Expert Commission on Energy Regulation: main report

Executive Summary

Energy assets tend to require extensive planning and significant investment and are built for long-term use. Any changes to the regulatory system underpinning that investment will require an adequate period of transition. Significant regulatory and market change tends to take a number of years to implement ^[3] , while changes to physical systems take longer. We have looked beyond the transition period to the longer-term, based on our assumptions of reasonable cooperation and joint intent and assisted by discussions with industry and regulatory bodies across the EU.

Regulation

Collaboration between Scotland and the rest of Great Britain on joint regulatory and system operation

• There is a strong technical and regulatory case for Scotland and the rest of Great Britain ( rGB) to retain a single- GB electricity and gas market, at least at the wholesale level, and to collaborate on a joint regulatory and system operators approach. There are international models of jointly regulated energy markets which show that this can be done.
• The Commission, and industry stakeholders, agree that maintaining a single wholesale electricity and gas market with rUK provides the most rational economic outcome. Proposals to divide the single system physically into two separate operating systems would incur significant cost, but deliver no material benefit to the consumers supplied by either system.
• We found no support in the industry, regulators or consumer bodies for such a division and we are heartened by the recognition by the Scottish and UK Governments of the continuing benefits of a single system.
• A multi-utility regulator covering electricity, gas and water is an approach adopted by many smaller nations. We think it makes sense in Scotland. The Commission has not addressed regulatory issues beyond the energy sector.
• The multi-utility model of regulation can offer a greater consistency of approach and achieve synergies where sectors have much in common, for example networks. The governance model should be designed to account for the differing demands of the sectors covered, both in terms of differences and synergies.

• Any extension of the scope of the proposed Scottish Regulator beyond electricity, gas and water requires thoughtful design due to the potential for competing demands on the expertise and capacity of the Regulator and its governing board, especially at a time of energy system investment and change.
• There are working European models for combined regulation of single electricity and gas markets across EU member state boundaries. Experience from these regulators demonstrate ways in which to meet the challenges and complexities of multi-utility regulation.
• Best practice can be drawn from these in establishing a combined economic regulatory model. Brussels sets a mandatory minimum requirement for duties and competencies of the NRA. There is also a strong and supportive EU framework on regulatory cooperation through CEER ^[4] , ACER ^[5] and the ECRB ^[6] .

Functions of new institutions to meet the requirements of EU law

• Joint regulation of the single markets for electricity and gas will require new institutions to meet the requirements of EU law. A single market, with good communication and cooperation between the regulatory bodies operating in Scotland and the rest of the UK (rUK) can be implemented. Regulatory decisions must respect all jurisdictions.
• An independent Scotland would want to put in place an independent National Regulatory Authority ( NRA), to designate a System Operator, and to put in place appropriate governance and operational agreements.
• The Regulator's duties and functions should be clear. It will,
  as a minimum, have the core duties required under EU law. Increasingly, regulatory requirements encompass social and environmental aspects as well as purely economic regulation.
• These duties should be reviewed periodically and settled for
  a fixed period to give regulatory certainty to industry and investors, and to maintain its independence.
• The non-core and delivery functions of the Regulator should be reviewed - these can diffuse the focus of the Regulator which should be on its regulatory role. Currently Ofgem has a number of non-regulatory functions, not all of which fit easily with its regulatory remit.
• The electricity sector is facing a period of investment and innovation, which will require asset renewal, low carbon generation and demand management technologies. The Regulator can proactively enable the development of the sector while these changes take place.
• It is important to encourage competition, not least for consumers. Joint jurisdictional arrangements should deliver a proportionate regulatory backdrop against which this competition can take place.
• GB currently operates a single AC synchronous power grid that is closely managed to ensure underlying system security; the provision of critical system interdependencies for supply, demand, and grid services will have to form part of any new arrangements.
• The current wholesale gas market involves the buying and selling of natural gas after it has arrived from offshore production sites and has one price for gas across the UK system irrespective of where the gas comes from. Gas supplies for Northern Ireland are provided from a supply point in the Scottish network. Regulation of the market and operation of the system will therefore also require appropriate arrangements with counterparties in rUK and Northern Ireland.
• The new regulatory arrangements should be flexible and capable of adaptation. This will be to the benefit of all Scottish consumers and the Scottish economy.

Making a Single Market Work Effectively

Establishing and maintaining an enduring single market:

• Amongst consultees, there is overwhelming consensus that the current integrated wholesale markets for electricity and gas should be maintained. They provide benefits for consumers in Scotland and the rest of the UK. Long-term continuation of a single GB wholesale market will require political and regulatory commitment from both jurisdictions to support and maintain existing market and operational arrangements.
• The European Commission is driving greater integration of wholesale markets and regulatory cooperation. We can learn from the single markets operating across borders in Ireland, Scandinavia and the Iberian peninsula, how best to create an effective structure for cooperation and governance.
• A strong relationship with the Regulator for the rest of Great Britain ( rGB) will be important from the outset along with a constructive and meaningful political partnership working to make the single market operate effectively.
• There may be differences in the policy approach or regulatory implementation between the two countries. These can be resolved through effective consultation and joint agreement to minimise market distortions and other unintended consequences. There could also be agreement that one jurisdiction can lead on specific aspects.
• Cost socialisation and apportionment are issues that should be settled by both Governments. Grandfathering the treatment of existing investment is a fundamental principle of good governance; it protects the investment framework and maintains investor confidence.
• As part of a single market, neither Scotland nor rGB will have unilateral control of arrangements within their geographical borders, but this is a reasonable trade-off to ensure that there are clear market signals for efficient investment across the GB system.
• The main role of joint governance of a single market will be to provide the right climate for necessary investment; however individual governments may need to consider whether different locational signals are needed to help attract investment and maintain secure supplies.
• Agreement and implementation of robust arrangements and processes, will give confidence to investors and governments that the settlement will endure, and that processes are in place to accommodate periodic change.

The current single market relies on established frameworks and systems to ensure it runs smoothly

• The current single GB wholesale market and business infrastructure will continue to be needed e.g. the BETTA and System Operator frameworks and a common settlement system. Elexon currently provides an important role in this system balancing services for the wholesale market. In future they will also provide services to the counterparty body for CfDs, capacity payments under EMR, and, implement any changes required under the EU Capacity Allocation and Congestion Management framework Guidelines ( CACM FG) ^[7] .

• The role of Elexon (for electricity), and Xoserve (for gas) is designated by Ofgem. Given the highly specific role that they play, the Commission recommends that the Scottish Government undertake further work to establish how these roles would be supported and governed for Scotland.
• Under EU law, the Regulator has to consider security of supply and diversity of generation to ensure continuity of supply. The development of interconnection is often an efficient route to secure additional capacity, although this may not always be the most optimal solution, when taking account of security of supply.
• In the UK, the 'big 6' electricity and gas supply companies have a domestic market share of around 95%. It is particularly important to maintain the attractiveness of the market to new entrants and other existing participants in Scotland, where this position is concentrated within the 'big 3' (Scottish Gas, SSE and Scottish Power).
• Retail market arrangements could, if so wished, develop differently in Scotland taking into account the wider single market business structure. Any change could affect the attractiveness of the market to existing and new entrants and hence the levels of competition. Where changes are mandatory and unilateral across a large single market, then the business impacts are uniform. Where they are borne only within a smaller part of that market, there will be differential impacts on market participants. The Regulator in Scotland will need to consider this in its approach to fostering competition.
• Any impact of intervention in the market either at the retail level, or through infrastructure support, to provide differential signals in Scotland to the rest of the GB-market will need to be assessed.
• Changes to apportion transmission charges differently in Scotland would need to consider any effects on the proportionate sharing of costs with consumers across the system.

Developing regulatory functions beyond those of the combined economic regulator:

• In the event of a vote for independence, the task of establishing new regulatory arrangements while maintaining a single market will extend beyond the creation of an energy regulator and an independent system operator ( ISO). They will also entail the establishment of authorities to oversee the financial and competition law applicable to energy markets, and the operational, health and safety regimes essential to good practice and maintaining public confidence.
• Scotland will need new regulators and institutions to licence the continuing operation of existing nuclear stations and coal mining, and new operations in fracking and unconventional gas. Arrangements will be needed to regulate the safe decommissioning of nuclear, coal and other energy related facilities on and offshore, and the funding arrangements to secure adequate provision for these and similar liabilities. It will also encompass appropriate health and safety regulation. These are significant projects and planning for these should commence soon, if not already underway.

Addressing technical challenges as the system evolves:

• At the outset, the new arrangements should be constructed to accommodate system change, and avoid the hidden risks of incremental change. These include impacts on voltage support, frequency management, system inertia and intermittency behaviours arising as a result of distributed generation, loss of thermal generation capacity and changing network demands.
• The Commission supports a proposal by the Institution of Engineering and Technology ( IET) for the role of a 'system architect' that would have a technical role in ensuring continued operability of the current system, but also the technical oversight of the more complex and integrated system that we are rapidly moving toward.
• The joint interests of the Scottish and rUK Governments to ensure supply security and resilience make it sensible to jointly address critical operational independencies. Scotland provides and receives system support functions via the transmission system from the actions of the GB system operator. An early priority for the Scottish system operator will be to establish unambiguous agreements and governance with the rGB system operator (e.g. management of constraints, response, reserve, and black start) and clear lines of command for emergency operational decisions and responses (e.g. emergency load-shedding, and black start co-ordination).
• In the event that these ancillary services could not be fully met from resources in Scotland, contracts should be in place for provision via the rGB system operator. Alternatively, Scotland could develop its own ancillary services market, or explore provision through interconnection. The chosen solution should take account of the costs to Scottish consumers.

Providing clear market signals for investment in flexible plant, as Scotland's thermal stations retire:

• A key issue in Scotland is the continuity of thermal generation capacity in the future where currently the prospect of a structural deficiency exists. Existing locational signals within transmission pricing are currently unlikely to deliver new thermal generating capacity in Scotland.
• The Commission recommends that the Scottish Government explores how the development of new thermal power stations in Scotland, either to maintain the technical operability of the overall GB system or to ensure security of supply, can be encouraged.
• A stronger CHP network in the industrial and commercial sectors can provide technical solutions for security of supply, but would need to be implemented on a significant scale.

Encouraging Renewables

Continuing Scotland's success in attracting renewable investment:

• Scotland is an economically attractive place within the single GB-market to locate wind, wave, and tidal generation due to its natural resources. This has driven a rapid growth in renewables capacity, and is coupled with a strong and enduring policy commitment to encourage renewables. That has been an important factor in Scotland's success in attracting investment in green energy.
• Future renewable development requires an increase in grid access and capacity as well as interconnection to provide a route to market.
• The Commission assumes that Scotland will remain with rGB within the EMR framework. A post-independent Scottish Government could, over time, tailor new and additional mechanisms to promote renewable expansion. These could prioritise areas which present a strategic opportunity, or a natural or competitive advantage for Scotland.
• The Commission supports the joint efforts being undertaken by the Scottish and UK Governments to encourage wind and marine energy in the Scottish islands, and sees this as an area of real potential for both energy generation and social impact.

Fuel Poverty and Energy Efficiency

Addressing issues that are most acute in Scotland

• Scotland has a real opportunity to make a difference to fuel poverty and in continuing to drive energy efficiency. Historically, the issue of fuel poverty has been more acute in Scotland, and the focus on it greater. Under devolved arrangements the Scottish Government has given greater priority to fuel poverty and energy efficiency and introduced its own arrangements to make greater progress towards a just and affordable system. Scotland has set more ambitious targets for alleviating fuel poverty but in the difficult economic climate since 2008, and within the constraints of the existing system, eradicating fuel poverty remains a huge challenge.
• While different criteria are used between Scotland and the rest of the UK to calculate the number of people in fuel poverty, any measure which consistently results in high numbers of consumers (2.39 million households were fuel poor in England in 2011), or a high percentage (with more than 27.1% of households in Scotland in fuel poverty in 2012) demonstrates that a more radical approach to tackling fuel poverty is required.
• Scotland has different market conditions to the rUK as a result of climate, housing stock condition, high rural component and low gas penetration in remote areas, all of which lead to higher cost heating solutions.
• The Scottish Government launched its own HEEPS programme in April 2013 to provide targeted funding support to help eradicate fuel poverty. This funding support was heavily predicated on funding contributions being available via the Energy Company Obligation ( ECO). The changes announced in the Chancellor's autumn statement have put this at serious risk.
• Removing the social obligations on electricity supply companies and transferring the burden into general taxation can place the funding obligation on those most able to pay. It decouples the funding from electricity charges enabling more direct control from Government. The Commission supports the proposals in this area by both the Scottish and UK Governments - provided that the revenues raised are allocated to the same degree for fuel poverty alleviation and targeted energy efficiency programmes.
• At present, a disconnect exists between the availability and access to data on socially disadvantaged and vulnerable customers and those with the funds and delivery network to effect change. This is inefficient, and undermines efforts to target assistance on those in society with the greatest need.
• Creating a Fuel Poverty Agency in Scotland could help drive a targeted and cost-effective means of delivering positive outcomes.
• Faster deployment of smart meters might help realise their benefits to consumers sooner. The division of responsibilities and rights between supply and distribution businesses deserves to be revisited.
• The roll out of the smart meter programme in the UK is taking considerable time to implement. While the meters will provide remote reading and more accurate billing, since the roll out programme commenced, there have been advances in smart meter functionality that could enable access to time of day tariffs and additional demand response services.
• The GB Smart Metering programme should signal the beginning of a major new consumer interface and range of opportunities. The Scottish Government should consider:
  • Revisiting the concept of smart metering 'supplier hubs'
  • The potential to transfer ownership and operation of the smart meters to Distribution Network Operators, which could bring a lower cost of capital as part of a regulated asset base that has a permanent physical connection to the consumer
  • Linking smart meters more closely with Network Operators as this could enable the move to smarter grids, improve the response to storms and outages and the use of smart meter data to support vulnerable customers
  • Whether the commercial and governance arrangements for the centralised GB Data and Communications Company ( DCC) are appropriate for the long term in Scotland.