–Contracts for difference fight against grid balancing system
Aug. 31, 2022– By Mathew Carr
Governments and energy regulators have been too slow to react to the Russia-Ukraine war.
This analysis from September LAST YEAR is a very good explanation that shows what’s (still) wrong with the UK power market a year later and six months after the start of the war — as the flawed system puts huge financial pressure on consumers.
Energy regulator Ofgem last month put forward a range of potential reforms to reduce Britain’s reliance on expensive gas imports and accelerate the transition towards cleaner, more secure and affordable supplies of home-grown energy.
But they will “take time”.
The delay does reflect a huge shift — to a world where the economics have changed, and renewable options are increasingly the cost-effective choice, Ofgem said.
Yet the measures are pushing the UK to take an even more unfair share of the global carbon budget.
Times of London on Scotland’s resistance to UK fossil-fuel expansion plans:
Still, this post by
Head of Trading at E (Gas & Electricity) Ltd
says consumers might be being unnecessarily scared:
“Given that we do not start purchasing Q2, 2023 wholesale gas and electricity till late November, its probably prudent to hold off on these wild forecasts. The price cap methodology takes the ICIS closing price for each of the trading days for cap window 10a, from 17th Nov-17th Feb and these will be used to set the price for April 2023. As we have seen, a lot can happen in 3-6 months. It feels like an unnecessary way to frighten people forecasting that period on last nights close prices.”
Consumers will continue to get new ways to feel ripped off:
The rush to better energy regulation is wide.
Back to the UK example, which I think provides a clear demonstration of what needs to be tackled, a way forward there and beyond:
So I repeat the second half of the linked article above — the cool explanation made year ago that still rings true — by Nick Speechley, Accenture Trading, Investments and Optimization Strategy (emphasis added — if you need explanations of the terms, click through the link at the top):
September 2021 was an unusually expensive month for electricity, and day-ahead prices have been higher than CfD strike prices in a number of periods. For example, on 20 September 2021, National Grid accepted a bid from a wind farm with a CfD to turn down its generation at £1061/MWh.
At first glance this seems like an absurd price for a generator to pay to stop generating electricity, however the wind farm’s CfD strike price for the period was £98.23/MWh and the market reference price £1189/MWh. Therefore, rather than pay £1091/MWh (£1189/MWh — £98/MWh) to the LCCC, the wind farm actually received £128/MWh (£1189/MWh — £1061/MWh), £30/MWh more than its CfD strike price (fig.3).
Balancing the electricity system is complex. Even in periods where generation output is expected to be low and demand high, National Grid will typically turn down some generation in order to maintain the stability of the system. This could be to maintain system inertia or increase reactive power, or to make room for a power station that can be turned up quickly in the event of an unexpected increase in demand.
What is the problem?
Put simply, the net impact for the GB electricity system are higher costs and higher carbon emissions.
By using this strategy, the aforementioned wind farm (fig.3) made an additional £40,000 profit in September. This is money that the LCCC would have otherwise recovered via difference payments. Currently, only a handful of generators have adopted this strategy, however should more generators with CfDs start using a similar strategy it is not unfeasible that the total loss to the LCCC could be tens of millions if high day-ahead prices persist throughout winter.
The cost of administering the CfD scheme is passed onto customers via a levy on suppliers, which in turn, is priced into electricity tariffs. A more expensive CfD scheme results in more expensive electricity tariffs for customers. At present, the CfD levy on suppliers makes up approximately 3.5% of a domestic customer’s electricity bill. This could increase as more CfDs are awarded in the upcoming CfD Allocation Round, due to take place in December 2021.
The National Grid accepts bids and offers via the Balancing Mechanism on the basis of several criteria, including price. If the Grid can reduce the total cost of its balancing actions by turning down a low carbon generator with a CfD in preference to more carbon intensive alternatives, then it will likely do so. This has two implications for the GB electricity system.
Firstly, when day ahead prices spike, the National Grid is incentivised to turn down renewable generation in lieu of higher carbon emitting alternatives. The net impact is less renewable generation on the grid and a higher carbon intensity energy system.
Secondly, the price market participants pay for their imbalance position is a function of the highest bid and offer prices accepted by National Grid in the Balancing Mechanism. As with the example above (fig.3), in periods where the day-ahead price for electricity is high, there is an incentive for generators with a CfD to bid a proportionally high price to the Grid to turn down. This results in higher imbalance prices, increased imbalance cost for market participants, and ultimately, higher cost tariffs for consumers.
Designing energy markets is no simple task, however, creating markets that incentivise the “right” behaviour is essential for the UK Government to meet its ambition to decarbonise electricity supply by 2035, and its legally-binding obligation to bring all greenhouse gas emissions to net-zero by 2050.
There are several options available to policymakers to address this potentially problematic interaction between the CfD scheme and the Balancing Mechanism. One such solution, would be to modify the volume upon which the CfD is calculated to incorporate an adjustment for balancing action volume. This modification would not prevent generators with CfDs from participating in the Balancing Mechanism, but would remove the incentive for generators to pay the Grid to turn down their electrical output. A generator, at its discretion, may still bid into the Balancing Mechanism, however regardless of acceptance they would be required to make/receive a difference payment to/from the LCCC.
The interaction between CfD contracts and the Balancing Mechanism is an example of electricity market design working against the UK’s net-zero aspirations, but further obstacles remain on the road to a decarbonised electricity system. The pace of change required cannot be overstated. For the UK to realise its ambitions to decarbonise the power system by 2035, it is vital that decision makers act swiftly to design wholesale market and system operation arrangements that support a cheaper, greener, electricity system.