Large, far away vs. small, close by – the new power paradigm

Change is coming from the edge to the centre

In March 2016, I wrote a piece for New Power on the logical future structure of the electricity market, given the imperatives of decarbonisation, affordability and security of supply (https://www.newpower.info/2016/03/competition-on-capacity-cfds-and-services-is-the-energy-markets-future-excluding-low-cost-renewables-will-drive-up-costs/). In it I argued that, since the wholesale power price becomes increasingly devalued as low-marginal cost power producers come to dominate, the carriers of value would be the investment instruments of the Contract for Difference (CfD) and the Capacity Market (CM), plus a much-expanded market for system services, including balancing and frequency response. All this continues to hold true, and I would recommend reading that article, at the risk of blowing my own trumpet. However, it is becoming increasingly clear to me that this is not the whole story of the future power market, though it will remain pretty dominant for a long time. New ideas at the fringes will come to change how we think about electricity over time, however.

The structure I set out a year ago holds true for the ‘bulk’ power market, where power is generated in large quantities, far away, mediated by a centralised wholesale market and with a central system operator procuring system-wide services. The majority of people and businesses will get the majority of their power from this arrangement for some time to come, but there will be an increasing move to generation that is smaller and more local, made possible by the distributed nature of many renewables and by battery storage, which is inherently modular. The coming digitalisation of power will allow fine control of individual parts of the system, with high granularity, bringing the demand side into the equation as an active participant.

Proponents of distributed generation (DG) and storage tend to portray the upcoming change to the system as a winner-takes-all battle, with DG like the small mammals scampering around under the feet of the dinosaurs: when the meteorite of cheap renewables and digitalisation hits, they think the small and nimble will take over the world and the big lumbering beasts will die. The reality will be much more nuanced. The physics of the power network as essentially one large machine, where the actions in one part of the system affect the whole, argues against this, plus in reality there is generally not enough distributed resource to meet demand, particularly in urban areas. However, physics does give us another analogy to work with.

The quantum revolution

In the early 20th century, the world of physics was turned upside down as our ability to understand the world became more sophisticated. In short, a well-functioning system that explained the world as it could be seen – the classical physics of Newton – started to break down at the edges. New information brought by innovation in experimental science was telling us that, when the scale changed, the world was different than we had thought. Much intellectual ferment in the first three decades of the 20th century led to the new ‘settlement’: classical and quantum physics co-exist, each appropriate for their respective scales, though with our overall understanding of the universe deepened.

The analogy with the current situation in the power sector should be clear. A paradigm of system organisation that has served us well is being challenged as new technologies and control techniques are developed. Using this analogy, one can see that if we get into the granular ends of the grid, the rules will be different, but it is important to note that both quantum and classical physics coexist and are appropriate at the right scales. Working out the modus vivendi between these two realms in the power sector is going to be tricky, when they both use the same network and need it to be stable. Where the analogy breaks down a bit is the feedback loop one can expect as the edge of the power system changes radically – the ‘classical’ power sector will not be unaffected by the coming revolution, while Newton still reigns at the appropriate scale in the real world. On the other hand, the lesson that existing systems can continue to function well even as there is a revolution in our understanding should not be ignored. There is a lot of ‘intellectual inertia’ in the current power system.

Implications of bifurcation

If we follow through this analogy we can perhaps divine some implications of this dual vision of the sector.

Clearly the real innovation is going to be at the distributed level – this is where the technologies coming forward are the most different to what we have now. This is not to say that storage and demand side response will not change how the bulk system will operate, but there is a qualitative difference in what will happen at the grid edge that will be revolutionary. There is going to be a tendency to draw away from the mainstream grid, with the rise of private wire or physical microgrid solutions, including onsite storage. Unless a place is especially blessed with renewable resources, however, there will still be a need to draw some power from the grid, but the quality of that interaction will be quite different, as well as being smaller in magnitude.

Business models at this scale will evolve rapidly to take advantage of new technological opportunities, but there will still be a need to interact with a wider wholesale market. This latter will evolve but should remain recognisably what it is today, even though its function will primarily be about managing dispatch and not about providing an investment signal. This is where the analogy with the interaction of quantum and classical physics may be most instructive: those (like me) who have studied physics at degree level will know that integrating the probabilistic quantum world up to the macro classical scale requires some fancy mathematics (Boltzmann equation anyone?) that is by no means simple to solve. This interaction between the ‘new’ system and the ‘classic’ power market is going to be the tricky part, as the behaviour of consumers/prosumers at the end of the grid changes with the advent of new technologies and controls, and the communication of new price signals to them.

If we are going to see the full flowering of the distributed power model, then we need to talk about network charging. Proper cost reflectivity will need to ensure that users pay for the wires in proportion to the burden they are placing on the system. If, at any node in the system, users generate, consume and balance electrical energy such that there is no physical flow from the wider system into that part of the network to serve that community of users, why should they have to pay for that wider network? I call this concept the ‘virtual microgrid’, since it creates the relationships that exist within a physical microgrid, while using the open public power network to mediate it. On the other hand, if you are physically connected to the wider system as backup or as a means to trade surpluses and deficits, then you have an interest in the existence of the system as a whole, and therefore some kind of fixed charge, perhaps based on the capacity of your connection, is also logical.

I would hence argue that users should pay for the network on the basis of a usage charge, strongly connected to the net charging principle, plus a fixed capacity charge – the balance between these would need careful consideration to ensure that the incentives are correct, but it surely must be right that consumers who are taking responsibility for their own energy supply and balancing be relieved of at least some of the costs of the infrastructure and balancing supplies needed for everyone else to get their electricity. This is why the Ofgem review of embedded benefits and its Targeted Code Review on are so pernicious in my view, since rather than deal with the root cause issue, the structure of demand network charges, the regulator has breached the principle of net charging for certain generators and users. They are arguing that the current arrangements are not cost reflective, while I would counter that net charging is the only way to ensure that customers pay for the system in proportion to their use of it. Having approved CAP264/265, and proposing that behind-the-meter generation can’t be used to avoid Demand TNUoS, I believe it will only be a matter of time before Ofgem will have to reverse out of the dead end that it has driven into, in order to reinstate net charging for all.

I would extend the net charging principle further, to apply to the levies that suppliers attach to bills to pay for the Renewables Obligation and the CfD. If a virtual microgrid runs on local renewable supply which has not benefited from support through one of these mechanisms, and thus is taking responsibility for its own decarbonisation, then why should it pay for everyone else’s? To my mind, one of the key barriers to truly merchant renewable investment is that burden of ‘legacy’ support mechanisms that all power supply is expected to contribute towards: the implicit assumption is that only the RO/CfD is being used to drive renewable investment. If we want an exit route from our current market structure to one that allows truly commercial low-carbon generation investment, then I think we have to bite the bullet and adopt a ‘pay for service’ approach – and if you don’t take the RO/CfD service, then you don’t pay for it.

It is worth noting the dangers of this approach: if we allow users to defect from the system, be it from network charges or decarbonisation levies, in whole or in part, then there is the risk of the slippery slope. If the relative attractiveness of defection is such that many jump on the bandwagon, leaving a smaller number to pay the same fixed costs, then that simply drives more people to defect – the so-called death spiral of the grid. I think this danger is exaggerated, as for full defection one needs to be able to generate all your power onsite at a competitive cost, and renewable resources are not distributed in such a way as to allow that – solar generation is at a minimum in winter when demand is highest, for instance. Perhaps a ‘renewables plus gas CHP’ or similar arrangement might allow it, but this would be a sophisticated solution not available to most. But it is true that the equity issues that arise from those who do not have the ability to defect being left holding the network and decarbonisation babies need to be addressed, and the danger of disruptive sudden waves of defection should be considered also. Nobody said revolutions are painless.

Impacts on the wider market

How might we expect the wider power market to change in reaction to the revolution at the fringes – in contrast to classical physics’ lack of change in the face of the quantum revolution? I can sketch the outlines of a new power market that the current one could evolve into, which would be commercial and market-based, but will take a considerable time to come fully into being.

The roll-out of storage, DSR and interconnection is going to provide a form of physical cap and collar to the power market: if prices are low, the batteries will charge, demand will move to that time or other markets will take the power; if prices climb, then the batteries discharge, demand moves away from that time or the interconnectors flow into the country. So while growth in renewable generation drives increasing price volatility, it will be curbed by the new flexibility options. With a track record of this contained volatility, someone, whether a supplier or perhaps a pure financial player, can be expected to step into the market and sign long-term PPAs in the form of a CfD indexed to the short-run power price, as long as the strike price is comfortably within the range of this compressed volatility. The key is going to be the track record of the market price in this arrangement, alongside the risk appetite of the PPA providers, as well as those providers’ credit rating in order for banks to lend against those PPAs.

In this environment, one can even see the way to more radical options, such as the privatisation of the Low Carbon Contracts Company. The vision above still relies on the risk reduction characteristics of the CfD, but doesn’t need the counterparty to be a state actor. In Government’s original conception of the CfD, the counterparty wasn’t going to be a legal entity at all but a ‘synthetic’ counterparty which took form from suppliers’ requirement to pay the CfD levy. This is merely taking that idea a step further; passing ownership of the LCCC to the collective of suppliers without there being the need for a legal sanction to underpin it. Suppliers could pool their needs for new low-carbon supply through a mutually-owned LCCC, and if they are able to provide for them without the need for the collective CfD they would be free to go that route also. In this scenario, the System Operator would retain control of the Capacity Market, as it is a security of supply measure, though how the procurement volumes would be worked out would be more difficult as the number of players with distributed storage escalates.

Finally, in the shorter term there is a good argument that CfD procurement should be divided out not by technology but by scale and geography. Large, far away generators, from new nuclear to tidal lagoons, offshore wind and onshore wind on remote islands, can conceivably compete on a technology-neutral basis. Such projects are similar enough in size, lead time and lifetime to allow for meaningful competition. Smaller, closer projects also have similarities but perhaps would need to compete regionally rather than nationally. At this regional level, the market for the CfD could blur into a form of local supply, with the need for collective procurement perhaps disappearing completely if such supplies do not attract decarbonisation levies.

In all, the quantum revolution left physics in a very different place than it was before, and so it will be in the power sector as the paradigm changes. But there were famously those who resisted, with Einstein himself unhappy with the randomness implied, saying “God does not play dice”. Stephen Hawking’s rebuttal, “Yes He does, and sometimes He throws them where they can’t be seen” also has a lesson for us. No-one can accurately forecast what will happen to our industry, as much of the action will happen behind the meter, where it can’t be seen. We are in for an exciting ride.

Dr Gordon Edge, Inflection Point Energy Consulting

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