HC 742 Electricity Market Reform

Ofgem Memorandum to Energy and Climate Change Select Committee

This memorandum is intended to provide the Committee with information regarding areas of interest to Ofgem ahead of our session on 18 January. It is divided into four sections covering energy supply, energy networks, energy generation and Ofgem’s role and performance.

1) Energy Supply

Retail Review

In November 2010 Ofgem announced that it would be reviewing the effectiveness of the retail energy market to see if further action was needed to protect consumers. The review, which we aim to finish by March this year will comprise of the following:

· an assessment of the current state of the effectiveness of the retail market

· a review of progress energy companies have made on implementing Ofgem’s reforms

· Our next quarterly Electricity and Gas Supply Market Report into retail and wholesale energy prices

There were a number of reasons why Ofgem instigated the review, one of which was our last quarterly report (November 2010) into retail and wholesale energy prices. This analysis (see graph below) showed that retail net margins had increased from £65 in September 2010 to £90 in November 2010 following price rises from some of the "Big 6" energy suppliers.

The analysis incorporated the new, higher prices of the three Big 6 energy supply companies that had already detailed price rises for this winter at the time of Ofgem’s announcement. Only one Big 6 supplier, EDF Energy, has promised to freeze prices between now and March 2011.

Whilst Ofgem would expect efficient firms to make a profit, the increasing margins concerned us. Correspondingly, we have sought to undertake deeper analysis to provide clarity on behalf of consumers that the market is transparent and is working as effectively as possible.

However, there were other supporting reasons why we felt a review was needed. Since the Retail Market Probe in October 2008, Ofgem has secured a series of important reforms for customers to improve transparency and ensure fair play. These are displayed in the table on the following page.

In addition to licence changes, we also published Standards of Conduct that we expected the companies to adhere to. As part of our current review Ofgem will be looking at how effectively energy companies have implemented all of these reforms as we have observed differing supplier performance to date. For example, some of the companies responses to providing consumption data to customers has been poor and we have also been concerned with suppliers’ doorstep activity, announcing in September investigations into four suppliers over potential mis-selling to customers.

Other relevant retail market work

Following on from our 2008 Retail Probe and measures to empower consumers with more information about how much they are paying for their energy, Ofgem has announced its intention to ensure companies provide advanced notification to customers of any price rises.

Currently, companies have up to 65 working days in which to notify consumers after they have put up energy prices. Consumers then have 20 working days to switch supplier if they wish to avoid paying the price increase. Under our proposals the position would be reversed, with companies required to give 30 calendar days notice before they increase prices. We support this approach in order to allow consumers more time, once informed of a price rise, to either switch supplier or take action to reduce their demand.

Fuel Poverty

In addition to our work regulating the retail market, Ofgem continues to specifically assist vulnerable and fuel poor customers in a variety of ways, including through the below. This helps contribute towards Government’s fuel poverty goals.

a) Regulation - Action undertaken through our previous energy supply probe, in particular relating to the banning of unfair price differentials, has particularly benefited customers who pay by pre-payment meter or who are not connected to the gas grid and have an electricity only tariff – the latter of whom suffer some of the highest levels of fuel poverty in Britain.

In our work through setting the current gas distribution price control we have created conditions to enable gas distribution companies to extend the gas network to non gas, fuel poor communities.

b) Monitoring - We continue to shine a light on suppliers' voluntary social measures through annual reports designed to share and recognise good practice and help inform consumer advisers about the range of help available. Collectively suppliers spent £153m on social programmes in 2009-10, exceeding the Government’s target of £125m. Of this spend £128m was on rebates or discounted tariffs with almost 1.6m customer accounts benefitting from some form of rebate or discounted tariff. Ofgem will monitor compliance for one more year before the voluntary scheme ends and the Government’s mandated scheme begins.

c) Debt and disconnection - We have a long and successful track record in promoting best practice among suppliers in the way they approach debt prevention, debt management and avoid energy disconnections. Energy disconnections overall have decreased substantially since 2004, from around 16,000 in 2003 to just over 4,000 in 2009.

We have strengthened licence obligations on suppliers to see more proactive identification of vulnerable consumers who may be in debt and at risk of disconnection and our ongoing work has seen two companies (Scottish Power and EDF Energy) take action to address their relatively high disconnections. EDF Energy has suspended electricity disconnections for the winter where it has been unable to install an electricity pre-payment meter and Scottish Power is undertaking a pilot scheme from October which it is forecasting will cut its disconnection by 44 per cent. It will also suspend disconnections if it is a particularly harsh winter this year. In this area we work with Citizens Advice, Money Advice Trust and Consumer Focus.

d) Advice and research - We have a three year partnership with Citizens Advice on the "Energy Best Deal" campaign which provides vulnerable consumers with tariff and energy efficiency information and advice. Over 64,000 consumers have received help as a result of this campaign. We also regularly undertake consumer research on issues relating to vulnerable customers, such as their ability to switch and take advantage of the market.

e) Forward look - A priority focus in this area of our work at the moment is updating the licence obligations to ensure they provide fit for purpose protection for consumers with smart meters, including vulnerable consumers. We will be publishing a consultation on our proposals at the end of January.

Enforcement

Ofgem continues to use its full range of powers to enforce the rules within the energy retail market and the other markets that we regulate. Below are examples of recent work.

Last summer, Ofgem successfully fined National Grid £15 million concerning anti competitive agreements struck with suppliers at the time the metering market was opened to competition in 2002.  The terms of these stifled new entry to the nascent gas metering market and ultimately limited the benefits to consumers from more competitive metering costs and innovative services. Our landmark case attracted the largest penalty in any abuse of dominance case to date.

Earlier this month, we announced our intention to impose a penalty of £8 million and to fine National Grid Gas in breach of obligations to provide us with accurate information over the reporting period 2005/06 to 2007/08. Ofgem takes failures by regulated companies to meet reporting obligations very seriously as this is an important part of ensuring that the "regulatory contract" is met and consumers receive value for money.

In 2010 Ofgem issued First Utility with a Provisional Order, instructing them to change their practises in too readily disconnecting consumers who had opted for their early smart meter packages. The consumer experience around smart meters is critical for the success of the programme and our early interventions in this area have set a benchmark for consumer protection to tackle issues emerging from the early rollout of the technology.

Other investigations underway include the afore mentioned investigations into four of the Big Six on mis-selling, all of the Big Six on complaints handling and three electricity distribution companies are being investigated on connections standards.

In addition, as well as our general enforcement work, we are also examining the conditions in which domestic customers are being automatically rolled over onto new contracts when their existing contract expires, as well as exploring suppliers’ practises in using deemed contracts when people move house.

2) Networks

Project TransmiT

Ofgem recently announced a comprehensive and open review of the charging regime and associated connection arrangements for using Britain’s high voltage electricity network and high pressure gas grid.

The electricity and gas grid transmission charging regimes have served customers well, for example, by encouraging power generators to locate close to where electricity is used. However, Britain is facing an unprecedented challenge as it moves to a low-carbon energy system and low carbon technologies such as wind and wave power stations have less flexibility on where they are sited than conventional power sources.

We are reviewing transmission charging arrangements for gas as well as electricity to ensure that a consistent approach is adopted for both. We are committed to undertaking an open, comprehensive and objective review drawing on a wide range of stakeholder input, including independent academic reports, international experience and alternative viable models.

TransmiT does not re-open the Government’s recent proposals for reforms to the electricity grid access arrangements but focuses on charging arrangements and other practical and commercial difficulties experienced by new generators which fall outside the scope of the Government’s work. Such difficulties to be examined include the significant financial commitments a generator has to sign up to before National Grid will begin work on their connection and the process by which the grid companies prioritise the engineering work required to physically connect generators to the electricity networks.

RIIO and the network price control process

Of the estimated £200 billion of energy related investment needed by 2020, as highlighted by Ofgem’s Project Discovery, about £32 billion needs to be in the energy networks. However, the new grid will have to be far smarter than the existing network in order to accommodate more low carbon sources of generation such as wind and decentralised energy, as well as to enable the infrastructure to deal with increased electrification of heat and transport. The way energy networks are designed, operated and priced is likely to need to change.

In order to deliver a smart grid, while ensuring security of supply, Ofgem has fundamentally changed its regulatory framework by reforming the old RPI-x regime. RPI-x had provided the framework that set each of the regional network companies’ regulated performance over each five year "price control" period. While RPI-x was successful in securing £35 billion of investment over its lifetime, Ofgem did not think it provided the required flexibility necessary for delivering the grid needed in the future.

RIIO (Revenue=Incentives+Innovation+Outputs) is the successor to RPI-x and is Ofgem’s performance-based solution to the challenge. The RIIO model takes the best from RPI-x, but places far more emphasis on the delivery of specific outputs (e.g. network reliability) through a framework which heavily encourages innovation. It will essentially protect consumers by rewarding those companies that innovate and invest efficiently, meeting their outputs, but will penalise those companies which perform badly for consumers with lower returns on their investment.

Key features of the RIIO model include setting longer eight-year price controls, offering incentives focused on delivering results, and expanding the £500 million Low Carbon Network Fund to fund innovative smart grid project trials (more below). Ofgem estimates the RIIO model could cut the cost of investment to consumers by £1 billion compared to the previous regulatory framework in the next ten years.

We are now consulting on our initial views on the specific outputs and other aspects of the first price control frameworks under RIIO for the gas and electricity transmission companies (RIIO-T1) and for the gas distribution companies (RIIO-GD1).

Low Carbon Networks Fund

Ofgem announced the Low Carbon Networks Fund (LCN Fund) in August 2009 as a fundamental part of the current price control regime for Electricity Distribution Network Companies that runs from April 2010 to March 2015. The fund will allow up to £500 million over five years, encouraging and enabling the companies to trial new technology, operating and commercial arrangements which can aid the transition to a low carbon energy sector.

There are strict criteria for winning projects and the lessons learnt from these ground-breaking initiatives will be shared with all network companies and interested parties, potentially benefitting millions of GB energy consumers.

In November 2010, Ofgem announced £62 million for the first year’s funding towards the following projects:

· CE Electric: Customer-led network revolution (£26.8 million) - A project in the north east exploring how a combination of smart technologies and changes in customer behaviour can reduce the costs associated with low carbon technologies.

· UK Power Networks: Low carbon London – a learning journey (£24.3 million) - A "smart city" initiative for London that will explore how to best use new technologies and active network management. The project will also seek to understand when, how and why consumers use energy and how this can be influenced.

· Central Networks: Low carbon hub (£2.8 million) – A project in East Lincolnshire to investigate ways of increasing the amount of electricity generation - mainly wind - that can connect directly to the local electricity network.

· Western Power Distribution: Low voltage Network Templates for a low-carbon future (£7.8 million) – A project in South Wales to examine the effect that low carbon technologies have on the network.

Investment in the offshore grid

The offshore regulatory regime for licensing offshore electricity transmission, introduced in 2009 by DECC and Ofgem, uses competitive tendering to ensure the offshore cable connections are delivered on time and at reasonable cost. Essentially, any company with the appropriate experience can bid for the right to own and operate offshore transmission links in return for a 20-year regulated revenue stream. The aim is to use competition to keep these revenue bids as low as possible by providing opportunities for new entrants to compete with existing players (National Grid, Scottish Power and Scottish & Southern are the existing onshore transmission operators).

The early signs are positive with the first round of tenders attracting high quality bids worth almost £4 billion of investment appetite for all nine transmission links (worth around £1.1 billion), connecting 2GW of offshore wind. It has resulted in overall forecast savings of £350 million for offshore wind farms and ultimately consumers, and attracted some new firms and investment capital to the sector.

In November 2010, Ofgem commenced a second transitional round of tenders for six wind farm assets for around 2.8GW of capacity, with a potential asset value of around £1.9 billion. Overall around £20 billion of investment could be needed for offshore transmission links in the next decade.

3) Generation

Electricity Market Reform

Ofgem’s Project Discovery used scenario analysis to test the current energy market arrangements to see if they could cope with the unprecedented combination of the global financial crisis, tough environmental targets, increasing gas import dependency and the closure of aging power stations. It concluded that all these factors combined to cast reasonable doubt over whether the current energy arrangements will deliver secure and sustainable energy supplies.

The five key factors affecting the market that emerged from Discovery were as follows:

· Unprecedented levels of investment (up to £200 billion before 2020) need to be sustained in difficult financial conditions and against a background of increased risk and uncertainty.

· Uncertainty in future carbon prices could delay or deter investment in low carbon technology and lead to greater decarbonisation costs in the future.

· Short-term market price signals at times of system stress do not fully reflect the value that customers place on supply security (for both electricity and gas) - which could result in insufficient incentives to invest in peaking capacity.

· Interdependence with international markets exposes GB to a range of additional risks that may undermine GB security of supply.

· Higher energy costs may mean that increasing numbers of consumers are unable to afford adequate levels of energy to meet their requirements, affecting the competitiveness of industry and business.

Ofgem therefore welcomes DECC’s Electricity Market Reform (EMR) consultation and looks forward to working with the Department to help change the electricity market to meet consumers’ long-term interests for reliable and low carbon energy supplies. Ofgem also believes that by starting the reform process promptly this should help to keep investment costs and energy prices as low as possible for consumers.

However, as the consultation itself points out, market reform alone is not necessarily sufficient for meeting Government objectives if other parts of energy policy are not aligned. Correspondingly, the work which Ofgem is undertaking to improve electricity market liquidity (more below), RIIO, TransmiT and other areas such as planning are crucial for delivering UK energy policy goals.

Liquidity

Over the last 18 months we have been monitoring and investigating the liquidity of wholesale electricity in Great Britain and have concerns that the wholesale market might not be delivering the products and signals that all market participants need to operate their businesses effectively. In particular, independent suppliers and generators have expressed concerns that they find it difficult to manage risk with the wholesale products currently available. This could be having a negative impact on the outcomes for consumers in the supply market, especially if it means that there is no viable threat to existing suppliers.

In 2010, we published possible options for intervention and a further assessment of the market, and stated our commitment to take action in the event that we do not see sufficient improvement.

While we have seen some positive signs, such as through a new trading platform (N2EX) and through efforts of one of the Big 6 to publish its commitment to selling energy "clips" in sizes more suitable for smaller suppliers, it is in the best interests of the market to have greater liquidity. Additionally some markets in Europe have achieved greater liquidity in electricity than we have in the UK. However, interventions in this area can have unintended consequences and with the EMR process going on in parallel it is important that interventions are beneficial over the long term. Correspondingly, we have decided to:

· Align our work on liquidity with wider market developments

· Continue to develop the detailed design of our options for intervention

· Continue to monitor the market, with a view to publishing our next assessment in Spring 2011

Security of Supply Outlook

DECC and Ofgem’s recent Statutory Security of Supply Report covered the outlook for electricity and gas going forward.

In terms of electricity, current capacity is sufficient and National Grid’s central case projection for peak electricity demand is for this to remain relatively stable, but the Large Combustion Plants Directive will lead to closure of significant quantities of coal and oil-fired fleet by 2016 at the latest. The Industrial Emissions Directive could also lead to further closures by 2023. Together these could lead to up to 37 thermal plants closing, which represents almost a quarter of GB’s 2009 generation capacity. In addition, significant existing nuclear generating capacity is reaching the end of its operational life with only one existing nuclear power station likely to be operating by 2025.

The Government has initiated EMR which is intended to tackle some of the issues on the electricity side and ensure that future capacity is forthcoming. In addition, the current Energy Bill contains additional work in this area with Ofgem potentially having a role in advising the Government on capacity margins.

The outlook for security of gas supply is broadly manageable in the near term. This does not mean that it is risk-free; there are risks, both in the short term, and towards the second half of the decade, when some uncertainties remain. UK annual gas demand is projected to trend downwards slightly in DECC and National Grid’s central case. There are however sensitivities around this leading to a wider potential range of outcomes, depending on factors such as relative fuel prices of gas and coal, the amount of gas fired generation in the electricity generation mix, and economic growth. Projections for peak demand show this remaining at current levels in the Central case or trending downwards to around 450 mcm/d in other scenarios over the period 2010 to 2025.

While production from the United Kingdom Coastal Shelf is projected to continue to decline, GB has an increasingly large and diverse range of import sources on which to draw. New import and storage capacity is at various stages of development and delivery. Should this come forward, the UK would continue to be well-served. In practice, it is noted, however, that projects might slip, and not all of this capacity might come forward.

Looking ahead, Ofgem has announced that it will be undertaking a "Significant Code Review" into gas security of supply. This will look at producing incentives to ensure that price signals continue to pull in gas supplies from around the world, particularly in times of system stress. This process is also referred to in the Energy Bill, which allows for it to be fast-tracked.

Ofgem has also recently consulted on other mechanisms for decreasing uncertainty around building new gas storage facilities. This has focussed on clearing up issues relating to third party access.

4) Ofgem’s role and performance

History

Ofgem was established in its current form in 2000 and operates under the direction and governance of the Gas and Electricity Markets Authority (‘the Authority’). The Authority is responsible for the economic regulation of the electricity and gas industries in Great Britain and has a primary regulatory duty to protect the interests of existing and future consumers wherever appropriate by promoting effective competition in electricity and gas markets. The interests of gas and electricity consumers are their interests taken as a whole, including their interests in the reduction of greenhouse gases and in the security of the supply of gas and electricity to them. Ofgem is responsible for carrying out the Authority’s regulatory duties on its behalf.

The main statutory powers that Ofgem has to support our duties are to:

· Issue, modify, enforce and revoke licences. All energy generation, transmission, distribution and supply companies in Great Britain are regulated through these licences;

· Investigate and issue fines of up to 10% of licensees’ turnover, where they have been found to breach licence conditions; and

· Set price controls over the prices charged by monopoly network operators

Ofgem also has powers under the Competition and Enterprise Acts to carry out investigations into companies suspected of breaching these rules and engaging in anti-competitive behaviour.

In addition to remit amendments in recent Energy Bills, Ofgem’s role has widened to include the administration of government programmes on behalf of DECC. Correspondingly Ofgem, in 2009, split its business into two separate units: ‘Ofgem E-serve’ administers environmental programmes on behalf of the Government generally by using GEMA’s regulatory powers, while ‘Ofgem’ is responsible for statutory regulation.

Ofgem is independent of Government, and accountable to Parliament, for all its statutory functions, which include the programmes delivered by E-serve.

Costs and Accountability

Ofgem’s operating costs in 2009-10 were £51.1 million, an increase of £9.1 million (22%) on the previous year. The increase reflects Ofgem’s involvement in new activities such as managing the tendering process for offshore transmission networks and administering E-serve programmes. As an indication of the rapidly expanding scale of Ofgem’s work, in 2001/02 Ofgem administered government environmental programmes worth £150 million – with 12 members of staff. At the end of the last financial year it was delivering £4 billion worth of programmes with a staff of 54 at a cost of £8 million.

Since 2005, we have controlled our own operating costs by limiting cost increases to the Retail Prices Index less a set percentage, currently 3 per cent. This has delivered £11.9 million savings over the past five years, and is expected to deliver savings of £12.5 million over the next five years.

Our core regulatory activities are funded by mandatory fees collected from gas and electricity licence holders, which are adjusted each year to cover planned expenditure and totalled £35.2 million in 2009-10. We also received £5.2 million from DECC to cover the costs of administering environmental programmes, with the remainder funding from the schemes themselves. The fines we impose for infringement of industry rules – over £50 million since 2002 - go to HM Treasury and are not used to fund Ofgem.

Ofgem’s Treasury-agreed estimates of its annual costs are presented to Parliament for approval and subsequently voted on. The Authority has a statutory duty under the Utilities Act 2000 to report to Parliament on its activities and progress during the year.

From 2010, we will judge performance on how we contribute towards our four key themes:

· contributing to the achievement of a low carbon energy sector;

· helping to maintain the security of Britain’s energy supplies;

· promoting consumer choice and value and protect vulnerable customers; and

· via Ofgem E-Serve, ensuring the timely and efficient delivery of Government programmes for a sustainable energy sector.

Remit changes and Ofgem’s future

The Energy Acts of 2008 and 2010 have further empowered Ofgem in our work to promote sustainable energy and take account of the interests of future as well as existing consumers. Across our work we can point to decisions that are impacted by these new statutory duties, and lay to rest the idea that an economic regulator cannot handle matters such as sustainability. In our networks businesses, our rulings on interim connect and manage (to get early renewable projects plugged into the system) or our new RIIO model reflect these changes. In energy supply, our rulings on 30 days advanced notification of price changes and our retail probe remedies also show Ofgem responding to its remit changes.

We are participating fully with DECC’s current review into Ofgem and are focussing on our current set of duties until the Government decides if it wishes to make any changes to our role and remit.

Meanwhile we are reviewing the responses to the DECC consultation process and are looking at a number of issues raised by the respondents to see whether we can improve our ways of working. We are also assisting DECC with their delivery landscape review insofar as it relates to Ofgem E-serve.