Public energy company: strategic outline case

Appendix B – Market and regulatory context

Market context

The gas and electricity (energy) sectors in Great Britain (GB) are broadly made up of import/extraction and generation, transmission and distribution networks, energy suppliers and customers. The sector is then overseen and governed by Government and regulators. This appendix provides an overview of each area.

Extraction, generation and import/export

Natural gas (gas) is extracted from gas fields around the world, including the UK Continental Shelf (UKCS) and traded globally. Gas extracted from the UKCS can be piped onshore, whereas gas extracted elsewhere in the world can be turned into Liquefied Natural Gas, shipped to GB, and then processed at one of several terminals. There are three gas interconnectors in GB, connected to Belgium, the Netherlands, and the Republic of Ireland, which can import and export gas.

Electricity is generated in GB through the conversion of energy from a number of different of sources:

• Fossil fuels: coal and gas
• Nuclear material: uranium
• Renewable sources: wind, solar, biomass, hydro, tidal.

Interconnectors also import electricity generated in Europe to GB (and vice versa). There is currently 4 gigawatt (GW) of interconnector capacity from four interconnectors, connecting GB to France, Netherlands, Northern Ireland and the Republic of Ireland.

Routes to market

Producers and generators have a number of ways to sell gas and electricity:

• Self-supply if they are vertically integrated, i.e. have their own energy supplier
• Structured contact, such as a Power Purchase Agreement (PPA) or tolling agreement
• Over the counter brokered bilateral trades
• Exchange-based, i.e. using a platform such as APX or N2EX
• Balancing Mechanism, where electricity is sold to balance supply and demand on a half hourly basis.

Overview of GB electricity trading arrangements

The GB electricity market is a decentralised bilateral electricity market, where suppliers and generators are required to take balanced positions by an hour ahead of real time (Gate Closure). Suppliers and generators trade energy up to Gate Closure allowing generators to sell an output equal the expected plant output and suppliers' will buy energy to match their expected load.^[36]

At Gate Closure, the National Grid (the System Operator) checks that the electricity market is balanced (i.e. generation and demand match). Where there is an imbalance, the System Operator can buy additional electricity, or pay for a reduction on generation, in the Balancing Mechanism from licensed generators.

Generators and suppliers that are physically over- or under-supplied going into Gate Closure face 'cash-out' incentives. The System Sell Price (SSP) and System Buy Price (SBP) are the cash-out or 'Energy Imbalance' prices that are used to settle the difference between contracted generation or consumption and the amount that was actually generated or consumed in each half hour trading period. For each half hour trading period, the 'cash-out' or 'energy imbalance' prices (SSP and SBP) will be associated with Balancing Mechanism Bids and Offers accepted by National Grid as well as the Balancing Services used for that specific half hour.^[37] At settlement SSP and SBP are the same in equilibrium.

Trading Risk

Many suppliers buy energy forward to hedge the energy price risk, with subsequent trading if there is a significant shift in the price and/or the suppliers' demand forecast.

One form of selling energy forward, particularly used by independent generators, is through a PPA, which commits the generator to sell an agreed volume of energy to another party at a pre-agreed price structure.

Energy networks

Networks are used to convey gas and electricity from points of generation and entry into GB, to industry, businesses, and households.

Both gas and electricity networks are broken down into two: the transmission network and the distribution networks. The transmission network moves gas and electricity, at high pressure and high voltages, respectively, across the country and interfaces with the distribution network. The distribution networks take gas and electricity, at lower pressure and lower voltages, respectively, from the transmission network and delivers to businesses and homes.

The national gas transmission network across the whole of GB is owned and operated by the National Grid. There are three separately owned, but interconnected, electricity transmission networks covering the whole of GB. The two electricity transmission networks operating in Scotland are owned by SSE and Scottish Power respectively. One out of the eight gas distribution network companies that operates in GB covers all of Scotland (Scotia Gas Network or SGN), while two of fourteen electricity distribution network companies operate in Scotland (SSE and Scottish Power).

Large scale electricity generation is connected to the electricity transmission network, whereas smaller scale generation, such as solar panels, is connected to the distribution network. Such generation is also referred to as distributed generation.

Both the electricity and gas transmission networks need to be balanced, i.e. supply needs to equal demand. There are two System Operators, one for gas and one for electricity, which manage the transmission networks to ensure they are balanced.

Energy suppliers and customers

Energy suppliers buy gas and electricity, from generators or traders, to sell to their customers, and also contract with network companies for the physical delivery of energy to their customers. Energy suppliers also meter their customers' usage in order to bill them. Energy suppliers in GB have been mandated to roll-out smart meters to all homes and small businesses which agree to the installation by the end of 2020.^[38]

Regulatory context

There are a number of licences and regulations impacting domestic energy suppliers in Scotland, limiting new entrants to the market who could help resolve the problems that the industry currently faces. This section provides further background on the current regulatory framework, licencing conditions and required programmes and policies.

Ofgem

Ofgem is the independent National Regulatory Authority for GB, responsible for regulating companies operating in the energy markets throughout GB to protect consumers' interests.

Ofgem is governed by the Gas and Electricity Markets Authority, which determines strategy, sets policy priorities and makes decisions on a wide range of regulatory matters, including price controls and enforcement. Ofgem's principal objective is to protect the interests of existing and future electricity and gas consumers. They do this by:

• promoting value for money
• promoting security of supply and sustainability, for present and future generations of consumers, domestic and industrial users
• the supervision and development of markets and competition
• regulation and the delivery of government schemes.

As a regulator, Ofgem works closely with suppliers to improve performance in several ways, including:

• handling consumer complaints
• fulfilling their social obligations, and
• providing support for vulnerable consumers.

Vulnerability is a key focus of Ofgem in Scotland, ensuring that suppliers are providing schemes and services to those in need.

Licence conditions

Ofgem regulates domestic energy suppliers by imposing licence conditions on them. Some key licence conditions relate to standards of conduct, tariff structures and fixed term contracts, compliance with industry codes (such as the Balancing and Settlement Code, the Uniform Network Code and the Smart Energy ode), prohibition of cross-subsidies to/from interconnector, distribution and transmission businesses owned by the licensee and the smart-meter roll-out.

Ofgem expects suppliers to self-report instances of non-compliance with their licence obligations, and resolve issues quickly.

Other obligations

In addition to licence conditions and Industry Codes, suppliers also need to comply with a range of policies and programmes, such as Government social and environmental policies (see below), and Guaranteed Standards of Performance. Voluntary codes of practice also exist, including Code of Practice for Accurate Bills and Safety Net for Vulnerable Customers.

As part of Ofgem's compliance monitoring, suppliers are required to submit specific pieces of information following a set timetable. Reporting requirements include data on switching, complaints, erroneous transfers, debt, and disconnections.

Government social and environmental policies

Domestic energy suppliers incur the costs of a number of social and environmental policies^[39],[40] (most of which have been introduced by Business, Energy & Industrial Strategy (BEIS) over the years), which are passed on to their customers.

Policy	Description	Applicable to gas (G), electricity (E), or both suppliers (B)?	Threshold for policy to apply to energy supplier
Energy Company Obligation	A scheme to increase energy efficiency and tackle fuel poverty by ensuring obligated suppliers promote primary measures of roof and wall insulation. They must also promote any measures which could improve the ability of low income and vulnerable people to heat their homes	B	Applicable to suppliers with more than 250,000 domestic customers, and provide more than 400GWh of electricity/ more than 2,000GWh of gas Once suppliers have crossed the threshold, there is a taper to initially ease the cost burden
Smart Meters (SM)	A programme to offer SM to all domestic and small business energy customers by the end of 2020, with the aim of making consumers conscious of how much energy they are using and reduce peak, and overall, consumption as a result	B	All energy suppliers must offer SM to all domestic and small business energy customers Suppliers with more than 250,000 domestic customers must roll-out SM Small suppliers must set out how they plan to deliver SM to their customers
Small scale Feed-in-Tariffs (FiTs)	A policy designed to promote the uptake of renewable technologies by paying for the electricity generated by certain eligible systems, even when the power is used onsite. Any exported power also attracts a payment	E	All electricity suppliers are required to make payments into the Ofgem FIT Levelisation Fund Suppliers with more than 250,000 domestic electricity customers must be a FIT licensee and offer FITs to customers
Renewables Obligation	The obligation on electricity producers is to increase the proportion of electricity they supply from renewable sources by funding a subsidy. This scheme is now closed to all new energy generating capacity with certain exceptions	E	Not applicable
Contracts for Difference (CfDs)	The contract aims to bring about investment in renewable electricity generation by providing a 'top-up' to the wholesale electricity price, to a fixed, elevated 'strike price. This reduces exposure to wholesale price movements	E	Not applicable
Capacity Market	The capacity market is a subsidy auction for electricity generation capacity which aims to incentivise sufficient investment in capacity to reduce the risk of supply shortages and corresponding spikes in wholesale prices	E	Not applicable
EU Emissions Trading Scheme (ETS)	Increases the wholesale cost of electricity by increasing the costs of using fossil fuels through certain installations having to monitor and report their level of carbon dioxide emissions. Emitters are allocated or must buy allowances for the amount they emit	E	Not applicable
Carbon Price Floor	This sets a minimum price per tonne of carbon dioxide emissions from electricity generators, which increases the wholesale cost of electricity	E	Not applicable
Warm Home Discount support	A government scheme aimed at tackling fuel poverty in GB. Under the scheme, larger energy suppliers support people who are in fuel poverty or are at risk of it. Some smaller suppliers also voluntarily participate in part of the scheme	B	Energy suppliers with over 250,000 domestic customers are required to provide support to all groups targeted under the initiative Smaller suppliers participating on a voluntary basis can only directly assist the Core Group (fuel-poor pensioners), not the Broader Group (wider group of fuel-poor) or help fuel-poor customers through third parties

The European Union

The UK, as a Member State of the EU has sovereign control over its energy mix, but has implemented and complied with a number of EU directives that impact the energy sector. Key areas of UK energy sector which are subject to EU decisions include:

• the Internal Energy Market
• security of supply and the role of EU interconnection
• the EU Emissions Trading Scheme
• the Paris Agreement resulting from the 2015 UN climate change negotiations in Paris (COP21)^[41].

As the UK prepares to leave the EU the exact implications for the areas listed above are unknown.