payment would be relatively straightforward to administer, and would provide certainty to capacity providers if structured as a long term contract. A top-up mechanism may also appeal to policy makers, as support would only be paid out when market conditions fail to meet the reference level. This would reduce the risk of potential windfall gains. Unintended consequences Under this approach, a revenue top-up would be available only to new investments that successfully bid into the mechanism. The new storage capacity that is generated as a result of this intervention would lower summer-winter spreads in the gas market. However, the main risk associated with this approach is that it would reduce the value of incumbent seasonal storage (via a fall in spreads as a result of the new storage investments), without creating any offsetting revenue stream for incumbents. Therefore, through this type of intervention, policy makers risk impacting the rest of the storage market in two ways: First, it is likely to deter entry of new seasonal storage facilities as a result of normal market signals as those signals would be dampened by the existence of the new facility whose entry was induced by the floor mechanism. This may be considered a second order effect with respect to the given that no seasonal storage has been developed since Evaluation of options against assessment criteria

59 October 2012 Frontier Economics 55 Second, it may hasten the exit of existing market participants, particularly if existing facilities require significant replacement expenditure to ensure ongoing operability. The top-up mechanism may therefore need to be extended to include major life-extension repex, which would increase the cost of the mechanism. However, the alternative is the risk that incumbent seasonal storage closes. This means that, over time, it is likely the entire gas storage market would become reliant on this type of mechanism. This is often referred to as the slippery slope effect which we discuss in more detail in the following section The fully regulated option (strategic storage or emergency stock) Under the fully regulated option, a pre-defined level of new storage would be centrally procured and held outside the gas market and dispatched only in response to very low probability events, like major supply failures or a very severe winter. This would require the mandatory building of new storage facilities with central control and dispatch. Strategic storage would not be used during the course of a normal winter. Therefore, the UK would need other forms of flexibility, including other commercial storage, to cope with cold (but not abnormally cold) winters. Conditions at which the strategic storage is dispatched would need to be determined in advance and be strictly adhered to. Straw man design Key elements of this approach are outlined below: First, there would be central determination of: the required level of reliability; the level of gas that the market is likely to deliver in the absence of intervention; and therefore whether there is likely to be a shortfall, relative to the level of required reliability. Second, the necessary volume of storage to meet this shortfall would be centrally procured. Strategic storage can, in theory, be procured in two ways: first, through procuring the mandatory construction of new storage facilities with central control and dispatch, to be withheld from the gas market; or second, by procuring the strategic withholding of a proportion of all storage (new and existing) from the gas market. Evaluation of options against assessment criteria

60 56 Frontier Economics October 2012 Mandatory construction of new storage facilities with central control and dispatch would be required in the UK, given the shortage of existing storage capacity. Technical conditions for the new strategic storage, including location, duration, timing of commission, could also be pre-determined centrally. We assume that storage developers would bid in an annual cost of delivering (at least) the targeted strategic reserve capacity over the longterm and Ofgem would select the most competitive bid/bids. 23 Finally, this centrally procured resource would be held outside the gas market, and dispatched only in response to very low probability events such as major supply failures or very severe winters. In order for strategic storage to be effective, the conditions for its dispatch would need to be determined ex-ante, and would need to be adhered to ex-post. These conditions for dispatch would include the price, at which the reserve enters the gas market, or the dispatch price, and the methodology for changing the price over time (using indexation to inflation, for example). The dispatch price, would, in effect, be a cap on the wholesale gas market price. When considering the option of a strategic reserve for the electricity market, Ofgem considered two options for setting the dispatch price: first is the option of economic dispatch, where the dispatch price would be set above the highest long-run marginal cost in the gas market, but below domestic VoLL; and second is the option of last resort dispatch, where the dispatch price would be set at domestic VoLL (so that the strategic storage would be dispatched only once all other capacity had been dispatched). Economic dispatch was Ofgem s preferred option, as it was considered to provide better value to customers, relative to last resort dispatch (where customers are effectively indifferent between paying for capacity and accepting blackouts and which would do little or nothing for security of price). We suggest a third, alternative approach to determining a dispatch price, which would be set just below domestic VoLL. Under this option, the strategic stock would be dispatched only when there are no bids in the market other than involuntary load shedding bids. This could be achieved by setting the dispatch price at 1.1 times the highest bid price, for example. The regulated strategic storage would be remunerated in the same way as any other fully regulated asset through the standard regulatory formula (in the form 23 Details such as the allocation of construction, performance and operating risk between the developer and the customer would need to be defined in establishing this type of mechanism. Evaluation of options against assessment criteria

61 October 2012 Frontier Economics 57 of operating expenditure, depreciation, RAB and WACC). This would be recovered through the SO charge and finally fed through to final customers. Assessment against criteria Effectiveness Investors in strategic storage would receive a stable regulatory revenue stream, rather than having to rely on a market-based return associated with volatile gas market prices, like commercial storage operators. By guaranteeing a regulatory return to investors, this approach would create strong incentives to invest in strategic storage. However, if not designed properly, this type of storage intervention could potentially have the unintended consequence of displacing capacity that may have already been planned outside the mechanism. This risk is discussed further under the section on unintended consequences below. Cost Strategic storage would be very expensive to implement, as the full costs of covering for a low probability high impact event would fall on the Government, and be passed on to consumers. Unlike under the other two storage-specific options that we have short-listed, the costs of building strategic storage would not be offset by lower costs to customers in the form of lower summer-winter spreads. 24 This is because (unlike under the other two interventions) strategic storage would not be allowed to operate in the gas market alongside commercial storage during the course of a normal winter. Due to the high costs associated with this option, during periods of high prices, there could be increased regulatory pressure to lower the despatch price as a lever to reduce wholesale prices. An unintended consequence of such an intervention is that it may distort investments outside the mechanism, meaning that the central body has to procure ever more storage capacity. This risk is discussed further under the section on unintended consequences below. Again we draw on Centrica s security of supply modelling (details of which are outlined in Annexe B) to estimate the potential costs of strategic storage. The capital and operating cost of a 3bcm storage is estimated at 1.9b over 20 years at a 6.5% real discount rate. There would be no transfer to operators of incumbent storage facilities. Annexe A outlines how these costs and transfers compare with the costs and transfers under the other storage-specific options that we short-list. Impact on wholesale market 24 To the extent that the strategic storage was priced below VoLL, it would arguably reduce summerwinter spreads by some, small, amount. Evaluation of options against assessment criteria

62 58 Frontier Economics October 2012 Under the conditions for dispatch set out in our straw-man design, strategic storage would not be allowed to participate in the gas market in the course of a normal winter, and would therefore have no impact on wholesale market prices. Unlike under the other two short-listed storage-specific options the costs of building strategic storage would not be offset by lower costs to customers in the form of lower summer-winter spreads. Therefore, if security of price is considered to be the main policy concern, a strategic stock may not be considered a viable option for further intervention. In other words, while the fully regulated approach would facilitate an improvement in physical security, a security of price risk would still remain. Annexe A outlines how these benefits compare with the benefits of the other storage-specific options that we short-list. Implementation As with any storage intervention, strategic storage will take time to implement, due to the large, lumpy nature of storage investments. However, given that gas security of supply is a risk in the longer-term, rather than in the short-term, we do not envisage this to be an issue. Nevertheless, there are two main implementation risks associated with strategic storage: First, the limited number of suitable sites may create competition between strategic and commercial storage. The development of suitable gas storage locations is dictated by access to sites that possess suitable geology, whether depleted gas fields or salt cavities. In the UK, as elsewhere, there is a finite number of depleted gas fields and salt strata that have the appropriate geological structure to support economically and technically viable gas storage. The construction of strategic storage would effectively mean Government and commercial entities would be competing for sites. Second, complexity of storage may mean that it may not function as expected when called upon. Infrequently used facilities are inherently less reliable when compared to those used by the market, and hence need to be frequently tested. Unintended consequences Strategic storage has the potential to undermine incentives for all forms of flexibility, if not appropriately designed. Any risk associated with the muting of price signals would reduce the incentives for the uptake of flexibility and energy efficiency. Therefore, the impact of strategic storage on incumbent storage (and other types of flexibility including demand-side management) is largely dependent on its conditions for dispatch. Under the approach we outlined above, the strategic stock would be dispatched only when there are no bids in the market other than involuntary load shedding bids. A possible benefit of this approach is that it would not distort the value of commercial storage and other forms of Evaluation of options against assessment criteria

63 October 2012 Frontier Economics 59 flexibility, by not capping the revenues that they would receive in the gas market. Therefore, the market signals to investors would, in theory, be preserved. However, designing strategic storage using this approach would make it very expensive to implement. Holding the strategic stock outside the market would mean that the full costs of covering for a low probability high impact event would fall on the Government, and be passed on to consumers. Figure 4 illustrates the trade-off associated with allowing the strategic stock to interact with the normal gas market. Figure 4. Trade-off with allowing strategic stock to interact with market Source: Frontier Economics On the one hand, allowing the strategic storage to be used in the market would lower summer-winter spreads in the course of a normal winter, therefore reducing the cost of gas purchasers for customers. The greater the utilisation of the strategic stock in a normal winter, the lower the net cost to customers. On the other hand, allowing the strategic stock to interact with the market would imply a reduction in the dispatch price to significantly below VoLL, and therefore setting a cap (via the dispatch price) on the gas market price. As a result of this price cap, incumbents would lose some revenue that they would otherwise receive at times of scarcity (sometimes referred to as scarcity rents ), when prices could potentially rise as high as VoLL. As a result of this effect, if being in the strategic storage mechanism and receiving a regulated payment is more attractive than remaining wholly in the gas market, it could lead to lack of investment outside of the mechanism, meaning that the central body has to procure ever more storage capacity. Ofgem refers to this type of distortion as the slippery slope effect. 25 These distortions could undermine the mechanism s ability to ensure secure supplies of gas. The greater the utilisation of the strategic stock in a normal winter, the greater the potential investment distortion. 25 Ofgem (2010), Electricity Market Reform Consultation Document, December, Page 94. Evaluation of options against assessment criteria