Consultation on Inflexible Offers Licence Condition (IOLC)

In its Call for Input (see our previous Law-Now here) on 4 November 2022, Ofgem proposed a number of intervention options to address high balancing costs incurred by NGESO which are ultimately borne by customers. Ofgem’s preference was to introduce a licence condition that would prevent generators obtaining an “excessive benefit” in the Balancing Mechanism in certain circumstances, largely based on the Transmission Constraint Licence Condition (“TCLC”).

Following the responses to the Call for Input, Ofgem has decided to press ahead with its initial preference, setting out a proposal to add a new licence condition to the Electricity Generation Licence in its Consultation published on 13 February 2023. Fourteen of the 22 responses received were in support of the new licence condition option. The aim of the proposed licence condition (referred to as the Inflexible Offers Licence Condition or “IOLC”) is to curb electricity generators from deriving an “excessive benefit” from inflexible offers in the Balancing Mechanism.

Responses to the consultation are open until 13 March 2023.

Background

National Grid Electricity System Operator’s (“NGESO”) role is to balance the supply and demand for electricity in real time; coordinating and directing the flow of electricity. NGESO must anticipate the imbalance in electricity production and demand, relying on market participants to signal to NGESO their anticipated production/demand and the costs they are willing to pay or be paid to adjust their electricity output or consumption. This is known as the balancing mechanism (“BM”).

Ofgem’s stated rationale for action

Ofgem and NGESO carried out investigative work which revealed that generators were reducing their physical notifications (“PN”) to zero, sending a signal that a generating unit intends to cease generating electricity in upcoming settlement periods. Typically, if a generating unit reduces its PN to zero it must remain at that level for a period of time to comply with the Minimum Zero Time (“MZT”) dynamic parameter reflecting its true operating characteristics. However, it was observed that the generating units would then increase the price of their offers to NGESO to continue generating during the period. This gave NGESO limited options. NGESO would be compelled accept the higher offers in order to meet demand, particularly during peak periods. Ofgem therefore considers that the behaviour of some generators participating in the BM has resulted in high balancing costs over long durations which, as mentioned, are passed onto consumers.

In light of this, the new licence condition aims to prohibit generators from receiving an “excessive benefit” from their BM offers when their units are operated inflexibly and enable competition to drive down prices for customers. Ofgem also expects that the new condition will encourage further investment in demand side response and new flexible production capacity or energy storage, making them more responsive to changing market conditions.

How it works in practice and what has changed since the Call for Input?

The IOLC will be triggered when a generator has:

• submitted to the NGESO a 0MW PN; and
• a minimum zero time (MZT) of longer than 60 minutes (i.e. is deemed to be “inflexible”).

If a generator meets the above conditions, it will be prohibited under the licence from gaining an “excessive benefit” in the BM, that is where its BM offer prices are (in Ofgem’s view) in excess of its costs plus a “reasonable” profit.

Ofgem has considered BM behaviours since the Call for Input along with stakeholder feedback and has decided to adjust the condition in two ways (see further below). Ofgem states that these adjustments should allow generators to follow one of two routes, the ‘flexible path’ or the ‘inflexible path’. The flexible path allows generators to operate fluidly in response to market and system conditions, meaning they would not fall within the scope of the IOLC. As such, “flexible path" generators will be able to genuinely reflect scarcity in capacity in their BM offers and would not run the risk of falling within the scope of the IOLC. The alternative, inflexible path, limits generators’ responsiveness to market and system conditions, meaning they would fall within the scope of the IOLC.

1. First adjustment (removal of operational day): The first adjustment is to remove the ‘within operational day’ limitation for when 0MW PNs are submitted. Ofgem justifies this adjustment on the basis that 0MW PN submissions before the operational day (ie, at the day ahead stage) can also drive high balancing costs and create the need for NGESO to accept high priced offers for longer periods.

Without this adjustment, Ofgem considers that the licence condition as proposed in the Call for Input would provide an incentive for generators to submit 0MW PNs at an earlier stage without breaching the licence condition.

2. Second adjustment (60-minute MZT limit): The second adjustment is to introduce a new limitation such that only generating units with an MZT greater than 60 minutes would fall within the scope of the IOLC. The Consultation justifies this modification by emphasising that the IOLC is intended to target the behaviour of generators who use their inflexibility to gain excessive benefit from their BM offers (as described above).

Therefore, restricting the scope of the licence condition to BMUs with an MZT longer than 60 minutes is expected by Ofgem to exclude battery and pumped storage BMUs being from the scope of the IOLC. Ofgem explains that storage units, by nature, have a much lower MZT which is reflected in their flexible and agile response to system conditions. The adjustment is intended by Ofgem to avoid capturing ‘business-as-usual’ optimisation practices for storage operators which are not accruing excess benefits at the loss of consumers’ interests.

Otherwise, the licence condition continues to largely replicate, and co-exist with, the TCLC, therefore adding to an already complex regulatory framework governing pricing. Notably, the draft licence condition does not define the term “excessive benefit”, which is at the heart of the new condition.

Instead (and consistently with the TCLC), the term “excessive benefit” will be interpreted in accordance with new IOLC guidance (also published alongside the consultation) setting out non-exhaustive factors that will collectively be taken into consideration when assessing if an offer is excessive, including variable costs / avoidable fixed costs / shutdown costs / reasonable profits etc.

Comments and next steps

It is encouraging that Ofgem has, to an extent, sought to address concerns regarding the IOLC by seeking to limit the scope of the prohibition to inflexible generators (i.e. using the 60 minute MZT), particularly to exclude storage operators. But it remains to be seen whether this limitation will be sufficient to ensure that legitimate trading practices employed by other generation technologies (or variants of the same) do not inadvertently fall foul of the prohibition.

It is also the case that MZT, as a dynamic parameter, must (under the Grid Code) reflect the true current operating characteristics of a generating unit. As such, certain generators wishing to follow the “flexibility” path (and therefore fall outside the scope of the IOLC) may find it difficult to simply reduce their MZT values to 60 minutes or lower without risking Ofgem enforcement action regarding this Grid Code requirement. It is therefore debatable whether it is truly open to generators to “opt” for a particular path (i.e. flexible or inflexible) using their MZT values in order to continue engaging in legitimate practices.

More fundamentally, the issue remains that the IOLC is adding yet another layer to a complex web of existing regulations governing pricing for market participants (i.e. the TCLC, REMIT and the Competition Act). The consultation confirms that the framework of the IOLC is different from the analytical framework for establishing unfair pricing under competition law, excessive benefit under the TCLC, or artificial pricing under REMIT, therefore suggesting parallel enforcement may occur. In circumstances where it is already challenging to ensure full compliance with the TCLC and REMIT, the introduction of the IOLC is likely to further increase the regulatory burden (and uncertainty) for market participants.

If Ofgem decides to press ahead with the IOLC, market participants will no doubt welcome more extensive and detailed guidance on how Ofgem will determine whether an “excessive benefit” has been obtained. The proposed draft guidance is, similar to the TCLC guidance, relatively vague and generic in this respect. For example, the guidance states that a “reasonable profit” is one that is commensurate with a level of profitability that is in line with an average for the GB electricity generation sector. This level of detail is unlikely to enable market participants to review their pricing in a certain and continuous manner with a view to ensuring compliance with the IOLC, particularly in unusual system conditions (or in constrained locations with a varied generation mix).

Finally, it would also be helpful if enforcement action under the IOLC would be subject to a right of appeal on the merits. Currently, enforcement action under the draft IOLC may only be challenged in the usual way before the courts on relatively narrow (mostly legal and procedural) grounds. It is worth highlighting, however, that when the TCLC was first introduced, the appellate body was the specialist Competition Appeal Tribunal who was able to redetermine the appealed matter or remit it to Ofgem. Creating a similar appeals regime for the IOLC (and perhaps reinstituting it for the TCLC as well, which is now also subject to the default appeals regime) would of course require primary legislation. But at a time when substantial investment in new capacity is needed to meet Net Zero targets and ensure security of supply, a stable and certain regulatory regime is of paramount importance.

Ofgem has proposed the following questions that are open for response until 13 March 2023;

1) Do you agree that our preferred option will effectively prevent the behaviour that caused last winter’s high balancing costs? Please provide reasons for your answer.

2) Is the proposed licence condition drafting in Annex 1 sufficiently clear? Are there any drafting edits or additions that you would encourage us to consider?

3) Do you agree with the initial list of factors to consider when assessing excessive behaviour? Are there any other factors that you would encourage us to consider?

4) Is there any specific information you would like to see in the accompanying guidance related to interpretation and enforcement of the new licence condition?