How To Make A Power Station More Flexible

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1 Smarter Network Storage Low Carbon Network Fund Electricity storage in GB: SNS4.13 Interim Report on the Regulatory and Legal Framework

2 Contents Executive Summary... 3 Headline messages... 3 Electricity markets are changing in pursuit of decarbonisation... 3 Business case for distribution connected storage can be complex... 3 Regulatory framework presents issues for distribution connected storage Introduction Context Purpose of this report Structure of this report Impact of decarbonisation on GB electricity system The generation mix is evolving in response to policy goals Implications of increased renewable generation Future need for energy storage to help provide flexibility Positive statements from policy makers regarding storage Energy storage has many forms and applications What is energy storage? How can storage be used? What are the challenges for further development and deployment? Regulatory framework building blocks Building blocks of EU framework Building blocks of GB framework Regulatory arrangements: what are the implications for storage? How is storage classified in the existing framework? How is ownership and operation of storage affected? How will storage investments be treated in price controls? Summary of issues for storage within regulatory framework Implications for SNS business models Market participation and service provision: how can storage realise value? Possible avenues for value realisation Wholesale market Balancing services Capacity market Levy Exempt Certificates Issues linked to value realisation Conclusions Key observations Next steps Annex A EU and GB Legal framework overview Annex B Generation requirements Annex C Wholesale market Annex D Balancing Services Annex E Capacity market UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 2 of 72

3 Executive Summary Headline messages The GB electricity system is evolving in pursuit of decarbonisation, with significant penetrations of autonomous wind and solar generation anticipated. Increased flexibility is needed to manage the unpredictability and variability of intermittent generation and deliver system stability. In this context, electricity storage has a potentially important role to play as a source of flexibility in the future capacity mix. Electricity storage is a diverse concept, encompassing a broad range of technologies with varied potential applications. This means that the business case for distribution connected storage is typically multi-layered, with several distinct components in the value stream, typically involving multiple parties. The feasibility of the business case is influenced by the regulatory framework. But, the legal and regulatory framework presents several issues for increased deployment of electricity storage within the GB market. These issues need to be appropriately addressed if the potential benefits of electricity storage to the system are to be realised. Electricity markets are changing in pursuit of decarbonisation The transition to a low carbon electricity sector will create challenges for the electricity system. A decarbonised electricity system requires a radically different generation mix from that seen conventionally. It will include a considerable quantity of capacity that is less flexible than the present fleet, whether due to technical inflexibility (such as variable or intermittent renewable generation) or commercial inflexibility (due to low or zero marginal costs, perhaps exacerbated by output-based support mechanisms). Meanwhile, the decarbonisation of the wider economy will require electricity to be used for heating and transport, significantly increasing total electricity demand and changing patterns of consumption. The Distribution Network Operator (DNO) will have an increased requirement to reinforce for peak load unless peak load can be smoothed. To manage these challenges, we will, in future, need to draw on flexibility from a wide range of sources to balance the system and provide security of supply. Energy storage is one source of flexibility which could help to balance the system and provide an alternative to traditional network reinforcement. At present, however, aside from pumped storage hydro, there is limited storage in the GB electricity market. This is, in part, linked to the underlying economics of storage options given limited deployment and traditional reliance on large scale conventional generation assets to meet demand. But looking beyond these factors, there is a genuine question regarding the ability of the existing regulatory and legal framework to support enhanced deployment and utilisation of energy storage options. The Smarter Network Storage (SNS) project is seeking to shed light on this issue. One of the aims of the SNS project is to review relevant aspects of the regulatory and legal arrangements for the GB electricity sector, in order to identify possible barriers to the wider introduction of electricity storage facilities on DNO networks. This report is the first element of this process. It initiates the review process by identifying the overarching framework for storage and potential issues for further investigation. Business case for distribution connected storage can be complex Distribution connected storage is likely to have mixture of applications. One value stream component lies in avoided or deferred capex linked to conventional system reinforcement options. Other sources of value stem from the ability of the storage asset to provide ancillary services and to participate in the wholesale market. In addition, there are potential wider societal benefits in the form reduced CO 2 emissions and avoided investment in other sources of capacity to provide flexibility. These possible value streams are, therefore, linked to a range of factors and typically require involvement from multiple actors across the value chain to be realised. For example, the distribution business must be involved to capture UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 3 of 72

4 benefits of avoided capex while wholesale market revenues necessitate involvement of market players. The multicomponent and multi-actor nature of the business case is illustrated in Figure 1. Figure 1 Business case components for distribution connected storage Avoided conventional capex Revenue from ancillary services Revenue from wholesale market Business case Value within DNO business Value outside conventional DNO business The SNS project considers several business cases 1 for distribution connected storage: DNO merchant: DNO builds, owns and operates the asset. Full operational control. DSO: DNO builds, owns and operates the asset. DNO has full operational control. DNO has been given a wider role in regulation in balancing or controlling aggregated demand and generation on its network (a DSO role). DNO contracted: DNO builds, owns and operates the asset. DNO has full operational control. Prior to construction, long term contracts (e.g. 10 years) for the commercial control of the asset outside of specified windows are agreed. Contracted services: DNO offers a long term contract (e.g. 10 years) for services at a specific location with commercial control in certain periods Charging incentives: DNO sets DUoS to create signals for peak shaving that reflect the value of reinforcement. Regulatory framework presents issues for distribution connected storage The feasibility of these business cases is influenced by the regulatory framework. However, there are several issues within the legal and regulatory framework which affect the deployment and utilisation of distribution connected electricity storage within the GB market. These result from a combination of EU-wide and GB-specific rules. The key messages which arise from the regulatory review for deployment of storage assets on distribution networks, with the involvement of the DNO are as follows: Default treatment of storage as a subset of generation creates uncertainty Unlike in the gas sector where storage is defined as a distinct activity, electricity storage is not explicitly recognised as a discrete activity or asset class in the GB and EU legal frameworks. In the absence of an alternative option, storage is treated as a type of generation asset. This is an accident of history through the liberalisation process rather than a deliberate design choice. Nevertheless, treatment of storage as generation is a pervasive issue which has a ripple effect on ownership and operation options. 1 Business models are outlined in full at: Storage-(SNS)/Project-Documents/Smarter-Network-Storage-Business-model-consultation.pdf UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 4 of 72

5 Generation licence exemption route does allow distribution connected storage projects of appropriate size in a manner consistent with unbundling requirements As part of the liberalisation process, unbundling has become enshrined in the regulatory frameworks at EU and GB levels. This seeks to separate network and non-network activities, restricting the ability for operators of network assets to be active in generation or supply sectors. For GB DNOs, the requirement is for legal, functional and accounting unbundling to ensure operational independence of the distribution business from other activities within the vertically integrated business. Therefore, in GB, distribution licence holders are prohibited from also holding generation or supply licences. This appears to block GB DNO involvement in storage ownership and operation. However, a class exemption exists for small generators, meaning that storage projects with either output below 50MW are exempted from the need to hold a generation licence, with individual exemptions typically offered to capacity below 100MW. This exemption is applied on a per site basis. Therefore, smaller-scale, distribution connected storage facilities qualify for this exemption. The exemption route does, consequently, provide an avenue for potential deployment of smaller scale energy storage assets by DNOs, with operational separation to a third party to handle energy flows, in a manner that is consistent with unbundling requirements. This is the model being employed in the SNS demonstration, with interaction of the storage asset with the balancing and wholesale markets being handled via third parties, independent from the DNO business. De minimis business restrictions do place a loose limit on deployment by DNOs Non-distribution business activities, such as income generation from storage projects, are limited by de minimis restrictions specified in the distribution licence. These restrictions mean that turnover from and investment in nondistribution activities must not exceed 2.5% of DNO business revenue or licensee s share capital respectively. However, this limit is relatively loose at present, creating the potential for projects to be progressed within this restriction. But, possible application and operation of assets is affected though by the need to ensure that competition in generation and supply is not distorted More critically, though, the distribution licence imposes restrictions upon activities of the distribution business in order to avoid distortion of competition in generation or supply activities. DNO operation of a storage asset would have an impact on the traded market and it will be necessary to demonstrate that this does not distort the market. This can be interpreted as a block on operation of a storage asset by a DNO for balancing purposes. It requires a contractual interface with a third party to handle the energy flows which necessitates the involvement of an additional player in the business case. This is the model in place in the SNS demonstrations, with third parties managing the interactions with the balancing and wholesale markets, and the trials will test arrangements for managing this third party interaction within the trading arrangements. Alternatively, it may be possible for GB DNOs to be allowed to trade for non-speculative purposes in order to deliver network services under a model similar to that within which National Grid operates as system operator. Treatment of storage investments in price controls is unclear The treatment of investment in a storage asset as an alternative to conventional investment options, its assessment and treatment within the price control process has not been tested. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 5 of 72

6 Summary position DNO-led development of smaller scale storage projects is, therefore, possible within the regulatory framework. However, the need to ensure that distribution licence holders do not distort competition in generation and supply blocks the ability for operation of the assets by DNOs. This creates the need for a contractual interface with a third party (potentially an operationally separate entity under the same organisation umbrella as the DNO business) to conduct market interactions (as is the case in the SNS demonstrations). The importance of the issues identified for DNO led development of distribution connected storage assets is summarised in a qualitative assessment summarised in Figure 2. Figure 2 Summary qualitative assessment of regulatory issues Default treatment of storage as generation Avoiding distortion of competition in generation and supply Unbundling requirements De minimis business restrictions Assessment of economic benefits under price control High Medium Low These regulatory issues have differing implications for the five business models discussed within the context of the SNS project. In general, these issues are of greater significance for the business models which entail DNO ownership and operation of the storage asset. This stems principally from the concern that DNO activity in storage projects could distort competition in generation and supply activities. A qualitative assessment of the implications of these issues for the business models is shown in Figure 3. Regulatory issues are less of an issue for the Charging Incentives model (and to a lesser extent the Contracted Services model). However, these models present more commercial risk for DNOs and provide less certainty regarding the actual progression of investment, potentially creating system security issues. These factors must be balanced against the reduced presence of regulatory issues under these models. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 6 of 72

7 Figure 3 Importance of regulatory issues for SNS business models Issue DNO merchant DSO DNO contracted Contracted services Charging incentives Default treatment as generation Distortion of competition Unbundling requirements De minimis restrictions Assessment of economic benefits Key: Low importance High importance There is scope for the regulatory regime to be modified to create a more appropriate framework within which distribution connected storage can be progressed by addressing the issues identified above. The next phase of this element of the SNS project will move onto consider potential solutions to improve the regulatory framework. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 7 of 72

8 1 Introduction 1.1 Context The generation mix is evolving in response to policy goals to pursue decarbonisation of the power sector and to increase the proportion of electricity generated from renewable sources. The proportion of generation provided by wind and solar capacity is increasing as a result and this trend is expected to continue going forward. Wind and solar generation are autonomous in nature and have limited commercial sensitivity to the system needs (in response to market prices). As a result, greater flexibility will be needed to manage the unpredictability and variability of intermittent generation. Electricity storage is one possible source of flexibility. However, deployment of storage is limited at present, with large scale pumped storage hydro schemes the main source. In addition to developments in generation, the evolution of smart technologies has the potential to change patterns of consumption and to open up new options for grid management. Electricity storage has a role to play here too, helping to manage potentially more variable patterns of usage and the implications for the grid. The Smarter Network Storage (SNS) project is focused upon demonstrating the potential benefits of employing storage solution on a distribution network in place of conventional network reinforcement. The business case for this is linked to the economic value of the avoided network reinforcement costs and the ability for storage to capture revenue from providing ancillary services and/or bulk energy trading. This, in turn, is driven by the regulatory and market arrangements and their implications for storage deployment. The SNS project explores several possible business models for distribution connected storage. These models are presented in Table 1 and are referred to later in this document. Two models in particular are being tested through the SNS demonstration; DNO contracted and Contracted services. 1.2 Purpose of this report This report focuses on the regulatory and market arrangements which affect the deployment and utilisation of electricity storage on distribution networks within the GB market. The aim is to highlight issues within the arrangements which could frustrate greater deployment of storage. This report does not consider regulatory issues concerning planning, consents and business rating. Such issues are being considered in a separate document related to planning. This represents the first step in the process. The next step is to consider how the arrangements could be modified to address the issues identified. The aim is to create an appropriate framework which enables deployment of projects such as that being demonstrated in SNS project as part of an effective and economic electricity market in GB, as we pursue decarbonisation. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 8 of 72

9 Table 1 SNS business models Business model Key points Description DNO merchant Full merchant risk, exposed to power price and balancing DNO builds, owns and operates the asset. Full operational control. services DNO monetises additional value streams directly on a short term basis (e.g. trading). Possible barriers: Costs of accessing the market, DNO skills and capabilities, regulation and shareholder expectations of risk. Distribution System DNO exposed to incentive scheme DNO builds, owns and operates the asset. DNO has full operational control. Operator (DSO) DNO has DSO role; coordinating portfolios of flexibility for both distribution and wider system benefit through a centralized control mechanism. DNO commercial risk is dependent on design of incentive scheme. DNO contracted DNO exposed to construction and operational risks DNO builds, owns and operates the asset. DNO has full operational control. Prior to construction, long term contracts (e.g. 10 years) for the commercial control of the asset outside of specified windows are agreed. Dependant on the feasibility of long term contracts. Contracted services Low commercial risk for DNO DNO offers a long term contract (e.g. 10 years) for services at a specific location with commercial control in certain periods. Third party responsible for building owning, and operating the asset and monetising additional revenue streams. Charging incentives No guarantee of asset being build DNO sets DUoS to create signals for peak shaving that reflect the value of reinforcement. Barriers: no operational control for DNO, therefore no guarantee on security. 1.3 Structure of this report The report is structured as follows: Section 2 provides context focusing on the evolution of electricity markets in pursuit of decarbonisation, the potential for storage and factors which influence its treatment; Section 3 outlines the diversity of electricity storage technologies and their diversity; Section 4 sets out important building blocks which form the basis of the regulatory and legal framework that affects electricity storage; Section 5 outlines issues which relate to the treatment of storage within the regulatory framework and the consequential implications; Section 6 considers issues relating to market participation and service provision by storage; and Section 7 summarises key messages and outlines next steps. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 9 of 72

10 GW GW Electricity storage in GB 2 Impact of decarbonisation on GB electricity system Many stakeholders within the electricity sector are calling for increased deployment of storage on the system. This section outlines the drivers behind this and highlights the emphasis being placed upon storage within the policy framework debate. 2.1 The generation mix is evolving in response to policy goals Power sector decarbonisation is a clear component of energy policy. This necessitates a dramatic transformation of Europe s electricity markets and renewable electricity has a particularly important role to play within the revised capacity mix. European markets are, therefore, expected to face an unprecedented rate of expansion of renewable generation in the future. Indeed in many countries, these targets have already fundamentally changed the generation mix, with much greater reliance on wind and solar generation. This coincides with the closure of thermal plants through the EU Large Combustion Plant Directive (LCPD) and the Industrial Emissions Directive (IED). 2.2 Implications of increased renewable generation A significant proportion of renewable generation developed to date is wind and solar capacity. Future renewable capacity development is expected to continue this trend. Wind and solar generation are autonomous in nature and have limited commercial sensitivity to the system needs (in response to market prices). In addition, as low-carbon support payments are delivery-based (i.e. per MWh of low-carbon output), this new low-carbon generation is less reliant than other generation on the rewards for delivery that can be obtained from trading with market participants. Pöyry has carried out a number of detailed quantitative studies exploring the impact of the intermittency on European electricity and gas markets. We draw on these studies to illustrate this issue. Figure 4 shows the impact for GB of the demand duration curves when we subtract the output of the wind from the total demand 2. These charts illustrate the proportion of a year that system demand is above a given level: the upper line shows the character of the gross system, and the lower line is the remainder when the intermittent generation is subtracted. It is the lower line that the other power stations on the system will have to supply. Figure 4 Demand duration curves for GB and Ireland in British market Demand Demand net wind 8 6 Irish market Demand Demand net wind % 80% 60% 40% 20% 0% % 80% 60% 40% 20% 0% -4 Installed capacity and demand from Core scenario. 2 Impact of Intermittency. How wind variability could change The shape of the British and Irish electricity markets. Summary report, July 2009, Pöyry Management Consulting. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 10 of 72

11 Figure 5 and Figure 6 illustrate how the generation and wholesale price patterns in Northern Europe could look in 2030 for two snapshot periods 3 which apply two different historic weather patterns to a potential future generation mix involving greater penetration of wind and solar capacity: Figure 5 is for a still period in the winter (i.e. relatively low wind output). Christmas 2006 was marked by a high pressure area across much of Europe. In GB, wind generation is very low for the period from 17 December to 28 December, but since this period coincides with low demand over Christmas, the effect on prices is dampened. Prices plunge on 28 December following a sharp pick-up in wind output. Figure 6 is for a windy period in the winter. A particularly windy period occurred on 11 January, when it was windy across many European countries together. In Germany, generation is sustained above 60GW throughout the day. The generally high level of wind generation has a clear effect on prices which remain low for a long period. The fall in wind output between 21 and 26 January is accompanied by a rise in prices. Figure 5 Still period across N Europe Dec 2030 (weather of 2006) (GW) CCGT Coal CHP Nuclear Onshore wind Offshore wind Intercon. and p. storage 3 Northern European Wind and Solar Intermittency Study. The impact of wind and solar generation on the electricity markets of Northern Europe. A multi-client study. Pöyry Management Consulting, January UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 11 of 72

12 Figure 6 Windy period across N Europe Jan 2030 (weather of 2009) (GW) Onshore wind Offshore wind Intercon. and pumped storage (2009 /MWh) 2.3 Future need for energy storage to help provide flexibility As a result, greater flexibility will be needed to manage the unpredictability and variability of intermittent generation (wind and solar). This could be provided by four sources: flexible generation, interconnection, demand side response and electricity storage. These four options and their ability to provide flexibility are illustrated in Figure 7. Whether and how the flexibility offered by these sources will be provided depends on the market and regulatory structure available to incentivise new capacity to enter the market, including storage. With this in mind, is important to note that there are positive statements from policy makers regarding the application of storage which creates an enabling environment for developing an appropriate market and regulatory framework to enable this to come to fruition. The position of policy makers is elaborated in the next section. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 12 of 72

13 Figure 7 Sources of flexibility Flexible Generation Increased interconnection Demand Side Response Electricity Storage Peaking capacity for low wind periods Interconnection to neighbouring markets Incentives for peak demand reduction Incentives for peak price avoidance / reduction Energy export for low wind periods Energy import for high wind periods Storage at point of generation small or large Flexible plants to deal with short-term variability Full utilisation of network to reduce wind curtailment Heat electrification with flexibility potential Full utilisation of network to reduce wind curtailment Flexible charging patterns from electric vehicles Storage of electrified heat Storage linked to electric vehicles Flexible generation at renewables sites Transmission reinforcement to link wind to demand Demand reduction for balancing services Provision of national or local for balancing services 2.4 Positive statements from policy makers regarding storage As understanding of the challenges presented by the drive towards decarbonisation, so has the desire to integrate renewables into the system more effectively and to ensure that flexibility is provided from other sources. Energy storage is often cited by policymakers as an important part of the solution What does the European Commission say? Future role of energy storage DG Energy outlines its views regarding the importance of energy storage in its January 2013 Working Paper 4 : In this it provides the following opinion: Energy storage will play a key role in enabling the EU to develop a low-carbon electricity system. Energy storage can supply more flexibility and balancing to the grid, providing a back-up to intermittent renewable energy. Locally, it can improve the management of distribution networks, reducing costs and improving efficiency. In this way, it can ease the market introduction of renewables, accelerate the decarbonisation of the electricity grid, improve the security and efficiency of electricity transmission and distribution (reduce unplanned loop flows, grid congestion, voltage and frequency variations), stabilise market prices for electricity, while also ensuring a higher security of energy supply. Furthermore, it states that the challenges of the future calls for a new approach to storage as a key component of the future low-carbon electricity system. This echoes the message within the Commission s Energy Roadmap 2050 which highlights the following as one of 10 conditions required to deliver a decarbonised energy system: 4 DG ENER Working Paper: The future role and challenges of Energy Storage DG Energy, January UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 13 of 72

14 A new sense of urgency and collective responsibility must be brought to bear on the development of new energy infrastructure and storage capacities across Europe and with neighbours. Delivering energy infrastructure including storage Trans-European energy infrastructure To support delivery of its objectives for an integrated energy market and to enable the EU to meet its broader climate and energy goals, the EC has identified strategic energy infrastructure priorities, including energy storage projects. Through Regulation 347/2013 on guidelines for trans-european energy infrastructure, the EC s aim is to make sure that strategic energy networks and storage facilities are completed by The Regulation identifies key energy infrastructure projects termed Projects of Common Interest (PCIs) located in priority energy corridors. For a project to be included in the list, it has to have significant benefits for at least two Member States; contribute to market integration and further competition; enhance security of supply, and reduce CO 2 emissions. PCIs stand to benefit from a streamlined permitting process, improved regulatory treatment and may have access to EU funding through the Connecting Europe Facility (CEF) to support their development. Electricity storage facilities which fit the following definition are classed as eligible energy infrastructure categories: electricity storage facilities used for storing electricity on a permanent or temporary basis in above-ground or underground infrastructure or geological sites, provided they are directly connected to high-voltage transmission lines designed for a voltage of 110 kv or more. Such a facility can be classed as a PCI if it fulfils the following requirement: the project provides at least 225 MW installed capacity and has a storage capacity that allows a net annual electricity generation of 250 Gigawatt-hours/year. Therefore, larger scale storage projects connected to high voltage transmission lines can be classed as PCIs. However, smaller scale, distribution connected storage projects are not supported through the PCI framework. 248 PCIs have been identified across the electricity, gas oil and carbon capture and storage networks 5, 14 of which relate to electricity storage (with two smart grid projects). The EC states that these projects will contribute to the better integration of the internal electricity market, enhance the preparedness of the grid to take up increasing amounts of energy from variable renewable sources and maintain system stability at the same time 6. There is, however, scope for a similar type of framework to be developed for smaller scale, distribution connected storage projects What does the UK government say? DECC acknowledges the potential role of storage as a source of flexibility that can help to match supply and demand in a system with increasing levels of intermittent generation. In its 2012 document Electricity System: Assessment of Future Challenges 7, DECC highlights the potential role for storage as follows: Storage has the technical ability to provide a number of benefits to the electricity system for example, by smoothing supply profiles from variable generation and potentially reducing constraint costs by allowing generation to run during periods of low demand. It can also potentially save or defer network upgrade costs that may be required in the future to meet peak demand COM(2013) 711 Long term infrastructure vision for Europe and beyond. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 14 of 72

15 DECC s 2012 Energy Security Strategy 8 emphasises this further, stating that to remain balanced, our system will need sufficient reliable capacity to meet demand as well as a variety of non-generation technologies, including storage, interconnection and demand side response. In recognition of the challenges facing the system as decarbonisation progresses, DECC and Ofgem established the Smart Grid Forum to focus on how electricity network companies can respond to become more flexible and integrated for the future. This includes consideration of the potential application of storage within smart grids. Also, to support the ability for non-generation balancing technologies, including electricity storage, to contribute to the responsiveness challenges, DECC is seeking to ensure that Electricity Market Reform is implemented in a way that allows the development of flexible solutions to generation challenges. We consider this further later in the document. 8 UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 15 of 72

16 Seconds Discharge duration Minutes Hours Electricity storage in GB 3 Energy storage has many forms and applications There is a rationale and political support for increased storage deployment, as outlined in the previous section. In this context, this section explores what is meant by storage and its potential applications. 3.1 What is energy storage? Energy storage is not a homogenous concept. The term energy storage encompasses a wide range of technologies with diverse capabilities. To illustrate the diversity, Figure 8 displays the power rating and discharge duration of a selection of storage technologies. Available storage options span these two dimensions, ranging from low power rating and short discharge duration options such as super-capacitors through to pumped storage hydro which combines high power rating and long discharge duration. Therefore, referring to energy storage is a generality which risks oversimplifying the diversity of energy storage and its potential applications. It also raises the question of whether there should be different classes of energy storage technologies, with the potential for differing treatment for each within the regulatory frameworks. Figure 8 Range of storage technologies and capabilities High Energy Super Caps Metal-Air Batteries Sodium- Sulphur Battery ZEBRA Battery Flow Batteries Advanced Lead Acid Battery Pumped Hydro Compressed Air Energy Storage Lithium-Ion Battery Lead Acid Battery Nickel-Cadmium Battery Nickel-Metal Hydride Battery High Power Fly Wheels 1kW Source: THINK report 10kW High Power Super Caps 100kW 1MW 10MW Power rating Superconducting Magnetic Energy Storage 100MW 1GW UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 16 of 72

17 Seconds Discharge duration Minutes Hours Electricity storage in GB 3.2 How can storage be used? The technical diversity on offer across the range of energy storage technologies means that, collectively, they can be deployed for a wide range of applications, with each technology suited to a different space within this range. Figure 9 shows the range of services to which energy storage can be applied. The nature of potential service provision spans a range of applications including: uninterruptible power supply: the provision of services to end-users to provide security and quality of electricity supplies; grid support: the provision of services to distribution and transmission network operators to deliver system stability, manage peak load, voltage/thermal contracting management and provide balancing services; and energy management: bulk energy trading. The ability for individual storage technologies to participate in these activities is linked to their technical characteristics. Figure 9 illustrates the relationship between the range of potential applications and technical characteristics in terms of power rating and discharge duration. Options with high power ratings and longer discharge durations are well suited to providing energy management services and balancing services to TSOs. Those technologies with lower power ratings and shorter discharge durations are better suited to provision of services to DNOs and end-users. Figure 9 Range of applications Uninterruptable Power Supply Grid Support Energy Management Bulk energy trading Primary reserve Arbitrage Secondary reserve Frequency control Blackstart Load levelling/following Voltage support Load factor increase Transmission stability Capacity deferral Voltage support Peak shaving Power quality Uninterruptible power supplies 1kW 10kW 100kW 1MW 10MW 100MW 1GW Power rating UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 17 of 72

18 Seconds Discharge duration Minutes Hours Electricity storage in GB Source: Adapted from THINK report Overlaying Figure 8 and Figure 9 provides a mapping between different storage options and their suitability for providing uninterruptible power supply, grid support and energy management, based on underlying technical characteristics. The output from this mapping is shown in Figure 10. It highlights, for example, that pumped hydro and compressed air energy storage are well suited to provision of energy management, while batteries are suited to grid support and/or end-consumer applications depending upon the particular technology. Figure 10 Mapping storage technologies to range of services Uninterruptable Power Supply Grid Support Energy Management High Energy Super Caps Metal-Air Batteries Sodium- Sulphur Battery ZEBRA Battery Flow Batteries Advanced Lead Acid Battery Pumped Hydro Compressed Air Energy Storage Lithium-Ion Battery Lead Acid Battery Nickel-Cadmium Battery Nickel-Metal Hydride Battery High Power Fly Wheels 1kW Source: THINK report 10kW High Power Super Caps 100kW 1MW 10MW Power rating Superconducting Magnetic Energy Storage 100MW 1GW This also serves to highlight that different technologies are dependent upon different and often multiple sources for their revenue. The sources of revenue include regulated sources, coming from contracts regulated businesses or directly from regulatory arrangements, and from non-regulated or market arrangements. This is illustrated in Figure 11, which provides a simplistic overview of how the nature of applications to which storage can be used influences its revenue sources. This highlights that where storage is applied to the provision of ancillary services or capex deferral, revenue streams are heavily driven by regulation. However, if storage is being used for energy management purposes, a greater proportion of its income can be derived from market sources. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 18 of 72

19 Seconds Discharge duration Minutes Hours Electricity storage in GB Figure 11 Sources of revenue Uninterruptable Power Supply Reduced reliance on income from regulated businesses Grid Support Reliance on income from services to regulated businesses Energy Management Reduced reliance on income from regulated businesses Income from regulated sources Income from non-regulated sources 1kW 10kW 100kW 1MW 10MW 100MW 1GW Power rating Source: Adapted from THINK report The nature of underlying sources of revenue affects the business case for storage: if the storage technology is likely to be predominantly used to provide services to regulated businesses, then the regulatory framework and processes for acquiring such services needs to allow storage to capture appropriate value to make it feasible; if the project is expected to focus on activities within competitive markets, then it needs to be able to access the market on an equal footing with other participants; or where revenue sources are split, the balance and relative priorities between regulated and non-regulated services must be structured in an appropriate manner to allow both the business case to hold and the required services to be delivered. The diverse capabilities of different energy storage options mean, therefore, that there is scope for much variation in the way in which different technologies are utilised and, as a consequence, in their sources of revenue. This means that the underlying business models for different applications of storage options vary, as do the regulatory and market arrangements required to support them. DG Energy concurs with this view, stating that in a future low-carbon energy system, storage will be needed at all points of the electricity system and also noting that business models, regulatory changes and incentives need to be developed to cover the range of relevant applications and stakeholders. One representation of the current status of different technologies in terms of maturity and range of associated power costs is highlighted in Figure 12. This shows that the majority of storage technologies are in research and development, early commercialisation or demonstration phases. There is also a broad range of costs associated with UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 19 of 72

20 installing storage capacity at present, which in most cases exceeds the cost of an open-cycle gas-turbine (~ /kW), which provides an alternative source of flexibility. Costs are expected to reduce as the technologies develop and deployment increases. But achieving greater deployment relies upon a valid business case for projects both now and in the longer-term. Figure 12 Storage technology power costs and maturity Source: Adapted from THINK report 3.3 What are the challenges for further development and deployment? Given the requirements for flexibility as the system decarbonises and the positive statements from policy makers regarding the deployment of storage, why is storage not more prevalent? DG Energy identifies the following challenges: technological, such as capacity and efficiency of existing technologies; economics; driven by technology costs; strategic, requiring a holistic approach for the development of storage given its ability to complement other features of the system; and market and regulation, relating to incentives for developing storage assets and the business case. Each issue is a valid consideration. Our focus in this report relates to the final category. The following sections explore the issues and potential barriers for storage in GB specifically relating to the legal and regulatory frameworks which have a potential impact on business models for storage. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 20 of 72

21 4 Regulatory framework building blocks The regulatory framework that applies to the GB electricity sector is formed by a combination of EU and GB rules. The EU arrangements provide an overarching umbrella, which must be reflected in national arrangements. In addition to reflecting the EU arrangements, the GB framework also details the specific arrangements to apply at a national level. The sections below summarise the frameworks in place and a number of the key components within them. Further details are provided in Annex A. 4.1 Building blocks of EU framework Architecture EU legislation consists of several layers, ranging from high level commitments to specific and directly applicable legislative acts, while it also includes non-binding legislative instruments. Figure 13 shows the hierarchical layers of EU legislation, from the high level objectives set out in the treaties to the specific regulations and decisions and the non-binding recommendations and opinions. Figure 13 Hierarchical layers of EU frameworks The EU legal framework is outlined in more detail in Annex A, but there are some important components that it is worth drawing out here. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 21 of 72

22 4.1.2 Key building blocks The Electricity Directive 2009/72/EC (also referred to as the 3 rd Energy Package ) is particularly relevant in the context of this project. The 3 rd Energy Package is the most recent of a sequence of Directives focused on promoting liberalisation, competition and an effective internal energy market across EU. One of the central tenets of this process is ensuring separation between vertically integrated entities that are active across both network related and market activities. The extent and nature of separation required varies depending upon the particular network activity. There is a distinction between transmission system operation and transmission asset ownership, for example. Similarly, there is a differentiation between transmission and distribution activities. This has a particular bearing upon ownership and operation of storage assets. This is discussed further in Section 5.2. The EU regulatory framework is also the source of one of the drivers behind a potential increase in the role for storage. In an effort to tackle climate change, the EU has an aspiration to reduce greenhouse gas emissions to 80-95% below 1990 levels by Decarbonisation of the electricity sector is central to Europe s plans to reduce carbon emissions, and EURELECTRIC has a commitment to achieve carbon neutral electricity by Achieving decarbonisation goals requires a dramatic transformation of Europe s electricity markets, switching from conventional fossil fuels to low carbon generation sources. The current framework for delivering these changes spans both European and national legislation. To date, this has been driven by the EU 2020 climate change package which set the following objectives for 2020: a 20% reduction in EU greenhouse gas emissions from 1990 levels; raising the share of EU energy consumption produced from renewable resources to 20%; and a 20% improvement in the EU's energy efficiency. In January 2014, the European Commission built on this by outlining its draft 2030 climate change framework 11. This includes the following targets for 2030: a 40% reduction in EU greenhouse gas emissions from 1990 levels; and raising the share of EU energy consumption produced from renewable resources to 27%. The EU 2020 climate change package, in combination with national support schemes, is a key factor behind the investment in renewable technologies including wind and solar. This is a driver for increased storage deployment, as discussed previously in Section European Council Conclusions 29/30 October Paragraph 7: The European Council calls upon all Parties to embrace the 2 C objective and to agree to global emission reductions of at least 50%, and aggregate developed country emission reductions of at least 80-95%, as part of such global emission reductions, by 2050 compared to 1990 levels; such objectives should provide both the aspiration and the yardstick to establish mid-term goals, subject to regular scientific review. It supports an EU objective, in the context of necessary reductions according to the IPCC by developed countries as a group, to reduce emissions by 80-95% by 2050 compared to 1990 levels. Recognising the responsibility of the power sector as a major emitter of greenhouse gas, sixty one Chief Executives of electricity companies representing well over 70% of total EU power generation signed a Declaration in March 2009, committing to action to achieve carbonneutrality by mid-century. The EURELECTRIC Power Choices study builds on this commitment and seeks to examine how this vision can be made a reality. Communication: A policy framework for climate and energy in the period from 2020 to European Commission, January 2014 UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 22 of 72

23 4.2 Building blocks of GB framework Architecture In the UK, primary legislation comes in the form of Acts of Parliament and statutory instruments constitute the majority of delegated (secondary) legislation. Statutory instruments are made in a variety of forms, most commonly Orders in Council, regulations, rules and orders. The form to be adopted is usually set out in the enabling Act. Statutory instruments (SIs) are a form of legislation which allows the provisions of an Act of Parliament to be subsequently brought into force or altered without Parliament having to pass a new Act. Acts of Parliament confer powers on Ministers to make more detailed orders, rules or regulations by means of statutory instruments. An Act will often contain a broad framework and statutory instruments are used to provide the necessary detail that would be too complex to include in the Act itself. Statutory instruments can also be used to amend, update or enforce existing primary legislation. Beneath legislation, there are licences which outline rules and responsibilities relating to specific activities within the sector. Generation, transmission, distribution and supply activities are all prohibited without the relevant licence, unless either a class or an individual exemption applies. An interconnector licence has latterly been added to the preexisting suite. Electricity storage is not a licensable activity. The next layer of the framework is made up of industry codes and agreements, which focus on arrangements for participation within the sector. Figure 14 Hierarchical layers of GB frameworks UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 23 of 72

24 4.2.2 Key building blocks The Electricity Act 1989 (as amended) is the main legislative component of the GB legal framework. It was the legislative vehicle that delivered liberalisation of the electricity sector and it remains at the heart of the GB electricity market framework today. It recognises generation, transmission, distribution and supply as distinct activities and, places a legal prohibition upon carrying out these activities without a licence (unless otherwise exempted). It is also the vehicle for ensuring that unbundling requirements within the 3 rd Energy Package are embodied within the GB system. The ambition for decarbonisation is also embedded within UK policy. Through the 2008 Climate Change Act, the UK established the world s first legally binding climate change target, stated as an aim to reduce the UK s greenhouse gas emissions by at least 80% (from the 1990 baseline) by Also, as part of the EU target for a 20% contribution of renewable energy by 2020, the UK has a national target for 15% renewable energy. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 24 of 72

25 5 Regulatory arrangements: what are the implications for storage? The current regulatory arrangements for the electricity sector affect treatment of electricity storage within the market and the potential deployment of storage assets by industry participants. This section considers the implications of the regulatory arrangements for storage, identifying issues that the current framework presents. The areas focused upon are as follows: the classification of storage; and implications of the arrangements for ownership and operation of storage. 5.1 How is storage classified in the existing framework? The liberalisation process defined distinct electricity sector activities The market liberalisation process, which began in the 1990s in GB, split the electricity supply chain into several distinct layers; generation, transmission, distribution and supply. This split separated natural monopoly, network activities (transmission and distribution) from areas where competition could develop (generation and supply), with the goal of enhancing efficiency across the sector as a whole. The medium for delivering efficiency improvements differs across the different layers of the supply chain, with direct regulation applied in the case of network activities and reliance on market forces in the competitive sectors. This structure remains in place today in GB and has become the common model across much of Europe, with clear delineation between the vertical layers of the industry. The current regulatory framework is a product of this process. The Electricity Act 1989 (as amended) was the legislative vehicle that delivered liberalisation of the electricity sector and it remains at the heart of the GB electricity market framework today 12. It recognises generation, transmission, distribution and supply as distinct activities and, through section 4(1), places a legal prohibition upon carrying out these activities without a licence (unless otherwise exempted). The activities allowed by these licences and relevant associated definitions are provided in Table The Electricity Act 1989 has been amended and supplemented by various provisions of the Utilities Act 2000, the Energy Acts of 2004, 2008, 2010 and UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 25 of 72

26 Table 2 GB framework electricity sector activity definitions Activities Definition Generation Licence allows the licensee to generate electricity for the purpose of giving a supply to any premises or enabling a supply to be given Generate means generate at a relevant place Transmission Licence allows the licensee to participate in the transmission of electricity for the purpose of enabling a supply to be given Transmission means transmission by means of a transmission system, where a transmission system is a system which consists (wholly or mainly) of high voltage lines and electrical plant and is used for conveying electricity from a generating station to a substation, from one generating station to another or from one substation to another Distribution Licence allows the licensee to distribute electricity for the purpose of enabling a supply to be given Distribute means distribute by means of a distribution system, that is to say, a system which consists (wholly or mainly) of low voltage lines and electrical plant and is used for conveying electricity to any premises or to any other distribution system Supply Licence allows the licensee to supply electricity to premises in cases where (a) it is conveyed to the premises wholly or partly by means of a distribution system, or (b) (without being so conveyed) it is supplied to the premises from a substation to which it has been conveyed by means of a transmission system, but does not include its supply to premises occupied by a licence holder for the purpose of carrying on activities which he is authorised by his licence to carry on. This split between electricity sector activities has also been enshrined within the European legislation in pursuit of a liberalised, single European energy market. This began with the establishment of Directive 96/92/EC 13, subsequently referred to as the first energy package and has been supplemented since, with third energy package, embodied within Directive 2009/72/EC 14, the latest development to the framework in this regard. This defines the principal electricity sector activities as outlined in Table Directive 96/92/EC of the European Parliament and of the Council of 19 December 1996 concerning common rules for the internal market in electricity Directive 2009/72/EC of the European Parliament and of the Council of 13 July 2009 concerning common rules for the internal market in electricity and repealing Directive 2003/54/EC. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 26 of 72

27 Table 3 EU framework electricity sector activity definitions Activities Definition Generation Generation means the production of electricity Transmission Transmission means the transport of electricity on the extra high-voltage and high-voltage interconnected system with a view to its delivery to final customers or to distributors, but does not include supply Distribution Distribution means the transport of electricity on high-voltage, mediumvoltage and low-voltage distribution systems with a view to its delivery to customers, but does not include supply Supply Supply means the sale, including resale, of electricity to customers Energy storage is not a defined activity within the electricity sector The pursuit of liberalisation within the sector means that the electricity frameworks in both GB and EU define the conventional electricity sector activities of generation, transmission, distribution and supply. However, energy storage is not explicitly recognised as a discrete activity or asset class (although within the gas market, gas storage is a distinct licensed activity). In the absence of an alternative option, energy storage has been treated as a type of generation asset. In GB, large scale pumped storage hydro assets such as the facilities at Ffestiniog and Dinorwig hold generation licences, while smaller scale facilities can qualify for exemption from the requirement to hold a generation licence 15. This default treatment of storage as a type of generation is an accident of history rather than a deliberate design choice. As the large scale pumped storage facilities can compete with generation in the provision of bulk energy or balancing services, it was simply convenient to include the pumped storage assets within the generation category, rather than progress an alternative solution. While larger scale assets which deliver energy on a comparable basis to conventional generation can operate under the generation banner, it is more problematic for smaller scale resources that have different applications. But what is really meant by generation and is the inclusion of storage as a subset of generation appropriate? From a European context, generation is defined as the production of electricity (as outlined in Table 3), while the definition in the Electricity Act 1989 simply links the activity to generating electricity for the purpose of giving or enabling supply of electricity to a premises (as outlined in Table 2)., Both are relatively generic definitions. The Electricity (Class Exemptions from the Requirement for a Licence) Order 2001 develops the definition of generation further, as highlighted in Table Exemptions from the requirement to hold a generation licence can be granted to classes of generators or to particular generators in specific circumstances specified in The Electricity (Class Exemptions from the Requirement for a Licence) Order A generator can be exemptible as a small generator if output to the total system (GB transmission system and all distribution systems) is less than 10MW, or if output to the total system is less than 50MW and the declared net capacity of the power station is less than 100MW. The definition of declared net capacity in this context is as follows: The declared net capacity of a generating station which is driven by any means other than water, wind or solar power is the highest generation of electricity (at the main alternator terminals) which can be maintained indefinitely without causing damage to the plant less so much of that capacity as is consumed by the plant. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 27 of 72

28 Table 4 GB generation definitions and applicability for storage Source Definition Comments Electricity Act 1989, 4(1)(a) Licence allows the licensee to generate electricity for the purpose of giving a supply to any premises or enabling a supply to be given What if storage is intended to provide network related services (at least primarily) and is not intended to directly supply or enable supply to premises? Order, Interpretations paragraph 2(d) A person shall be treated as generating electricity at any time if he is the operator of plant or equipment which at that time (i) is generating or capable of generating electricity; or (ii) is not capable of generating electricity only by reason of the maintenance, repair or testing of the plant or equipment. Does storage actually generate electricity? It could be argued that electricity storage technologies without a turbine (such as the SNS project) do not actually generate electricity, but rather import electricity for subsequent export. Pumped storage hydro may be considered to generate electricity as it produces electricity by flowing water from reservoirs through turbines. Order, Schedule 2, Class A Persons (other than licensed generators) who do not at any time provide more electrical power from any one generating station than (1) 10 megawatts; or (2) 50 megawatts in the case of a generating station with a declared net capacity of less than 100 megawatts. This links exemption for small generators to declared net capacity (which is considered in the row below) Order, Schedule 1 The definition of declared net capacity includes the following: The declared net capacity of a generating station which is driven by any means other than water, wind or solar power is the highest generation of electricity (at the main alternator terminals) which can be maintained indefinitely without causing damage to the plant less so much of that capacity as is consumed by the plant. Declared net capacity is linked to production at the main alternator terminals. An alternator converts mechanical energy into electrical energy. But, an alternator is not necessarily a feature of electricity storage technologies. As this does not work for batteries, the definition needs to be revised to reflect the equivalent interface on a battery storage system UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 28 of 72

29 When considering whether storage can be treated as generation, a case can be made either way. On one hand, it is possible to argue that storage technologies that do not involve a turbine (such as the SNS project) does not actually generate electricity, rather it stores electricity for subsequent release. On the other hand, it is possible to say that at times storage is capable of generating or at least acting like a generator. This highlights two important messages in relation to the GB framework: first, that the definition of generation is unclear; and second, that storage does not sit comfortably within the definition of generation as its stands. In the context of smaller-scale, distribution connected storage projects, the generation licence exemption conditions become important. Points to note are that exemption is granted: on a plant by plant basis (not across a portfolio); and to plants with output below 10MW or below 50MW if net declared capacity is below 100MW. This allows small scale electricity storage facilities to fall under the Small Generator class exemption, thereby obviating the requirement to hold a generation licence for such facilities. These thresholds are more than sufficient for most distribution constraint avoidance applications, for which assets of sub-10mw are required. While storage does share some features with generation, it is also different in many regards e.g. demand consumption which is greater than output potential due to round-trip efficiency. Interconnection and demand side participation also share some features with generation, but they are not subject to the generation licence regime. Indeed, the Electricity Act 1989 has been amended to make interconnector operation a licensable activity, making it a discrete activity with its own licence (as discussed further below), while demand side response is not a licensable activity. The treatment of storage within the regulatory arrangements should be given specific consideration, rather than persisting with default treatment as a type of generation. Revised treatment of interconnectors Although not explicitly recognised as a distinct activity in the early stages of liberalisation, interconnection has latterly been defined within the legislative framework. The EU Electricity Directive defines an electricity interconnector as equipment used to link electricity systems and, in GB, the Electricity Act 1989 has been amended to define interconnection as a licensable activity (Section 4(1)(d)). The inclusion of interconnection as a defined activity is linked to its role in delivering the internal market with effective cross-border trades. Regulation 714/2009 states the following: The precondition for effective competition in the internal market in electricity is nondiscriminatory and transparent charges for network use including interconnecting lines in the transmission system. The available capacity of those lines should be set at the maximum levels consistent with the safety standards of secure network operation. Licensing provided a route for allowing non-discriminatory access to and cost reflective charging for interconnectors. It is their importance for delivering efficient cross-border flows and hence delivery of an effective internal market that triggered the change in regulatory approach for interconnection. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 29 of 72

30 5.1.3 Summary: energy storage is not explicitly reflected in the regulatory framework Neither the GB nor the EU regulatory frameworks for electricity explicitly recognise energy storage as an asset class or activity. In the absence of an alternative, the default position is that energy storage is treated as a subset of generation. However, the definition of generation is unclear and the inclusion of storage within its scope is questionable. This suggests that storage should be explicitly acknowledged within the regulatory framework, with its treatment linked to the underlying application of the technology (i.e. network use, wholesale market interaction, ancillary service provision or a mixture). Storage could be a separate licensed activity, which would provide clarity within a specifically developed set of arrangements. Alternatively, it could simply be made clear that storage is not a subset of generation, with storage potentially an unlicensed activity such as demand side participation. As things stand, however, the default treatment of storage as generation has implications for ownership and operation of energy storage assets. Treatment of storage as generation is a pervasive issue which has a ripple effect on ownership and operation options, as discussed below. 5.2 How is ownership and operation of storage affected? Unbundling requirements have implications for ownership and operation options The liberalisation process not only distinguished between vertical segments of the electricity sector, but it also created, over time, restrictions on ownership or operation of activities between the different levels. This particularly restricts the ability for operators of network assets to be active in generation or supply sectors. The separation between network and non-network activities is referred to as unbundling and it is enshrined in the regulatory frameworks at EU and GB levels. At an EU level, the third energy package sets out the requirements for unbundling. The purpose of unbundling is clearly set out in paragraph 9 of the introductory text, which reads: Without effective separation of networks from activities of generation and supply (effective unbundling), there is an inherent risk of discrimination not only in the operation of the network but also in the incentives for vertically integrated undertakings to invest adequately in their networks. With this valid goal specified, the third energy package outlines the unbundling requirements which apply for distribution system operators (DSOs) and transmission system operators (TSOs). The requirements are more onerous for TSOs, who have a choice between three models: ownership unbundling: which requires full ownership separation to ensure full independence of network ownership from supply and generation interests; independent system operator (ISO); which requires that an independent TSO with no interests in generation or supply operates the system, while allowing ownership of the transmission network to remain within a vertically integrated undertaking; and independent transmission operator (ITO): which allows asset ownership and operation to remain within a vertically integrated undertaking, but ITO has full operational independence from the rest of the business with stringent rules on ring-fencing. Ownership unbundling and ISO models require distinct ownership separation between an entity engaged in TSO activities and any market related activities. This blocks TSOs from owning generation and, by extension, storage. The ITO model does allow for common ownership, but requires full independence and ring-fencing from an operational perspective. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 30 of 72

31 For DNOs, the requirement is not for ownership unbundling, but rather for legal unbundling, functional and accounting unbundling to ensure operational independence of the distribution business from other activities within the vertically integrated business 16. Exemptions are possible for DNOs serving less than 100,000 connected customers. The key elements of the unbundling requirements are: legal unbundling of the DNO from other activities of the vertically integrated undertaking not related to distribution; functional unbundling of the DNO in order to ensure its independence from other activities of the vertically integrated undertaking, including management separation, effective decision making rights and a compliance regime; and accounting unbundling creating a requirement to keep separate accounts for DSO activities. The GB system endorses the EU model. Section 7(2A) the Electricity Act 1989 (as amended) outlines that the transmission licence conditions may prevent the holder from carrying out another activity that requires a licence. This is backed up by Standard Condition B6 which prevents a transmission licence holder from conducting any business or carrying on any activity other than the transmission business, which blocks the ability for the TSO to engage in generation or supply activities for which licence exemptions are available. For distribution, section 6(2) the Electricity Act 1989 (as amended) prevents an entity that holds a distribution licence from holding either a supply licence or a generation licence. The Distribution Licence furthers this. Standard Condition 42 and 43 within Chapter 11 (Independence of the Distribution Business) of the licence require managerial and operational systems that prevent other licensed entities from accessing confidential information, supported by a compliance regime to ensure that separation is maintained. DECC has stated that these conditions address the unbundling requirements specified in the 3 rd Package 17. The business models being tested in SNS comply with unbundling requirements by having third parties in place to manage the interaction of the storage asset with the market. This delivers separation between the DNO business and operation of the asset within the market. Table 5 GB and EU unbundling measures Source Definition Comments Electricity Act 1989, 6(2) The same person may not be the holder of both a distribution licence and a) a generation licence; or b) a supply licence Licence exempt generation possible, providing avenue for smaller storage Third Energy Package 2009/72/EC, Article 26, 1 Where the distribution system operator is part of a vertically integrated undertaking, it shall be independent at least in terms of its legal form, organisation and decision making from other activities not relating to distribution. Those rules shall not create an obligation to separate the ownership of assets of the distribution system operator from the vertically integrated undertaking. Legal rather than full ownership unbundling. Does require operational separation of storage from distribution business Article 26 of the Electricity Directive. Implementation of the EU Third Internal Energy Package Government Response, DECC, January UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 31 of 72

32 5.2.2 DNO ownership of generation licence exempt storage is possible under unbundling, with operational separation The unbundling requirements mean that, as a general rule, TSOs and DNOs must be independent from generation and supply activities. As energy storage is classified as a subset of generation by default, this means that TSOs and DNOs are unable to own and operate storage assets that require a generation licence. This acts as a block for the deployment of large storage facilities by network operators as an alternative to conventional reinforcement or for network management purposes. However, as highlighted above, it is possible for exemptions from the requirement to hold a generation licence to be granted. Four defined class exemptions 18 exist, of which one is relevant here. This allows projects to be exemptible as a small generator : if output to the total system (GB transmission system and all distribution systems) is less than 10MW; or if output to the total system is less than 50MW and the declared net capacity of the power station is less than 100MW. It is important to note that the small generator class exemption applies on a per generating station basis. This means that exemption is possible for multiple projects that fall under the defined size thresholds, regardless of the cumulative scale of the projects when considered collectively and the potential impact that they could have on the market in aggregate. Additionally, power stations which do not fall into any of the exemption classes listed above may apply to DECC to seek an individual exemption. Power stations capable of exporting between 50MW and 100MW to the total system that connected after 30 September 2000 are generally granted exemption via this route 19. Some instances of network ownership and operation of storage do exist In Italy, Art 36, paragraph 4, decree law 93/11 allows the TSO (and DSOs) to build and operate batteries. However, this must be justified through a cost/benefit analysis that shows that the energy storage system is the most efficient way to solve the problem identified (e.g. compared to the build of new line). Remuneration from the storage asset should not be higher than the (measurable) cost of alternative solutions. Terna, the Italian TSO is currently working on six pilot projects with a rated capacity of 6MW and 40MWh, and two of 15MW. In addition to these pilot plants, the company s Terna Plus subsidiary, which is responsible for new business development in Italy and abroad, is looking to commercialise energy storage alongside other emerging technologies such as renewables and smart grid systems. Belgian law allows some level of control by TSO/DSOs on electricity storage facilities but subject to conditions that would ensure the functioning of an open, fair and transparent market. These conditions are set out in Article 9 (1) of the Belgian Electricity Act: the electricity is generated for balancing purposes only, with an explicit prohibition for commercial purposes; the stored electricity is called upon as a last resource; under the form of negotiated drawing rights; to the limit of the power needed for ancillary services; upon the prior approval of the regulator; and after having completed all relevant procedures for calling upon the market. Class exemptions are specified in The Electricity (Class Exemptions from the Requirement for a Licence) Order UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 32 of 72

33 The exemption route does, therefore, provide an avenue for potential deployment of smaller scale energy storage assets by DNOs, with operational separation. The business models being tested in SNS deliver operational separation by having third parties in place to manage the interaction of the storage asset with the market Deployment by DNO businesses is limited by de minimis restrictions However, the possibility for income generation from smaller scale storage by DNOs must be considered in the context of restrictions upon the activities of DNOs specified in the distribution licence. Standard Condition places limitations on non-distribution activities. It restricts: total turnover from non-distribution activities to 2.5% of the DNO s distribution business revenue; and total investments in all non-distribution activities to 2.5% of the licensee s share capital in issue, its share premium and its consolidated reserves. Therefore, there is a cap on the permitted revenue from and the overall level of investment in storage assets (as part of a de minimis business), if such activities are possible. However, the limit is relatively loose and estimates suggest that up to 15 projects equivalent to SNS could be deployed on some distribution networks before either of the thresholds are close to being reached (subject to the scale of other activities which may already feed into the de minimis pot). While the limit appears loose currently, arrangements for distribution network led storage projects need attention now to avoid this becoming an undue restriction Obligation not to distort competition in supply and generation of affects arrangements for and practicality of storage operation More significantly, however, the Distribution Licence imposes restrictions upon activities of the distribution business to avoid distortion of competition in generation or supply activities and to avoid cross-subsidy, as outlined in Table 6. Operation of a storage device must be considered in this context. There are two ways in which flows into and out of storage can be handled: unmetered flows; or trade to buy/sell power linked to charging/discharging of storage asset. Whilst the net position is not material due to high round-trip efficiency, instantaneous charges and discharges are far larger than the footprint of other network equipment (such as substation heating and lighting and technical losses in cables and transformers) and larger than individual unmetered (i.e. estimated) connections such as streetlighting. If a DNO were to adopt either approach, it would need to demonstrate that it was not acting in a way which could distort the market. In the first case, the effects of import and export flows are borne by other parties through effects on losses in a nontransparent manner. This contradicts the 3 rd Energy Package which states that: Each distribution system operator shall procure the energy it uses to cover energy losses and reserve capacity in its system according to transparent, non-discriminatory and market based procedures, whenever it has such a function (Article 25.3). Therefore, unmetered flows into and out of the storage facility may be problematic. This requires metering by the DNO or by a third party, which must be accounted for within the settlement processes, supported by trading activity to manage imports and exports. 20 Standard Condition 29: Restriction of activity and financial ring-fencing of the Distribution Business. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 33 of 72

34 This takes us to the second case. If the DNO undertakes trading activity to support the operation of the storage asset it clearly involves direct DNO participation in the market, potentially affecting wholesale market activity. Trading does not necessarily require either a generation or a supply licence. As already discussed, generation licence exemption is available for storage assets of the size being considered here anyway. Also, trading to charge or discharge the storage asset does not mean that the operator is seeking: to supply electricity to premises, which is how supply activity is defined in the Electricity Act 1989 (see Table 2); or to participate in the sale, including resale, of electricity to customers, which is how supply activity is defined in the 3 rd Energy Package (see Table 3). Therefore, trading to charge/discharge the storage asset does not appear to require a supply licence. Nevertheless, trading by a DNO is likely to have an impact on generation and supply competition, which creates a potential distortion. This effectively blocks operation of a storage asset by a DNO for balancing purposes. These factors point to the need, under today s regulatory framework, for a contractual interface with a third party to handle the energy flows when the storage facility is used for network purposes or for broader system-wide offerings. Therefore, an additional player must feature in the business case, potentially increasing its complexity. This third party could potentially be a separate entity under the same organisation umbrella as the DNO business, as long as the distribution business itself is appropriately ringfenced from such activities to comply with unbundling requirements and associated licence restrictions. This includes the need to manage the potential for cross-subsidy between different activities within the Independence of the Distribution Business compliance regime. The SNS business models being tested manage this issue by having contractual arrangements with third parties. Under the DNO contracted model, while the DNO owns the asset, the energy flows linked to its operation are handled by a third party under contractual arrangements. To allow the DNO to capture benefits of deferred conventional capex, this suggests that there needs to be a monetary flow from the third party to the DNO for use of the storage assets as part of the long-term contract arrangements. Under the Contracted services route, ownership and operation are both in third party hands and so independent from the DNO. Here, the DNO does not face any capex and the monetary flow is more likely to be from the DNO to the third party for provision of ancillary services. The trials will test different arrangements for the managing this third party contractual interface within the trading arrangements. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 34 of 72

35 Table 6 Distribution licence conditions Source Definition Comments Standard Condition 4.1 The licensee must at all times manage and operate the Distribution Business in a way that is calculated to ensure that it does not restrict, prevent, or distort competition in the supply of electricity or gas, the shipping of gas, the generation of electricity, or participation in the operation of an Interconnector This is generally interpreted as a block on DNO trading. Trading to charge / discharge storage for network security purposes does not imply trade for commercial benefit. Nevertheless, trading in the wholesale market does involve interactions with generation and supply activities. This can be managed by having a third party undertaking trading activity. Distribution Licence, Condition 4.9 The licensee must ensure in carrying on its activities that the Distribution Business does not give any cross-subsidy to, or receive any cross-subsidy from, any other business of: (a) the licensee; or (b) any Affiliate or Related Undertaking of the licensee. If the storage asset is operated by a separate entity within the same organisation umbrella as the DNO business, then costs and revenues need to be allocated on an appropriate basis between the relevant businesses to avoid crosssubsidy. National Grid, as TSO, is, however, able to trade electricity for balancing purposes. It has a licence obligation to operate the system in an efficient, economic and co-ordinated manner 21. To achieve this, National Grid is able to purchase balancing services, including the ability to trade electricity for balancing reasons. Trading for other purposes is prohibited 22, including speculative trading 23. However, ownership and operation of storage assets by the TSO is not possible given unbundling provisions and the risk that to do so would distort competition in generation and/or supply. There is scope for considering whether this model can be applied to DNOs to allow trading that enables charging and discharging of storage assets for network services, with appropriate restrictions to prevent speculative trading. Indeed, the 3 rd Energy Package contains provisions which apply for DSOs to taking on a balancing role: Where a distribution system operator is responsible for balancing the distribution system, rules adopted by it for that purpose shall be objective, transparent and non-discriminatory, including rules for the charging of system users of their networks for energy imbalance (Article 25.6) Standard Condition C16: Procurement and use of balancing services. Standard Condition C2: Prohibited activities. As specified in the Procurement Guidelines. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 35 of 72

36 5.3 How will storage investments be treated in price controls? Assessment of storage investment in price control needs clarification If we assume that DNOs are able to own storage for network purposes, its treatment within the price control process needs consideration. If a DNO opts for a conventional asset replacement or reinforcement approach, it will be assessed in comparison to expected efficient costs for that type of asset and a determined efficient cost level will feed into the base revenue and the regulatory asset value. However, the treatment of investment in a storage asset as an alternative to conventional investment options is unclear. If DNOs were to deploy a storage device today under one of the licence exemptions, it would likely be overspending against its Capital allowance; but receiving income under the de minimis restrictions. Both the capital expenditure and the income are visible to Ofgem through the regulatory account, but perhaps not in a clear enough manner to allow benchmarking against other similar projects once several DNOs were deploying storage. Relevant issues for consideration include: the availability of appropriate comparator cost data for storage deployment upon which to make an assessment, which is complicated by the number of storage options, the range of associated costs and their maturity; and how the assessment methodology will consider wider benefits of storage beyond those delivered to the DNO in order to reach a decision as to whether or not the investment is efficient and justified. To allow investment in storage to be feasible, an appropriate assessment methodology within the RIIO price control framework is needed. In the RIIO handbook 24, Ofgem indicates that the case made in business plans may also be strengthened where they have considered other potential delivery solutions, including operational solutions such as demand side management and alternative asset-based solutions. The reference to alternative asset-based solutions could include storage. But this needs confirmation as does the methodology for assessing storage investments. 5.4 Summary of issues for storage within regulatory framework The combination of unbundling requirements and licence restrictions in the interests of promoting competition in generation and supply places limits on the potential for network businesses to own and operate storage assets. The restrictions are especially stringent for TSOs. There may be scope for DNOs to own small scale assets which are exemptible from generation licence requirements, within the limits of the de-minimis restrictions. But operation of the assets in terms of wholesale market participation must be conducted via a licenced third party (which could potentially be another legally separate entity in the same umbrella organisation as the distribution business), given restrictions on trading activity by DNOs. Finally, to invest in storage assets as an alternative to conventional network assets, the regulatory assessment of efficient costs needs to handle storage appropriately. There are several issues within the legal and regulatory framework which affect the deployment and utilisation of storage within the GB market. These result from a combination of EU-wide and GB-specific rules. The key messages which arise from the regulatory review for deployment of storage assets on distribution networks, with the involvement of the DNO are as follows: 1. Default treatment of storage as a subset of generation creates uncertainty and raises potential issues. 2. But generation licence exemption route does provide flexibility to progress distribution connected storage projects of appropriate size in a manner consistent with unbundling requirements. 3. De minimis business restrictions do place a limit loose limit on deployment by DNOs, if storage continues to be classed as generation. 4. But, possible application and operation of assets is affected though by the need to ensure that competition in generation and supply is not distorted UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 36 of 72

37 DNO-led development of smaller scale storage projects is, therefore, possible within the regulatory framework. However, the need to ensure that distribution licence holders do not distort competition in generation and supply blocks the ability for operation of the assets by DNOs, necessitating the involvement of a third party to manage energy flows linked to the asset. The importance of the issues identified for DNO led development of distribution connected storage assets is summarised in Table 7. Table 7 Summary of issues linked to legislation and licensing Issue Implication Importance Default treatment as generation Neither the GB nor the EU regulatory frameworks for electricity explicitly recognise energy storage as an asset class or activity. In the absence of an alternative, the default position is that energy storage is treated as a subset of generation. However, the definition of generation is unclear and the inclusion of storage within its scope is questionable. High. Storage could be a separate licensed activity, which would provide clarity within a specifically developed set of arrangements. Alternatively, it could simply be made clear that storage is not a subset of generation, with storage potentially an unlicensed activity like demand side participation. Treatment of storage as generation is a pervasive issue which has a ripple effect on ownership and operation. Avoiding distortion of competition in generation and supply Unmetered operation and DNO management of energy flows could both distort competition High. May prevent DNO from buying/selling electricity to charge/discharge storage. This creates requirement for third party contracts to manage energy flows which complicates the business case. Unbundling requirements De-minimis restrictions DSOs are unable to own and operate storage assets that require a generation licence This blocks deployment of storage facilities by network operators as an alternative to conventional reinforcement or for network management De minimis restrictions place a cap on the permitted revenue from and the overall level of investment in storage assets Medium. The generation licence exemption route does provide an avenue for potential deployment of smaller scale energy storage assets by DNOs, with operational separation. Requires third party involvement. Low. The limit is relatively loose and estimates suggest that up to 15 projects equivalent to SNS could be deployed on some distribution networks Assessment of economic benefits under price control Unclear if assessment during price control process allows other benefits of storage used by DNO to be recognised in assessing economic merit when determining if investment justified/efficient Medium. RIIO-ED1 framework could expand assessment scope to capture all benefits/revenue streams (of appropriate projects given other regulatory requirements) to show positive overall economic case UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 37 of 72

38 5.5 Implications for SNS business models These regulatory issues have differing implications for the five business models discussed within the context of the SNS project. In general, these issues are of greater significance for the business models which entail DNO ownership and operation of the storage asset. This stems principally from the concern that DNO activity in storage projects could distort competition in generation and supply activities. A qualitative assessment of the implications of these issues for the business models is shown in Table 8. The importance of the issues themselves is not weighted, but the traffic light colour coding from Table 7 is shown to give an indication of weightings. For DNO Merchant and DSO business models, the role of the distribution business in the operation of the storage assets is a major factor. For these models, the requirements to avoid distortion of competition and to adhere to operational unbundling requirements are key issues. These issues have less importance in DNO Contracted and Contracted Services business models, as the distribution business takes a progressively reduced role in asset operation in these models. These issues could be addressed by providing distribution businesses with the ability to trade for balancing purposes (and so operate the storage asset in this context), in a manner similar to National Grid, with associated restrictions on speculative trading. For the Charging Incentives model, the identified issues are not important factors as storage ownership and operation fall to a 3 rd party, meaning that the tensions with unbundling and distribution licence requirements are not applicable. However, while regulatory issues are obviated, other challenges are apparent in this model. Notably, the DNO has reduced certainty that investment will actually proceed, which has important implications for system security. In addition, the challenge of making the business case work falls to the 3 rd party, which may not appropriately incorporate the benefit of the investment to the distribution business. Both factors mean that, while regulatory issues may be lessened, the Charging Incentives model (and to a lesser extent the Contracted Services model) entail greater commercial and system security risks. Table 8 Importance of regulatory issues for SNS business models Issue DNO merchant DSO DNO contracted Contracted services Charging incentives Default treatment as generation Distortion of competition Unbundling requirements De minimis restrictions Assessment of economic benefits Key: Low importance High importance UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 38 of 72

39 6 Market participation and service provision: how can storage realise value? The characteristics of electricity storage means that it can be utilised for a variety of applications, as outlined in Section 3. Multiple uses means multiple sources of potential value, which creates a multi-layered business case. Making a business case work across these layers can be complex. 6.1 Possible avenues for value realisation To re-cap on the messages from Section 3, electricity storage has a broad span of potential applications across the sector. The range of applications and, therefore, sources of potential value are summarised in Figure 15. In addition, storage can provide wider benefits to the system such as the displacement of carbon emitting generation and/or high operating cost plants. Figure 15 Range of possible applications across the value chain Generation Reduce imbalances as part of a portfolio Generate revenues through arbitrage Displace higher carbon generation capacity Network Optimise network reinforcement Contribute to quality of supply targets Ancillary services Contribute to ancillary services requirements Reduce the need for additional capacity Supply Wholesale hedging requirements Some value stems from market activities, such as participation within the wholesale market or provision of ancillary services to the transmission system operator. An additional possible revenue stream is being created through the introduction of a capacity market in GB. Other sources of value are linked to benefits from avoided network capex and displaced generation capacity. The stack of possible sources of value is illustrated in Figure 16. In reality, these sources of value can be difficult to access. A market-led project may expect to capture market-based value but benefits of avoided network capex are more difficult to realise. A DNO-led investment can more easily capture the avoided network capex benefit but faces barriers to realisation of market-oriented value. The ability for distribution connected storage to realise value via these routes is considered in the following subsections. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 39 of 72

40 Figure 16 Costs and benefits of an example storage facility 6.2 Wholesale market Overview of wholesale market The wholesale market, or the British Electricity Trading and Transmission Arrangements (BETTA), is illustrated in Figure 17 and can be summarised by the following elements: forwards and futures markets, that allow contracts for electricity to be struck up to several years ahead; short-term spot power exchanges, enabling participants to fine-tune their contracts up until Gate Closure (currently one hour before delivery); a Balancing Mechanism (BM), which opens at Gate Closure, in which National Grid as System Operator (SO) accepts offers and bids for electricity to enable it to balance the transmission system; and a settlement process for charging participants whose contracted positions do not match their metered volumes of electricity. Further details are provided in Annex C, with the sections below pulling out a number of important elements. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 40 of 72

41 Figure 17 Great Britain electricity trading arrangements under BETTA Sources: Ofgem and Pöyry Management Consulting Options for participation in wholesale market In principle parties seeking to trade wholesale power have various route-to-market options. These range from a pure merchant approach where various products are sold spot via their in-house trading desk, to long-term all-inclusive bilateral offtake agreements where an offtaker takes volume risk and defines at the outset of the contract pricing rules (including price-risk mitigation measures) for all products bundled together. Along this spectrum, there are numerous combinations entailing a higher (or lower) market commitment, hence a higher (or lower) risk for the generator and potentially higher (or lower) realisable value: Traditional Power Purchase Agreements (PPAs) with, typically, licensed electricity suppliers, are the most common approach for independent producers. They may take various forms and predominantly differ for the structure of the electricity pricing terms, e.g. fixed prices, floored and/or indexed. In each case the counterparty will expect to take a share of the total value to compensate it for transaction costs it incurs, any risks it is taking on under the contract and to provide a margin. Trading services approach involves outsourcing trading activities to an external entity that is active in the market and will interface with the market on behalf of the generator. This is the model envisaged under the SNS Contracted services business model. Trading on own account is predominantly used by larger players, including utilities, that can benefit from economies of scale and in-house trading expertise. The generator may incur additional balancing, trading and risk management costs under this strategy, but is generally able to retain a higher value. This is the model envisaged under the SNS DNO merchant and DSO business models. This range is graphically summarised in Figure 18. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 41 of 72

42 Figure 18 Spectrum of potential routes to market The trade-off between these options balances the overheads of direct market participation (e.g. trading functions, accession to industry codes, posting credit cover, etc.) versus the discount to the power price associated with outsourcing trading. If a DNO owns the storage asset, it will not be able to trade it directly given the block on DNO trading in today s regulatory arrangements mentioned previously, leaving either of the other two routes available. If the storage asset is owned by a market participant then all routes are open, with the choice linked to the circumstances of the individual Factors affecting inclusion in trading arrangements Trading Parties Under any route-to-market, the energy linked to a storage asset must feed into the settlement processes. Settlement arrangements are specified in the Balancing and Settlement Code (BSC) and any entity who wishes to physically trade power must be a Trading Party and hold energy accounts to manage their physical and contractual positions. Distribution licence holders are parties to the BSC. However, they are not Trading Parties and do not hold energy accounts. The BSC does not itself block distribution businesses from market participation. This stems, instead, from the licence requirement to avoid distortion of competition in generation and supply, as discussed in Section Balancing Mechanism Unit classification All trading parties have two energy accounts (production and consumption) into which feed the physical flows of Balancing Mechanism Units (BMUs) linked to the party. BMUs are the units of trade and settlement, used to account for physical flows at smallest aggregation of independently controllable apparatus. Most large generation units are an individual BMU, with small generators often aggregated within a supplier s BMU. The linkage between BM Units, production/consumption accounts and trading parties is summarised in Figure 19. On any given settlement day BM Units also need to be registered as either production or consumption units (P/C Status). This defines which Energy Account a given Unit s energy production/consumption feeds into on said settlement day (i.e. Production BM Units are linked with the Production Account and vice versa). UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 42 of 72

43 Figure 19 BM Units and Production/Consumption Accounts Contracted energy sale volume nominated to Production a/c Energy sale contract volume Trading party Production a/c Consumption a/c Metered volume Metered volume Contracted volume Contracted volume Contracted energy purchase volume nominated to Consumption a/c Energy purchase contract volume If Generation Capacity > Demand Capacity, BM Unit classed as Production Production BM Unit metered volume Consumption BM Unit metered volume If Generation Capacity < Demand Capacity, BM Unit classed as Consumption All metered volume from Production BM Units is credited to Production Account Credited Energy Volume BM Unit 4 BM Unit 3 BM Unit 2 BM Unit 1 BM Unit 5 BM Unit 6 BM Unit 7 BM Unit 8 All metered volume from Consumption BM Units is credited to Consumption Account Credited Energy Volume There are several types of BM Unit, each representing different aspects of the system: BM Units directly connected to the transmissions system (typically generation units); BM Units embedded in a distribution system; BM Units related to an interconnector; and BM Units covering supply. There is no specific category for storage and the existing definitions within the BSC would treat (at least some categories of) storage as a generating unit, as illustrated through the reproduced definitions in Table 9. Distribution connected storage would be treated as an embedded BM Unit. However, given that there will be energy flows into and out of a storage BMU, arrangements more analogous to those in place for interconnector BMUs may be a more appropriate reflection of the physical nature of a storage asset. The interconnector arrangements are summarised in the box below. Table 9 BMU definitions relevant for treatment of storage Term Definition Generating Unit means any Apparatus which produces electricity Apparatus means all equipment in which electrical conductors are used or supported or of which they form part UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 43 of 72

44 Interconnector BMUs under the BSC Given the two-way electricity flow from a storage device it can, to some degree, be likened to the dynamics of an interconnector. It is thus worth considering BSC arrangements for interconnectors and how this can potentially be applied to assist the future deployment of storage. Section K5 of the BSC sets out the following requirements for interconnectors: The metering system must allow for quantities of imports and exports to be measured separately. An Interconnector Administrator and an Interconnector Error Administrator must be appointed. An Interconnector BM unit is a notional BM unit. Upon being appointed, an Interconnector Administrator is automatically allocated two BM units (designated as a Production BM Unit and a Consumption BM unit). This is in contrast to other apparatus/collections of apparatus where a single BM Unit is assigned. In relation to Production Interconnector BM Units the value of demand capacity shall at all times be zero. In relation to a Consumption Interconnector BM Units the value of generation capacity shall at all times be zero Implications of trading arrangements for value of flexibility In addition to influencing participation in the wholesale market, the trading arrangements influence the value that storage assets may realise through the market. The imbalance settlement arrangements are a particularly important driver of value. The intention of electricity imbalance (or cashout) arrangements is to settle energy taken or produced without a contract. Further details are provided in Annex C.2.2. But the current calculation methodology serves to dampen cashout prices and so weaken the signals and incentives that they provide: The current main imbalance price is calculated on the basis of the weighted average of the 500 MWh most expensive energy trades needed to balance the system. This approach serves to dampen cashout prices, as the costs of more expensive balancing actions are muted through the averaging process. This creates a mismatch between the costs of balancing the system at the margin and imbalance exposure for parties who are out of balance. Therefore, the weighted average approach dampens cashout prices and the signals that they create for parties to balance their positions. The way in which the costs of STOR feed into cashout prices has a dampening effect on cashout prices. When exercised through the Balancing Mechanism, utilisation fees do feed directly into cashout price calculation as accepted offers. But the price levels are fixed in the tender process, well in advance of potential delivery, meaning that they cannot reflect the underlying supply/demand fundamentals and system tightness in real-time. In periods of tightness, Balancing Mechanism offers linked to STOR contracts are likely to displace other offers which are (a) not cross-subsidised by an availability payment and (b) likely to reflect increased scarcity value linked to system tightness. Utilisation fees for non-balancing Mechanism STOR are not reflected at all. Availability payments are included in cashout prices in periods of historic utilisation of STOR through a Buy Price Adjuster (BPA), which is an adder to the prices derived from other balancing actions. It is an imperfect proxy for when reserve is actually used and valued most. In extreme circumstances, the SO can instruct the Distribution Network Operators to reduce demand through voltage reduction (brownouts) or disconnection (blackouts) in order to balance the system. These balancing actions are not included in the calculation of cashout prices. As a result, cashout prices at periods of system stress are dampened as they do not reflect the costs of these balancing actions. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 44 of 72

45 Overcoming these weaknesses will sharpen cashout prices and the incentives for parties to balance. This will increase the value of flexible and reliable capacity, such as storage, which can help parties to balance their positions. This is recognised by Ofgem in its Electricity Balancing Significant Code Review (EBSCR), which has led to the development of a proposed package of reforms to the cashout arrangements outlined for consultation in July as follows: to make cash-out prices more marginal by reducing the volume of actions on which the cash-out price is based to 1MWh (a fully marginal cash-out price); to improve pricing of reserve by amending the price of STOR actions in the cash-out price calculation such that they are based on a Reserve Scarcity Pricing function; and to introduce a cost in the cash-out arrangements for voltage control (brown-outs) and disconnection (black-outs) emergency balancing actions. In addition, Ofgem is proposing the adoption of a single cashout price for all imbalances in a given settlement period, rather than the current dual price approach. Ofgem s analysis suggested that the proposed reforms would make cashout prices sharper and improve incentives for investments in flexible capacity. 6.3 Balancing services Overview of balancing services In the GB market, generators dispatch their plant to meet their contracted electricity sales. However, it is ultimately the responsibility of National Grid to ensure that generation and demand are balanced at all times and in all locations. In order to fulfil this duty, National Grid employs a range of tools. These tools (collectively known as Balancing or Ancillary Services) can be broadly broken down as follows: Frequency Response: the automatic provision of increased generation or demand reduction in response to a drop in system frequency. This can be further subdivided into Primary and Secondary response: o Primary response is defined as the sustained output from 10 seconds to 30 seconds following a loss of 0.8Hz. o Secondary response is defined as the sustained output from 30 seconds to 30 minutes for a loss of 0.5Hz. Reserve: the manual provision of increased generation or demand reduction over a period of minutes or hours in response to an instruction from National Grid; and System Security: the provision of generation or demand variation (i.e. increase or reduction as appropriate in the specific circumstances) in order to ease local transmission constraints or other system security issues. Figure 20 below provides an overview of balancing services provided by National Grid. Further details relating to STOR, fast reserve and frequency response are provided in Annex D. Importantly, a number of these services can be offered by non-bm Units, creating scope for participation by non-conventional source, potentially through an aggregator. 25 Electricity Balancing Significant Code Review Draft Policy Decision, Ofgem, July UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 45 of 72

46 Available to demand side non-bm Units? Minimum volume (MW) Response time (seconds/minutes) Provision perion (minutes) Availability payment? Holding/positional payment? Utilisation payment? Electricity storage in GB Figure 20 Categorisation of Balancing Services procured by National Grid Balancing Mechanism Frequency Response Mandatory FR Firm FR 10 <2sec n/a FCDM 3 <2sec >30 Commercial FR 3 <2sec n/a Reserve STOR 3 <240min >120min Warming / BM Start UP Fast start Fast Reserve 50 <2min >15min Demand Management System security Constraint management Intertrips dependent on circumstances dependent on circumstances dependent on circumstances Source: National Grid and Pöyry Management Consulting analysis National Grid, in accordance with its Procurement Principles, is required to procure Balancing Services in an economic and non-discriminatory manner. In order to do so, it defines a number of different services based on technical parameters such as speed of response to instruction, as well as speed, duration, repeatability, scale and reliability of provision of generation. It has discretion to procure a portfolio of these services in the mix it feels is both technically required and most economic. These services have tended to be linked to historical requirements and the different technical characteristics of generating technologies prevailing at that time. This historic perspective risks overlooking new system needs and the offerings of new technologies. However, there has been recent evolution of services (as discussed below) and the Procurement Principles allow provide flexibility for non-standardised services to be procured under bespoke contractual arrangements. An additional factor which warrants consideration in the context of balancing services provision is the associated carbon emissions. The utilisation prices for fossil fuel providers will include the carbon price (EU ETS and carbon prices support), but this does not reflect the overall cost of carbon. There may be scope, therefore, for a fuller account to be taken of the associated cost of carbon during assessment of balancing service tenders. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 46 of 72

47 6.3.2 Evolution of services There has been development of balancing services to open up potential for and to recognise the potential contribution of non-conventional providers, including storage: STOR is open to both BM participants (generally transmission connected generation from large power station sites) and non-bm participants (generally small transmission or distribution connected generation and demand). Non-BM providers are able to provide a flexible service, with scope for variation in terms of the number of hours for which they must be available and the timing of them, relative to the committed service provided by BM participants. This is beneficial to storage providers given potential discharge duration and recharging timescales. Also, providers under the minimum 3MW capacity requirement can be aggregated into a combined offering. The flexible service opens up the STOR market to a wider range of potential providers and enhances the ability for non-conventional sources of capacity, such as storage, to participate and realise value. More recently, NG has announced that it is considering introducing an aggregated fast reserve service from non- BM providers. The aggregated package must meet the standard minimum service provision (50MW delivered within 2 minutes). This trial opens up the potential for non-conventional providers, including storage, to offer fast reserve as part of an aggregated offering. NG has also proposed revisions to the firm frequency response service, including the introduction of a week-ahead tender time frame (intended to overcome longer-term forecasting limitations) and the introduction of aggregation. Both initiatives have the potential to enhance participation from non-conventional service providers. Ongoing evolution of the suite of balancing services is an important step in ensuring that appropriate services exist for the future system challenges and that the capabilities of non-conventional technologies are incorporated in an appropriate manner. 6.4 Capacity market Overview of proposed capacity market DECC has been progressing Electricity Market Reform (EMR) proposals for several years as a means to deliver its objectives of ensuring a secure electricity supply and sufficient investment in sustainable low-carbon technologies, while maximising benefits and minimising costs to taxpayers and consumers. The EMR package is summarised in Annex D. The key element of the package for ensuring a secure electricity supply is the proposed introduction of a Capacity Market. The aim of the Capacity Market is to deliver generation adequacy. It offers capacity providers a capacity payment revenue stream, in return for which they commit to deliver energy in periods of system stress or face exposure to penalties if they fail to deliver. Capacity contracts will be allocated to providers through auctions intended to secure a capacity requirement needed to meet a 3-hour loss of load expectation reliability standard. The Capacity Market is intended to be technology neutral across generation, storage and demand side providers (and, in time, interconnected capacity)and to allow new entrants and existing capacity to participate. The auction clearing price forms the basis of the capacity payment to successful auction participants. The first auction is expected to run in 2014 for delivery of capacity from 1 October 2018 to 30 September 2019, subject to State Aid clearance. In addition, auctions will be held one year ahead of delivery for demand side response (including embedded generation and smaller storage 26 ), with the first auction taking place in 2015, for delivery in 2016/17. Certain elements of the current design proposals influence the ability of storage to participate in the Capacity Market. The sections below are based on the capacity market proposals specified in October Precisely what is meant by smaller storage is unclear UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 47 of 72

48 6.4.2 Storage is eligible to participate either directly or indirectly As mentioned above, the intention is for storage to participate in the Capacity Market on an equal footing with other sources of capacity. Indeed, the auction to be held one year ahead of delivery is specifically intended for storage, alongside demand side participation, and it can also bid into the four year-ahead auction. The 2MW de-minimis size threshold may exclude some smaller capacity projects from direct participation, but involvement through aggregation with other capacity is possible. However, the capacity that storage can offer into the Capacity Market will be limited to the export capacity only. The impact of storage reducing imports during charging will not be factored into capacity agreements, meaning that capacity payments cannot be earned for the full swing capacity. Storage will, however, be entitled to over-delivery payments if it stops importing at a time of system stress Nature of capacity obligation appears prohibitive for many Parties who are successful in an auction are awarded a capacity contract. This entitles them to the capacity payment (based on the auction clearing price) while requiring them to deliver energy in line with the underlying capacity obligation in system stress periods. Failure to deliver will result in a penalty. System stress events are defined as any settlement periods in which either voltage control or controlled load shedding are experienced for a period of 15 minutes or longer. To allow market participants to manage the risk of exposure to penalties, the System Operator will issue a Capacity Market Warning (CMW) at least 4 hours ahead of an anticipated system stress event. This is intended to give capacity providers 4 hours in which to respond. Contracted providers not delivering in line with their obligations 4 hours following a CMW will be liable to financial penalties. If a stress event occurs unexpectedly without the provision of a CMW or before the 4 hour window has elapsed, no penalties will apply for the relevant periods. A key issue is that the period for which a CMW may apply, once issued, is undefined. The CMW can remain in place until either: the end of the day of issue in the event that a system stress event has not occurred on the day of CMW issue; or the end of the day on which the system stress event ends in the event that a system stress event has occurred on the day of CMW issue. Therefore, there is no defined time limit over which delivery must be maintained, making the obligation to deliver energy open-ended in nature. This is a problem for storage as discharge duration is limited. If fully discharged before the end of the period affected by a CMW, the storage device will face exposure to potentially substantial penalties equivalent to the volume of under-delivery multiplied by a price linked to Value of Lost Load (VoLL) (~ 17,000/MWh) up to a penalty cap of 100% of the annual capacity payment. This is a significant liability to take on which is likely to serve as a deterrent from participation for projects with shorter discharge durations. Penalty exposure could be mitigated by offering less than the full capacity into the market (i.e. self de-rating) which will allow a lower volume of delivery to be maintained for a longer duration. However, this undermines the true capacity that storage can offer and compromises the ability for storage to capture its true value. Another option for mitigating penalty risk in the event of an extended CMW period is to participate in secondary trading to buy delivery of your obligation from another provider. However, this is likely to be very costly given that the system is expected to be very tight and so available capacity to take on the obligation will be limited, if available at all. Reliance on secondary trading, certainly during the early years of the Capacity Market when the secondary market will be embryonic at best, is unlikely to offer a viable route for mitigating non-delivery risk. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 48 of 72

49 6.5 Levy Exempt Certificates Overview As part of a range of measures designed to help the UK meet its commitment to reduce greenhouse gas emissions, the UK Government introduced the Climate Change Levy (CCL) on commercial and industrial energy users in April CCL is an energy tax administered by HM Revenues & Customs (HMRC), under primary legislation introduced through the Finance Act It is levied on energy consumed by industrial and commercial users (but not domestic consumers). CCL rates are set annually in the Chancellor s Budget Statement. Electricity generated from renewable sources is exempt from CCL and most renewable technologies are eligible for LECs. Eligible renewable generators may claim a LEC for each MWh of renewable electricity, and a LEC serves as evidence that the associated electricity is exempt from CCL. The main exception is Hydro generation with a capacity greater than 10MW. Hydro aside, the CCL exemption is available to all technologies eligible for ROCs, plus renewable generation generated overseas (if consumed in the UK) and the biomass fraction of energy from waste generation. In order for a renewable generator to be issued with LECs: the electricity must be sold to a non-domestic end user in the UK either directly to the customer or indirectly via a licensed supplier; a paper trail must be in place to demonstrate that the quantity of LEC qualifying electricity supplied to final consumers matches that generated; and generation data must be submitted to Ofgem within two months of generation. Electricity suppliers can avoid paying CCL by purchasing a LEC from a renewable generator. The CCL exemption value is realised through the trading of Levy Exemption Certificates (LECs), although the certificates cannot be unbundled from, and have to be sold alongside, the electricity from which they were generated Relevance for storage The treatment of storage under the CCL is unclear. The Statutory Instrument 28 that defines the CCL framework defines renewable sources of energy as being sources of energy other than fossil fuel or nuclear fuel and includes waste provided that it is not waste with an energy content 90 per cent or more of which is derived from fossil fuel. This may give latitude for storage qualifying as a renewable source of energy, as it is not fossil fuel or nuclear. However, this then leads to another question. The SI states that the amount of a supply of renewable source electricity is to be calculated at the point at which such electricity is first delivered from a generating station to a distribution or transmission system within the United Kingdom (excluding territorial waters). This confirms that a LEC is allocated at the original point of generation. As export from storage relies first on import of existing generation output for which, if it was from a renewable source, a LEC has already been issued, issuing a LEC at the point of export from storage would be double counting. This could suggest that storage should not qualify for LECs. However, linking this back to the discussion in Section 5.1, in the absence of an explicit definition of storage the default position is that energy storage is treated as a subset of generation. If this holds in the context of the CCL, then it could be argued that export from a storage device could be considered as a point of origin for generation. This serves to highlight the lack of clarity regarding the treatment of storage under the CCL and so the ability or otherwise for storage to qualify for LECs. 28 The Climate Change Levy (General) Regulations UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 49 of 72

50 6.6 Issues linked to value realisation There are multiple sources of value for distribution connected storage, a number of which relate to participation in market activities. There are a number of aspects of the various market arrangements which affect the ability for distribution connected storage to realise value: Distribution connected storage can participate in the wholesale market, most likely through inclusion in a supplier s portfolio. However, there is scope for consideration of the treatment of storage within the BM Unit classification options and its treatment within the settlement. Additionally, the possibility of DNOs becoming trading parties needs consideration. There are opportunities for participation in balancing service provision, with evolution of the products enhancing this. But the underlying nature of service specifications and requirements remains influenced by historical technologies and capabilities and there is scope for further evolution. The opportunity for storage to realise value from the proposed capacity market appear limited given the openended nature of the obligation to deliver energy and the potential penalty exposure that this creates. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 50 of 72

51 7 Conclusions 7.1 Key observations Electricity storage projects are trying to find a way to work within a regulatory framework that was not really developed with storage in mind. The existing frameworks are a product of the main objectives for the sector at the time they were created, namely the progression of liberalisation and promotion of competition in the traditional activities within the sector. The arrangements have been effective in delivering these goals. But as the challenges facing the sector evolve and the potential role for storage in helping to manage the system increases, it is important to appraise whether the regulatory framework itself is presenting issues for increased deployment of storage. This review has identified that there are several issues within the legal and regulatory framework which affect the deployment and utilisation of distribution connected electricity storage within the GB market: 1. Default treatment of storage as a subset of generation creates uncertainty and raises potential issues. 2. But generation licence exemption route does provide flexibility to progress distribution connected storage projects of appropriate size in a manner consistent with unbundling requirements. 3. De minimis business restrictions do place a loose limit on deployment by DNOs, if storage continues to be classed as generation. 4. But, possible application and operation of assets is affected though by the need to ensure that competition in generation and supply is not distorted. These regulatory issues have differing implications for the five SNS business models. They are of greater significance for the business models which entail DNO ownership and operation of the storage asset. This stems principally from the concern that DNO activity in storage projects could distort competition in generation and supply activities. The qualitative assessment of the implications of these issues for the business models is shown in Table 10. DNO-led development of smaller scale storage projects is, therefore, possible within the regulatory framework. But, ensuring that such activity avoids distorting competition in generation and supply is a major factor which appears to block operation of the assets by DNOs under the current framework. Table 10 Importance of regulatory issues for SNS business models Issue DNO merchant DSO DNO contracted Contracted services Charging incentives Default treatment as generation Distortion of competition Unbundling requirements De minimis restrictions Assessment of economic benefits Key: Low importance High importance UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 51 of 72

52 7.2 Next steps The next phase of this work is to progress from issue identification to development of potential solutions. The issues that have been identified to date will form the starting point. Focus areas include options for: clarifying/modifying treatment of electricity storage within the framework, including classification and requirements for licences to operate; enabling DNO operation of electricity storage assets for balancing purposes in a transparent and non-distortionary manner, delivering consistency with unbundling requirements; considering the potential for GB DNOs to trade in a non-speculative manner under a model similar that that under which National Grid fulfils its system operator role; and including storage investments appropriately within price controls. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 52 of 72

53 Annex A EU and GB Legal framework overview A.1 European context A.1.1 Overarching Treaties The Treaty of Lisbon places energy at the heart of European activity. It effectively gives it a new legal basis which it lacked in the previous treaties. Article 194 of the Treaty on the Functioning of the European Union (TFEU) sets out the overarching objectives for EU energy policy. Objectives expressed in Article 194 are as follows: 1. ensure the functioning of the energy market; 2. ensure security of energy supply in the Union; 3. promote energy efficiency and energy saving and the development of new and renewable forms of energy; and 4. promote the interconnection of energy networks. The aims of the policy are supported by market-based tools (mainly taxes, subsidies and the CO 2 emissions trading scheme), by developing energy technologies (especially technologies for energy efficiency and renewable or lowcarbon energy) and by Community financial instruments. Furthermore, in December 2008 the EU adopted a series of measures with the objective of reducing the EU s contribution to global warming and guaranteeing energy supply. A.1.2 Liberalisation and internal energy market The development of a single European energy market began in 1996, with the establishment of Directive 96/92/EC 29, subsequently referred to as the first energy package. In pursuit of liberalisation and enhanced competition, Directive 96/92/EC required: accounting separation for different activities within vertically integrated entities; market opening in the supply sector; and non-discriminatory access to transmission and distribution systems. Directive 96/92/EC was followed in 2003 by the second energy package ; Directive 2003/54/EC 30. This strengthened and built upon the provisions of its predecessor with requirements for: legal separation for different activities within vertically integrated entities to ensure independence between distribution and transmission operators and any generation/supply companies; and third party access to networks based on non-discriminatory and cost-reflective tariffs. The second package has now been superseded by the third energy package, which is embodied within Directive 2009/72/EC 31, also known as the Electricity Directive, which pushes market integration further. It introduced requirements for: separation of transmission system operation from generation and supply activities through either ownership unbundling or transfer of system operation control to an independent system operator; Directive 96/92/EC of the European Parliament and of the Council of 19 December 1996 concerning common rules for the internal market in electricity Directive 2003/54/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in electricity and repealing Directive 96/92/EC. Directive 2009/72/EC of the European Parliament and of the Council of 13 July 2009 concerning common rules for the internal market in electricity and repealing Directive 2003/54/EC. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 53 of 72

54 non-discriminatory access for third parties to retail distribution networks in both electricity and gas sectors and to storage capacities in the case of gas; establishment of a single National Regulatory Authority independent from government and from any other public or private entity; establishment of the Agency for the Cooperation of Energy Regulators (ACER) with the aim of exercising at Community level the tasks performed by the Member States regulatory authorities (Regulation (EC) No 713/ ); and adequate social protection without distortions of the market s competitiveness. a framework for cross-border exchanges in electricity in order to alleviate barriers to competition in the internal market in electricity was laid down in Regulation (EC) No 714/2009. Figure 21 Overview of EU s third package legislation A.1.3 Security of supply EU security of supply policy is embodied in Directive 2005/89/EC 33 concerning measures to safeguard security of electricity supply and infrastructure investment. According to Directive 2005/89/EC, Member States must define general, transparent and non-discriminatory policies on security of electricity supply compatible with the requirements of a competitive single market for electricity, taking into account the need to: ensure continuity of electricity supplies; study the internal market and the possibilities for cross-border cooperation in relation to security of electricity supply; reduce the long-term effects of growth of electricity demand; introduce a degree of diversity in electricity generation in order to ensure a reasonable balance between different primary fuels; promote energy efficiency and the use of new technologies; and continuously renew transmission and distribution networks to maintain performance. They must define and publish the role and responsibilities of competent authorities and different players in the market. Transmission network operators are required to set minimum rules and obligations to ensure continuous operation of the transmission and, where appropriate, the distribution network under foreseeable circumstances Regulation (EC) No 713/2009 of the European Parliament and of the Council of 13 July 2009 establishing an Agency for the Cooperation of Energy Regulators Directive 2005/89/EC of the European Parliament and of the Council of 18 January 2006 concerning measures to safeguard security of electricity supply and infrastructure investment UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 54 of 72

55 In order to balance supply and demand, Member States need to: encourage the establishment of wholesale markets; require network operators to ensure that an appropriate level of generation reserve capacity is maintained; facilitate the development of new generation capacity; and promote energy conservation and technology for demand management in real time. In addition, a framework must be laid down for providing information to network operators which facilitates investment. Finally, Member States or competent authorities, in cooperation with transmission network operators, must prepare a report on security of supply, as provided for in the directive on the internal electricity market. A.1.4 Trans-European energy infrastructure Europe s energy infrastructure needs to be modernised and interconnected across borders, in order to support the EU s climate and renewable energy targets, as well as the core energy policy objectives of competitiveness, sustainability and security of supply. To ensure a timely development and the interoperability of trans-european energy networks, the Regulation on guidelines for trans-european energy infrastructure (Regulation (EU) 347/ ) was adopted on 21 March 2013 and entered into force on 1 June 2013, repealing Decision No 1364/2006/EC and amending Regulations (EC) No 713/2009, (EC) No 714/2009 and (EC). The Regulation defines 12 strategic trans-european energy infrastructure priorities the implementation of which by 2020 is vital for the achievement of the union s energy and climate policy objectives. These priorities cover different geographic regions and specific areas in the fields of electricity, gas and oil, such as electricity transmission and storage, gas transmission, storage and liquefied or compressed natural gas infrastructure, smart grids, electricity highways, carbon dioxide transport and oil infrastructure. Member states will propose Projects of Common Interest (so called PCIs) contributing to the development of the trans-european energy infrastructure priority corridors and areas. In order to achieve this goal the regulation provides criteria to identify such projects of common interest (i.e. cross-border projects or projects which benefit two or more Member States), which may be eligible for EU funding under the Connecting Europe Facility financing instrument. The regulation also provides for new, more transparent and accelerated procedures to grant permits for these projects, which should generally not exceed 3.5 years. In addition, it lays down rules on the possible cross-border allocation of construction costs for infrastructure projects of common interest. The Commission aimed at adopting a first EU-wide list of projects of common interest on the basis of regional lists by 30 September Subsequent lists are to be drawn up every two years. Six months after the adoption of the first list, the Commission will establish a publicly accessible infrastructure transparency platform containing information on projects of common interest and, no later than 2017, a report will be published on the implementation of these projects. 34 Regulation (EU) 347/2013 of the European Parliament and of the Council of 17 April 2013 on guidelines for trans-european energy infrastructure and repealing Decision No 1364/2006/EC and amending Regulations (EC) No 713/2009, (EC) No 714/2009 and (EC) No 715/ UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 55 of 72

56 A.1.5 Renewable Energy Directive 2009/28/EC 35 on the promotion of the use of energy from renewable sources (also known as the Renewables Directive ), establishes a common framework for the production and promotion of energy from renewable sources as part of the EU 2020 Climate & Energy Package. Each Member State has a target calculated according to the share of energy from renewable sources in its gross final consumption for This target is in line with the overall ' ' goal for the Community. Moreover, the share of energy from renewable sources in the transport sector must amount to at least 10 % of final energy consumption in the sector by Countries are to establish National Renewable Energy Action Plans (NREAPS) which set the share of renewable energy consumed for electricity and heating, as well as for transport for The national action plans also include the necessary procedures for reform in planning, pricing and network access to promote the development of renewable energy sources. A template for National Renewable Energy Action Plans under Directive 2009/28/EC was created with the Commission Decision 2009/548/EC 36 in June Cooperation between Member States for the achievement of the targets is provided for, as Member states can exchange an amount of renewable energy by agreeing on a statistical transfer. Therefore, surplus or deficit of renewable energy generation are exchanged between Member States by subtracting the corresponding amount from the statistical figures of the exporting member state and adding it to the official RES statistics of the importing member state. Each Member State must be able to guarantee the origin of electricity, heating and cooling produced from renewable energy sources. Transmission and distribution network access is a prerequisite for the development of renewable energy sources. Member States should therefore ensure that operators guarantee the transport and distribution of electricity from renewable sources and provide for priority access for this type of energy. A.1.6 EU Emissions Trading System The EU Emissions Trading System (ETS) was introduced with Directive 2003/87/EC 37 which came into force on 25 October 2003 and established a scheme for greenhouse gas emission allowance trading within the Community. The directive was subsequently amended in 2004 with the Linking Directive (2004/101/EC) 38 to enable Member States to allow operators to use credits obtained through Kyoto Mechanisms (CERs - Certified Emissions Reductions and ERUs - Emission Reduction Units). In 2008 it was amended again to include aviation starting from 2012 ( Aviation Directive 2008/101/EC 39). The latest amendment in the EU ETS legislation came in April 2009, Directive 2009/29/EC 40 (Phase Directive 2009/28/EC of the European Parliament and of the Council of 23 April 2009 on the promotion of the use of energy from renewable sources and amending and subsequently repealing Directives 2001/77/EC and 2003/30/EC bl=6&pgs=10&hwords= Commission Decision 2009/548/EC of 30 June 2009 establishing a template for National Renewable Energy Action Plans under Directive 2009/28/EC of the European Parliament and of the Council Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC Directive 2004/101/EC of the European Parliament and of the Council of 27 October 2004 amending Directive 2003/87/EC establishing a scheme for greenhouse gas emission allowance trading within the Community, in respect of the Kyoto Protocol's project mechanisms Directive 2008/101/EC of the European Parliament and of the Council of 19 November 2008 amending Directive 2003/87/EC so as to include aviation activities in the scheme for greenhouse gas emission allowance trading within the Community UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 56 of 72

57 III) to improve and extend the trading scheme. The revised EU ETS Directive formed part of the EU 2020 Climate & Energy Package agreed in December A.1.7 Energy Efficiency In March 2011 the EC adopted the Communication Energy Efficiency Plan , proposing a set of concrete measures to create energy efficiency benefits. Following this communication, the EU published the Energy Efficiency Directive (2012/27/EU 42 ) in The directive s aim is to create an effective common framework of measures to promote energy efficiency within the EU in order to achieve the target of 20% reduction in energy consumption by 2020 and to lay the foundations for further improvement in this area beyond Member States are required to increase their energy efficiency efforts across the entire energy chain, from generation to distribution and final consumption. The directive is expected to help in overcoming current impediments and addressing market failures related to energy efficiency, providing for the establishment of indicative national energy efficiency targets for EU s 2020 energy efficiency consumption target was legally defined and quantified at 1,483Mtoe of primary energy or no more than 1,086Mtoe of final energy (revised after the accession of Croatia). Member states were obliged to set an indicative national energy efficiency target for 2020 by Moreover each country has the obligation to achieve certain amount of final energy savings over the obligation period (01 January December 2020) by using energy efficiency obligations schemes or other targeted policy measures to drive energy efficiency improvements in households, industries and transport sectors. A.2 GB context A.2.1 Liberalisation and internal energy market A Liberalisation The GB market is the oldest liberalised electricity market in the EU, with the first steps taken in the Electricity Act of 1989, and privatisation and the formation of the Electricity Pool in Since then, both primary and secondary regulation has shaped and developed the market, including the introduction of NETA in NETA created a wholesale market open to all generation and demand through bilateral Over the Counter trades and power exchanges. The Energy Act 2004 provided powers in relation to the introduction of a new system of electricity transmission access and settlement across England, Wales and Scotland (BETTA) which came into effect in April The Electricity Act 1989 provided for the privatisation of the electricity supply industry in Great Britain and the establishment of a licensing regime and an industry regulator, the Office of Electricity Regulation (OFFER). The Utilities Act 2000 reformed the regulatory regime for electricity and downstream gas in Great Britain. In particular, it formalised the merger of OFFER and Ofgas into a combined regulator, Ofgem, and amended the statutory duties of the regulator. Subsequent legislation has reinforced the powers of Ofgem, most notably with the Energy Act 2010, which enhanced the powers of the regulator to deal with exploitation of electricity distribution constraints by generators and also increased its power to fine companies. In the same Act Ofgem s objectives on tackling climate change were clarified, ensuring secure energy supplies and the role of measures other than competition in protecting the interests of consumers Directive 2009/29/EC of the European Parliament and of the Council of 23 April 2009 amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community Communication Energy Efficiency Plan 2011 [COM/2011/0109] Directive 2012/27/EU of the European Parliament and of the Council of 25 October 2012 on energy efficiency, amending Directives 2009/125/EC and 2010/30/EU and repealing Directives 2004/8/EC and 2006/32/EC UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 57 of 72

58 A Internal energy market The Electricity Directive (2009/72/EC) and the Gas Directive (2009/73/EC) have been fully implemented in Great Britain through the Electricity and Gas (Internal Markets) Regulations The regulations designate Ofgem as the National Regulatory Authority (NRA) for Great Britain, enhance the level of information available to consumers, reduce switching time between suppliers, change the license modification process and create a new appeal procedure. Greater regulation is introduced for those exempt from the requirements to hold a distribution or supply license. Other changes made include the full ownership unbundling, the Independent System Operator (ISO) model and the unbundling derogation for arrangements providing greater independence than the Independent Transmission Operator (ITO) model available in the electricity and gas markets. A.2.2 Renewable energy The Renewables Obligation (RO) is currently the main support scheme for large scale renewable electricity in the UK. It is a green certificate scheme providing support on top of any revenues gained from the sale of wholesale electricity. It has been in existence since April 2002 and lasts until 31 March Since its introduction it has been adapted significantly with a movement to technology differentiated support through banding, and a movement to more stable certificate prices through the introduction of the headroom mechanism. There are three RO schemes operating in the UK, the England and Wales Renewables Obligation (RO), the Renewables Obligation Scotland (ROS) and the Northern Ireland Renewables Obligation (NIRO). The schemes generally work as a single unit, with the green certificates known as Renewables Obligation Certificates (ROCs) interchangeable between them. The Department for Energy and Climate Change (DECC), alongside the Scottish Executive (SE) and Department for Enterprise, Trade and Industry Northern Ireland (DETINI), is responsible for setting the rules of the scheme including the Obligations on suppliers. The primary legislation, setting out the high level objectives of the scheme is in the Energy Act 2008 which amends the Electricity Act The secondary legislation, with the detailed rules of the scheme, is the Renewables Obligation Order 2009 (as amended in 2010 and 2011) 43. Ofgem is responsible for the administration of all three schemes including accrediting generating stations, issuing ROCs and ensuring suppliers comply with their Obligations. It has published a guidance document for generators which sets out its administrative procedures for the implementation of the RO 44. More information on the operation of the RO is provided in Ofgem s annual reports. These include details of generating stations accredited, ROCs issued, supplier s Obligations and supplier s compliance with their Obligations. As part of the Energy Act 2013, a new support mechanism for renewable generation has been introduced. The Feedin Tariff with Contracts for Difference (FiT CfD) will initially operate alongside the Renewables Obligation, subsequently replacing the RO once this closes to new generation in Figure 22 shows the timeline of the transition to the Feed-in Tariff with Contracts for Difference scheme Statutory Instrument 2009 no.785; Statutory Instrument 2010 no.1107 and Statutory Instrument 2011 no.984. Renewables Obligation: Guidance for Generators Ofgem, May UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 58 of 72

59 Figure 22 Commissioning date will determine eligibility for support scheme The Feed-in Tariff will operate as a Contract for Difference around the wholesale electricity price, where the low carbon generator receives revenue from the wholesale market for its output and either receives or makes a payment based on the difference between a reference market price index and the strike price (tariff) agreed in its contract. Payments will be made on metered output, with payments to a generator capped at their respective strike price to avoid increasingly negative prices. A.2.3 Climate change The UK is the first country to introduce a long-term legally-binding framework nationally to tackle the dangers of climate change, through the Climate Change Act The Act provided the UK with a legal framework, including a long-term target for emissions in 2050, 5-year carbon budgets on track to that target, and the development of a climate change adaptation plan. The Climate Change Act 2008 also established the Committee on Climate Change (CCC), an independent, statutory public body, tasked with assessing how the UK can best achieve its emissions reduction targets for 2020 and 2050 and the progress that is being made toward meeting statutory carbon targets. The Committee on Climate Change is required to advise the Government on the levels of carbon budgets to be set, the balance between domestic emissions reductions and the use of carbon credits, and whether the 2050 target should be increased. The CCC is also required to publish annual progress reports. The Greenhouse Gas Emissions Trading Scheme Regulations 2003 transposed the EU ETS into UK law and were subsequently amended and replaced by the Greenhouse Gas Emissions Trading Scheme Regulations Phase III of the EU ETS, which runs from 2013 to 2020, started in January Phase III has seen the introduction of a number of measures aiming to broaden and strengthen the environmental ambitions of the scheme, as set out in the revised EU ETS Directive (2009/29/EC). The Greenhouse Gas Emissions Trading Scheme Regulations 2012 (the 2012 Regulations) implemented these measures in the UK by fully transposing the revised EU ETS Directive into domestic law. These Regulations also consolidated and replaced previous EU ETS legislation. The Climate Change Act 2008 provided the government with powers to establish additional domestic trading scheme by means of secondary legislation. Under these powers, the Carbon Reduction Commitment Energy Efficiency Scheme Order 2010 requires large public and private sector organisations outside the EU ETS which consume electricity above a certain threshold to purchase a new form of allowance. The introductory phase of the scheme runs from April 2010 to April 2014, when Phase 2 will begin. A.2.4 Energy efficiency The Energy Act 2009 introduced the Green Deal, the government s flagship policy to improve energy efficiency in British domestic and non-domestic buildings. The Green Deal provides a finance mechanism for installing energy efficient upgrades, giving households and businesses the opportunity to borrow up to 10,000 and repay the loans over 25 years via energy bills. The aim of the policy is to remove the upfront cost of installing energy efficiency improvements, which renders the installation decision unattractive for most households, since related energy savings occur over the course of several years. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 59 of 72

60 The Energy Company Obligation (ECO) was another measure introduced with the Energy Act 2009 to complement the Green Deal and alleviate fuel poverty by providing low income and vulnerable households with subsidies to install insulation and heating measures. The ECO replaced the Carbon Emissions Reduction Target (CERT) and Community Savings Programme (CESP) which ended in 31 December UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 60 of 72

61 Annex B Generation requirements B.1 Introduction Requirements and obligations for generators depend upon a number of characteristics. These include: whether the generator is classed as licence exempt; the size of the generator; and the treatment of the generator under the Connection and Use of System Code (CUSC) and the type of bilateral connection agreement that the generator may have to sign with National Grid. B.2 Licensed versus licence-exempt In general, a power station requires a licence in order to generate electricity for purposes of supplying consumers 45. Exemptions from this requirement can be granted to classes of generators or to particular generators in specific circumstances 46. The circumstances in which class exemptions apply are as follows: Exemptible as offshore generator: if the power station is situated on an offshore installation; and the power station only supplies electricity to offshore installations. Exemptible as small generator: if output to the total system (GB transmission system and all distribution systems) is less than 10MW; or if output to the total system is less than 50MW and the declared net capacity of the power station is less than 100MW. Exemptible as generator not exceeding 100MW: if the power station was connected to the total system on (or before) 30 September 2000; and output to the total system is less than 100MW. Exemptible as never subject to central dispatch: if the power station was connected to the total system on (or before) 30 September 2000; and the power station has never been subject to central dispatch. Additionally, power stations which do not fall into any of the exemption classes listed above may apply to DECC to seek an individual exemption. Power stations capable of exporting between 50MW and 100MW to the total system that connected after 30 September 2000 are generally granted exemption via this route. If the power station is capable of providing 100MW or more to the total system, it must be licensed (unless never subjected to central dispatch, as above). B.3 Size categorisations The Grid Code specifies three categories of power station size which vary according to geographic location of connection: Large: o o >100MW in England and Wales; >30MW in South Scotland (Scottish Power s transmission area); or Section 4 of the Electricity Act (1989). Class exemptions are specified in The Electricity (Class Exemptions from the Requirement for a Licence) Order UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 61 of 72

62 o Medium: o o Small: o o o >10MW in North Scotland (Scottish Hydro-Electric s transmission area). 50MW to 100MW in England and Wales; and N/A in Scotland. <50MW in England and Wales; <30MW in South Scotland (Scottish Power s transmission area); or <10MW in North Scotland (Scottish Hydro-Electric s transmission area). Within these size categorisations, National Grid refers to licence-exempt embedded generators as: Embedded Exemptible Large Power Stations (EELPS); Embedded Exemptible Medium Power Stations (EEMPS); and Embedded Exemptible Small Power Stations (EESPS). The treatment of power stations under the CUSC differs depending upon its licence status, size categorisation and point of connection, as discussed below. B.4 CUSC and Bilateral Agreements After accession to the CUSC, the following generators must enter into some form of Bilateral Agreement with National Grid, as follows: transmission connected generators (licensed and licence-exempt alike) must enter into a Bilateral Connection Agreement (BCA) with National Grid; embedded, licensed generators are required to enter into a Bilateral Embedded Generation Agreement (BEGA); and EELPS can choose to sign a BEGA or a Bilateral Embedded Licence exemptible Large power station Agreement (BELLA) with National Grid. EEMPS and EESPS are not normally required to enter into a Bilateral Agreement with National Grid. However, if they do choose to enter directly into a Bilateral Agreement with National Grid (rather than allocating their output to another party) they must enter into a BEGA. Table 11 summarises the high-level implications attached to the different Bilateral Agreements. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 62 of 72

63 Table 11 Implications of different Bilateral Agreements Implications BCA BEGA BELLA Grid Code Requires full compliance with the GB Grid Code Requires full compliance with the GB Grid Code (subject to any approved derogations) Requires partial compliance with the Grid Code Use of system Confers financially-firm transmission access rights and so requires payment for use of the GB transmission system charges (TNUoS and BSUoS) for licensable generation Does not confer financially-firm transmission access rights or liability for generator charges (TNUoS and BSUoS) Connection Requires payment for connection to the GB transmission system Does not require connection to the GB transmission system and so does not require payment for connection to the GB transmission system UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 63 of 72

64 Annex C Wholesale market C.1 Overview of BETTA arrangements This section provides further information on the British Electricity Trading and Transmission Arrangements (BETTA), which commenced operation in 2005 in England, Wales and Scotland (extending the NETA arrangements that were intrtoduced in England and Wales in 2001). Figure 23 presents an overview of the current electricity trading and balancing arrangements in GB. BETTA can be summarised by the following five elements: forwards and futures markets, that allow contracts for electricity to be struck up to several years ahead; short-term spot power exchanges, enabling participants to fine-tune their contracts up until Gate Closure (currently one hour before delivery); a common scheme for transmission access and charging; a Balancing Mechanism (BM), which opens at Gate Closure, in which National Grid as System Operator (SO) accepts offers and bids for electricity to enable it to balance the transmission system; and a settlement process for charging participants whose contracted positions do not match their metered volumes of electricity. Figure 23 Great Britain electricity trading arrangements under BETTA Sources: Ofgem and Pöyry Management Consulting. UK Power Networks (Operations) Limited. Registered in England and Wales. Registered No Registered Office: Newington House, 237 Southwark Bridge Road, London, SE1 6NP Page 64 of 72