PÖyry point of view - October Building the modern electricity network: regulation and innovation

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1 PÖyry point of view - October 2015 Building the modern electricity network: regulation and innovation

2 Beyond vertical separation? Electricity Regulators and Policymakers need to recognise that the electricity market value chain paradigm that underpins much of their policies and philosophy is no longer fit for purpose. At best inaction is causing inefficiencies at worst, it is stifling the deployment of potentially innovative technologies and business models. Deployment of renewables and other small scale generation at transmission and distribution levels, the growing use of small storage technologies, and demand side engagement all blur the different sectors interfaces and networks role is being increasingly drawn into debates long faced by generators and suppliers. Market design for the 21st century now needs to encourage institutions and organisations to bridge these artificial divisions and move beyond conventional asset-based solutions (for example increasing networks Regulatory Asset Base RAB - to allow for transformer upgrades). It is increasingly clear that while the logic for having the current market divisions are beneficial, they also create situations where one sector s cause is another s problem. However, unlocking this value fundamentally requires Regulators and Policymakers and Transmission and Distribution System Operators (TSOs and DSOs) to change their mindsets. They need to take the first experimental steps now to deliver a strong, efficient low carbon system in the coming years. 2 PÖYRY POINT OF VIEW

3 Traditional industry unbundling Increasing signs that the old paradigm of a stratified value chain now needs adjusting Twenty five years have now passed since the first countries in Europe took the brave steps to restructure their electricity systems. Economic benefits from introducing competitive markets in generation and supply, breaking up vertical integration and regulating the networks are widely recognised. But there are now growing signs that this market structure is becoming outdated even as the last few countries in Europe adopt it. The very system that was devised to introduce competition and innovation now risks stifling the next generation. In the last decade there has been a significant move from stable power systems dominated by fleets of large thermal plants that could deliver many necessary system support services (e.g. frequency control, voltage regulation) needed to keep the system running. Many of these plants have retired, or will retire soon, and at the same time renewables are growing rapidly. Many of the renewables are intermittent (e.g. wind and solar PV) and furthermore, many of the projects are connected to distribution networks operating at lower system voltages. The concept of a homogenous network is now outdated with new challenges and opportunities becoming the norm. In working towards the EU 2020 renewables targets and pursuing longer-term decarbonisation ambitions these trends are only going to accelerate. Future power systems will be characterised by more decentralised generation, widespread intermittency in all its guises, more active customer engagement and flexibility, with far more pressure on networks. PÖYRY POINT OF VIEW 3

4 Growing symptoms of a failing system two symptoms of a failing system are now quite clear: Many DNOs have connection queues, and/ or are installing more equipment to accommodate growing amounts of intermittent renewables that dramatically alter the size and direction of their power flows and voltage stability. Building new lines and upgrading transformers might be a conventional way of overcoming this but nowadays local storage and demand-side response capability can be a far more effective way to manage down such network investment and reduce operational risk levels. This could be on a commercial basis (i.e. contracted) just as much through physical ownership. Transmission System Operators (TSOs) are buying a longer list of ancillary services that are needed to provide a stable Grid, for example standby reserve, reactive power, frequency response. Different perspectives Some countries are hitting these problems earlier than others Ireland is a good indicator of what s to come for the rest of Europe. Its island situation and rapid deployment of wind power means we can see today many of the problems that will arise elsewhere in Europe in the future. To keep the system stable the TSO has introduced limits on the amount of wind on the system. This triggers the need for constraint payments which lead to consumer anger over handouts at a time when bills are rising, increased connection delays for new windfarms, and the TSO now has plans to procure fourteen separate ancillary services. Even in Germany, which enjoys strong electrical interconnections in virtually all directions, there are times now when the country s electrical needs are completely met by wind and solar generation. If this sounds like a good headline, then this isn t how the grid operators see it many of the key services to keep the grid stable are being imported from neighbouring countries. Of course the neighbouring systems may need these for themselves and Germany will need to find its own solution. 4 PÖYRY POINT OF VIEW But technical developments since the 1990s, and particularly since 2000 mean that the networks, generators and supply sectors are all converging. Novel business models and new market paradigms are increasingly challenging traditional energy market structures which can either solve, or at least alleviate these issues. For example what is a distribution-connected battery? Is it a: Generator, providing active power and ancillary services? Distribution network asset, saving the need or more transformers or lines? A customer consuming power from the system? In practice it can be all of these. It can defer the cost to a DSO of a line reinforcement or transformer upgrade, but can also contribute to local and national system stability. In addition as well as enjoying some profit from market arbitrage, it can be charging up buying in power. Similarly, demand-side aggregators can participate in national capacity markets as well as help reduce investment in local distribution networks. Together the profits from such multiple revenues can make a compelling investment case even today but the problem with the current market arrangements is that this is not allowed and therefore the investments will not happen despite its fundamental value.

5 The old world of hundreds of thermal plants is rapidly being replaced by a new world consisting of thousands and millions of market participants Similar situations will happen with many pioneering smart grid applications, and are probably happening now. Unlocking the value needs a fundamental rethink that allows cross market segment value to become a core feature of market structures: Technology innovation in all parts of the value chain is continuing to develop rapidly both in its performance and costs so we should expect to see a wider variety of business models based on energy storage, smart metering and demand-side participation. Many of the opportunities are on distribution systems, but they spill into transmission, and in any case there is growing crossover between TSOs and DSOs operations. These problems are only likely to become more acute across much of Europe, but understanding the highly technical issues of network stability and operations will challenge most regulators and policymakers. Any change away from the current market structures will not be easy some European countries are only just completing the various business separations and initiating competitive markets. And there is a great deal of comfort for Regulators and Policymakers and even utilities - in working with a set of clear market building blocks and using the relevant licences to keep things apart. The signs are for a continuation of this theme: the European Commission is shortly to consult on a New Market Model to further refine the Target Model. Its themes are further refining shorter term markets and to get the best out of interconnectors. But the vertical separation paradigm remains central to its philosophy. On the other hand there are some signs of change for the rules for DNOs in Great Britain the RIIO approach to rate setting is a start towards focusing on outputs rather than simply reducing network costs and the innovation funds are being used somewhat to explore how Distribution Networks can become more Smart but this is only just the beginning. 5

6 Incremental steps On another level, the institutional separation of DSOs from TSOs means that a great deal of the responsibility for ensuring that the entire network stays within normal frequency, voltage etc, falls on TSOs, when in fact the DSOs may be well placed to help manage this increasing challenge. Unfortunately the highly technical dimensions involved in running power grids do not lend themselves easily to less-well technically qualified regulators and policymakers. Perhaps the TSO is actually comfortable with the situation in which the problems of maintaining grid stability remain its responsibility. After all, this is an important and traditional role for TSOs. But it is increasingly apparent that DSOs could have a more active responsibility many of the services e.g. demand response, storage that could provide value to the local problems can also participate at a national level as well, albeit only occasionally. With such local problems, a more optimal structure could incentivise the DNO to sort out its own problems rather than have the TSO provide an ever growing list of ancillary services. Business structures in which the cause of a problem are separated from its solution tend to lead to a great deal of inefficiency that is removed when they are aligned or consolidated. The UK s changes to DNO regulation by moving towards a totex regime (that effectively allows some innovation across boundaries) and supporting Low Carbon Network Funds are a good start, but policymakers at a European level and in all countries need to change their mindset and embrace these clear and present changes. Innovative service providers should be able to access the full value of their service. However you look at it, physical asset boundaries should not prevent functional or commercial participation in the market. In practice, this could mean: Changes in distribution regulation structures; Putting more responsibilities on DNOs to actively run their systems to reduce pressure on the Transmission System; and fundamentally Initiating structures that recognise system-wide and local value of assets regardless of where they are on the network. These are, of course dramatic changes from historical market designs. While the value of separating out business segments should be recognised and preserved, the concept needs to move with the times. Definitely time for a rethink. 6 PÖYRY POINT OF VIEW

7 Policymakers at a European level and in all countries need to change their mindset and embrace these clear and present changes If you found this Point of View useful, you may be interested in the following related Point of View reports... PÖYRY POINT OF VIEW 7

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