Expert Commission on Energy Regulation: main report

The Role of a Scottish Regulator in the Optimal Operation of the UK Energy Market to Deliver Affordability, Security of Supply and Environmental Sustainability

• Scotland will need an independent National Regulatory Authority ( NRA)
• Scotland's Regulator for electricity and gas should be established with a clear mission, duties and responsibilities. At a minimum these should include:
  • ensuring that consumer interests are protected
  • delivering a regulatory framework which ensures system operability and security. This is an enabler for 'just, transparent and affordable' energy costs for current and future consumers
  • evaluating and advising on current and future system risks while providing advice and reports on Security of Supply, gas storage and Environmental Sustainability
  • certifying a Scottish Transmission System Operator ( TSO) and assessing its investment plans
  • overseeing access to the transmission and distribution networks
  • encouraging innovation in the sector to promote cost-effective solutions to the challenges ahead, such as the integration at scale of low carbon technologies
• These roles can fit within a multi-utility regulatory structure
• The tendency to load non-regulatory and delivery functions on the Regulator should be resisted
• Scotland's Regulator should establish a comprehensive and constructive relationship and set of working agreements with its counterpart in the rest of Great Britain ( rGB), including periodic review
• Scotland's Regulator should recognise underlying socio-economic, climatic and geographic differences in Scotland to the GB-market and help deliver local solutions - including, for example, the regulation of heat networks and off-grid supplies
• There should be a settled set of principles for an agreed period governing the Scottish Regulator's duties, its reporting and accountability to the Scottish Parliament.

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 Scottish Government's proposed combined economic regulatory ( CER) model has a very wide scope and will require 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. The Commission has not addressed regulatory issues beyond the energy sector.

Scotland's energy regulator must have a clear mission statement and set of duties, plus sufficient resources (within the multi-regulatory model envisaged by the Scottish Government) to ensure that it can deliver. It must be properly independent of Government, but operating with a clearly defined framework and working relationship.

Work should begin as a priority to explore the nature and content of the joint agreements and working practices that will need to be in place from the outset between the Scottish Energy Regulator and its rGB counterpart. This will be based upon trust and a high degree of technical understanding and competence.

This process should also recognise and establish from the outset, areas (the retail market, for example) where Scotland's specific circumstances and the needs of Scottish consumers might require a different approach to be taken.

The agreements and working practices developed with other jurisdictions should be robust and encourage cooperative and shared working. A strong framework will ensure that arrangements function well and prevent delays to the important energy industry changes that are already underway.

An effective response to the industry changes ahead will be facilitated by promoting innovation in the sector. As these changes form part of an international agenda, it is likely that high-quality jobs and exports could be a further beneficial outcome.

The Commission encourages both Governments to tackle the resolution of complex issues as the regulatory arrangements are established. Experience in other countries shows that this is the best approach, rather than making changes once operations and market systems 'go live'.

The core focus of the Scottish Regulator should be on the economic regulation of electricity and gas networks and markets, with an appropriate level of resources to deal with the associated complexities. The tendency to load non-regulatory and delivery functions on the Regulator should be resisted and delivery functions which are not part of this core focus will need to be reviewed and potentially reallocated elsewhere.

Environmental objectives and ambitions will remain key issues for Scotland and could present opportunities for new approaches to be taken. In time, for example, regulation could potentially extend to include heat networks and off-grid supplies.

The Role of the Regulator

It is a legal requirement of article 35 of the EU Electricity ^[30] Directive and article 39 of the EU Gas ^[31] Directive to establish a National Regulatory Authority ( NRA) that is independent of both Government and Industry. Whilst Member States may designate additional powers to the Regulator, as a minimum set of competences the core duties (in summary here) of the Regulator include:

1. Tariffs for access to transmission and distribution networks: fixing or approving, in accordance with transparent criteria, transmission or distribution tariffs or their methodologies
2. Unbundling: ensuring that there are no cross-subsidies between generation, transmission, distribution, storage, supply activities and liquefied natural gas
3. General oversight of energy companies: ensuring compliance on the part of transmission and distribution system operators, system owners (where relevant) and electricity or gas undertakings with their obligations under the Directive and other European Union legislation, including as regards cross-border issues
4. Consumer protection: helping to ensure, together with other relevant authorities, that consumer protection measures are effective and enforced; publishing recommendations, at least annually, in relation to compliance of supply prices with
   Article 3; ensuring access to customer consumption data.

In addition to these minimum competences, the Regulator will also need to ensure that it cooperates with neighbouring NRAs and with ACER with respect to cross-border issues.

The Regulatory Philosophy

The Scottish Government's Regulatory Reform (Scotland) Act 2014, will require a Scottish Regulator to take account of the requirements for sustainable economic development. The Act supports the Scottish communities' economic purpose (to focus Government and public services on creating a more successful country, with opportunities for all of Scotland to flourish, through increasing sustainable economic growth) and all the related elements of the National Performance Framework.

The Scottish Government's policy is to eliminate obsolete and inefficient regulation, tackle inconsistencies in regulatory systems and enhance Scotland's competitiveness by:

• Promoting the five principles of Better Regulation - Proportionate, Consistent, Accountable, Transparent and Targeted
• Carefully assessing the impact of any new regulations
• Working closely with key delivery partners, including Local Authorities and other regulators and the independent business-led Regulatory Review Group.

The Commission commends this approach on regulation generally.

Establishing a Scottish Regulator

The Commission has engaged with regulators and experts ^[32] in the UK, EU and beyond in order to:

• discuss and focus on the key areas and issues which are critical to an effectively functioning regulator
• benefit from their extensive practical experience in the oversight, design, or joint regulation of single wholesale markets, renewable energy support schemes, and network codes.

The Scottish Government will want to consider the following points with respect to the establishment of a Scottish Regulator.

1. There is a direction of travel within the European Union and other jurisdictions towards a multi-utility regulator or combined economic regulatory model - i.e. a regulator that has responsibility for a number of sectors e.g. electricity, gas, and water. Indeed, it may be both desirable and highly prized in a small country driven by a resource efficiency approach to seek to exploit potential synergies between regulatory disciplines that can be applied to more than one sector
2. The desire for a CER covering a large scope of sectors and interests should be balanced with the requirements for a focused role on the sectors in question, especially as part of a joint regulatory role with its rUK counterparts for electricity and gas
3. The stated 'mission' of the Regulator is a critical element. The mission should be clear, within the ambit of the Regulator to deliver, and focused - the Regulator should not be set too many priorities which it has to deliver
4. The primary duties of the Regulator will focus on economic regulation, and should include the evaluation of the economic, social or environmental benefit that would be delivered from different regulatory approaches
5. Secondary duties may be raised under guidance or could be delivered through other designated bodies. For example, Ofgem E-serve acts on behalf of the UK Government to support the delivery of government consumer and environmental schemes and programmes
6. The capacity and depth of expertise of the Regulator's staff are key to effective delivery. If there are too many competing demands e.g. competition commission referrals and crises in other sectors addressed by the CER, this can significantly affect its capacity to deliver on all sectors and maintain its credibility
7. The operability of the system should feature within the Regulator's priorities. By understanding the challenges facing existing system operation it may be possible to alter operational limits or market data timings and to justify the provision of greater flexibility in advance, before entering into large scale investments that may impact consumers
8. This is relevant in the context of the changing landscape of the sector within the UK- smart grids, increasing renewables, CCS, demand response as raised by the IET ^[33] . The recent consultation undertaken by Ofgem on moving to half-hourly settlement periods for consumers ^[34] , draws from international examples, such as the agreement between the Electricity Reliability Council of Texas ( ERCOT) and the Public Utilities Commission of Texas ( PUCT) to reduce the time period from gate closure to delivery of power to 30 minutes. This has significantly increased the forecasting accuracy for wind generation, provided greater certainty for demands on conventional thermal generation and enabled one of the highest penetrations of wind generation onto any electricity grid
9. Issues relating to regulation and system operability could be jointly addressed through the Scottish system operator ( SO), working with the Regulator and rGB SO within the limits of an agreed system Security, Quality and Standard of Supply ( SQSS) standard or common framework
10. The Regulator's governance processes and structure will benefit from careful planning. The design of the regulatory organisation to address the skills and disciplines required for each sector will be complemented by the monitoring and evaluation processes overseen by the Board of the Regulator
11. Clear outputs and outcomes on the part of the Regulator will be important, as will their delivery within set timescales
12. The existing arrangements suffer from lack of clarity of long-term objectives and the perception of continual legislative and regulatory change. There should be a settled set of principles for an agreed period governing the Scottish Regulator's duties, its reporting and accountability to the Scottish Parliament. The Energy Act 2013 placed a requirement for a Strategy and Policy Statement to be agreed between the UK Government and Ofgem. A Scottish Regulator will need to establish a comparable process in order to operate independently of Government, but with a clear process and set of policy outcomes and principles in respect of which material changes to the regulation of the electricity and gas sectors must have regard. The energy sector is entering a time of on-going change and it will be important that governance arrangements facilitate progress and efficient outcomes.

These are some of the key issues involved in the establishment and role of a competent, effective and credible Scottish Regulator for electricity and gas markets. To be effective and credible from the outset the Regulator will need to be adequately resourced and will need to clearly demonstrate its competencies and capacity to deliver. There will be a limited period of time in which to deliver the functional set-up of the Regulator, and to attract suitable staff with the appropriate experience and track record.

Gas Regulation

As indigenous supplies have declined, and import capacity has increased, the sources of GB gas supplies have changed. As recently as 2000, GB gas was sourced, almost wholly, from the North Sea. The situation today is different, and much of the gas consumed within the UK is sourced through major pipelines from Norway and the Continent, as well as through LNG imports. Nevertheless, the main flow of gas within the network is North to South.

The expectation is that supply of gas from the UK continental shelf will decrease over coming decades, while supply by pipeline from the continent will increase ^[35] . This will change the direction of the flow of gas so that the dominant flow is South to North, necessitating approval for, and investment in the network for upgrades to accommodate changes in flow direction. A Scottish Regulator will need to have strength of competence in specific areas of expertise, both in gas and electricity regulation.

Innovation and Flexibility

Scotland's Regulator would have a greater ability to take account of underlying socio-economic, climatic and geographic differences in Scotland to rGB and help deliver local solutions - including, for example, the regulation of heat networks and off-grid supplies and support for the development of smart grids.

Whilst not a major component of the system at present, the development of heat networks - particularly using renewable fuels - is likely to become a larger part of our energy supply. Oversight of the sector will be needed prior to the potential regulation of the sector given its network and monopolistic attributes.

Innovation-based regulation and output metrics provide the greatest flexibility for market actors and will assist in the delivery of system improvements and appropriate aspects of social and environmental aims via tools e.g. smart cities, quality of supplies, storms response, treatment of DG connections, and risk mitigation.

In looking at regulatory regimes abroad, the Commission was attracted by the approach taken in Minnesota, USA. The Regulator there is tasked with delivering 'just, transparent and affordable' energy costs for current and future consumers. The recognition of trade-offs between the short and long term, and of the need for transparency to create trust in the system are important albeit that security and environmental drivers must also be addressed.

A change in the 2007 Next Generation Energy Act of Minnesota ^[36] altered what had previously been a spend target of 1.5% into a 1.5% annual savings goal as an output metric for all utilities.

The utilities in Minnesota were not evaluated on their level of spending on conservation programmes, but on the level of energy savings actually achieved. This was significant because it put the emphasis of the programme on the results that they brought about in order to achieve 1.5% savings of their total retail sales. This is a very significant saving in the context of energy conservation programmes.

The state of Michigan recently passed legislation that requires its utilities to achieve energy savings of 1% over a three-year period. This was the first time the state had mandated a utility conservation program. In Minnesota these programs have been in place since the early 80s, and the goals represent nearly a doubling of the level of achievements that had previously been attained ^[37] .

These examples from the US highlight a shift towards incentivised regulation - i.e. based on outputs rather than inputs, and the Commission believes that a similar approach and focus should be considered for energy regulation in an independent Scotland.

Provision of Regulatory Advice to the Scottish Parliament

Regulatory accountability for specific duties enables action to be taken where the Regulator possesses the levers of control and influence. With respect to the security of supply of the electricity and gas system, the Regulator is only one part of the system. While the Regulator may have specific powers, or may request action on the part of others to address security of supply issues, it cannot be accountable for the action, or inaction, of others within a market. The Commission considers this is formally a Government accountability.

With access to increasing volumes of market information and intelligence, particularly when smart metering becomes prevalent, the Regulator will be well placed to provide regular advice and formally report to the Scottish Parliament on issues such as current and future system risks, Security of Supply, gas and electricity storage capacity and environmental sustainability. The Commission recommends that the Regulator is accountable for advising the Scottish Parliament on these matters.

The System Operator ( SO)

A key requirement under the EU Directives is that the NRA designates the system operator ( SO) in order to a) ensure that it has the competence and capacity to undertake the SO duties and b) ensure that (for certification in relation to third countries) by notification of the EU Commission, the granting of certification to the SO will not put at risk the Member State's security of energy supply.

This raises some interesting questions relating to the role and current structuring of the National Grid Company, and changes that may be required in the event of an independent Scotland. Structurally, the SO will need to show that in legal form and organisational structure it meets the unbundling requirements of the EU Directives, and demonstrate business separation and accountability from other activities.

National Grid is the SO for electricity transmission in GB (and Transmission Owner ( TO) in England & Wales), and is the SO and TO for gas transmission across the whole of GB. In addition to its regulated interests, National Grid is a commercial entity; it is also currently providing technical support to the UK Government on EMR, specifically on the CfD and Capacity Mechanisms.

As part owner of the UK electricity transmission network that is undergoing a series of investment upgrades, and to which new projects will connect, as well as acting as the GB SO, there are inherent conflicts between these duties that have been managed to date through the separation of business activities. In the event of independence, there would be an increased focus on how best to operate across two jurisdictions.

The SO role in Scotland could remain with National Grid as a service arrangement, be undertaken by one of the Scottish network companies, or be provided by a newly created body in Scotland. There are some important details to be resolved with each of these options: for example, would National Grid be required to operate the Scottish system in a ring-fenced manner, particularly if policy divergence arises between the jurisdictions over time; would it be acceptable for the Scottish network companies to hold this role as they are vertically integrated companies owning generation interests; and if a new body was created would the investment needed in staff, physical assets and IT facilities be cost-effective?

Further considerations include:

• It would be important to have clarity on National Grid's role in relation to Scottish transmission investment decisions, if it remained the Scottish TO and at the same time, rGB TO. There is clearly potential efficiency in a TO role covering the whole of the GB system, but the TO will owe duties to each jurisdiction which may give rise to differential obligations. The EC requirement to have a separate Scottish TO implies some requirement for ring-fencing.
• Currently, the Electricity Networks Strategy Group ( ENSG) brings together key stakeholders in electricity networks that work together to support UK Government in meeting the long-term energy challenges of tackling climate change and ensuring secure, clean and affordable energy. Stakeholders include network companies, generators, trade associations and devolved administrations. The ENSG is jointly hosted by DECC and Ofgem.
• The SO has a key role in ensuring compliance with the EU Target Market (network codes and guidance) and the Regulator will need to have technical capacity to oversee implementation. The Scottish SO will be required to demonstrate compliance with the Directive in order to be independent and this may require the splitting out of vertically integrated companies.
  The Commission is unconvinced that the role of SO could
  be undertaken by a current Scottish TO company without
  some unbundling.
• The framework of design and operational standards that would apply to the 'networks' in Scotland and what governance structure would operate.

In discussion with stakeholders, there was strong agreement that these issues need to be addressed through a formal change management process.

This provides certainty to the industry and investors that the technical and regulatory changes are known and the risks quantified, and that the technical operability and security of the system will be retained. In the unlikely event that agreement cannot be reached then the system must be able to default to a position that maintains supply security and safety.

Relationship with the rGB Regulator

A priority for Scotland's Regulator and its rGB counterpart should be the establishment of a comprehensive and constructive relationship and set of working agreements, including periodic review and practical arrangements for on-going evolutionary change.

A collaborative relationship between Scotland's Regulator and its counterparts elsewhere should be in place from the outset. This will require a coalition of the willing built on trust, goodwill, technical understanding and competence.

It is clear from discussions with ACER and CEER, that while some of the discussions and arrangements are technically demanding, the starting position amongst regulators is collaborative. In the event of a lack of progress in resolving cross-border or internal disagreements, ACER will act to deliver a binding solution for the parties. This framework prevents dysfunctional arrangements and undue delay to the important industry changes that are already underway.

These issues are considered further within the section of this report which responds on the question of 'how the strategic energy partnership with the Government of the UK will operate'.