Your ref.
Our ref.
Cemil Altin
Head of Price Control Development
The Office of Gas and Electricity Markets
9 Millbank
LONDON
SW1P 3GE
21 February 2003
Dear Cemil
DEVELOPING NETWORK REGULATION: OPEN LETTER TO CHIEF EXECUTIVES
Thank you for the opportunity to respond to Callum McCarthy’s letter of 13th January
2003, that set out Ofgem’s further thoughts on how the regulatory framework could be
developed to provide distributors with the correct incentives to respond appropriately to
the increases in distributed generation (DG) required to meet the Government’s energy
and environmental policy objectives.
I am writing on behalf on NEDL and YEDL, who continue to be enthusiastically committed
to the work that is required to establish a technical and regulatory framework that can be
an effective platform for the pursuit of the Government’s policy objectives with respect to
distributed generation. Hence we welcome the significant contribution that Ofgem have
made to the overall debate in recent months, and see your letter as another positive sign
of progress.
You will be aware that Ofgem’s open letter raises a large number of extremely significant
issues for our sector, and we encourage careful consideration of them. You will be aware
that our Chief Executive, Greg Abel, has already responded to Callum McCarthy’s letter.
This response builds on some of the points that Greg Abel raised in his letter, that may be
summarised as:
 The importance of introducing interim incentives for distributors to support
distributed generation connection in the period before the commencement of the next
price control. If incentives on generating capacity connected (MW) or system
capability made available (MWh) are to be introduced, it might be appropriate to set a
baseline as at January 2003 to reward investment of intellectual and financial capital
in the next two years;
 The importance of providing early signals of the nature of the arrangements that are
anticipated post 2005. These could build upon the interim arrangements discussed
above, releasing benefits through the next price control;
 The vital issue of recognising the need to establish effective arrangements for the
ever increasing need for distributors to manage counter-party risks and our
contention that these additional risks ought to be reflected in the assessment of the
cost of capital being applied to distributors.
 The need to establish meaningful and effective incentive arrangements that
encourage the right commercial behaviours by distributors, such as economic
management of the network and processes that establish generator connections as
quickly as reasonably practicable. Greg Abel’s letter indicated our preference to see a
balanced set of incentives, which are appropriately weighted, that define and then
encourage the factors upon which successful facilitation of DG connections rests.
 The importance of establishing a long-term vision for distribution network
operation, and in particular a review of common ground between distribution and
transmission. Transmission systems deploy complex processes on simple networks,
while distributors deploy simple processes on complex networks. For example, there
are fewer than 300 substations on the GB transmission system, but even a small
distributor like NEDL has around 20,000 substations. As Ofgem has noted, we should
align distribution with transmission only where there is a clear benefit to customers of
doing so.
Clearly, we consider the above to be the most important strategic issues raised by Callum
McCarthy’s letter. However, there remain a number of issues that, despite being less
strategically significant, have the potential to disturb the process of effectively handling
increased DG penetration on distribution networks. We are pleased to be able to share
some of our thoughts on these matters with you at this stage.
However we would stress that the volume and complexity of the issues lead us to believe
that it is important that we continue an effective working dialogue with Ofgem on a range
of issues. A number of these issues are being addressed as part of the Distributed
Generation Co-ordination Group, its Technical Steering Group and other important
Ofgem projects such as the Structure of Charges Review. Other areas will benefit from a
more focussed interaction between our organisations and we remain committed to
devoting the necessary resources and time to working with you to establish effective
solutions.
A more detailed consideration of the questions raised at the end of the open letter is
attached.
I trust that you find these comments helpful. As we have stressed a number of times in
this letter, we believe that DG requires a great deal of attention. We welcome the
opportunity to exchange views created by the open letter. Furthermore, we believe that it
will be important to maintain an active dialogue on these issues. To that end, we look
forward to meeting with Ofgem to discuss these issues further in the coming weeks.
Yours sincerely
PHIL JONES
Director
The objectives identified for this project
The objectives of the project, as represented in the document, appear to us to be the right
ones. The separation of these commercial issues into a clear project is welcome, as it
allows them to be considered alongside, but not be amalgamated with, the considerable
technical issues that attend this matter.
We encourage Ofgem to maintain their commitment and the pace of development in this
area. After the value of Renewable Obligations Certificates, the decisions that are taken
with respect to the upcoming periodic review will arguably be the single most influential
factor on the level of penetration of DG that will be achieved by 2010. Based on the
industry’s experience of addressing these issues, particularly over the last four years, this
is a subject area that will require a great deal of effort to resolve the various inter-related
strands.
The appropriateness of interim arrangements, and the form of the arrangements
We believe that the steps taken so far, such as the revised connection charge
regulations, the staged payment proposals and the governance of standards have been
well-placed steps to remove institutional barriers that unduly deter DG development.
However, as the open letter recognises, more still needs to be done.
As Greg Abel pointed out in his earlier letter, we see a need to generate additional
impetus at this point. The industry would miss an opportunity if it recognised that
incentives are required for that period, but nothing were done to build momentum running
into that period. We strongly advocate a simple, straightforward incentive that will
encourage companies to accelerate the process of addressing the technical issues, the
customer liaison and the investment planning techniques that will need to change to build
increasingly generation-rich networks.
There is a finite intellectual resource available to distributors, with a temptation for
managers to divert effort from DG (with distant deliverables and uncertain reward) to the
periodic review. Providing an incentive based upon connecting DG before 2005 would
help maintain the profile of the issue. For example, if incentives on generation capacity
connected (MW) or system capacity made available (MWh) are to be introduced, it might
be appropriate to set a baseline as at January 2003 to reward investment of intellectual
and financial capital in the next two years
Remunerating distributors for DG Costs – and the impact on consumers
Clearly, there are going to be costs associated with increasing levels of DG on networks,
since projects of this nature inevitably involve a degree of network reinforcement and reengineering. Equally clearly, it will be necessary to remunerate distributors fairly, as they
are affected by the changes.
We welcome the wide-ranging debate on charging principles, including the opportunity to
contribute to the Structure of Charges Working Group and attend that workstream’s
seminar on 20 February.
We support the emerging consensus that demand and generation should be subject to
the same charging principles. This leads us to ask two questions:

Where should the boundary be drawn between connection and distribution use of
system?; and

How should distribution use of system costs be attributed between demand and
generation?
We strongly support aligning the connection/use of system boundary on the lines of the
current demand regime, which has been demonstrated to balance the interests of
distributors and their customers. This approach, specifically the 25% rule, limits the
extremes of cost to either party.
Most commentators agree that shallower regimes are superficially attractive but rely upon
highly disaggregated transportation charges. Without this, there will be undue crosssubsidy between customer groups and a tendency to inefficient investment.
The loss of cost signals for generation and demand will lead to less efficient development
of networks. It is self-evident that, with elastic demand (which clearly exists for DG) lower
prices will lead to more requests for connection. With limited economic signals, these
additional requests are likely to be for higher capacities or in more (electrically) remote
locations than would otherwise be the case.
As noted earlier, distribution systems are far more complex than the transmission system.
Nodal charging will lead to hundreds, if not thousands, of separate agreements. The only
meaningful form of zonal charging that we have so far identified is by primary substation,
which still implies hundreds of zones within each distributor. Such arrangements would
not only be complex to administer but, if retaining any reflection of cost, would have
volatile charges.
Meaningful cost signals should reflect the forward cost curve within the charging zone.
For instance, one would expect generation below a demand-rich primary to receive a
credit (or at least a lower tariff than for equivalent demand) to recognise the deferral of
reinforcement. In turn, this might be expected to encourage generation to locate in that
area. This might then change the zone from demand- to generation-rich, reversing the
credit available. This would not assist DG project financing.
It has also been suggested that the impact of distribution charges on end-users is diluted
by the limited degree of disaggregation in suppliers’ bills. All of this shows that the ability
to send cost signals in distribution use of system charges is severely limited.
This implies common tariffs within a distribution services area, with the exception of the
largest sites. Even proponents of DG recognise that this leads to cross-subsidy of highcost developments by low-cost ones, which militates against efficient development of the
network.
Demand customers face a double penalty. Not only might they face a disproportionate
share of costs but, if DG developers do not face the costs they impose on the system, the
overall costs of a generation-rich network might be unduly high.
There are also regional issues here. If demand customers face a disproportionate share
of use of system costs, their bills will rise as DG penetration increases. This represents a
cross-subsidy of the national good by customers in resource-rich areas. It seems more
appropriate for the regulation of distribution to provide a level playing field for generation,
and for Government (e.g. through the RO) to create national subsidy to promote the
national good.
Shallower approaches also appear to conflict with many of the principles behind gas and
electricity transmission reform. This area involves two key issues which will deliver
benefits to customers through more efficient development of networks, specifically:

Unbundling services from use of system; and

Driving network investment by customer requirements clearly matched to a
preparedness to pay.
Shallower charging approaches reverse unbundling, and reduces the link between
payment by customer demand (reflected in the payments they make) and investment in
the network.
The impact on distributors’ cashflow of shallower regimes must also be recognised.
Increased and more volatile levels of investment, both of which flow from shallower
charging regimes, will adversely affect distributors’ ability to raise capital. This was
recognised by ORR in allowing Railtrack an 8% return to fund its major expansion
programme.
Principles for assessing different incentive arrangements
The principles set out in the document seem to us to be a reasonable way to assess the
effectiveness of any set of incentive arrangements. They are a comprehensive set of
criteria that ought to guide the discussions that need to follow.
We are particularly keen to see the principle of predictability given adequate priority. It
seems that a sensible starting point is to establish a straightforward set of behaviours that
we wish to see encouraged. We believe that this should be an early deliverable from the
project, that will then act as a touchstone for the rest of the process.
The initial thoughts on incentive mechanisms for distributors in relation to DG
The incentive arrangements that are presented are a helpful overview of a number of the
key possible scenarios. As a company, we commented on these in Greg Abel’s letter to
Callum McCarthy. For completeness, we have included the observations made in that
letter below;
Incentive
Commentary
As discussed above, we are in favour of an incentive based on
differential treatment of the regulated asset base dependent on the
investment driver. Another strand of a RAV incentive may also be
to provide incentives to exploit synergies between investment
RAV
Incentive triggered by connection requests and distributors’ investment
(Reinforcement) programmes. This can be achieved through means such as a
commitment to treat such cost savings as efficiency gains and a
suitable rolling RAV adjustment mechanism. The way forward on
the boundary for connection and transportation charging may also
impact on the RAV incentive.
As identified, a MW driver does have difficulties (i.e. inefficient
MW capacity - investment), but it can be an effective proxy for the rate of
based
driver connection and the efficiency/effectiveness of the connections
(reinforcement)
process. However, it becomes less important should a MWh
incentive be adopted
It is clear that the development of ancillary service markets is a
Investment
longer-term objective. Ancillary services may, at least in the early
avoided
stages, be developed on a site by site basis. Experience from this
(Operation)
should be used to develop a more formal market structure should
this be deemed appropriate.
Whilst the open letter focuses on the application of a MWh driver
based on the actual output of a generator, other treatments may be
more appropriate to ensure that the scope of the incentive remains
MWh
driver focussed on matters within the control of the distributor. A MWh
(Operation)
driver based on the availability of the network (i.e. exclude MWh
lost due to distributor constraints) and not the actual output would
achieve this. Such a driver would act as an appropriate proxy for
the constraints applied by a distributor to generation.
Losses
Incentive
(Operation)
The incentivisation of lower losses is undoubtedly an area where
DG can play an important role. Whilst there are some cases where
it can be a positive factor, there are equally situations where it can
be a dis-benefit. Resolution of the issues presented by DG in this
area requires detailed industry analysis to determine how an
incentive regime could operate.
We continue to work in this area to consider alternatives and are in the process of
developing our thinking. We look forward to sharing these ideas with you as they develop
in the coming weeks and months.
What is clear to us is that three of the highest priority issues in this area are;
 To ensure that companies have appropriate incentives to invest. In practice, this
means assembling a set of incentives that makes additional, justified capital
investment an attractive proposition to distributors. In general, efficient management
of networks means containing the capital demands of the asset base whilst improving
or maintaining security and service. In that situation, customers win in every way, and
companies benefit from out-performance gains for a short time.
Companies do not invest to earn a return on a higher rate base. They invest to
improve the risk/performance profile of the business. This implies that:

Significant and immediate returns are required to encourage companies to make
discretionary investment which does not deliver tangible benefits in risk reduction
or customer service enhancement; and

Excessive demands for non-discretionary investment may lead to other projects
being deferred. In turn, this could adversely affect both risk and customer
performance.
It is not enough for a regulator simply to dictate that investment should be made.
Companies need clear and immediate rewards, in revenue or in improving risk and
customer performance, before they will invest. Investing to support DG will rarely
deliver other benefits, and so requires preferential treatment under price control.
 To ensure that strong incentives are in place for companies to drive down the
cost of executing the investment work, thereby minimising the cost impact on
users. This could be achieved by a number of methods, such as setting target
benchmark costs, monitoring performance against them and operating a regime of
benefit sharing not unlike that which is commonplace in risk sharing construction
contracts. Alternatively, the £/MW and £/MWh drivers discussed in the open letter
encourage companies to connect and facilitate generation for less than the
benchmark rate.
 To ensure that the treatment of losses adequately raises the profile of this issue
without becoming a conflict to the pursuit of DG penetration. In practice, there
may be occasions where it is necessary to recognise that the two virtues of rapidly
increasing the concentration of renewable energy sources on networks and reducing
losses are directly at odds with each other. It is therefore essential that each
workstream considers the impact on the other.
Ensuring flexibility in the arrangements to align with the transmission framework
We agree that it is important to review the application of transmission approaches to
distribution. As discussed earlier, distribution systems are several orders of magnitude
more complex than transmission, and the labour-intensive solutions applied to
transmission should therefore be read across only when, as Ofgem suggests, it is clearly
in the best interests of customers.
It is unclear to what degree a supplementary services market is viable in distribution.
Creating a market in which users may sell services such as reactive power implies one in
which those products are also sold to customers. NGC has created an ancillary services
market only on the back of unbundling its product offering. It is also unclear how
distributors could co-ordinate a market in which (for example) reactive power is generated
at one point, then carried through a reactive network to another, with a large number of
other users connected in between.
Without a supplementary services market, it is also unclear whether a System Operator
role becomes sufficiently distinct from other distribution operations for separate treatment.
Although a full access rights auction seems impractical at the moment, the same
principles can be satisfied by more appropriate means. We might define the basic product
offering of a distributor as connection to, and transportation of energy across, a network
optimised for supporting demand. Generators would therefore experience such
constraints as such a network would create, with no compensation for constraints. Should
individual users, whether generation or demand, require a higher level of security, they
are free to approach distributors for a price. This satisfies the basic principle that
investment should be driven by proven customer requirements.
Notwithstanding these issues, we agree that the evolution of a framework for DG should
not preclude migration towards an approach closer to that for transmission, except where
there is a clear and lasting benefit to customers of divergence.
Issues raised by Power Zones
We are of the view that the power zone concept is a very important one, although we
would not claim to have advanced our own thinking on this matter to any significant
extent. What seems clear to us is at this stage that concentrated areas of very high DG
penetration will be vital for companies to develop a view of how the networks will develop
after 2010, rather than before it (although we wouldn’t suggest that no contribution would
be made to the shorter-term considerations).
Our current view is that initiatives of this type are an important consideration in the light of
the forthcoming energy White Paper. If the Government sets out to pursue a lower
carbon economy of the magnitude proposed by the Royal Commission then establishing
how to run the networks beyond 2010 will be an important long-term consideration.
We do plan to carry some work forward internally this year in this area and look forward to
sharing the progress and outcomes with Ofgem.
The initial timetable and links to other projects
This issue is obviously one that interacts with many others. The most obvious areas,
where we would stress the need for Ofgem to ensure proper connectivity, are the Price
Control Review, Losses and Structure of Charges. Clear views of the mutual
dependencies of these three vital areas of work will be an important factor in ensuring
effective outcomes and co-operation from the distributor community.
One particular dependency is the type of information on DG scenarios that is likely to
feature as a requirement of price control submissions. If these requirements are not
confirmed quickly, then the uncertainties that attend the penetration levels and the
corresponding prognosis of future costs will result in wildly inconsistent submissions from
distributors. We would encourage Ofgem to make this an early output of the DG/DPCR
workstreams.
There is a lesson from the last distribution periodic review, where defining the quality
cases requested from distributors was left to the discretion of individual companies. Due
to the understandable variation in approaches, the information was hard to compare and
it is unclear that it informed the review.