How we Approached Our Task
The Commission examined the current regulatory landscape for electricity and gas in Scotland, i.e. as part of a single GB-market that has a single system operator (National Grid) and a single regulator for electricity and gas markets (Ofgem) whose high-level objectives, duties and powers are framed within European regulation. We have explored how the regulation and physical systems might change in the event of independence. We have also provided advice on a number of policy questions we were asked, and considered aspects of the transition.
Our recommendations recognise that regulatory systems need to evolve over time. We have looked at the direction of travel in the UK and the EU, as well as the Scottish Government's proposals for multi-utility regulation under a combined economic regulator model.
The purpose of a regulatory system is to provide a stable and efficient framework to encourage necessary investment, which fairly balances the interests of consumers, producers and network operators and controls abuse of market power. In an industry characterised by long life assets, we have looked at frameworks that will meet the needs of successive Governments over coming decades. Whatever the outcome on the 18 September 2014, we hope our advice will be useful as regulatory regimes evolve, both in a Scottish and UK context.
The following sections provide a high-level summary of some of the issues that provided context for the Commission's work.
The Current System is Changing
The UK electricity sector is supported by a highly complex interconnected power system. The companies that operate the generation, transmission, distribution, and supply activities are all too aware of the significant challenge that the UK is facing to deliver a major cycle of reinvestment and development to replace aging power plants, provide GB-wide smart metering, upgrade the power grid, and respond to de-carbonisation challenges.
The electrical behaviour of the power system at national and local levels is already seeing potentially disruptive changes as we move from what is in effect a 'passive' power grid, reliant on centralised controllable generation and predictable demand. In future, we will see a 'smarter' system that integrates smaller distributed power sources and storage, virtual power plants, electric vehicle charging, and increasing volumes of intermittent generation.
If this is combined with growing numbers of intelligent consumers and home energy control systems, we can expect the sector to evolve from today's model of 'generating whatever is consumed' to a new paradigm of 'consume whatever is generated'  . Such a system will look very different from the one we see today, and is being explored actively internationally.
Gas Transmission and Distribution
Electricity is generated and delivered to consumers instantaneously in order to match supply with demand, with a very limited amount of electricity storage available from the UK's pumped storage hydro stations - amounting to around 3% of installed capacity, according to the most recent Digest of UK Energy Statistics  . This system of supply and demand has to be precisely controlled and managed by the system operator in order to ensure that it remains in balance at all times. The GB gas network is also complex and carefully controlled, but it differs in its nature from the electricity system as it has a degree of inherent storage capacity either arising from gas compression in the pipeline or through dedicated gas storage facilities, which also provide some security and resilience of gas supplies.
All gas in GB passes through National Grid's National Transmission System ( NTS), a high pressure gas network consisting of terminals, compressor stations, and a pipeline system some 6,300km in length, on its way to consumers. As the sole owner and operator of gas transmission infrastructure in GB, National Grid works with other companies to ensure that gas is available where and when it's needed.
The Gas National Control Centre ( GNCC) keeps the NTS balanced between the gas demands of the consumers (both industrial and domestic) and supplies. The GNCC moves gas through the NTS by using over 25 compressor stations strategically sited around the country.
To perform its duties, the GNCC liaises with the Distribution Networks, shippers, traders and operators of gas terminals (around the UK coastline) and gas storage facilities and large gas consumers. Its systems are comprehensive and sophisticated - they receive hundreds of thousands of elements of data every day, which allow the GNCC to monitor flows, pressures and gas quality around the system and take any actions necessary to ensure that the NTS remains in balance across the diurnal cycle.
The gas transmission system in Scotland was historically built to transport gas North to South, commencing in Scotland. The gas processing facility operated by National Grid at St Fergus near Peterhead in Scotland is one of four in GB processing gas landed from the North Sea. The St Fergus site receives an estimated 20% of the GB total gas landings.
The UK's gas storage capacity is modest compared to many other markets and represents, on a space or volumetric basis, about 5% of national annual demand. Many other EU countries have 15% to 20% of national annual demand  . With less demand from England and Wales, Scotland's resilience is essentially the capacity of the pipe network as there are currently no gas storage facilities located in Scotland.
Gas leaves the transmission system and enters the distribution networks at high pressure. It is then transported through a number of reducing pressure tiers until it is finally delivered to consumers. The chemical composition of gas can vary, and a key role of National Grid is to ensure that gas quality is monitored to ensure both value to customers and the safe operation of gas-burning appliances.
System Adequacy and Security of Supply
The security of our energy supplies is always a high priority for Government - both the available electricity generation capacity that can be depended upon to meet demands at times of system stress, and the source of supply and ability of the GB system to store gas supplies via existing pipelines and interconnection  .
The single, integrated GB-wide power system has evolved to provide what has been judged to be the most effective and economic arrangement for ensuring security of supplies across GB.
Long-term capacity requirements for new power stations have not been reflected in recent electricity market price signals. In addition, there have been many closures of fossil (predominantly older coal-fired) power plants, which cannot meet (on an economic basis) more stringent emissions requirements (through the Large Combustion Plant Directive and the Industrial Emissions Directive). This has already resulted in significantly fewer power stations available within the UK to meet peak electricity demand, exacerbating concerns in the period beyond 2015  .
Reproduced courtesy of Ofgem
The gas Security of Supply Regulation No. 994/2010 'concerning measures to safeguard security of supply' aims to enhance security of supply by providing common assessment of Member States' energy security arrangements. The regulation is designed to ensure:
- Member States provide gas to protected customers
- a minimum standard of infrastructure resilience
- Member States make adequate preparations for a gas supply emergency
- improving coordination between Member States
- the internal market for gas functions for as long as possible in the event of an emergency.
Security of electricity supplies is addressed as part of Directive 2005/89  , which contains measures designed 'to safeguard security of electricity supply and infrastructure investment'. The Directive requires Member States to take into account the need to:
- ensure continuity of electricity supplies
- study the internal market and the possibilities for cross-border cooperation in relation to security of electricity supply
- reduce the long-term effects of growth of electricity demand
- introduce a degree of diversity in electricity generation in order to ensure a reasonable balance between different primary fuels
- promote energy efficiency and the use of new technologies
- continuously renew transmission and distribution networks to maintain performance.
The Regulatory Landscape
Regulation is a necessary component of certain market structures. It provides a proxy for competition where markets are small, where there is market concentration, or where the asset base supports natural monopolies e.g. pipes or wires.
The key roles for effective regulation must be to:
- protect the interests of consumers, today and in the future
- ensure competition and competitive markets
- encourage and support investment
- incentivise innovation
- regulate natural monopolies.
The Utilities Act 2000 established the GB gas and electricity markets Regulator, Ofgem, which is responsible for the economic regulation of the gas and electricity industries and is governed by the Gas and Electricity Markets Authority ( GEMA). GEMA determines Ofgem's strategy, sets policy priorities and takes long-term decisions on a range of matters including price controls and enforcement. GEMA must have regard to guidance on social and environmental objectives issued by the UK Secretary of State for Energy and Climate Change. Ofgem also administers and regulates a number of environmental programmes devised for Government. Decisions by the Regulator must be independent of both Government and industry, as well as provide transparency for industry and consumers.
Ofgem's main priority is to protect the interests of consumers. For network activities, Ofgem has established price control mechanisms that restrict the amount of revenue that can be earned by the regulated businesses while incentivising customer service.
The Gas Act 1986 and Electricity Act 1989 (as amended) provide the fundamental legal framework for gas and electricity companies. The Acts establish the licences for electricity generation, transmission, distribution and supply, and for gas transmission, distribution, shipping and supply. The legislative requirements are then delivered by the designation of certain functions through a set of industry codes which govern market operations for both electricity and gas.
Liberalisation of the European electricity and gas markets has been implemented through legislative packages starting in the 1990s, designed to open up national electricity markets to greater competition, to regulate natural monopolies such as networks, and to increase competition within retail markets. The Third Package (2007) continues this process "to ensure a real and effective choice of supplier and benefits to every single EU citizen. The [ EU] Commission's proposals put consumer choice, fairer prices, cleaner energy and security of supply at the centre of its approach". The Third Package also promotes a 'Target Model', where networks and markets will adopt common principles to facilitate cross border trade and reduce transaction costs to the benefit of business and consumers.
The UK is implementing the requirements of the Third Package in the electricity and gas systems. However, there is more prominence politically around the effects of current and forthcoming regulatory changes, asset investments and emissions reduction legislation on the UK electricity sector.
Ofgem has played an active role in Europe as the lead Regulator in the Electricity Regional Initiative Project. This was initially launched in 2006 as an interim step to speed up the integration of Europe's national electricity markets by the designation of regions of operation that would work towards a more harmonised, or common, set of market regulation arrangements.
The UK is part of the France- UK-Ireland ( FUI) regional electricity market ( REM), which has an annual electricity consumption across France, Ireland and UK of 780 TWh or around 30% of the EU 25 electricity market.
A key priority for the region has been the implementation of the Capacity Allocation and Congestion Management ( CACM) Target Model for electricity, which sets out the vision for intra-day, day-ahead and long-term trading, cross-border balancing and capacity calculation, with the aim of integrating the national markets in the three Member States.
A major step towards a single EU market for power was made on 4 February 2014 when power markets across 15 Member States were coupled for day ahead trading. The project is part of the EU's Third Package of legislation. "Market coupling favours price convergence, which fosters competition and therefore better services, and ultimately better prices for consumers." (Alberto Pototschnig, director of ACER).
The FUI electricity REM includes the two biggest national economies in the EU that are also very active in electricity markets. Integration will facilitate regional development and accelerate cooperation and coordination at the European level. Interconnectors and compliance with the CACM Guidelines, intra-day trading, reciprocal access to balancing markets and wholesale market transparency  are the key priorities of the electricity REM  .
Without a coupled system for 'balancing services', Member States are still reliant on having adequate national capacity available at times of system stress as physical delivery of energy via interconnection may not always be possible.
In the event of independence for Scotland, the Commission believes that a single, synchronous physical system operating across Scotland and rUK, with technical agreements in place on how the system will operate, provides more effective and economic system security in comparison to alternatives such as provision of electricity or gas supplies via interconnection agreements.
The GB Wholesale Market Framework
The wholesale electricity market has operated since 2005 under the British Electricity Trading and Transmission Arrangements ( BETTA). Under BETTA, wholesale trading has three components that operate for different time periods.
i) Bilateral market - in which generators, suppliers and others trade a variety of contract types, either directly or via brokers or power exchanges. These markets and contracts function up to the point of 'gate closure', which in the GB wholesale market is one hour from the point of electricity delivery, and is via the spot or day ahead markets out to seasons or longer.
ii) Balancing mechanism - run by the GB System Operator, in which generators with flexible generation and suppliers with flexible demand can be paid to vary their output or demand to help balance the system. This market operates at the point of 'gate closure' forward to the point of delivery and enables oversight and control of the whole GB system in real time by the System Operator.
iii) Imbalance settlement process - which pays for the balancing actions taken by the GB system operator on a minute by minute basis.
Bilateral contracts are privately held between the contract parties. In the wholesale electricity market, trades are at a price set by the 'market' and have remained relatively low over the 2013-2014 winter quarter as demand has been suppressed by the mild weather. Power stations selling into that market have different generation and development costs relating to planning and site conditions. Once operational, power stations also have different operation and maintenance costs which they must pay, including the cost of transmission from the site of generation to the point of consumption.
Large scale renewable energy generation is sited where it is most economically efficient to do so and is driven predominantly although not solely by the quality (intensity) of the natural resource availability. This has resulted in a significant capacity of onshore wind generation in Scotland, subject to the parameters of locational pricing signals within the GB transmission system.
Electricity Market Reform ( EMR)
Proposals for the introduction of EMR were announced in the UK Government White Paper Planning our electric future in July 2011, with the Energy Bill receiving Royal Assent in December 2013. To undertake the most fundamental redesign of the UK electricity market structure since privatisation has been a significant task; the consultation and design process is not yet concluded almost three years later, with additional detailed work being undertaken on a range of issues, as well as the development of secondary legislation.
EMR will operate under a Levy Control Framework  ( LCF) which limits the total market support that can be offered across all forms of generation for the years up to 2020. By then the LCF will have a maximum annual cost of £7.6 billion that will cover the existing installed capacity currently subsidised through the Renewables Obligation ( RO), the renewable heat incentive  and small scale feed-in tariff mechanisms. The LCF will also cover new projects established under the EMR framework. EMR will introduce a very different market, which has three main elements:
- An emissions performance standard ( EPS), which will restrict the level of permissible emissions from new fossil fired generation. This will result in the construction of either new unabated gas plant which can meet this emission level without emissions capture technology, or new coal-fired generation fitted with carbon capture and storage ( CCS) technology
- A Contract for Difference (CfD) mechanism that replaces the RO (although it retains the RO's differentiated support for different technology types) and extends to cover support for all low carbon generation - including Carbon Capture and Storage ( CCS) and new nuclear power stations
- A Capacity Market, designed to encourage the operational availability of existing and new generation capacity to ensure generation adequacy of the system at times of peak demand.
Investors display a range of responses to changes in the status quo. The changes created by EMR have been designed to encourage future investment in low carbon generation, yet still bring new and unknown risks compared to existing mechanisms.
The original concept for the RO was technology agnostic, supporting the lowest cost, and most scalable, renewable technologies available at any point in time. Technology banding introduced an element of political discretion between technologies and an element of political risk that has been carried forward to EMR.
Combined with political intervention in the retail markets to address affordability of energy, this has seen an increase in perceived regulatory risk. Some investors are comfortable with the proposed changes under EMR; however, investment projects compete on risk and return with other opportunities open to the large, multi-national companies that dominate the sector. With EMR details still not complete and transparent at all levels, and the outcomes of sector investigations unclear, certainty on investment returns for projects is reduced leading to deferrals in the construction of capacity.
Consumer interests will play a key role in the development of our future power system. The recent behaviour of some electricity supply companies with respect to consumer billing and tariffs has been very poor, resulting in heavy fines from the Regulator. This has led to problems with consumer trust and an accompanying critical, political and media focus upon energy suppliers.
As noted by Ofgem in their 2013 State of the Market Assessment report  , "there is declining consumer confidence with 43 per cent distrusting energy companies to be open and transparent. This may deter consumers from engaging in the market and prevent them from getting a better deal for their energy.
- There is continuing uncertainty over whether the vertical integration of the large energy companies is in consumers' interests,
- retail profits increasing from £233 million in 2009 to
£1.1 billion in 2012, with no clear evidence of suppliers becoming more efficient in reducing their own costs, although further evidence would be required to determine whether firms have had the opportunity to earn excess profits, and
- suppliers consistently setting higher prices for consumers who have not switched."
The decision taken by Ofgem in March 2014 to refer the electricity supply companies for a full investigation by the Competition and Markets Authority may improve the outcomes for consumers. However, the inquiry is likely to take 18 months to complete.
The Political Landscape
As part of the political focus on the energy sector in Scotland, the Scottish and UK Governments have both published information and analyses for consideration.
The Scottish Government published Scotland's Future which highlighted:
- the lack of a coherent approach to energy
- failure of the current energy market arrangements and the consequent underinvestment in capacity
- the major risks presented by proposed reform of the market
- that the current single GB-wide market for electricity and gas should continue, helping r UK provide secure supplies and meet its binding renewable targets.
The Department of Energy and Climate Change ( DECC) published Scotland Analysis: Energy which put forward a number of points, including the view that:
- An independent Scotland and rGB would have different policy objectives, making it difficult to agree a common approach which would be required to maintain a fully integrated system
- Without a fully integrated system, the costs of supporting Scottish energy network investments, small-scale renewables and programmes to support remote consumers would fall solely on Scottish bill payers
- The integrated market maintains energy security and market access for renewable energy; the continuing UK could choose to buy its energy supplies from other Member States in the event of Scotland becoming an independent State.
There is a strong degree of commonality between the views:
- A single GB-wide market is in the interests of Scotland and rUK
- The transparency of energy costs for consumers must be improved in order to deliver choice and value for money
- Subsidies for renewable energy schemes and energy efficiency programmes should not be placed on consumer bills for the poorest in our society
And equally a range of points on which they differ:
- Whether a single GB-market could operate under joint regulators in the event of Scotland becoming an independent state
- The case for new nuclear power as part of the energy mix
- Continuing the socialisation of Scottish transmission and distribution network costs across all GB consumers
It is the people of Scotland who will decide the outcome of the referendum in September 2014. Points of agreement and difference will then be discussed or negotiated with respect to future arrangements under any outcome.