New licence condition proposed to reduce balancing costs

Ofgem has proposed a new licence condition for generators as its preferred option to reduce balancing costs following the record-high prices seen in the Balancing Mechanism last winter.

The licence condition would prohibit generators from gaining “excessive benefit” after submitting a zero-megawatt physical notification to National Grid Electricity System Operator (ESO).

The proposal comes in response to a sharp increase in balancing costs last winter (November 2021 to February 2022), which rose to more than £1.5 billion, compared to an average of just under £500 million over the previous four winters.

Ofgem said this increase was primarily driven by higher offer prices, rather than greater volumes, as geopolitical developments led to uncertainty and volatility in energy markets, with periods of tight margins and high fuel and emissions costs.

The ESO subsequently commissioned an independent review of balancing costs, whilst Ofgem carried out its own investigate work in parallel. Neither of these processes found clear evidence of participants breaching market rules, however they did identify instances of what Ofgem described in an open letter in July as “immoderate behaviour”.

These included instances of generators initially signalling their intention to generate during a settlement period but later reducing their physical notification to zero to signal their intent to cease generating, sometimes only minutes before gate closure.

Once it ceases to generate, a unit must remain at zero output for a set period known as its ‘minimum zero time’ reflecting its pre-determined technical capability. Gas generators typically have a minimum zero time of six hours.

Ofgem said there were cases last winter when gas generators informed the ESO with little notice that they would cease generating in the afternoon, meaning they would be unavailable during the evening peak in demand.

The ESO can prevent this from happening by accepting the generator’s offers in the Balancing Mechanism. The regulator said in some of these instances generators also significantly increased the price of their offers to continue generating in the afternoon.

In its open letter in July, Ofgem set out a broad range of potential interventions to prevent this behaviour in future. It subsequently narrowed this down to a shortlist of six, which were presented to an industry roundtable in early October. It now outlined the potential options in a call for input, whilst also identifying its preferred option.

Summarising the issue, the regulator said: “In isolation, occasional high offer prices may be necessary to allow companies to respond to scarcity signals in a way that recovers their investment costs. These price signals have an important role to play in orchestrating supply to meet demand and may also incentivise investors to bring forward additional generation when there is scarcity of capacity.

“However, when high offer prices were combined with a reduction of physical notifications to zero, lengthy minimum zero times and limited spare generation capacity available to meet peak demand, the ESO often had limited options available and incurred much higher costs than anticipated to maintain system security.”

Option one – Price cap on Balancing Mechanism offer prices

Ofgem said this could either take the form of an explicit cap on all offers in the Balancing Mechanism or a cap on a unit’s offer prices for specific settlement periods after submitting zero-megawatt physical notifications.

The regulator said both of these variants would directly target the behaviours in question, whilst giving certainty to markets participants about the prices that would be acceptable. It said respondents at the roundtable were not against this option but had concerns over how they would be designed and how adaptable they would be to market conditions.

Ofgem said a lot of work would be needed to ensure the cap is set at the right level to prevent the undesired behaviour without excessively dampening price signals and competition. It said any cap would inevitably dampen price signals and competition to some extent, which could impact both security of supply and investment.

Option two – Changes to bid/offer structures

Ofgem said the structure of bids and offers could be either be made more complex, for example with variable prices depending on units’ state or output; or simplified, for instance by removing information on units’ technical capabilities – known as dynamic parameters – from the ESO’s decision making so the implications would need to be internalised into their bids or offers.

The regulator said this option may reduce balancing costs and have a positive effect on price signals but would not directly target the undesired behaviour, whilst also making the ESO’s decisions more complicated or less transparent.

Respondents at the roundtable also raised concerns about the ease of implementation, noting that it may not be compatible with the ESO’s current IT systems and therefore take several years to implement.

Option 3 – A new balancing service to procure firm reserve

This option would allow the ESO to “lock in” reserve capacity in advance, preventing participating generators from reducing their physical notifications to zero. Ofgem said this could reduce balancing costs but these savings would be offset by the costs of the service itself, which would need to be sufficiently valuable to attract participants and could be seen as rewarding the behaviour it seeks to prevent.

Respondents at the roundtable welcomed this idea, but said its success would depend on how well the service was designed, including how it interacted with other services.

Option four – A new licence condition preventing excessive benefit after submitting a zero-megawatt physical notification

Ofgem said this would be targeted at situations in which physical notifications are reduced to zero with little advance warning. If it suspected that a market participant was seeking to gain “excessive benefit” after doing this, they would be asked to justify their offer prices.

The regulator said this measure would directly target the undesired behaviour without dampening price signals or unduly disrupting existing trading arrangements and would be more flexible to changing market conditions than a price cap.

Although some roundtable respondents considered this a straightforward intervention, there were also questions about how market participants would be given sufficient clarity about how the new licence condition would be applied, and in particular, how “excessive benefit” would be defined.

Option five – Restrictions on amending physical notifications close to real time

Under this option, physical notifications would be considered final at earlier point in time rather that at gate closure. Some changes could be made after this point but only for a limited set of justified reasons such as unplanned outages.

Ofgem said this would prevent the undesired behaviour without impeding price signals but would represent a significant departure from the current self-dispatch market arrangements. The regulator said it could also create unintended barriers for intermittent renewable generators which have greater difficulty in forecasting their output in advance.

Roundtable respondents also considered this overly interventionist and said it could stymie intraday flexibility.

Option six – Clarifying ‘good industry practice’ in the Grid Code

Ofgem said this could include stating explicitly that it is not good industry practice to reduce physical notification to zero when system margins are tight and when healthy revenues are likely available in wholesale markets.

Roundtable respondents welcomed the proposal to clarify definitions and said it would be easy to implement but said the success of the measure would depend significantly on the clarity of Ofgem’s expectations.

Preferred option

Ofgem judged the options against four criteria – balancing costs reduction, compatibility with the existing market design, impact on price signals and ease of implementation – and on this basis selected number four as its preferred option. The regulator rated this option as positive on the first three criteria and said it would be also reasonably easy to implement.

If it decides to proceed with this option, Ofgem said it will publish guidance on what it considers “excessive benefit,” which will cover factors such as overall system tightness; whether prices have changed significantly after a physical notification has been reduced to zero; whether the physical notification has significant affected system margin; and to what extent the offer price is in line with other prices in similar periods of scarcity.

The deadline for responses to the consultation is 5 December 2022.