Ofgem considering restrictions on Balancing Mechanism prices

Ofgem has revealed it is considering introducing restrictions on Balancing Mechanism offer prices following a sharp rise in balancing costs over the past winter.

In an open letter to industry, the regulator listed this as one of a number of potential short-terms interventions to address concerns over “immoderate” behaviour by market participants.

According to the letter, total balancing costs during the winter season – November to February – averaged less than £500 million per year between 2017 and 2020 but “rose alarmingly” to more than £1.5 billion for the winter of 2021.

Ofgem said the large increase in costs was primarily driven by increased offer prices rather the volumes. It said this was partly because energy markets and the geo-political landscape were “volatile and uncertain,” resulting in periods of tight margins and high fuel and emissions costs.

However, the regulator said the frequency of extremely high prices, combined with inflexibilities in participants’ offers, “raised questions” as to whether their behaviour was a “reflective response to scarcity.”

After seeing a record-high daily bill of over £60 million on 24 November, National Grid Electricity System Operator (ESO) commissioned an independent review of Balancing Mechanism costs by LCP, Frontier Economics and Cornwall Insight.

Summarising the findings of the review, which was published on Friday (15 July), the ESO said in its own accompanying report that it “did not find any specific evidence” of participants breaching market rules.

But the ESO said the review did identify several important phenomena, the first being some coal plants had been offering all of their capacity in the Balancing Mechanism at a price of around £4,000/MWh: “This change in operating characteristics to no longer sell capacity in forward markets and only engage through the balancing market contrasts with previous years and was consistently observed across all periods, not just on the high-cost days.”

The behaviour of combined-cycle gas turbine (CGGT) generators also changed after coal warming up instructions and tight margins indicated that offers would be accepted at such high prices.

The ESO said this problem was exacerbated by the inflexibility of these generators as their long lead times to ramp up and down meant “expensive” offers had to be accepted over multiple hours in order to meet the evening peak in electricity demand.

In the case of coal plants, offers had to be accepted for their full minimum non-zero time of typically around 6 hours, whilst in the case of CGGTs, their minimum zero time of around 6 hours meant offers had to be accepted earlier in the day to delay their planned desynchronisation in the afternoon.

“Price changes were typically set at very high levels for the full duration of the extended run required to keep the generators available,” the ESO explained. “This is in contrast to what can be seen in the day-ahead and intraday markets where scarcity pricing was observed, but only for short periods as these markets do not explicitly account for technical inflexibilities.”

In its open letter, Ofgem said it carried its own investigative work in parallel with the ESO’s review and that to date is has found “no conclusive evidence” of market participants acting outside their obligations. “However,” the regulator added, “we remain concerned that evidence showed behaviours of some generators that appear to be immoderate.”

“Evidence such as generators submitting persistently high prices, inflexible and expensive offers, and intentionally exacerbating tight margins by scheduling to desynchronise their units with little notice just ahead of peak demand periods, shows that there is room within the existing market arrangements for changes that better ensure energy markets deliver in consumers’ interests,” it said.

The letter, which was published ahead of the launch of the government’s consultation on its Review of Electricity Market Arrangements (REMA) on Monday, said Ofgem is considering a range of short-term interventions to protect consumers over the next few years ahead of any longer-term market reforms.

It said these options include:

• Direct measures to restrict offer prices, either through an explicit price cap or an extension of the existing transmission constraint licence conditions, which prohibits parties from submitting excessive bid prices when they hold market power behind a network constraint
• Limiting generators’ ability to amend their schedules at short notice, for example, by requiring generators to submit and keep to their day-ahead schedules and only allowing amendments based on open, transparent intraday trading
• Restricting access to bidding flexibilities for generation capacity that is withdrawn at short notice
• Changing the rules for how parties structure their offers, with specific options including increasing the complexity of pricing structures to better reflect underlying costs or removing dynamic parameters so market participants internalise their own technical characteristics into their trading strategies
• Introducing new licence obligations that require generators to behave in a way that maintain consumers’ interests, for example, by prohibiting actions that knowingly exacerbate tight system conditions

Ofgem said it will share its proposals for intervention in “due course”. The regulator said it will continue to monitor balancing markets in the meantime and will not hesitate to take enforcement action if it finds conclusive evidence of market participants acting outside of their obligations.