Consultation on the Inflexible Offers Licence Condition (IOLC) – Update

In a previous article, we looked at Ofgem’s proposals to introduce the so-called “Inflexible Offers Licence Condition” (“IOLC”) into the standard conditions of the electricity generation licence, intended to bring an end to certain specific practices by which Ofgem considers generators to be “abusing” the Balancing Mechanism (“BM”) to achieve excessive profits, ultimately at the cost of consumers. Having reviewed the responses to its February consultation, Ofgem has decided to proceed with its proposal to introduce the IOLC, and published its statutory consultation in this regard on 29 June 2023 (the “Statutory Consultation”). In this article, we consider the key areas in which Ofgem’s proposals in the Statutory Consultation have moved on since February.

By way of brief recap of the context for the proposed IOLC: the BM allows participants to submit bids and offers to National Grid Electricity System Operator (“NGESO”) to be paid to increase/decrease their transmission system imports/exports as against the positions set out in their Physical Notifications (“PNs”) to NGESO, providing NGESO with a crucial means of balancing supply and demand on the system. Certain less flexible generators have been achieving large returns from the BM by: (1) submitting a PN to NGESO on short notice to reduce their notified export to 0MW; and then (2) submitting a disproportionately high BM offer to NGESO for NGESO to prevent them going offline (the “Relevant Practice”). The IOLC aims to prevent generators from obtaining excessive benefits from the Relevant Practice.

Key Updates to the IOLC

Ofgem has made very few material changes to the draft text of the IOLC in the Statutory Consultation, save that Ofgem has reversed an aspect of its February approach on the time range within which PNs must be submitted to be caught by the IOLC. The Statutory Consultation also includes an updated draft of the guidance to be published alongside the IOLC coming into effect, which in particular provides more details on what offer prices will be considered “excessive” for the purposes of the IOLC. We consider each of these updates in more detail below.

Time range (reinstatement “of within Operational Day” requirement)

In its February consultation, we noted that Ofgem had opted to remove the “within Operational Day” limitation for when 0MW PNs are submitted. In the Statutory Consultation, in light of stakeholder feedback, Ofgem has proposed to reinstate the “within Operational Day” requirement, such that relevant generators will be prohibited from obtaining excessive benefits from the Relevant Practice only where the 0MW PN is submitted on the same Operational Day (i.e. 24-hour period starting at 05:00) as the relevant Settlement Period in which electricity is actually to be exported.

Ofgem acknowledges that the IOLC is likely to capture a substantially smaller proportion of the excessive benefits realised via the Relevant Practice if its scope is narrowed in this way. However, Ofgem also recognises that changes in market conditions may warrant legitimate changes in approach between different days, such that the IOLC could create market distortions if applied across too long a time period.

Ofgem intends to keep the “Operational Day” requirement under review and intervene further if it leads to costs that are not in the consumers’ interests.

One aspect of the design of the IOLC that has not changed since the February consultation is the inflexibility requirement. Ofgem’s proposal remains that the IOLC will apply to generators whose dynamic parameters include a “Minimum Zero Time” (“MZT”), i.e. the period after ceasing export within which they may not resume export, of more than 60 minutes. This effectively means the IOLC applies to less flexible operators such as thermal generators but not to more flexible operators such as energy storage providers. Ofgem has maintained its position that the application of the IOLC to only less flexible generators is justified by the more prolonged impact that any 0MW PN will have when coming from a less flexible generator, together with the greater bargaining power of stable long-term generators and the relatively limited scope for abuse by “energy limited” storage operators. Reversing the approach on the “Operational Day” requirement appears to some extent to be a “compromise” on Ofgem’s part to address concerns expressed by thermal generators as to the potential discriminatory impact of maintaining the inflexibility requirement.

Determining Excessive Pricing

While Ofgem maintains that it would not be appropriate to include a comprehensive definition of “excessive benefit” within the IOLC, Ofgem has provided further guidance on what will be considered an “excessive” amount to include in a generator’s BM offer to stay online despite a 0MW PN. The key aspects of this updated guidance include the following:

1. Ofgem will assess whether an offer price would result in a significantly higher profit than the generator would have obtained had they not revised their PN to 0MW, considering the generator’s likely costs (including opportunity costs) in each scenario.
2. As Ofgem had already made clear, the costs that Ofgem will take into account when undertaking this comparison will include variable costs (such as fuel, operating costs, emissions, chance of plant failure etc.), avoidable fixed costs (such as start-up costs) and shutdown costs. 
3. Licensees may seek a reasonable level of profit through their offer prices; however, what is reasonable will depend on the specific circumstances. Ofgem emphasises that generators should not obtain a total margin that is significantly greater than what would be expected without revising the PN to 0MW within the operational day.
4. Ofgem has provided some further details on the factors it will consider in assessing whether the profit margin obtained by the generator is reasonable, which the draft guidance states will include:
   1. The prices at which the unit’s output had been sold prior to the PN being revised to 0MW within the operational day;
   2. Profit margins of comparable generators (typically of the same technology type);
   3. The profit margins of other units operated by the same generator that have not revised their PN to 0MW within the operational day;
   4. The generator’s historic prices and profits;
   5. Any profit targets or other internal benchmarks used by the licensee; and
   6. The specific pricing strategy of the generator.
5. Ofgem has also provided some additional detail on overall approach – e.g. Ofgem will seek to analyse differences in average prices over sustained periods of time, rather than comparing single instances, as it can be difficult to compare the conditions under which offers are being submitted by different generators.
6. The Statutory Consultation also clarifies that the IOLC is not intended to prevent generators from building in a scarcity premium into their pricing at times of genuine shortage of generation capacity.

Ofgem believes this guidance-based approach to the concept of “excessive benefit” strikes a balance between allowing flexibility in evaluating specific circumstances while providing a steer to market participants. The impact of this approach on the Relevant Practice and generator offer pricing remains to be seen.

Pricing high to avoid acceptance

The IOLC applies whether or not NGESO actually accepts a generator’s “excessively” priced offer. However, Ofgem has now acknowledged that it may be legitimate for generators to submit artificially high offer prices in order to avoid their BM offers being accepted by NGESO (rather than to make an excessive profit by being paid to stay online). Ofgem has clarified that the IOLC is not intended to prevent such conduct, provided that the generator can evidence that the intention behind any such high offers was to avoid acceptance in this way.However, Ofgem has not yet provided any further guidance on the sorts of evidence it would expect to see in this regard.

Next Steps

The period within which industry stakeholders can submit their feedback on the Statutory Consultation ends on 27 July 2023. After the consultation concludes, Ofgem will publish its final decision with the aim of implementing the new rules before winter 2023.

Comment

Generator revenues from the BM have made headlines at a time when consumer energy prices remain high and are likely to remain under pressure as the costs associated with the energy transition and the push to net zero flow through. While huge investments are made to increase electricity network capacity and flexibility, Ofgem will be keen to limit the costs incurred by NGESO on the BM, ultimately borne by consumers, in the meantime. Ofgem will no doubt therefore have been reluctant to narrow the proposed scope of the IOLC by reintroducing the “within Operational Day” limitation. However, generators will be pleased to see that their comments with respect to market stability and system security have been heard.

The effect of Ofgem’s proposed guidance-based approach to determining whether profits derived from the Relevant Practice are “excessive” remains to be seen. Ofgem clearly views the assessment of reasonableness of profit as a complex and fact-sensitive question. Generators will be reassured by aspects of the proposed methodology – e.g. that Ofgem intends to respect a degree of increased profits in the event of genuine power scarcity. However, given the degree of uncertainty remaining in the proposed guidance-based approach on “excessive” benefit, less flexible generators are likely to encounter challenges in pricing their BM offers while minimising the risk of regulatory enforcement action. Even if the intention is to accommodate a degree of genuine scarcity pricing within the “reasonable profit” that a generator can price into its BM offers without triggering the IOLC, less flexible generators may not have sufficient confidence to do this in the absence of a clear, comprehensive definition of “excessive benefit”.  

It will be interesting to see if anyone seeks to bring an appeal to the CMA in respect of the licence modification, assuming that Ofgem decides to proceed with it. In our view, the IOLC does mark a significant intervention in the competitive generation market and the justification for targeting specific generators/bidding practices does not seem as clear cut as it was in the case of the Transmission Constraint Licence Condition.

Article co-authored by Emily Lakeman, Trainee Solicitor at CMS