UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 1040-i

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

ENERGY AND CLIMATE CHANGE COMMITTEE

ELECTRICITY MARKET REFORM TECHNICAL UPDATE

TUESDAY 24 JANUARY 2012

MELLE KRUISDIJK, PROFESSOR NEWBERY, MARK RIPLEY, SIMON SKILLINGS and NICK WINSER

Evidence heard in Public

Questions 1 - 94

USE OF THE TRANSCRIPT

1.    

This is an uncorrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.

2.

Any public use of, or reference to, the contents should make clear that neither witnesses nor Members have had the opportunity to correct the record. The transcript is not yet an approved formal record of these proceedings.

3.

Members who receive this for the purpose of correcting questions addressed by them to witnesses are asked to send corrections to the Committee Assistant.

4.

Prospective witnesses may receive this in preparation for any written or oral evidence they may in due course give to the Committee.

Oral Evidence

Taken before the Energy and Climate Change Committee

on Tuesday 24 January 2012

Members present:

Mr Tim Yeo (Chair)

Barry Gardiner

Ian Lavery

Dr Phillip Lee

Albert Owen

John Robertson

Laura Sandys

Sir Robert Smith

Dr Alan Whitehead

Examination of Witnesses

Witnesses: Melle Kruisdijk, Director Market Development, Wärtsilä Power Plants, Professor Newbery, University of Cambridge, and Simon Skillings, Trilemma UK, gave evidence.

Q1 Chair: Good morning and welcome. Thank you very much for coming in. May I start by asking generally whether you think the proposed institutional framework, which we have now had from the Government, meets reasonable expectations in terms of governance, accountability, independence, technical expertise, value and so on?

Professor Newbery: Yes, I think it does. The framework set out in the technical update is adequate. There are some details that probably will need to be, and presumably will be, spelled out when the system operator gets down to business and Ofgem gives it the right kind of guidance as to what it should be doing.

Simon Skillings: I do not disagree with that. I would probably say that there is no reason why not, but it is too early to say. There are so many aspects of how the governance of the institution needs to be established and confirmed to answer the question firmly, but there is no reason why not. There clearly are some issues to manage, but they are not unmanageable.

Melle Kruisdijk: I agree. I think it is a good start, but there are still a lot of open points there. That is also recognised, and it is a very important point to make the future mechanism work. We will come back to that later, I suppose. I think it is a good starting point, and it gives open all the inputs that are needed to make it work.

Q2 Chair: What are the other elements you mention that are not covered so far?

Melle Kruisdijk: I think the current mechanism does not differentiate between the types of capacity that would be needed in a capacity mechanism. It treats a megawatt as a megawatt, and given the future integration of wind power into the system you would have to differentiate into criteria of the capacity that you would have to have in the rest of the portfolio to deal with the fluctuations of wind. That differentiation is not so clear for me at the moment.

Simon Skillings: The key issue about the institutional framework is that the delivery institution-the system operator-is going to have a critical role in this market. There is no way that Government can define policy to a level of detail that will allow implementation and roll-out of all the mechanisms. There will be a significant gap to bridge, and the delivery institution has to do that. The key point is that they will have a massive role in this industry, and because they will have a massive role in this industry, we need to have a very clearly specified basis on which they do that work.

Professor Newbery: The missing element is the directive that they should be delivering the renewables target at least social cost. That will include not only the cost of whatever renewables are built, but the transmission, the reserves and the various methods of handling constraints. The system operator is in a good position to do that. They have, as the report notes, a conflict of interest in that they are interested in their transmission aspect. Making that an independent system or an independent planning organisation is consistent with the present arrangements, but it probably needs to be made more explicit.

Simon Skillings: As David says, there is a lot of relevant expertise within the national grid, but there are also big expertise gaps. I agree that we should be looking to deliver best-value outcomes for consumers, but I think that most people recognise that the demand side and driving investments in demand reduction and demand response are critical. They have not been areas of core competence within the National Grid Company. If we are going to seriously tackle those issues and put the resources in, that is a big departure from where the grid company currently is.

Q3 Chair: Are they sufficiently independent?

Professor Newbery: Not at the moment. They need to become, as they are in Scotland, an independent system operator, with the right kind of Chinese walls with the transmission investment business. The problem is that they will have to be involved in transmission investment design, because where the wind in particular is located will involve investment in transmission.

Simon Skillings: We are clearly on a road towards an independent system operator. Whether we do that in one leap or a series of steps, at a minimum there needs to be some rigorous business separation regulations imposed on the way they operate as the delivery institution for EMR and the way they operate in terms of the owner and investor in the transmission network.

Q4 Chair: I am not quite clear what you are envisaging. We have National Grid, which is not very independent and has an addiction to 1960s technology for its main transmission business, and which we are now entrusting with a huge new role. It does not seem to me that they have done much to show that they are well qualified to be able to do it.

Simon Skillings: Well, I guess the counter-argument to that is that there is probably no one else who is in a better position. They have a huge amount of knowledge related to the aspects of system operation, system balancing, the operation of generation and the impacts of renewable generation on the grid. That is a pretty good starting point and it is not obvious that anyone else would be at a better starting point. What you are doing is building on that, but we have to recognise that it is not just something that we can tuck away within National Grid’s business and forget about it. We are creating something that is absolutely central at the heart of this industry and that probably needs to become an independent organisation over time.

Q5 Chair: Is that not saying that we are going to have something that is a bit of a botch-job at the start, because it will have to change quite quickly?

Simon Skillings: You could argue that that has been the history of liberalisation over the past 25 years. It is constantly evolving. It is big, tough and complicated. The idea that we can dot every i and cross every t at the start is rather over-ambitious. The mistake would be to pretend that we can.

Q6 Chair: But you think that they-not Ofgem anyway-are the right people?

Professor Newbery: Yes.

Simon Skillings: Yes, because they need to be regulated.

Q7 Chair: Are there going to be any EU regulations which bear on this?

Professor Newbery: There are already unsatisfactory regulations for interconnection, which are not helping our building of more interconnections, which we will increasingly need with the large amount of wind power.

Simon Skillings: I am sure that we will move on to the capacity issue, but there is a pretty fundamental issue, which is that the Government are aspiring to establish a process of resource adequacy within the UK, to fix a security margin within the UK to ensure that we have a more secure system, but they have not explained how that is at all compatible with the single market, in which you may be connected to a neighbouring market that has no security margin and all that happens is that you need to keep running to stand still, because every time you build something to get your margin, they will shut something next door to keep their price going up. You cannot do it under a single market. It is part of a range of issues that have not been thought through yet.

Q8 Sir Robert Smith: On the EU, though, would there be any other EU rules in terms of the role of National Grid, the separation and the Chinese walls?

Simon Skillings: I have heard there are issues about the separation of system operation and transmission operation that are written into the liberalisation directive. I would imagine your witnesses from National Grid would give you more detail on those, but there are some issues there, I know.

Q9 Albert Owen: I want to take this potential conflict of interest a bit further, with National Grid as a commercial arm and also implementing capacity mechanisms and feed-in tariffs. In your earlier reply, Professor Newbery, you were relaxed about it. You said it could happen but it could be managed. Is that what you see-that there is a potential conflict of interest, but it can be managed?

Professor Newbery: It comes down to the design of these contracts for differences for wind. If you insist that they get the same price regardless of location, then you are building up a huge problem on co-ordinating the transmission investment and the location. If you can design a system which allows for different prices in different places, and it is very transparent how you are doing that, it can be externally verified whether they are doing the least total cost combination of investment in generation and transmission. You could spoil it by designing the contracts badly, or you could make it transparent and therefore much easier to regulate.

Simon Skillings: Another issue arises from a lot of evidence from the States, where there are a lot of programmes to drive forward demand side investment and demand side response. All the evidence is that what they avoid is transmission investment, rather than generation investment. Now, I am not pretending that it is an exactly transferable situation from the States to here, but it is clearly an issue that needs to be managed, to make sure that we are genuinely getting the best value investments.

Q10 Albert Owen: How can you manage it?

Simon Skillings: There is a number of ways. First, it clearly needs to be independent from making money out of transmission investment, although it is very difficult to avoid that; there need to be clear best-value objectives; it may even be, particularly given the complexities of the demand side and the fact that that requires new behaviours, an appropriate situation for a financial incentive. In other words, if you save lots of money for society by having lots of demand side investment, you can keep some of it-which is a bit like the current system operator incentive regime. So there is quite a strong argument for that.

Melle Kruisdijk: Can I add to the point Professor Newbery made? If you position your power plants a little bit smarter around the country, you could actually avoid a lot of constraints on the grid, and investments could co-ordinate with that, so that could be a target of the new mechanism-to incentivise plans where load is required, instead of transporting it through the grid.

Q11 Albert Owen: To follow up on that, how would we be able to measure that National Grid is impartial in the future?

Professor Newbery: If we have a system of nodal pricing, where the price of each node on the grid is calculated according to an independently verified computer programme, of which there are many, then you can immediately judge the value of supply side response or intermittent wind or whatever it is at each location. Then you can easily judge whether the way the system is evolving makes sense.

Q12 Albert Owen: It sounds very simple. As a Committee if we are looking at this in the future, we will just have a sheet of data and be able to say, "You are doing a good job," or not?

Professor Newbery: It is question of process. You get some competent engineers who can judge whether the plans that are being proposed make sense, in much the same way that Ofgem at the moment has to when it is looking at investment plans.

Simon Skillings: I guess this is all very second order to the underlying policy: what is it that the institution is being asked to deliver? What flexibility is it being allowed to have in trading off different technologies? If it is being told, "We want this much nuclear, this much CCS, this much renewables," it has not actually got a great deal of flexibility, but if it is being given some sort of carbon envelope, and told, "Find the cheapest way of doing that," then it has huge flexibility. It has flexibility in terms of technology. It has flexibility in terms of how it portfolio-manages its contracts-does it lock it all in for 10 years, or a little bit for 10 years? It has vast flexibility and it can have a huge impact on cost.

Q13 Albert Owen: So the contract is key?

Simon Skillings: Absolutely, yes.

Q14 Dr Whitehead: The technical update itself reflects on the fact that they think there may be conflicts of interest in the idea of the National Grid running the system. They say there will be a project in January 2012, which will report in detail after legislation is complete. Is that the right way round in your view, bearing in mind that, presumably, a project could conclude that it is rather more difficult to ensure the independence of National Grid than one might think?

Simon Skillings: I think I am less worried about that than I am about a number of other processes that are running beyond legislation to do with balancing, review, electricity efficiency, FIT and those things, because I am pretty sure there is an answer to that problem. You can put in place regulations to ensure independence-there are examples of business separation regulations. It is a well trodden path, so I am sure there is an answer to that, but there are other things that I think are a bit more troublesome in terms of the legislative timetable.

Melle Kruisdijk: I agree with Simon. The biggest challenge is how the institution-whoever they are-implements this to make full use of the renewable energy sources at the lowest cost and at the lowest emissions. How does it design its capacity mechanism to deal with that? The biggest challenge for them will be dealing with the large amount of wind capacity that is planned to be installed and integrated on to the grid.

Q15 Dr Whitehead: There is a chart in the technical update, which I personally think is quite amusing. It appears to suggest that the "System Operator advises Government through draft delivery plan…" Then, "After iterative process, Government finalises the legislative framework", and then the "System Operator reports annually to Government on performance against delivery plan". There is not in that chart, apparently, a review of the possible conflicts of interest and how that might then affect the first part of the chart, which is the system operator advising the Government in the first place.

What is the feedback that might or could be there to ensure that National Grid, once the legislation is passed, actually has to do anything at all in order to ensure its own independence? What if National Grid just said, "No, we are not going to make any changes in our operation."? Assuming there were required changes in how National Grid operated in order to ensure that flow was two ways rather than one way, what might ensure that National Grid did what it should do?

Simon Skillings: There are two aspects to your question. Is the advice sensible and trustworthy, and how do we make sure they do it? The second is easier, because there will be a regulatory licensing framework, and the consequences of not fulfilling the licence are very serious for a regulated business so I do not think they would contemplate that. The more difficult question is how we know they are coming up with good advice and not just doing something that is easy and in line with previous experience of operational practice. It is difficult to imagine the Government will not need some expert advice to counter-balance the advice from the system operator. An example might be the Energy and Climate Change Committee doing an independent review of whether the advice is consistent with legislative targets. That is the sort of thing that one might imagine.

Q16 Dr Whitehead: You would not envisage circumstances in which the Government were to say to National Grid, "We or the system operator think it is a good idea, however you must divest yourself of x interests and y arrangements and z concerns in order to do it."

Simon Skillings: My personal view is that you do not need to impose divestment if you have robust business separation. In the businesses where I have worked the experience is that if you genuinely have robust business separation, the business logic takes over and there is no need to hold those two activities together. so the business makes its decision itself. All the regulating the Government need to do is make sure that they take rigorous business separation.

Professor Newbery: It is also worth pointing out that the really fun bits of National Grid are the design, and that is where the smart engineers will want to get it right. If they are allowed to do that, they probably will take some professional pride in doing it properly.

Q17 Sir Robert Smith: Professor Newbery, you mentioned locational charging in the contract for difference. I just wonder if that is somewhat counter to the current cruder thinking that the bulk of the renewable resources is in the north, and we need to get away from disincentivising it in the way that current locational charging is putting a barrier to some of the wind developments at the moment.

Professor Newbery: The present system is a cunning plan where the English subsidise the Scottish wind producers unnecessarily generously, just because it is windier in the north of Scotland than it is in East Anglia. Whether it is cheaper, given that you have to move that power down through some pretty expensive investment, is something that needs to be judged. Paying the same price regardless of where it is is not a recipe for making the right location decisions.

Q18 Sir Robert Smith: If you are trying to build a long-term structure and thinking of putting the boot straps in down both sides of the country, do you not need to have some strategic thinking?

Professor Newbery: I am deeply sceptical of the concept of strategic thinking. I believe in cost-benefit analysis. It may well be that the least cost solution is everything in the top left-hand corner and lots of investment in transmission, but I would like somebody to do the sums and demonstrate it, rather than just think, "It sounds like a good idea."

Q19 Sir Robert Smith: Do you think that the iterative process and the sum of the contracts will be enough of a signal to the market to deliver that, if that is the right solution?

Professor Newbery: Well, you can imagine having tenders to build and connect in various parts of the country and then this independent planning authority saying, "We’d get less value from the wind here, but we would save much more money on the transmission investment, so it’s a better deal than the one in a windier place."

Q20 Chair: You spoke in one of your answers about the least social cost. What is the distinction between the social and the financial cost?

Professor Newbery: The financial cost will be determined by the particular structure of charges that National Grid has been encouraged by the regulator to impose. They will not necessarily be the real costs on the system, because they are essentially a balance of interests that has tried to deal with the locational pricing problem by having uniform prices. It is about getting behind that and asking about the engineering costs, at the very least.

Q21 Chair: The engineering costs can be quantified in financial terms?

Professor Newbery: They can, but they will not necessarily be reflected in the prices and charges.

Q22 Chair: I understand that, but when you refer to social costs, are you simply saying that this is introducing some other financial costs, which might not be included in the equation, or are you looking at some non-financial element?

Professor Newbery: There will be non-financial elements, because we will at the very least have to decide the value of renewables, whether all the renewables are equally valuable, what is the value of carbon, and so on. These things are not necessarily well reflected in market prices.

Simon Skillings: May I quickly counterbalance the idea that cost-benefit should reign supreme? We are in an incredibly uncertain world. The challenge we face is to risk manage delivery of some quite challenging objectives in a hugely uncertain future world. That is absolutely the territory of strategic thinking and is killed by cost-benefit analysis that pretends to know things about future costs that it does not know.

Q23 Dr Lee: Just to clarify whether cost-benefit analysis is the only measure of what one should do in terms of direction of travel. Are you suggesting, Professor Newbery, that that was not done before these decisions were made? Essentially, you are saying that we are potentially pouring money into something in Scotland that we could have done more cheaply elsewhere. Are you suggesting that that type of analysis has not been done before?

Professor Newbery: The present regime says that we connect and manage. A wind farm can say, "I want to be here," and National Grid has to say, "Okay. This is what it will cost to connect," but those decisions are not jointly made, so there is nothing to stop someone locating in a place where it would be quite expensive to transmit the power.

Q24 Sir Robert Smith: Do they not have to pay the higher price at the moment?

Professor Newbery: Not under connect and manage; they just get the constrained off-payments.

Q25 Dr Lee: Is that not an argument for some strategy?

Professor Newbery: Well, Project TransmiT was supposed to be the strategic thinking about how we managed all this massive investment.

Q26 Dr Lee: I am not following. Essentially, you are saying that we are ending up doing something potentially uneconomic-

Professor Newbery: That is a risk, yes.

Dr Lee: -but you are also saying that it should be about cost and benefit and market. Is there not an argument for a strategic vision, so that you might in some situations subsidise a bit more, or is that just not possible?

Professor Newbery: Yes, you could say, "Look, the only way in which you are going to get this stuff built is to go hell for leather. Let people build and we’ll connect, and worry about the cost after the event." Or you could be strategic in the sense of, "Let’s try to think of the best way of doing the whole thing-not just the transmission or the investment in renewables, but both of them together." That is what I am suggesting is possible in a system in which you design contracts that are specific to location.

Q27 Dr Lee: Why do you think that was not done?

Professor Newbery: Because under the renewables obligation certificate, you got one ROC per megawatt-hour regardless of where you were.

Q28 Dr Lee: Yes, but why was that legislation put in place, so that you did not get to that? What do you think drove it? Politics? Economics?

Professor Newbery: A lot of people made a lot of money out of saying that it was a really good idea to let the market decide, and a market instrument like a tradable renewables obligation certificate has a certain ideological attraction from that point of view.

Simon Skillings: The big issue is the rate at which we have to do this. If we could just dribble along and build bits and pieces, we could do it in a nice, optimal way. The extent of the challenge is such that we have to grab the opportunities that exist. The reality is that the major constraint on building is planning and permitting: there are places where you can do it, and places where it is really, really difficult. If we are supporting the rate of investment that is needed, we have to grab the opportunities that are there and manage the consequences in the most cost-effective way.

Q29 Sir Robert Smith: Can we go back to the models and diagrams in the document? There is a lovely diagram showing: setting the policy, translating the policy, administering the mechanisms, reconciling data and monitoring compliance and enforcement. Are the roles of Government regulator and delivery body properly defined in the plan?

Professor Newbery: Nowhere in that is the careful design of the contracts to deliver the whole thing at lowest cost and the right speed to meet the targets.

Simon Skillings: The problem is that we lack a coherent policy that can sit behind this-a policy that is credible in that it is sufficiently ambitious to bring it in line with the climate objectives, but sufficiently flexible to take advantage of opportunities that emerge as we go on. The consequence of that is that no one believes that there will not be changes going forward. We are therefore left with a situation in which the Government-to shorthand it-are saying, "We’ll make our mind up as we go along about how much we can afford. You tell us how much we can get for that. We’ll do a quick check to see whether it all squares up. Off you go and do it." That does not tie in with a clear, long-term policy that will give investors, in particular, confidence that we have a sustainable framework.

Melle Kruisdijk: If you talk about costs and planning, you should think about the total system costs and how they can be reduced. If you are going to have a vision of integrating the wind power into the system, whoever is going to design a contract should also think about what sort of thermal power do I need in future to compensate for that wind, when do I need it and how much? Do I need it to be very fast? Do I need it to be online to give the flexibility? Or do I want them to start from zero and give the flexibility when needed, and then shut it off when I do not need it any more? If the plant is running at, say, a minimum load point to provide the flexibility, it is burning fuel, producing emissions and actually limiting the amount of wind power on to the grid, and it is producing power and that is exactly not what you want. Those sorts of considerations should be taken into account by whoever designs these contracts. There should be some sort of strategic planning behind it.

Q30 Sir Robert Smith: How does that fit into the structure that the Government have envisaged?

Melle Kruisdijk: I think it is still open. The capacity mechanism is now market-wide chosen. I do not see the differentiation, as I said: is it a flexible megawatt or is it a steady megawatt? It still leaves room to implement it, but it is not mentioned at the moment. That sort of thinking should now be developed to design in what sort of capacity is needed, when it is needed and how much of each sort of capacity is wanted in the system.

Q31 Sir Robert Smith: Mr Skillings, you are sort of saying that how policy making and policy delivery should be separated have not really been thought out.

Simon Skillings: Yes. I am not pretending that it is easy. I guess what I would conclude is that we will inevitably end up with Government setting a policy that is at best high level and potentially ambiguous. The delivery institution will therefore have to go and do something with it and that will be a big job-to actually operationalise that. In the discussion on the capacity mechanism, for example, we have seen this debate going forward at geological pace over the last two years to arrive at a point which is still a long, long way from remotely being specified, and the security of supply challenge is not heading off into the future.

Q32 Sir Robert Smith: Is DECC going to have the skills to set things like strike prices and so on?

Simon Skillings: The issue in policy is that someone somewhere is going to have to make some big judgments about the trade-offs between consumers and investors. There is a sharing of risk between consumers and investors. It really should be Government who make that decision-how much the consumer has to pay.

If you are talking about building a nuclear power station, that is likely to be a complicated public procurement process. I find it inconceivable that that can be delegated to a delivery institution. It sounds to me like something that must be held within Government. Carbon capture and storage is not a mile away from that, certainly in its early territory.

In the realm of renewables, there is much more evidence about what the costs are, so there are many fewer risks to manage up-front in terms of the costs you are sharing, so you can delegate more of that. The demand side, as I said, is an open book and because there really is not the expertise, certainly in this country, to flush it out. You need new mechanisms, such as incentivisation to really flush that through.

Melle Kruisdijk: The strike price, for example, is meant to attract investments in those sort of renewable energy sources, so setting the strike price will lead to a certain capacity of that technology and a certain fluctuation of production in the power grid. That will need some sort of counterbalance on the rest of the portfolio to deal with that. When setting the strike price you already have to think about the future: when do I need that capacity to come in to counterbalance the fluctuations of these renewable energy sources?

Q33 Chair: Are we proposing to entrust these very important decisions to a publicly quoted private-sector company?

Professor Newbery: I would not even think about the strike price. On wind farms, I would say, "Tender to me the price at which you want to be paid for capacity and megawatt hours in each place", and then we can have a transparent process of deciding which is the least-cost portfolio of solutions. You do not get to get the price; the market will tell you.

Q34 Chair: Well, it will tell you once you have decided how much capacity you want from that sector. You still have God acting somewhere there, haven’t you?

Professor Newbery: When you are subsidising things, you either have to decide how much you are going to subsidise in financial terms or in physical terms. You cannot get away from that.

Q35 Chair: I am trying to get clear in my mind who you think should make that decision.

Professor Newbery: If it is the amount of money that will be levied on consumer bills-this would seem to be a sensible way to go-it is essentially a Treasury or a Government decision.

Simon Skillings: I would say that for nuclear, it is Government; for CCS, it is Government. There is more flexibility for wind and you have to devolve demand, because it is the discovery process.

Q36 Sir Robert Smith: Do you think that Ofgem is the right body to oversee National Grid’s performance in this role?

Professor Newbery: Obviously.

Simon Skillings: As I say, I would also have a body that has clear long-term policy objectives, such as the Committee on Climate Change, looking at it as well.

Q37 Barry Gardiner: Professor Newbery, I am slightly confused by what you said and I want to clarify it. My understanding is that at the moment, the cost of connection and transmission that generators pay is based on location. I did not understand your side-swipe at the north of Scotland, saying that this was not a proper cost-benefit analysis. Surely if the companies are paying increased costs because of their location, a cost-benefit analysis has in fact been done that is based on cost of transmission, as well as costs of production and the increased wind power and so on, and they have made a clear decision based on that. Are you saying that the costs charged to the generators, although based on location, do not reflect remoteness adequately or is there something else that I am missing?

Professor Newbery: The system of locational charging, which by the way is excellent in comparison with other countries, was designed for the traditional fossil base-load generation, which, when it was designed, was going to be running for 80% to 85% of the time. It is not particularly well designed for intermittent generation, such as wind, and it is more of a cost-recovery system than a proper incentive system to choose the right place to locate for that generation.

Q38 Barry Gardiner: But if it is a cost-recovery system, surely intermittency would mean that they had to recover a higher cost per unit, proportionate to the costs of connection and transmission, and therefore it would disadvantage a more remote location. I am seeking clarity only.

Professor Newbery: You are quite right, but compensating for that, if you have twice the megawatt hours of wind per megawatt of capacity in the north, you get twice as much money and that balances off. It may, just by coincidence, perfectly match, but it is unlikely. I am saying, why do we not do the sums properly and work out what the wind is worth and what the cost of incrementally connecting this kind of generation to the existing system would be? The current rules do not give me confidence that that will automatically be delivered.

Q39 Barry Gardiner: Surely what you need to predict on your model, and with some accuracy, is just how many megawatts per annum you will produce from a particular installation and then charge it at that rate-calculate your recovery on that basis. I am talking about recovery of connection and transmission charges.

Professor Newbery: The financial sums are perfectly straightforward. A wind-farm developer will have good local wind information and can work out how much revenue he will get, and he will know what it will cost to connect. I am questioning whether the commercial decisions necessarily coincide with the least cost for the whole system.

Q40 Barry Gardiner: You were making a slightly different point earlier: that there was a covert subsidy going from south to north, because the costs of transmission and connection were, you indicated, inadequately recovered from the generator.

Professor Newbery: I am making two quite separate points. The first is that paying the same amount per megawatt-hour, when the amount of megawatt-hours is very different across the country, overly subsidises windy locations. The second point I am making-

Q41 Barry Gardiner: No, sorry, I don’t accept that. Surely, what you want to pay for is the electricity. What you were saying earlier was that you have to calculate how much electricity you want and then pay for that. The point you were making linked to that was about the way in which the transmission and connection costs were somehow clouding that. Surely, they are a separate issue. If they are being properly recovered because of the remoteness of the location they do not impact on that at all.

Professor Newbery: I said there were two points. One is the megawatt-hours and I will come back to that. The second is, under a connect and manage regime, before all the investments have been made that would allow you reasonably and economically to evacuate the wind, you are going to have to manage the system and endure considerable constrained off-cost payments just because you have that regime in place. That in a sense is over-encouraging connection in places where you do not have the transmission already available.

To come back to the question of the subsidy, as a consumer, I want to get this wind on at the least cost to me, the consumer. That means that if, where it is windy, I can pay less per megawatt-hour and the economic investments still stack up, I would prefer that to a system in which I give them more money just because, in order to get somebody to locate in a less windy place, I have to make it sufficiently attractive.

Q42 Barry Gardiner: You want to have your cake and eat it here.

Professor Newbery: Of course.

43 Barry Gardiner: I don’t just mean for the benefit of the taxpayer, but for the benefit of your argument. On the one hand, you are saying, it is windier there, therefore they get cheaper electricity; but you now want to separate that out from the increased costs of connection and transmission, because it is more remote. The point is that those two things do in some ways counteract each other and cancel each other out. You may say that they do not perfectly cancel each other out, but then the question is how to ensure that they do. You cannot just separate one off and say because it is cheaper to produce electricity in a remote area you shouldn’t subsidise that electricity by as much. You should ensure that they pay the proper costs of the transmission and connection.

Professor Newbery: I entirely agree with you. When you have the chance of tailoring the contracts to the location as well as to the technology, you could achieve that. The beauty of the new design is that you have the instruments available to achieve what you want to do at least cost. I just want to ensure that we take advantage of that.

Q44 Laura Sandys: When one looks at this and takes forward some of the arguments you have already made, does the choice of National Grid for the operation of the feed-in tariff scheme have any implications? Because we are talking in terms of National Grid, which we were not before we knew that this was a Government suggestion, we have now got our mind round a system that is very transmission driven. In many ways, we have a human system and we are looking at the heart and vein structure as being the core. Does the fact that National Grid will be running the scheme change how one would operate the feed-in tariff if, for example, some other body were running it?

Professor Newbery: They have an additional advantage because they have not only the expertise to design this transmission system, but the expertise to dispatch it. In the case of wind, that means all of the balancing and having good wind forecasts. It seems quite sensible that one expert body should concentrate all that talent, especially on the wind forecasting front, rather than having the present system, whereby everybody has to do it themselves.

Q45 Laura Sandys: But when you start to move into the actual contracts, do you think that it should be National Grid that defines that because, in many ways, it will be looking at it through the prism of transmission, or should it be DECC?

Simon Skillings: I find it inconceivable that you could devolve the negotiation of the construction of a new nuclear power station to National Grid, because that is not a very simple feed-in tariff. It will be a process of public procurement, with huge risks to society that need to be managed. To some degree, the same applies to early carbon capture and storage.

Q46 Laura Sandys: The problem is that if you have got different technologies with different people managing the contracts and taking responsibility, there is going to be a whole load of opportunities for buck-passing, conflict and, in many ways, judicial review in the sense of people saying, "Why is my contract for delivering energy being handled in a different way from somebody else’s?"

Simon Skillings: I entirely agree with that. There is a minefield here. The key point as far as the National Grid and the feed-in tariff are concerned is that that is a departure from its core expertise. It does not have a lot of expertise in discovering and costing resources and managing the least-cost procurement processes of these resources, except in its own territory. Therefore, it is going to have to do something new and different. As I said, any institution would have to. All we need to worry about is whether the fact that it runs the transmission system is going to be a problem for it doing that. There potentially are issues if the choices of technology have knock-on issues for the transmission system. Again, that comes back to the extent that it is given a choice of technologies. We do not know that yet. Within the policy framework, we do not know that.

Q47 Laura Sandys: Obviously, the other thing we do not know is which design elements will need to be flexible and whether DECC will get involved with intervention on this. Carrying on from what Robert was saying, the governance, the hierarchy and the interrelationship are not at all clear. In many ways, that is where the conflict, the inertia and the lack of investment will happen as a result.

Simon Skillings: That is right. My big concern is that we will end up doing the easy things, rather than necessarily the right things. I have mentioned the demand side a few times. It is difficult and new, but the benefits are the greatest. That seems to be the biggest risk in all of this: complexity.

Melle Kruisdijk: I agree. If you now have the opportunity to design it properly and you do it wrong, you might end up with a system that is not properly designed to interact with wind power at the lowest cost-the lowest emission. It may well deal with wind power, but not in the best possible way. National Grid has a good view on the impacts of renewables on the grid.

Q48 Dr Whitehead: Are you all clear that the choice that DECC has made to choose capacity market over strategic reserve is completely the right decision?

Simon Skillings: I am not clear what decision it has actually made, to be perfectly honest. I see so many holes in what it has said. I have already mentioned the single market one. Melle talked about the fact that the key challenge coming up is one of flexibility and dynamic response as much as, if not more, than pure capacity. There is no evidence that I have seen that an auction that goes four years out has any impact other than a very marginal one on new investment, so I do not see how this in any way solves any potential capacity issues. There is no sense of long-term trajectory. Where does this capacity mechanism take us, in view of the single market? It is so shot full of holes that when I read it, my reaction was that we are not far off the drawing board and will be back there fairly soon.

Q49 Chair: Do you have a shared view?

Melle Kruisdijk: I share that view. My main concern is about flexibility, which at the moment is not fully addressed. If you integrate the amount of wind, you need flexibility to deal with it. Flexibility can be provided with different technologies and different criteria, so you have to differentiate what sort of capacity I need, when I need it, and how much I will need it for. I do not see that currently addressed in the chosen mechanism. Perhaps it will be developed later on, but we are not sure. If you do not design it properly, you might end up with capacity that will provide flexibility, but at a higher cost, with higher emissions, perhaps even wasting wind power, because it cannot be taken on to the grid because plants are running to provide flexibility. Perhaps that is not the proper solution.

Q50 Dr Whitehead: May I be clear about this missing flexibility issue? My understanding of the capacity market is, essentially, that there will be an auction process, which will, to all intents and purposes, be an undifferentiated auction, by and large. I presume that that means that the question of how you compare what it is that you are bringing into capacity is not easy, because you are comparing the different kinds of capacity that you are bringing into the system on the basis of that auction.

Melle Kruisdijk: That is correct. That is also how I understand it. There is no differentiation between the megawatts, so to speak, but the differentiation should be there.

Professor Newbery: The system operator will have to procure a whole range of ancillary services and pay for them. If you are thinking of building plants, if you can supply them and make profits out of them, you will be willing to do it. Providing that the security of supply standards, which are the duties of the system operator, have been properly specified-as far as I know, they have-and providing that the system operator can procure in the market, the right balance of fast reserve, slower reserve and so on should be available and made available.

Simon Skillings: It may not be made available efficiently, because if the grid is hamstrung with this capacity-only option, it may then have to go out and procure flexibility separately, which it has done already through the so-called STOR-short term operating reserve-mechanism, rather than integrating the process. If it has the flexibility to integrate those processes, so that it makes sure that it gets enough of the right sorts of capacity, fine, but at the moment there is no evidence of that in the design.

Professor Newbery: It comes back to what sort of instructions you give. If you say, "Deliver these security standards at least cost and tell me how you are going to do it," that is very different from the Government laying down in legislation that there will be tender auctions for so many megawatts of capacity, regardless of location and time.

Q51 Dr Whitehead: Forgive me, but aren’t you essentially saying the same things? There isn’t anything in the paper at the moment that indicates exactly what kind of instructions might mitigate the generality of an auction process.

Professor Newbery: The good news is that it does not rule that out.

Q52 Dr Whitehead: You mean thereof there is silence at the moment.

Professor Newbery: Yes.

Q53 Dr Whitehead: If we were to fill the silence with something that might be relevant, what sort of instructions might need to be given on two issues? The first is the question of demand side, where you will be bidding for de-capacitising the system in a way that, at first sight, looks rather difficult to reconcile with an auction process. Secondly, what might be done in terms of the things that you might call a public good for the system, such as flexibility, storage, interconnectors and possibly CCS, when those arrangements are not necessarily economically viable to the extent that you might expect from an auction system, but are definitely good for the future operation of the system as a whole?

Simon Skillings: There was a lot in that question. Let me try to make it simpler to think about. The challenge that we have going forward is no longer making sure that we have enough capacity to meet overall demand. We have instead a net demand that results from overall consumer demand take away the low carbon stuff. That is a very different character from the overall demand. It is less predictable and more volatile. It sometimes goes negative. It does all sorts of different things. What we need is a mechanism that can efficiently deliver that. Picking up on your demand side point, there is a lot of evidence that there is a lot more latent flexibility and capacity within the energy system as it is now, and that is both on the generation assets and particularly on the demand. There is a lot of evidence around the world on how you flush that out. You can flush that out through some shorter term auction design, albeit with particular discovery incentives to flush out the demand side.

It gets a lot more complicated if you want to build new stuff because then you have to start giving people long-term earning certainty if you really want to make much of a difference to their investment decision. That is quite a big Rubicon to cross and then you are almost in the territory of feed-in tariffs. You need to be clear about what the procurement process is that will enable those longer term investments to come forward. None of this is talked about, so I am just giving you a flavour of what is a very rich and complicated field that needs to be thought through. The high-level message is that it has not been thought about.

Q54 Dr Whitehead: In the light of those and other comments, would you think that some kind of separate auction system for different modes of capacity might be necessary, if one is to proceed on an auction system?

Simon Skillings: You can do it all through a single multi-component auction so that people can bid prices for capacity with various qualities associated with it. You then just stack it up so that you get enough capacity to do this or to do that.

Q55 Dr Whitehead: Does that proceed through one auction or do you segregate the auctions into the different things that you want to obtain? Therefore, you auction within what it is you want to obtain?

Melle Kruisdijk: It might be easier to have separate auctions where you have different criteria for the capacity that you auction. You must make sure that you get what you need. For that, you have to understand what sort of capacity you need, when you need it and in what amount.

Q56 Dr Whitehead: Isn’t that a bit like a strategic reserve?

Professor Newbery: The idea is much simpler than that. You start by specifying the security standards that you want to meet, which we have already done. The only missing bit is to have an institution that procures these at least cost. You can leave it to the last minute and it will then be very expensive or you can contract ahead and it will be cheaper. If you need it in a particular place for a certain length of time, you obviously go out and procure it. Again, the main question is can we trust the body that is doing it to do it at least cost and in an intelligent way.

Q57 Dr Whitehead: So, that is in fact a strategic reserve with some market arrangements?

Professor Newbery: It is a whole range of things. It may be Black Start capability. It may be fast-response reserve. The system operator will know what is needed to keep the system balanced to within the specification of security.

Melle Kruisdijk: But you do need to look at the total system cost. Perhaps you can provide the flexibility that is required, but you need it from a running plant. That means that the plant always has to be in operation. It may be at the minimum point, but it would still produce electricity that goes into the grid. It may be blocking wind power, which could also be taken by the grid. You have the same flexibility but at higher cost and with higher emissions, so that should be taken into account.

Simon Skillings: You do have to be careful with labels in this territory because it is a nightmare. The same name means completely different things to different people. I would steer clear of using words such as "strategic reserve". I thought the point that you were touching on was with things such as storage and demand side. There is definitely scope for an innovation policy to be wrapped around the capacity. In the same way as we have an innovation policy driving renewables, there is no reason why we should not have an innovation policy associated with the technologies to help integrate renewables. You mentioned storage, and there are different views on storage but there are certainly strong arguments for targeted goals on the demand side to try to kick-start that part of the market.

Professor Newbery: We do have the low carbon network fund, which is exploring exactly these kinds of questions. It is inviting proposals for managing the future system.

Chair: Thank you very much. I think we have run out of our allotted time. We are very grateful to you for coming in.

Examination of Witnesses

Witnesses: Nick Winser, Executive Director, National Grid and Mark Ripley, Project Director for Electricity Market Reform, National Grid, gave evidence.

Q58 Chair: Good morning, and thank you very much for coming in. I think you heard most of the previous evidence. Could you start by saying how the system operator role will equip you to implement the capacity mechanism and the premium tariff?

Nick Winser: Good morning, and thank you for the opportunity to address the Committee. We think that DECC’s conclusion or suggestion in the update document that National Grid should administer these mechanisms has some very good evidence in there as to why the Department has come to that decision. Broadly, you will recognise the characteristics of National Grid, I hope, as a substantial company that is well established in the industry with an enduring and solid role, which is part of the rationale. At the same time, as well as being a private company we are-I think it would be fair to use the word-heavily regulated, so all our decisions and actions are subject to legitimate scrutiny by Ofgem. We work very closely with stakeholders in industry forums, particularly in the context of the Rio process, so we are used to that degree of scrutiny. We also understand how the electricity system works, which was a comment made earlier by the Committee. We operate the balancing mechanisms at the moment, and we operate the control rooms, so we see how it all fits together in real time and we have a very substantial body of experience of that, which we have built up over time.

In terms of contracting, which is at the centre of this, we have over 20 years of experience of not only contracting for ancillary services and a variety of balancing products, but evolving all that contracting as we have seen the needs change. I like to think we have done a good job of evolving that. That is something that we do at the moment that has clear linkages across to the capacity mechanism and, from there, to the feed-in tariff. We have well established relationships with all the companies in the industry, and the industry knows us well. A significant part of what it is being suggested we should do is to analyse the energy futures and help Government and Parliament to make the significant decisions that need to be made on behalf of customers. The fact that we already publish a whole host of documents with a variety of different sectoral analyses on the energy industry and overview documents discussing how it all comes together is, obviously, a good platform for building the sort of transparent analysis that we will need to do for EMR. That is to speak to the characteristics of National Grid that equip it to carry out this function.

Q59 Chair: So you have got the skills and expertise within the organisation already to do all this?

Nick Winser: We have certainly got a lot of skills and expertise in the organisation. We will think, and we already are thinking, about what extra skills and expertise we will need to bring in. We will be doing a significant amount of work this year, looking at all the modelling capabilities that we currently have, and looking around the world at best practice for modelling energy systems, best practice for the methods for looking at uncertain futures and multiple scenarios and how to interact effectively and transparently with all stakeholders on building, if we can, that shared view of what the future looks like, working with the Committee on Climate Change and DECC, obviously.

Q60 Chair: Will you be contracting part of this role to Elexon?

Mark Ripley: One of the fundamental things we’re keen to ensure is that we deliver the service at the least cost to consumers. Therefore, to the extent to which it is possible to use existing technologies and capabilities, that would seem sensible. Elexon already has a settlement role within the industry whereby it has access to all the meter data and all the relationships with generators and suppliers. Therefore, they are a strong candidate in that space, but until we have got through to the next phase of detailed design of both the feed-in tariff and the capacity-making with DECC and the industry, it would be premature to say that we are or we are not. But subcontracting is an option in terms of achieving best value.

Q61 Chair: Does that apply to other services you will be providing?

Mark Ripley: Quite possibly. I think the same comments would carry again. We would look for the best value for consumers, and in any set-up of an organisation, that is quite often a combination of in-house services and out-of-house services.

Q62 Chair: How soon could you administer a capacity auction or a feed-in tariff contract?

Nick Winser: The technical update talks about 2014. We think there is a lot of sense in looking for a date like that. We do analysis ourselves, which comes to rather similar conclusions to other analysis out there, of by what date you would have to be signing feed-in tariff CFDs to deliver the carbon and renewable targets. As you know, we also do ongoing monitoring of security of supply anyway, as advice to Government, which will inform how soon the capacity mechanism gets away. Suffice it to say, I think it is going to be very important that we get all this up and running smoothly as quickly as possible. We will certainly be looking to deliver in early 2014 or before.

Q63 Chair: Are there institutional changes that are needed to do all that?

Nick Winser: Ofgem will be looking with DECC at other institutional issues around this, which we welcome. They will be looking at exactly how the system operator will perform in this context, so there’s clearly quite a lot of extra work to do on this.

Mark Ripley: We are in the process of developing our internal capability and thinking about what structures we need to put in place. Again, that will be informed by the detailed design process, and we will work with Ofgem and DECC to ensure that is the right structure within the context of the things that we already do and of providing good value for consumers.

Q64 Sir Robert Smith: Have you identified any areas where there could be a conflict of interest in this new role and your existing roles?

Nick Winser: There has been some debate on that already, of course. We are very used to putting transparent arrangements in place. At its heart, the whole debate is about the conflict with our basic role of providing transmission. I think the answer is that it is not clear what that conflict is, for a couple of reasons. First, in advising Government and indeed in letting contracts, we expect the process of letting those contracts to be extremely transparent. We expect at least DECC and Ofgem to have very close scrutiny. So that would immediately be a check on any worry. I always sort of break sweat trying to work out exactly what the conflict might be here, but at least at that contracting level and at the analysis level there would be very significant transparency, and other parties will oversee that process.

Of course, the transmission system itself is highly regulated. Ofgem has the ability to disallow funding for investments that it thinks were not made economically. We are used to that; we have lived with that for 20 years. So it is difficult in that centrepiece to see exactly even what we would wish to do, let alone how we could do it to serve, in any sense, our business.

Q65 Sir Robert Smith: The scenario seems to be that, in looking at contracts, you might be less incentivised to go for ones that have the least transmission costs associated with them, so that you could be seen to award a contract for where the location of the contract-

Mark Ripley: In the earlier sessions, there was a lot of talk about how it might work and some of the decisions have drifted towards what you might describe as quite a central planning role. I think we would all acknowledge that the technical update is an update, and there is still a lot of detail to be worked through.

We certainly don’t envisage a central planning role; we envisage providing advice to Government. One of the things that Government have asked for in that context is our interpretation of what network costs and system operator costs would be in the context, to allow Government to have a full picture of what the costs would be. As it says in the technical update, decisions would then be informed by further independent advice. So we are not in a central planning policy setting role; that is not how we envisage it. It is an advisory capacity that we are in with Government making decisions, which gets to the transparency point through the openness of our process.

Q66 Sir Robert Smith: Have you ring-fenced your operations in terms of the way that you operate in Scotland at the moment?

Nick Winser: We are used to ring-fencing conditions. We have a whole variety of ring fences within the business at the moment between transmission and distribution. On the gas side, there is a good example. With offshore transmission, we have a ring fence. So all of that is overseen by Ofgem. We formally report to Ofgem on compliance and Ofgem formally scrutinises that. So, at its very heart, it is difficult to see what we would want to do, even if we were free to do it, but transparency has to be very high. Obviously, Ofgem will consider whether any further ring fences are appropriate, and we are used to those ring fences. Those are really the safeguards that one would expect in this process.

Q67 Sir Robert Smith: Are there any EU rules that will make the whole thing difficult to set up?

Mark Ripley: I do not believe so, no. I think that the EU separation was largely about generation and transmission. So, we do not believe so, but clearly we will keep abreast of EU developments as the codes, in particular, are finalised.

Q68 Laura Sandys: You mentioned twice the aspect of being, in some ways, the custodian of the customer-protecting the customer and giving the customer value. You are also saying that you are looking to DECC to help you with the criteria by which the policy that you use to make judgments across the whole system is established. When you look at being the custodian of the customer and delivering the customer value, do you include not only price but security and decarbonisation as part of that process? What is the value to the customer? It is a big question, because we do not necessarily know, and DECC does not necessarily know either. This is a changing environment, and for you to manage feed-in tariffs or any of these policies, there has to be absolute clarity on what value for the customer means.

Nick Winser: We would see that as part of the work that is under way and that will go on over the next couple of years. To take one example, if we are to operate a capacity mechanism, we will have to have a way transparently of measuring securing of supply and a way of comparing what is being bought generally via the market or via these processes with what customers are willing to pay. We would expect to be devising ways of articulating those trade-offs, which would then be part of the discussions with Government. Government would then endorse particular ways of describing those trade-offs.

Q69 Laura Sandys: I appreciate we are all at the very beginning of this sort of discussion, but what you are really saying is that you will make the decision about what policy we implement for our energy cost base across the UK.

Mark Ripley: No. It is a combination of meeting our low-carbon targets, affordability and security of supply. The broader question is what is the right balance for those things. In terms of carbon targets, we have some binding targets as a nation, and some ambition, which places a fix on that, if you like. As Nick says, we will need to come to a definition of what security of supply is from the point of view of generation availability, and that might be the same level of security of supply that we have enjoyed to date. Against that, we would advise against what we believe is the lowest-cost route to achieving that for consumers.

Q70 Laura Sandys: But in a strange way, shouldn’t DECC have developed some of these things?

Mark Ripley: Then there is a Government role to decide whether that is affordable, on behalf of consumers.

Nick Winser: We see a very clear distinction between deciding policy, which is a matter for DECC and Government, and our two roles, of providing some input in that process in terms of analysis, and then, with an agreed set of policy objectives, in a transparent way, at least to DECC and Ofgem, delivering contracts which meet those obligations.

Q71 Laura Sandys: In a strange way, although you are merely responding to the brief, they are asking you to fill in some of the gaps where policy has not been developed to frame this whole arrangement.

Nick Winser: We have a role in terms of making sure that all the policy questions are asked in a very clear way, such that Government can come to a view on them. I do not think National Grid has a role in deciding energy policy or, in any sense, in signing contracts which commit customers to paying money through their bills-it is the Government’s role to set what we need to do.

Q72Laura Sandys: You are not expecting to be the counterparty to feed-in tariff contracts.

Mark Ripley: There has been much discussion in the industry about the robustness of the counterparty in terms of its credit ratings and how the financials work. The main issue is not who the counterparty is, but the robustness of the arrangements-their enduring nature-to give investors and consumers certainty. I would see our role as the management of the contract and, if you like, allocating contracts against the criteria that we would agree as part of the process. I would not necessarily envisage us being the counterparty, but I am not sure that that is the major concern for the parties here.

Q73 Laura Sandys: Following on from that, flexibility is one of the issues we have had a lot of conversations about with investors. Flexibility is fantastic and creates huge uncertainty at the same time. That is also something we have found with DECC and the over-layer of the Treasury getting involved. Would you be requesting or demanding from DECC and the Government that there is, in some ways, some sort of framework for that flexibility for you to be able effectively to operate the system?

Nick Winser: As long as we can be clear that it is short of setting policy. I think it is carefully articulated in the technical update. Some degree of flexibility, obviously with Ofgem oversight, in how we actually operate these processes might be wise, but that absolutely must stop short of any implication that National Grid is in any sense setting energy policy, which cannot be the case.

Mark Ripley: This comes back to one of the charts, and we went through the various stages earlier. The technical update talks about doing things on a five-yearly basis-whether it is exactly five years is yet to be determined, but frequent reporting to the Government about how things are progressing. As Nick says, things evolve and we evolve the service we provide and the information available will change over time, so it is important to provide certainty for investors that the contracts they have signed will endure, but it is also important that we reflect back to Government how things are progressing against policy objectives.

Q74 Laura Sandys: I am not worried about your flexibility as much as about the Government wanting to change things.

Mark Ripley: Exactly. That is clearly something that we have been discussing with generators and the Government. All parties recognise the importance of having arrangements that are sufficiently robust to get confidence, but also have the right level of flexibility to reflect the fact that things change over the time frames we might be talking about.

Q75 Dr Whitehead: Let me turn to the question of capacity payments. The technical update says that the system operator-in other words, yourselves-would draw up the auction itself, but it does not specify who would draw up the contracts or, indeed, what those contracts would look like. What is your understanding of how that might work? Would it be that the Government would draw up the contracts, supply those to you and you would then conduct the auction, or do you think you would do the contracts?

Nick Winser: I think we envisage that we would draw up the contracts. The important policy stage of this is to help us define with the Government what we are trying to achieve, and that is all about articulating, in this case, the capacity mechanisms-how we measure security of supply, how we make sure that that is a good deal for customers and how it, broadly, fits with what customers are willing to pay for. That is the debate that needs to be had with the Government, quite clearly. Having agreed that and agreed how the process will work, we would then expect, probably with DECC oversight at the beginning, for us to draw up contracts which we thought implemented that structure. I do not think we should ignore Ofgem’s role in this. We would expect Ofgem to oversee these markets that we will be operating as well, and it will clearly have a view on those contracts.

Q76 Dr Whitehead: In that process of drawing up contracts, would you take guidance or receive a structure based, for example, as we have heard-indeed, as we have heard this morning-on the possible necessity of specific auctions for different capacity, with flexible capacity as part of that? Would you envisage that you would have that entire landscape responsibility for, if necessary, differentiating auctions?

Nick Winser: We currently run auctions for a whole variety of products, so there is some backdrop to this already. The likely approach would always seem to me to be, as much as possible, to resort to contestable processes. Trying to work out what the cost of something is is something that the parties can do, but trying to test it in the market seems ultimately to give more comfort that customers are receiving a fair deal and that we are minimising customers’ bills. That needs to be traded off against the fact that there is a whole array of different things that contribute to security of supply, some of which we already do, by buying frequency response, for example. So, it is about making sure that the suite of things, including the capacity mechanism, buys all the right things with the maximum contestability that we can get into it.

Mark Ripley: This is one of the questions that I think will come out of the detailed design because, having decided on a market-wide mechanism, there are various models around the world. You can go from what you might call a wholly financial model, in which people can bid in what they want and financial incentives manage whether they turn up on time, to an administrative role, in which you might go out and physically check on a regular basis, and have only the types of capacity that you know are turn-on-and-offable at the whim of the operator. There is probably a compromise in there, between the right level of certainty that the capacity you are buying will be available and deliverable and a very high administrative burden.

We do some of this today, with some of the contracts we provide-STOR, for example. We have a test regime that strikes the right balance between an overly intrusive administrative burden and increasing your security that it will be there on the day. We talked earlier about flexible capacity versus general capacity. On the purely financial mark, wind might bid in and yet we might know that it will be there only on a certain number of days. Those are the discussions that we need to have through the detailed design, with DECC and the industry.

Q77 Dr Whitehead: Do you think that things such as storage and interconnection demand reduction?

Mark Ripley: Yes. They all have a role, and let us take them in turn. We use demand-side services now, but we use them very much in the near term for managing the system. A very well-known example is the aluminium smelter that used to provide us with services within day for half an hour, and which was very cost-effective compared with other sources. At the moment, the number of demand-side storage services that might counteract the wind not blowing, for a period of perhaps weeks, are not well developed, but that is not to say that they cannot be well developed. We need to ensure that whatever we design as a capacity mechanism is able to accommodate those services if they become more established, like our storage services. In terms of hydro and stocks of coal, they are established, but in terms of battery technology, they are relatively new. As time goes on, that might become something that we can accommodate.

Interconnection was also mentioned. Interconnection from a feed-in tariff perspective is desirable but challenging, because you cannot necessarily differentiate that it is low-carbon power that is coming across the interconnector. But from a capacity perspective, you could probably do something in there, and we are keen to look at that, as I know are DECC and a number of industry players.

Q78 Dr Whitehead: When you say "keen to look at that," how far off the drawing board is that, to coin a phrase that has been used today?

Mark Ripley: It is probably a step behind generation.

Nick Winser: Clearly, on interconnectors, the question that we will need to wrestle with, in a sense, is: how do you know that the power is going to come when you ask for it to come? You can imagine that there will be some debate about that. Interconnectors can clearly flow in either direction, so this debate is all going to be about firmness, essentially.

Q79 Dr Whitehead: In terms of paying for the whole capacity payments arrangement, at present it is envisaged that this is a combination of cost to the consumer and penalties on non-supply of capacity. Penalties, as far as I understand them at the moment, simply go to the energy suppliers, when capacity is not provided. Isn’t that free money? What methods do you envisage to ensure that the payment arrangements of a capacity market drive a proper balance?

Nick Winser: At the most basic level, we would expect there to be contracts for providing output when it was called, and to the extent that either in a test regime or in real time when it was needed it did not show up, one would expect there to be an impact on whether those payments were clawed back or whether there was something paid above the payments that were made to provide the capability in the first place. So, there must be some relationship between what we are paying you for, if you are a generator, and what you have to pay if the plant does not turn out to be available when it is called. That sort of philosophy is broadly in the contracts that we have today.

Mark Ripley: It is how we manage the cost of ancillary services today.

Q80 Dr Whitehead: Would you stop energy suppliers, as it were, banking the penalties?

Nick Winser: I am not sure why you think that they bank the penalties.

Q81 Dr Whitehead: There is an implication that they pass them on to customers, although that is not necessarily the case, is it?

Nick Winser: Currently, to the extent that there were penalties paid under ancillary services contracts, that would reduce the cost of electricity in the wholesale market. The question of whether there is a smooth pass-on of costs from the wholesale market to retail is obviously a broader issue, which the Committee has discussed at other times, but if a penalty is paid, you should see the wholesale market price come down-albeit by a fraction.

Q82 Dr Whitehead: Those people who are investing in low-carbon generation in particular will presumably want to see that the subsidy that is agreed in long-term contracts will be available for the whole lifetime of their assets. As a system operator, you would understand that and guarantee that, would you?

Mark Ripley: Again, there is a design question here. At the moment, the RO goes up to 2037, which gives an indication of the length of certainty that people would like for these projects. We know that power projects tend to have long operational lives.

We keep coming back to detailed design, because there is still a lot to do. The update is just an update, and it is not the finished article. There has to be discussion about what would be the duration of the contracts. Particularly with the feed-in tariff, the contract for difference arrangement is effectively saying that we will provide a hedge not just for the generator, but also for the consumer in the event that it did become economic in the absence of support mechanisms. The contract for difference has helped manage that longer-term risk for both parties.

Nick Winser: It is not completely obvious to me that they would necessarily always be for the lifetime of the plant. However, you would expect there to be quite a link.

Q83 Dr Whitehead: I would have thought they would be rather keen to have it for the lifetime of the plant.

Nick Winser: That may be the best value for customers, but clearly, generation of all types can get life extension, and we would have to think about what that meant in the context of these contracts.

Q84 Dr Whitehead: Were that to be agreed for a certain period or, indeed, for the lifetime, would that be underwritten by yourselves or by the Government?

Mark Ripley: That comes back to the earlier question about the counterparty, and it is actually about the robustness of the arrangements. We do not anticipate being in a position where we guaranteed it ourselves off our balance sheet, because we are managing other people’s money. It is not our own money. We are very keen to work with the Government, so that the arrangements are very robust and can only be modified in a very narrow number of circumstances, to give certainty to generators that, on balance, this is a very bankable arrangement.

Q85 Dr Whitehead: Who would actually guarantee it?

Mark Ripley: The arrangements and the regime would be the guarantee.

Q86 Dr Whitehead: So it would not be a guarantee.

Laura Sandys: The Government could change it.

Nick Winser: Generators and other providers of these services will clearly have strong views on how reliable those contracts are. The latest thinking on how the contracts are settled essentially means that the guarantee is provided by suppliers who would take power in any particular period in the future.

How does the generator know that the arrangements are not going to be changed such that they will not get paid sometime in the future? Well, that is a matter for DECC and the Government to decide what foundation of certainty they will provide.

Q87 Dr Whitehead: That is the nub of my question. Who provides a guarantee at that point? Is it yourselves or is it the Government? Bearing in mind what you have said, do you think that there is a general nexus of certainty around this, rather than a guarantee as such, and that an additional guarantee from the Government may be required?

Nick Winser: We would expect there to be, somewhere in the legislation or the subsequent supporting documents, an articulation of the conditions, if any, in which contracts that have been signed would not be seen out for their full term. Generators and other suppliers will clearly argue quite strongly that there should not be any conditions for that, and that they want to be able to rely on the contracts. I understand that argument. That seems to be the starting point for the discussion.

Q88 Dr Whitehead: What happens if Gazprom comes along and puts to you an offer for the entire company that you cannot refuse, and National Grid is sold? Do the guarantees go with the sale?

Nick Winser: The discussion we have just had sort of says that National Grid itself is not providing the guarantee to participants in these mechanisms. A contract will be signed, which then commits to those payments being made to generators over a period of time. Those payments will be made under the current thinking anyway and through the market mechanism broadly, or a bolt-on to the market mechanism. So it comes back to the point whether the National Grid is backing those contracts or not and our balance sheets. We are currently expecting that they will not be backed financially by National Grid.

Q89 Dr Whitehead: But not by the Government either.

Nick Winser: The current thinking, which may well change, is that those contracts will be struck. They will be confirmed as essentially a good contract and that that will entitle the holder of the contract to a stream of revenue per half hour or per day that will be paid for by whoever buys electricity in the wholesale market in those half hours.

Q90 Dr Whitehead: We hope.

Nick Winser: That is the working proposition at the moment. That is the detail of how it is expected to happen. It is a matter of semantics whether you entitle that a guarantee and from whom. It is a contract that has been struck, which will have some wording around it that it will be honoured in all or most circumstances, I am sure.

Q91 Dr Whitehead: By somebody, you know not whom.

Nick Winser: By the people who are selling electricity period by period across the length of the contract. That is quite clear. In my mind, this is not that different from what we have today. Generators who build power stations today are relying on revenue streams for 25 to 30 years. What is the nature of their guarantee today?

Q92 Dr Whitehead: We have no capacity payment mechanism in place. That is why, presumably, we need a capacity payment.

Nick Winser: Hear me out. What is the nature of the guarantee they have today that allows them to bank the projects that they are building today? The nature of the guarantee is that they participate in the market and, whatever is the price per half hour through the anticipated period of operation of that power station, they will be paid that price unless they sign a bilateral contract, which varies the price. That is there today. Do you call that a guarantee by Government? I don’t think so. We call it a market mechanism, where people are expecting to get revenue over the period of the contract-over the period of operation-from the wholesale market. That is how they will support financing these projects. The only difference is that rather than saying, "You will be entitled, if you take part in the market, to get a variable set of revenues, depending on what the market price is," these contracts, particularly the CFDs, will say, "We are firming that up." The obligation stays in the same place, which is with suppliers.

Q93 Dr Whitehead: My point is that when you are looking at what might be the case where you have instituted a capacity payment system-which you have agreed to introduce because you know that you need a certain amount of guaranteed capacity, in a way that you are not doing at the moment-it looks on the face of it that it should go along with some guarantees that are different from the guarantees that there are when you do not have a mechanism to provide guaranteed capacity.

Nick Winser: Yes, I think that is fair, and we would expect that to be the case. That comes back to the debate about penalties. We already have lots of these arrangements. We have contracts which extend multiple years ahead-STOR is a great example of that. It allows people to, in this case, build some small fast-start plant. When they build that, they know that they have a contract that provides that ultimately that money flows from whoever buys electricity in whatever half hour in the future, as the cost of the contract is allocated across those half hours. I do not think it is any different from what we have today, in that sense.

Q94 Sir Robert Smith: The crucial thing is to end any uncertainty in investors’ minds, wherever possible, that the thing might be changed by future Governments. That was the thinking behind having a contract that could not be interfered with.

Nick Winser: Yes. It seems absolutely crucial that considerable certainty is given; otherwise, this will not be successful.

Mark Ripley: DECC has been quite clear that, in developing this statutory contract framework, it needs to be clear and up-front on what the circumstances are, if any, where it can be modified.

Chair: Thank you very much indeed. That was very illuminating.

Prepared 26th January 2012