Ofgem outlines potential options for net zero reforms

Ofgem has set out a range of potential reforms to reduce Britain’s reliance on expensive imported gas and accelerate the decarbonisation of the energy system.

In a new discussion paper, Ofgem said the current market, regulatory and institutional arrangements are not geared up to run a net zero energy system in the most cost-effective way and predicted the changes outlined in the document could save consumers up to £10 billion per year by 2050.

“Record gas prices are driving the cost-of-living crisis, causing real harm to customers and the wider economy,” said regulator’s chief executive Jonathan Brearley.

“As well as doing everything we can to protect customers now, we must diversify Britain’s energy supplies away from gas as soon as possible.”

He continued: “Recent months have demonstrated that the arguments for boosting our energy security and building a home-grown supply have never been stronger. The economics of energy have fundamentally changed with green energy no longer a desirable but costly alternative, instead, it is now the secure, more reliable, and cheaper option.”

Strategic planning and coordination

Ofgem stressed that creating a net zero energy system would require hundreds of billions of investment in new infrastructure in the coming decades at a scale and pace that cannot be delivered by free markets alone.

The regulator said high levels of uncertainty, long lead times, natural monopolies, new and emerging technology, and dependencies between different types of assets will mean a mixed approach is required, combining strategic planning and coordination with competition and markets to keep costs down.

“Greater strategic planning – across electricity, gas and emerging energy assets such as heat networks, at national and local levels – will help to ensure that major infrastructure assets are built in the right places at the right time,” Ofgem explained.

“A key planning challenge is to determine the optimal balance between network capacity and greater use of flexibility, specifically, how much expensive new infrastructure is needed to take power generated from key areas of renewable generation to the areas of greatest demand.”

As announced in April, the regulator is therefore working with the government to establish a new independent Future System Operator (FSO) that will be tasked with leading the strategic national planning of electricity and gas networks; advising governments and Ofgem on the planning of generation, heat and transport; and facilitating competition to deliver new infrastructure.

Ofgem said the FSO’s advisory role could include presenting the implications of different generation mixes on the power grid; calculating the optimal quantity, location and type of generation to meet systems needs at the lowest cost; or outlining options for the decarbonisation of heat and potential decommissioning of network assets.

Alongside the paper, Ofgem also released a consultation on its minded-to decision as part of its Electricity Transmission Network Planning Review for the FSO to act as a central network planner, leading the delivery of a Centralised Strategic Network Plan.

The regulator said the delivery of an overarching plan for the transmission network every two to three years would enable the coordination of investments, including offshore transmission and interconnectors, and provide clear and timely signals to ensure network capacity is ready when it is needed.

It would also enable the co-optimisation of the transmission network with the wider energy system, for example, providing signals to energy storage, electrolysers or sources of demand to connect in particular locations to avoid the need for network reinforcement.

Ofgem said it would additionally enable the FSO to consider innovative, time-limited and non-network alternatives to reinforcement.

The publication of the discussion paper and consultation comes shortly after National Grid Electricity System Operator (ESO) released its Holistic Network Design, which identified the need for nearly £54 billion of transmission network investment to achieve the government’s target of deploying 50GW of offshore wind generation by 2030. This comprises £21.7 billion of onshore infrastructure and £32 million of offshore infrastructure.

Ofgem’s discussion paper said the FSO, which is set to be established by or in 2024 could also take on roles in distribution-level system planning and markets, data, heat, transport, hydrogen and carbon capture and storage (CCS).

The regulator said there is likewise a need for reforms at the sub-national level, noting its call for input in April on the future of local energy institutions and governance. The call for input presented four main models, ranging from internal separation of distribution system operation (DSO) functions within distribution network operators (DNOs) to the creation of regional system operators with democratic oversight.

Ofgem said these institutions must be properly equipped to plan the strategic development of local energy networks, facilitate the use of flexibility to defer or avoid network investment and send signals to optimise the use of distribution networks and other assets. It also highlighted the need for greater coordination both across vectors, including transport, gas and heat, and between transmission and distribution.

Optimising the energy system and wholesale market reform

Ofgem identified two key issues in this area, the first being that of marginal pricing in the wholesale electricity market. It said even if only small amount is needed to balance the electricity system, marginal gas generation sets the price for the whole market, potentially leading to higher than necessary costs for consumers.

The regulator said one way to fix this problem would be to split the wholesale market into two: one for intermittent or low-carbon generation such wind and solar that would be paid a fixed price per unit based on average costs; and the other for firm power that would be paid at market price, as is currently the case.

However, Ofgem said this would represent a major reform of the energy market and would take time to implement. It said a faster and simpler alternative to deliver much of the benefits of a split market would be to expand the use of Contracts for Difference, which already pay generators a fixed price for electricity but currently only cover roughly one tenth of generation.

The second issue identified by Ofgem is the need for more granular market signals. It said one solution would be to split the wholesale market into “nodes” or “zones”, allowing prices to different by location. Both options were explored by the ESO in a recent report, which identified nodal pricing as its preferred option.

As with a split of the wholesale market between firm and intermittent power, Ofgem said the introduction of locational marginal pricing would be a major reform that would take time to develop and implement.

It said alternative options include dynamic network charges that vary by time and location depending on capacity and constraints on the transmission and distribution networks; introducing locational pricing signals into the balancing market by splitting into zones or nodes; and expanding the use of flexibility markets to address specific network constraints.

The regulator said it is already undertaking a detailed technical assessment of the benefits, costs and implementation requirements of locational pricing, including the distributional impacts and effects on investor confidence and market liquidity, that will be released in Autumn 2022.

Ofgem said there may also be a case of further reforms to the wholesale market such as a return to central dispatch and settlement.

Although it is a common feature of most nodal markets, the regulator said even without locational pricing, central dispatch could be more efficient than current arrangements. And whilst the centrally dispatched pool Britain had between 1990 and 2001 had a complex settlement process that was considered opaque and open to gaming, Ofgem said experiences elsewhere suggest market design and rules can ensure bids are generally efficient and reflective of marginal costs.

Furthermore, Ofgem highlighted the need for support for long-duration storage to absorb surplus power during the summer and support the system during windless periods of winter. It said the aforementioned changes would provide incentives for investment in storage, but primarily for short-duration storage that charges and discharges on a regulator basis. It said market signals along may be too uncertain to bring forward investment in long-duration storage.

Ofgem said its discussion paper is not a formal consultation but is instead intended to spark debate: “The proposed reforms span the breadth of the energy system, and many are for government to decide.

“They are at various stages of development: whilst some reforms, such as the creation of an independent system operator, are well underway, in other cases, there is not yet a definitive solution and further investigation and stakeholder engagement is needed.”