May 2016
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2 | The effects of changes to Embedded Benefits on the Energy Trilemma

Government and regulatory policies have encouraged investment in small scale electricity generation connected to local distribution networks. More than 25 GW is now connected in
Great Britain and, in some locations it now exports energy to the national transmission grid used for bulk power transport. Distributed generation helps ensure that electricity supply and demand is balanced, especially during stress events and times of peak demand. Over recent years, as capacity margins have fallen, this flexible generation has played a key role in reducing peak demand, underpinning security of supply.
Generators connected at up to132 kV on the distribution system in England and Wales are called embedded or distributed generators and are treated as negative demand for the purposes of transmission charging. These generators do not pay transmission charges and they may also receive a benefit from suppliers because they help reduce their peak demand and transmission charges. Together, this is known as “embedded benefits”. There are significant variations in the level of embedded benefits for different plant depending on technology and location.
There is a debate to be had around what constitutes a fair and costreflective arrangement for meeting the costs of the electricity network in an energy system with high levels of distributed generation, However, changes to the current incentive regime risk significant reductions in distributed generation and increased risks to security of supply at a time when short term capacity margins are tight. Currently, Ofgem (along with Government) is considering if embedded benefits should be modified, as they are perceived to be encouraging the development of distributed generation rather than the larger-scale transmission connected generation needed to support long term capacity margins.
The rapidly changing market dynamics we face today present a huge challenge for the Government,
Ofgem and the industry as a whole.
Regulatory and associated charging regimes are and should be reviewed periodically to ensure that they are fit for purpose for the future as well as today. Retrospective action is very rare in the UK irrespective of the political party in Government. Given the level of distributed generation on the UK system, Ofgem and Government will need to carefully consider the impact of their decision on the investment decisions thus far in distributed generation and the impact of any changes in regulation on short and long term security of supply.
UK Power Reserve Ltd, a United
Kingdom-based energy company, has commissioned KPMG to conduct an independent analysis of the effect of potential changes to the embedded benefits regime on the achievement of UK energy policy objectives to provide policy considerations for the Regulator and Government. This report has examined the advantages and disadvantages of options for changing the current embedded benefits regime. This report, however, does not aim to provide alternative methodologies to the current charging regimes.
Headlines from the Analysis
We have analysed the impact of two stylised alternative policy options for changes to the embedded benefits regime, compared to a ‘Status Quo’ scenario. These are:
1) The immediate removal of
Triad payments for all distributed generators could lead to: a) security of supply risks
An immediate removal of embedded benefits could make a proportion of existing distributed generation uneconomic. We estimate that if embedded benefits were removed for all plant, approximately 2,100MW of new distributed generation in the
T-4 2015 auction could be withdrawn.
This withdrawal could have significant impacts on near term security of supply.
b) increase in cost to consumers:
Any sudden changes to the current embedded benefits regime that investors perceive as retrospective could increase costs of capital for a wider range of energy projects reflecting increased regulatory and political risk.
1 National Grid, ‘Future Energy Scenarios 2015’, Figure 68,http://fes.nationalgrid.com/fes-document/
2 See http://data.parliament.uk/writtenevidence/committeeevidence.svc/evidencedocument/energy-and-climate-change-committee/security-of-supply/oral/25123.pdf, Q10
3 | The effects of changes to Embedded Benefits on the Energy Trilemma
The removal of embedded benefits is likely to increase the price at which distributed generation bids into future Capacity Market auctions.
This will shift the supply curve of participating plant upwards, and could increase the clearing price in future auctions compared to Status
Quo, although these impacts are highly uncertain at this stage.
We estimate an upper bound net cost increase in future auctions of £1.3bn in a scenario where the removal of embedded benefits means new CCGT becomes the marginal plant. In addition, we believe that the 2,100MW of new build distributed generation that has been successful in the 2014 and 2015
T-4 auctions will struggle to reach financial close. Our estimates of the cost of replacing this lost capacity in future capacity market auctions ranges from £19m to £63m, or £285 to £945m over the typical 15 year contract duration for new build plant.
2) Transitional arrangements, where embedded benefits are partially protected for existing distributed generators and new build projects that are financially committed. Our conclusions were :
In this scenario, the impact of policy change on investment sentiment would be more limited, provided that a decision to pursue this policy was made quickly. Delayed decisions and policy uncertainty would have a negative impact on investment sentiment.
Future embedded benefits removal would have an impact on the supply curve of participating plant in future auctions, but this would be more limited compared to Option 1, as existing plant would continue to bid into the market as they do currently.
Our estimate is that an auction with the same parameters as the T-4 2014 auction would have been £200m more expensive compared to the
Status Quo.
Potential impact of change
Sudden changes in the embedded benefits regime could have a significant impact on the UK energy market. Investors have financed embedded generation (renewable and conventional) in recent years with the expectation of a stable regulatory regime. While there are calls for a review of the charging methodology, a sudden change for existing investments would impact investor confidence for the future, not only in distributed energy but across the entire energy sector.
This could result in substantial risks to security of supply and increased costs to consumers.
As a part of the report, KPMG analysed the potential advantages and disadvantages of change to the embedded benefits regime on the UK electricity market as summarised on opposite:
Enhance security of supply and reduce costs to consumers by removing distortions in the Capacity Market to the to the development of large, economic transmission connected generation by removing distortions in the Capacity Market development of large, economic transmission connected
Reducing incentives for development of diesel generation and the associated environment impacts
Ensure fair charging arrangements – discriminatory/ cost reflective network charging arrangements to reflect transmission system costs nondiscriminatory/cost reflective network charging arrangements to reflect transmission system costs.
— Non-
Investor uncertainty —
Retrospective policy action and a negative impact on investment confidence
Affordability —
Retrospective policy action will raise financing costs as investors to compensate for policy/political risk security risks
Security of supply —
Distributed generation
Balancing services —
Dis-incentivises flexible distributed generation that can ramp up quickly to meet peak demand disincentivises flexible distributed generation that can ramp up quickly to meet peak demand
Decarbonisation — dis-incentivises low-carbon renewables dis-incentivises low-carbon renewables
Affordability – increased capacity
Network investment — policy action will raise financing costs as investors factor in increased regulatory/political risk reinforcement
Network investment- distributed
Implementation of change — network upgrades or reinforcement implement in a rapidly changing and complex charging regime
Implementation of change – may take considerable time to implement in a complex charging regime, taking account of (for example) locational impacts and energy profiles.
The effects of changes to Embedded Benefits on the Energy Trilemma | 4

Transitional policy considerations
The immediate removal of embedded benefits could lead to the withdrawal of large amounts of distributed generation and put pressure on the
UK’s short term capacity margins.
If changes are deemed appropriate, the report identifies a number of transitional measures that could be considered under Ofgem’s review, helping to maintain investor confidence. These focus on:
• Transition from existing Triad arrangements: transitional arrangements that allow existing distributed generation to continue to provide Triad services, recognising that existing capacity market bids were based on assumptions of embedded benefits.
• Change Capacity Market tender rules – a choice could be introduced into future Capacity
Market tenders where new build generation was offered the choice to either obtain a 15 year contract or a Triad embedded benefit but not both.
• Gross TNUoS charging - for future
Capacity Market auctions, changes could potentially be made to the TNUoS embedded benefit calculation, i.e. move from net to to gross from net to remove
TNUoS embedded benefits being paid to new build exportable distributed generation. The future level of embedded benefits for new capacity could be adjusted by a sharing factor such that a proportion of transmission charges are passed through to distributed generation.
• Changes to Triad charging methodology - for example, switching from the current three peaks approach to a 4-7pm winter weekday baseline calculation could reduce the incentive for Triad avoidance.
• Achieving policy aims through targeted instruments outside of the embedded benefits regime.
This could include an emissions performance standard for diesel generators or limits to their running hours
• Whole Systems Approach to energy policy. In reviewing the charging methodology, Ofgem and Government should not consider power sector in isolation from both heat and transport, which will each have significant impacts on the power sector and require significant investment in infrastructure.
A transition path could well be a combination of changes that both maintain the benefits of embedded generation with closer alignment to consumers’ interests. KPMG in this report has not attempted to create such a transition matrix and analyse the options, but recognises the possible value in doing so in the future.
Stability of future charging regimes is crucial to allow generators to accurately forecast revenue and provide investor confidence. Any recommendations to change the structure of network charging should consider future impacts on both energy production and consumption.
For example, fixed, forecastable cost signals will incentivise different behaviour from ex-post cost variations; location signals for generation stations should be strong enough to drive the most cost reflective outcome for the consumer.
Potential regime change will need to consider such issues, and how to make changes.
Network charging concepts and methodologies have undergone a revision in the last decade as Ofgem has operated under a widening statutory remit. The economics of plant, especially geographically remote based renewables and nuclear, have called into question the previously laudable long run marginal cost (LRMC) approach. The difficulty associated with this debate, and the legitimacy of a range of approaches, has spawned reviews of charges that take years to conclude. For example, project Transmit has run for over five years.
Any changes to charging regimes must recognise the hurdles that legitimate consultation and challenge provide.
Short term security of supply
Implementation of change must take account of impacts on security of supply, especially in the short term.
Ofgem’s latest view of security of supply for winter 2016/17 was published in Summer 2015 and is set out below. They state ‘ Uncertainty around the outlook for winter 2016/17 has increased. Margins could tighten if further power stations close or mothball. However, we have identified a significant potential for the market to respond positively and reduce the risks to security of supply’.
Ofgem’s current review of embedded benefits will be played out against a very tough security of supply backdrop in the short term. Whilst arguments for change may be valid in a world of plentiful capacity this very tight capacity picture may provide a very useful parameter for the debate in the short term. We note that the Secretary of State said in her November Energy Policy Reset statement ‘Energy security is the first priority’.
5
Figure 1: Ofgem review of security of supply for winter 2016/17
5 | The effects of changes to Embedded Benefits on the Energy Trilemma
Amber Rudd’s speech on a new direction for UK energy policy, November 2015, https://www.gov.uk/government/speeches/amber-rudds-speech-on-a-new-direction-for-uk-energy-policy
The effects of changes to Embedded Benefits on the Energy Trilemma | 6

Table 1: Summary of energy trilemma impacts versus Do Nothing under policy options
Distributed generation no longer supplies power at peak — increased risk of blackouts.
Build constraints on new CCGTs mean this capacity cannot be instantly replaced
Successful new build plant in
Capacity market auctions unable ot reach financial close.
Transitional arrangements must be designed so as to allow distributed generation to supply power at peak while capacity margins remain tight.
Upward pressure on Capacity
Market price in future auctions
Savings associated with removing embedded benefits small
(£250m–£300m)
Upward pressure on Capacity
Market price in future auctions
CO
2
Less renewable generation
More transmission connected capability meeting peak demand
— this must run on part load at other times, thus increasing emissions
Less renewable generation
Retrospective policy action increases costs of capital across energy sector
Translational arrangments must be designed so as to avoid appearance of retrospective policy action.
7 | The effects of changes to Embedded Benefits on the Energy Trilemma