Expert Commission on Energy Regulation: main report

To Consider How a Strategic Energy Partnership With the Government of the UK Will Operate - its Span of Competence and the Processes For Cooperation With the UK

• The benefits of single markets for electricity and gas to all parties are generally acknowledged
• An effective energy partnership is important to ensure the best operation of market arrangements and security of supplies to all parties
• The negotiation and settlement of the strategic energy partnership needs to be kept separate from the arrangements for its on-going governance and operation - 'settle as counterparties, govern as equals'
• A clear governance framework, and institutional relationships that tackle the difficult issues will help ensure robust and enduring arrangements
• Mechanisms and processes need to be designed to accommodate change in an efficient way
• Safeguards protecting the rights and interests of all parties must be agreed
• Any policy changes intended to influence behaviours within a geographic part of the market will take place in the context of an integrated GB electricity system that cannot escape the laws of physics.

The Scottish and UK Governments recognise the shared benefits that the single market provides. Post-independence, the retention and operation of single energy markets for electricity and gas will need a strategic relationship and agreement between Scotland and rUK, which will extend to structural and governance arrangements between the Scottish and rUK Governments and the relationships between the National Regulatory Authorities.

The agreement between Scotland and rUK will need to be governed effectively to ensure robust protection of majority and minority rights. Both jurisdictions need to be confident the arrangements agreed cannot be unilaterally altered or nullified by the other party.

The interface between Government and the Regulator in each jurisdiction should be clearly defined on a range of issues, including the role of Government in setting policy, the relationship of Government to the Regulator, and the role of the Regulator. It will also require an in-built capacity for review of the operation of the market and the effectiveness of the energy partnership after specified periods of time.

Scotland is presently a consistent net exporter of electricity to the rest of the UK and in 2012 exported 13 TWh, or over a quarter of all the electricity generated in Scotland. Under current forecast scenarios of high renewable generation installation in Scotland and closure of current coal and nuclear generation, Scotland is likely, at times of low renewables availability, to import electricity from rUK in order to continue meeting demand and for necessary network ancillary services.

The integrated nature of the GB electricity system highlights the need for a collaborative relationship between governments, regulators and TSOs such that any changes which may affect its operation are developed by mutual agreement.

There is a variety of international comparators of joint regulatory models where two or more countries co-operate in the operation and regulation of a single market. Each of them has features tailored to their specific circumstances, and differs in scope.

These models could usefully be applied to a jointly regulated market for Scotland/rUK and demonstrate that a cross-border single market can be made to work effectively. Experience suggests that it is preferable to address the important issues and accountabilities including governance at the outset to avoid gaming or uncertainty later when joint arrangements are commercially operational.

An agreed change management process will be required to accommodate lessons from operation and changed circumstances.

If Scotland wished to operate the electricity system 'more independently', for example to achieve greater security of supply, this would be technically achievable and could be agreed within the limits of a jointly regulated system. However, any changes would require an evaluation of the costs and lead-time for implementation.

Setting up a Strategic Energy Partnership

The continued operation of a single GB energy market, based upon a strategic relationship and partnership between Scotland and rUK will require a series of governance and institutional arrangements to be established between the Scottish and rUK governments and energy regulators.

Certain fundamentals should underpin the Energy Partnership:

• That both Governments recognise the mutual benefits and strengths presented by current system operability, regulatory and market arrangements, and that this common ground presents a solid foundation upon which to enter negotiations
• That the current policy thrust and the resulting targets applicable in Scotland and rUK will remain consistent - with both Governments continuing to pursue binding renewable and low carbon energy targets, at fair and affordable prices for consumers as part of a wider focus to ensure sustainable and secure supplies of energy
• That the models for the necessary governmental and regulatory partnerships, working arrangements and systems of governance which exist in other parts of the world can provide useful templates and guidance for the task facing both governments in working together
• That the necessary arrangements to meet the EU obligations for a National Regulatory Authority ( NRA) and System Operator ( SO) are implemented in Scotland.

A clear governance framework, and institutional relationships that tackle the difficult issues, need to be established from the outset. This will then be developed in such a way as to ensure robust, lasting and balanced arrangements. A strategic energy partnership between the governments of Scotland and rUK should encompass:

• The political will and commitment to deliver a mutually beneficial outcome - ideally in the form of a pragmatic memorandum of understanding (MoU), which sets out in full the overarching aims and intent of both parties
• The commitment to provide the necessary resources required on both sides to ensure that the institutions are properly equipped to succeed
• The duration and scope of the transitional arrangements that will need to apply while new structures and bodies - including a Scottish Regulator and System Operator - are established and resourced
• A realistic and detailed process map and timetable, intended to guide the participants and stakeholders through the process and the steps necessary to jointly retain and operate the single energy market - including delivery of the necessary legislation and related consultations.

The negotiation and settlement of the terms of the strategic energy partnership need to be kept separate from the arrangements for its on-going governance and operation; the guiding principle should be 'settle as counterparties, govern as equals' although the UK Government has signalled that a partnership will be difficult to reach due to differences in objectives in a number of areas.

A well governed strategic partnership, with clear lines of communication at Ministerial and official level can both prevent, and speedily resolve the unintended consequences of policy changes implemented by one jurisdiction which has impacts in the other.

Case Study - The Single Energy Market ( SEM) in Ireland

The introduction of a carbon price within the Republic of Ireland changed the merit order for electricity generators in the SEM, resulting in a more favourable economic position for fossil generation in Northern Ireland which was not subject to the carbon price. This led to the displacement of carbon emissions from the Republic of Ireland into Northern Ireland, and lower generation output (and revenue) for fossil plant in the Republic of Ireland. Once this position became apparent, Ministers intervened to remove the carbon price in the Republic of Ireland. Subsequently, when proposals for the Emissions Performance Standard ( EPS) were made as part of the UK electricity market reforms, Northern Ireland was granted an exemption due to the distortive market impact.

Where there is intergovernmental commitment to retain the single market, the resultant arrangements will be robust. Evidence shows that governance arrangements for a strategic energy partnership are most effective where they are established on an equal basis, with neither party in a majority position. Typically these have been detailed within a Memorandum of Understanding (MoU) agreed between Ministers.

InterGovernmental Memorandum of Understanding

The exact detail of the intergovernmental MoU on a strategic energy partnership will be part of the negotiation and settlement process following the outcome of the referendum. The MoU should address the following areas for electricity and gas:

Scope of the Agreement

There needs to be agreement on the scope of the arrangements. The MoU should make clear where there is agreement on joint operations and regulations, such as transmission and interconnectors, and areas where a degree of national autonomy may be preferable such as policies for fuel poverty, energy efficiency or heat distribution networks.

For electricity, elements within this scope may extend from the wholesale market only, through to the full system as it is currently operated; however, due to the number of constituent parts of the electricity system it would be logical to set out the scope of the agreement by system functions such as interconnection agreements, operation, transmission systems, distribution systems, retail and supply, fuel poverty and energy efficiency (including demand side management and smart grids), renewables and incentives.

For gas, a similar functional structure within the scope of an agreement would cover supply contracts, landing points, network standards, storage, transmission and distribution, shipping and interconnection.

Transitional Arrangements

There will need to be a sensible period of transition prior to implementation of any new structures. Transparent arrangements will maintain confidence in the system until Government, Regulatory and operational changes are implemented. Transition arrangements should include establishing inter-Governmental and industry working groups that will address the technical, operational, legal and financial issues as well as the timescale over which they will report.

Governance of the Status Quo

During the transition period, an appropriate governance structure will be required to ensure that the current system is maintained operationally, as well as supporting the implementation of system changes already agreed, and apportioning their associated costs. This will need to be supported by both jurisdictions and will cover:

Operational control

Practical arrangements are required to run the electricity and gas systems to meet existing licence conditions, technical codes and standards. Functional responsibilities within jurisdictions on how the electricity and gas systems are run also need to be clear as it is a dynamic system with constantly changing levels of generation and demand.

The compliance with common standards to underpin reliability and security of supply will be important to both parties.

Emergency Response and Support

For the electricity and gas sectors this will detail:

• The Role of Operators
• The Role of Regulators
• The Role of Governments

The system must be able to respond to natural events, strikes, system failures, or cascading faults in a consistent and coordinated fashion such that critical system interdependencies are safeguarded; roles and accountabilities including who leads in emergency response must be unambiguous.

Technical changes to system

During the transition period the technical and code change alterations designed to address developments and issues affecting the system will continue to be needed.

The industry codes also underpin the electricity and gas wholesale and retail markets. Licensees are required to develop, become party to, maintain, or comply with the industry codes in accordance with the conditions of their licence.

The codes define the terms under which industry participants can access the electricity and gas networks; it is a dynamic governance framework with rolling amendments and modifications.

Neither overarching EU legislation nor the dynamics of the system will stand still. Both issues will need to be catered for.

Change Management Process and Policy

If a strategic energy partnership can be established, then a longer-term change process will need to be in place. Depending on the scope and subsidiarity agreed, there will need to be a change management process to provide a robust and proportionate structure during the transitional and implementation phases arrangements for:

• notification of changes agreed to be within each national jurisdiction's remit
• consultation and controls on limited impact measures proposed by either partner
• reserved matters requiring joint consent for more fundamental changes

For example, measures that are agreed to be minor - that is, considered to be straightforward and low impact in terms of any cross-border effect, and thus purely a matter for each separate Government - may be dealt with through a relatively simple process of notification. This might encompass new policies or initiatives to tackle fuel poverty, support community renewables, or to support supply chain development.

Where policy, technical or regulatory changes are considered to have greater potential to influence prices or supply across the respective borders, they would be subject to formal consultation prior to their introduction and include analysis that quantifies potential impacts.

The arrangements under the strategic energy partnership should also recognise that there will be some reserved matters - that is, areas of policy where any change within one country is considered likely to have a fundamental impact on the other, or on the single market as a whole (such as further significant reform to the wholesale market). Such changes would need to secure mutual consent prior to any implementation.

Periodic Review Mechanism

Periodic review of the strategic energy partnership will enable both jurisdictions to notify, establish and agree the direction of policy and regulatory development for a given period of time. This will build confidence in the intergovernmental process, and also certainty for industry in the policy and regulatory landscape. The periodic review mechanism would operate under certain basic principles. It could be used to respond to significant market events and would provide the opportunity to consider any major changes - such as what may, in time, replace EMR.

The process could incorporate a standard impact assessment in order to identify the thresholds, analysis, and consequent rights to proceed or block proposals that are put forward by each jurisdiction - through a dispute resolution process.

A Code Change Authority

The current legislative framework in the UK requires market participants to obtain a licence in order to generate, transmit, distribute, or supply electricity at scale; establishes processes for licensing; and uses licence conditions to require market participants to be party to different Codes and Agreements which establish the rules for the wholesale and retail markets, transmission and distribution access, and market settlement.

Scotland and rUK should pursue consistent legislation which establishes the requirement for licences, the standard terms for those licences and which obliges the licensees to be party to Codes and Agreements.

From discussions with a number of regulatory bodies and market experts in Europe, there is agreement that the governance structure of the joint regulatory model has an important influence on the effectiveness of the market regulation activity.

For a joint regulatory structure to be effective, the rules for operation and settlement of the wholesale market - including the capacity mechanism - would need to be identical in Scotland and rGB ^[48] , although different incentives for different technologies can be envisaged.

EMR will substantially increase Ministerial involvement in the market through decisions on the capacity mechanism. Following independence, these decisions will need joint Ministerial accountability. If a unified approach to supporting low carbon generation is maintained, joint oversight will also be required over the award of CfDs unless there is a settlement between Governments on a market allocation of the Levy Control Framework that an independent Scotland would control.

In other respects a single electricity market could incorporate diversity. Approaches to network regulation and charging could differ, provided third party access was retained. The market already accommodates different approaches to measuring consumption (interval meters and profiles) and with different transmission and distribution system charges for generation and demand customers across the UK, it will continue to do so. If one country moved to half hourly settlement for all consumers and the other did not, this should be perfectly manageable.

There are two high-level approaches that could be adopted to ensure consistent market rules following Independence. These are: i) a coordinated approach to rule change or ii) a code change authority.

i) Under a coordinated approach to rule change, the two NRAs would undertake the economic regulation of networks in Scotland and rGB respectively. The two NRAs would also licence relevant activities within Scotland and rGB.

Model 1 : A Coordinated Approach

The licences would require the parties to be subject to the relevant codes and agreements, on a consistent basis across the market. Market participants in each country would manage code change and seek approval from the relevant NRA. The NRAs would coordinate to ensure the codes and agreements remained fully consistent.

This approach has obvious problems of duplication - with two NRAs considering similar rule changes - and risks that the codes would diverge.

ii) An alternative arrangement would be to separate out code change from economic regulation. Economic regulation would remain with the NRA in each country. Code change would be managed by an agency or committee jointly established by the two countries.

Under the second approach, licencing and economic regulation would still be undertaken by a Scottish NRA and its rUK equivalent. The licences would carry an obligation to be subject to the relevant codes. Licences could also impose obligations specific to Scotland, such as participation in energy efficiency schemes or output metrics.

Model 2: A Code Change Authority

Consistency would be maintained through a single agency that approved code change. This agency would need to be given appropriate legislative power to approve code changes in Scotland and rUK, or delegation of the NRA's powers with respect to Code change. The approach would also need to be consistent with the requirements of the EU's Third Package.

A code change authority could be more effective in ensuring a single market over time. It might also be possible to consolidate other functions (such as licencing) to further promote market integration.

Industry stakeholders have confirmed that a transparent change management process and accompanying timescale to implement future changes would maintain confidence in a different regulatory structure.

Inter-Governmental Coordination

An effective and meaningful strategic energy partnership will need formal structures to administer, monitor and review the implementation of the partnership agreements once they have been reached.

Experience from the SEM, Nordic and the MIBEL markets has demonstrated that the most effective regulatory approach is delivered by a joint governance model where the respective regulatory authorities have an equal responsbility and accountability that engenders a rational discussion of the 'market' issues as opposed to national interests.

This could be delivered in the form of an inter-governmental agency. Meeting on a regular basis, its remit would focus on ensuring that the partnership as agreed was being duly and properly implemented. This would require procedures for raising and resolving unforeseen issues, and it would also provide a forum for the initial consideration of policy developments and issues as they arise.

There is a variety of different options for such an agency's constitution and operation (see Annexe A for summaries on the structure and role of international regulators). A relevant example is the Irish Single Electricity Market Committee which operates on the basis of equal representation from each jurisdiction in Ireland, but also includes independent membership. This latter element, if coupled with a system of binary decision-making and a binary choice mechanism, provides a stronger incentive to reach agreement in the event that any disputes arise.

The Spanish/Portuguese MIBEL model has many similarities, including equality of representation on the joint Board. That comes from recognition that both jurisdictions must have confidence in the implementation of the settlement reached and that a joint single market structure requires acceptance of constraints and safeguards.

An inter-governmental forum would also sit at the head of a pyramid of necessary institutions and structures - such as a joint regulatory committee or equivalent body, the respective TSOs and key industry technical groups. It would also form part of the interface with other relevant organisations, such as ACER.

Depending on the scope and the partnership body, policy issues would still fall back to the Governments, meaning that it would be prudent to have a liaison forum for the Energy Ministers of the two Governments. This could simply be a bilateral structure or something more permanent, possibly informed by relevant external bodies such as the Climate Change Committee, the Fuel Poverty Fora or in future, perhaps a Security of Supply Committee to inform on the Energy Trilemma.

The Commission considered that a partnership structure along the lines of the SEM or MIBEL, but possibly with wider scope such as seen in the Nordic model which encompasses trading in renewable energy certificates, could be a suitable model for the two Governments to consider. The independent member requirement, seen in the SEM, may also be worth considering though this could prove challenging given the relative shares of Scotland/ rGB within the single markets.

Inevitably these arrangements are focused on electricity and gas and primarily on wholesale market coordination. As the regulatory model proposed by the Scottish Government also covers other utilities, the arrangements applying for coordination with rUK for these areas would also have to be considered. The Commission has not attempted to address these areas.

Establishing a Strategic Relationship

The insights gained from discussions with stakeholders have confirmed that the following elements would offer best practice in establishing a Scottish Regulator, and the strategic relationship with rUK:

• Establish a mutually constructive relationship with Ofgem and the Regulator in Northern Ireland ( NIAUR), with simple and clear mechanisms for decision-making
• Map today's technical and commercial arrangements wherever possible as the starting point, but avoid leaving complex issues to be 'resolved later'
• Implement structures and frameworks from the start that can be brought into alignment with longer-term aspirations when required: future-proof the designs now rather than try and change them later when processes are 'live'. Co-operative working between jurisdictions will encourage inward investment and should a be priority
• Maximise adaptability, and minimise bureaucracy to accommodate the continual changes anticipated as the power sector develops, decarbonises, and integrates more closely with consumers, communities and other sectors ^[49]
• Innovation at all stages will help deliver cost-effective outcomes in the energy sector, particularly in the regulated network companies where normal competitive innovation pressures are absent and sub-optimal 'traditional solutions' remain available

Settle as Counterparties, Govern as Equals

The nature of the joint regulatory model and the strategic partnership between Scotland and rUK Regulators for electricity and gas will be established through a negotiated settlement in the event of Scotland becoming an independent state. The outcomes of this process cannot be known in advance, and will be subject to a counterparty discussion between respective Governments.

However, once this settlement is agreed it is important that on-going arrangements and operation are governed effectively to ensure robust protection of majority and minority rights. Both jurisdictions need to be confident that arrangements agreed cannot be unilaterally altered or nullified by the other party, and equality of representation on the governing body is one means of addressing this.