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Out-Law Analysis 7 min. read

UK energy market regulation in midst of shake-up

The regulation of the UK energy market is undergoing a number of changes in a bid to ensure energy resilience and set the market up better for the transition to net zero.

The government and the energy regulator, Ofgem, have recently unveiled proposals in three separate areas, laying out the potential for an overdue ‘whole system’ approach and shake up of the energy system.

The government announced the creation of a ‘Future System Operator’ (FSO), a new independent public body to oversee the energy network – covering both electricity and gas. The FSO will work with energy suppliers and networks to help achieve net zero, balance the UK’s electricity systems and ensure energy resilience and security.

Separately, in its response to a consultation on energy code reform, the government said Ofgem would be given new strategic functions to oversee energy codes and their evolution, to make changes to the codes and to licence code managers. The market expectation is that the industry codes will be consolidated and made more user friendly, and also adapted for net-zero transition.

Finally, Ofgem is consulting on the future of electricity network planning and operation, and whether this should continue to be done by electricity distribution network operators (DNOs), or separated out at regional level to new independent distribution system operators (IDSOs), a new regional system planner, or a combination of these.

Future System Operator

In their response to the FSO consultation (62 page / 612KB PDF), the government and Ofgem proposed that the FSO would oversee the energy system as a whole. It will work with networks and suppliers to balance the electricity system and ensure continued energy resilience and security; and provide strategic oversight of the UK gas system by taking on longer-term planning. However, real-time operation will remain with National Grid Gas.

The expectation is that Ofgem’s new strategic code functions will result in a long-term net benefit for industry and consumers, with no adverse material impact on consumer energy bills

Energy secretary Kwasi Kwarteng said in his foreword to the response that the creation of the FSO indicated that the energy system is at a “transformative moment” and that a fundamental change is needed to match the scale of net zero ambitions, but that that change must be implemented efficiently to keep consumers’ bills as low as possible.

At the same time, a ‘whole system’ approach was needed to coordinate electricity and gas systems, both onshore and offshore, while looking ahead to the emerging markets of hydrogen and carbon capture, usage and storage (CCUS).

The consultation response envisages the FSO as an independent public body, free from asset ownership and commercial interests and also from day-to-day operational control of the government. The FSO will provide independent advice to government and Ofgem, as well as other energy market stakeholders.

The FSO will be a data-led organisation, with statutory powers to request information and data from other licensees and exemption holders. It will also have a statutory duty to have regard to the need to facilitate innovation and should be considering new and better ways of undertaking its functions, including the potential for better collection and use of data and digital technologies to improve customer experience and outcomes.

The establishment of the FSO would impact on the current electricity and gas system operators owned by National Grid, because the FSO would be founded on some of the existing roles and capabilities within these organisations, requiring a transfer of ownership. Creating the FSO will require primary legislation, as well as secondary legislation, new and updated licensing arrangements, and amendments to industry codes.

The FSO will take on all the main existing roles and responsibilities of National Grid Electricity System Operator (NGESO) and the longer-term planning, forecasting and market strategy functions in respect of gas. However, it will not have real-time gas system operation or Network Emergency Coordinator functions.

The government will grant new electricity system operator and gas system planner licences to the FSO, and the body could also take on other roles in the future – for example in relation to distribution system operation, data, heat, transport, hydrogen and CCUS.

The FSO will be a public corporation, licensed and regulated by Ofgem, and funded by consumers through price control arrangements.

The expectation is that the FSO will be created by the end of 2024.

Code governance reform

The government has also issued a response to its 2021 consultation on the design and delivery of energy code reform (59 page / 436KB PDF), in which it lays out proposals to give Ofgem new strategic code functions. These include the ability to establish and regulate, via licence, one or more code managers.

The expectation is that this will result in a long-term net benefit for industry and consumers, with no adverse material impact on consumer energy bills.

Ofgem’s scope will extend to the 10 current electricity and gas codes, as well as relevant central system delivery bodies and engineering standards.

Ofgem will be required to publish an annual strategic direction to set out its vision for how the codes should evolve over the following year, which the code managers will then implement. The document will need to consider advice from the FSO and be subject to public consultation.

The duty to publish a strategic direction from Ofgem could be transferred to the FSO, subject to public consultation, if it emerges that the FSO is better placed than Ofgem to exercise this specific function.

Ofgem will have the ability to change the codes directly in a limited range of circumstances where the normal processes would not be appropriate. This includes where the change is urgent; where the relevant code manager may have an adverse conflict of interest; where the change is particularly complex; or where the change is related to code consolidation. However, all direct code changes will be subject to public consultation, a potential veto by the secretary of state, and a right of appeal to the Competition and Markets Authority.

Ofgem will continue to play its existing role in code governance, but code administrators and code panels will be replaced with a class of newly licensed code managers, who will be responsible for playing an enhanced role in the code change process and delivering the strategic direction set by Ofgem.

The transition from the current governance structure to the new governance structure will take place on a code-by-code basis, with a code considered to have ‘gone live’ once its first code manager has been put into place. To facilitate this transition, Ofgem will be granted powers to modify relevant codes and licences, as well as to modify or terminate contracts, for an anticipated period of up to seven years from the passage of legislation.

These new functions could be established as early as next year, although the majority would take more time before they were live.

Distribution network operators

In its call for input on the future of local energy institutions and governance (45 page / 922KB PDF), Ofgem has identified challenges in the existing institutional and governance arrangements for DNOs. The regulator is exploring whether changes are needed at distribution level for delivering cost effective net zero.

The challenges identified include institutional gaps and a lack of accountability in regard to the delivery of certain energy system functions. Even where there is clear accountability of roles and responsibilities, Ofgem said it was not clear that these are assigned to the institutions best placed to perform them in future.

Ofgem also said there is insufficient, or ineffective, coordination between actors across the energy system at a sub-national level, and that confusion and regional variance in approaches to delivering functions could delay the transition to net zero.

Demand for electricity is predicted to double by 2050 due to the increased use of electric vehicles and heat pumps, meaning that strategic investment in electricity network infrastructure is needed, particularly at the distribution level. However, the call for input also considers gas and heat due to the impact that changes to the electricity system will have on other energy systems.

Flexibility could significantly reduce the amount of network infrastructure that will be needed, with the potential to save consumers between £6 billion and £10bn per year in 2050, according to Ofgem. Distributed low carbon assets will need to have routes to market their services in order to reduce the burden of increasing demand and also keep costs down for consumers.

The call for input identified three key energy systems functions: energy system planning; market facilitation of flexible resources; and the real-time operation of local energy networks. The three functions help manage demand and make better use of renewable energy in the system.

However, data needs to be shared securely between parties and the call for input notes that digitalisation will enable energy systems functions, provided there was urgent progression and adoption of consistent, open data standards and frameworks, with all participants recognising that their actions form part of a public good.

Ofgem said it was key that energy system planning is coordinated across institutions to drive the most cost-effective decarbonisation outcomes. As asset owners and operators, DNOs may have an inbuilt technical and risk bias towards asset solutions, which could result in underutilisation of flexible solutions.

The call for input said it was necessary to consider whether existing arrangements provide DNOs with sufficient incentives to make efficient trade-offs between asset and non-asset based solutions. It also queries whether the DNOs are best placed to bring forward an efficient real-time flexibility market due to potential conflicts and lack of skills and resources.

There are four potential framework models for taking the DSO function forward: internal separation of DSO roles within DNOs; independent DSOs; regional system planner and operator; and interacting organisations.

The call for input is open until 7 June 2022.

On the horizon

As well as these three pieces of work, further responses and decisions are expected: on the initial findings of Ofgem’s 2021 Electricity Transmission Network Planning Review; a decision on the development of early competition in onshore electricity transmission networks; and the publication of the Electricity Networks Strategic Framework.

The work will help to integrate the changes required to facilitate net zero and make the energy market more flexible and agile.

However, it remains unclear whether the reforms will be implemented quickly enough for the UK to be able to achieve its net zero 2050 targets, and whether they will bring down energy costs.

Energy efficiency has not yet been discussed as part of the reforms, and this could play a key role in reducing energy requirements in the future.

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