So far in our blog series on the DSO model, we’ve talked about how the nature of the UK power industry is changing (blog 1), about the challenges and solutions for the DSO role (blog 2), and about the benefits of a separated system operator (SO) (blog 3). In this blog, we take our discussion of a separated SO a little deeper into its objectives and define what this separation will actually look like.
The first objective should be to embrace the change in philosophy. The SO is no longer the sole controller of a single, directional system with few suppliers. It must coordinate with others to make the market, creating a flexible, competitive, and secure distribution system focused on delivering real value to consumers.
This will be achieved by promoting innovative solutions to demand/supply problems and opportunities, promoting optimum system use through the exploitation of smart/demand-side management and driving efficiency and competition through all areas of the system. The SO will therefore have to take the market lead in several areas:
- Neutral market facilitator – The SO will be the single point for capacity auctions and other connection tenders to provide the system with the necessary capacity to make it work effectively for all. This role will require the SO to create changes in the regulatory and market rules to support the residual balancer role. This is likely to be the SO’s main revenue stream.
- Driving a whole system view – Although a part of the DNO role today, there will be greater emphasis on reviewing all options available to help solve distribution problems on the network, promoting efficient solutions that do not require reinforcing or adding to the network – for example, working to alter generation and demand, or utilizing storage.
- Taking an active role as residual balancer – The SO will have a proactive role in ensuring that the system balances country-wide effectively. This will need to go beyond simply managing system imbalances as they occur and will be where they will work most closely with the GBSO/TSO and other SOs.
What separation will look like?
There are four broad options for separation which the industry must consider:
- Accounting separation: Separate financial accounts required for the AO and SO but shared operational activities remain possible
- Functional separation: As with accounting separation, but separate operational and management activities are required
- Legal separation: As with functional separation, but the AO and SO become separate legal entities. Common parent company ownership would be possible, but decision making within each entity will be independent and clear “Chinese walls” must be in place
- Ownership separation: No one legal entity can hold majority shares in both the AO and SO.
To avoid any conflict of interest, legal separation is the most likely result, albeit through the interim step of accounting and functional separation over many years. It would be impossible for an SO to be owned by an AO as the conflict between the interests of asset ownership and the purpose of the SO to operate an efficient power market agnostic of capital solutions would remain. The journey to legal separation is likely to run to the timeline below:
Common ownership between a fully regulated and a partially regulated competitive organization would inhibit competition, hindering new market entrants. Should the SO become a lightly regulated competitive role with external market challengers (which it is likely to become), then this further supports legal separation by 2027.
How will the separated SO-AO model operate from 2022?
A previous paper developed a conceptual model for how the SO-AO commercial/contractual relationships might look:
Implications for the regulator
The RIIO price-control mechanism will need to be fully reviewed with a view to providing a supporting framework in RIIO2, with the requirement to divide it across the SO and AO elements. There will need to be clear joint and several license obligations for both bodies – even prior to a split. In addition, Ofgem must provide an interim mechanism to enable existing DSOs to recover the costs associated with executing the legal separation to SO-AO.
While the SOs will be commercial and are likely to be privately owned or PLCs, they will need to be regulated in a way that ensures public accountability. This will likely require the SOs to create their own officially recognized body, or adapt the existing Energy Networks Association (ENA) model, to negotiate an efficient and proportionate regulatory framework with Ofgem and BEIS.
Any new regulatory regime would have to address the following areas:
- Enabling the AO to make effective build/no-build decisions in response to SO needs
- How to enable the new neutral markets, which will be the centerpiece of the SO’s day-to-day interaction with their customers, including guidance on commercial arrangements for all parties under the new model
- A revised set of operations-focused obligations aimed at the SO that support the public good and at the same time allow the SO to operate in a competitive market
- Revised, published KPI suites for both SO and AO operations and a mechanism for engaging both parties on those KPIs from a licensing perspective
- Both AOs and SOs having industry level financial incentives to drive benefits for consumers, even given a competitive open-market situation for the SO
- A customer forum to represent the broader nature of the DSO customer base to provide an understanding of customer requirements as they evolve
- Clarification of security of supply requirements and how those obligations sit between parties acting in the SO and AO roles.
Given the rapidly changing nature of energy distribution needs and the technology surrounding it, an eight-year regulatory cycle is not the most effective way to operate in the AO-SO world. Something more agile is called for, with regulations centering on whole-system efficiency to benefit the consumer.
The above would mean that RIIO2 will not be in the same form as RIIO1. Instead a more transitory model will bridge the gap between the end of RIIO1 and the end-state new regulatory world. This is not to abandon all the principles of RIIO, but it must be recognized that the new model will rely more upon market forces and open competition to support the overall system goals.
In the next blog, we will look at the commercial and operational side of DSOs. In the meanwhile, I would be happy to discuss the DSO model. Feel free to reach out to me via my profile or on social media.