We need a strong National Grid to help us transition to a low carbon power sector
20 Jul 2016
Even in the aftermath of the referendum, there are two power sector stories that (almost) stand on their own. The first, a Competition and Markets Authority investigation of the retail energy market (gas and electricity) was the subject of an earlier comment. The second, covered here, is the House of Commons Energy and Climate Change Select Committee on the case for breaking up National Grid. Both reports fail to take proper account of the impact we should expect from commitment to a low or zero carbon economy. The market and competition paradigms that have dominated since the 1980s now need re-examination and if necessary re-interpretation. I argued that a new system architecture, especially for the power sector, may lead us to promoting much more effective competition in retail supply. But in the case of the grid there are some powerful counter arguments, not against competition per se, but in recognition of the necessity for ensuring a strong National Grid to handle the transition to a low carbon power sector.
Select Committee makes the argument for breaking up National Grid
The Select Committee on Energy and Climate Change has in its report on low carbon infrastructure recommended the breaking up of the National Grid. One of the key complaints about the current structure of the power sector, and the role of National Grid in particular, is that National Grid suffers severe conflicts of interest, the most obvious being its ownership of profitable assets such as interconnection facilities, along with the responsibility for transmission and system operation, both of which are regulated as public service activities.
Prima facie this is a legitimate concern in the context of the power sector as it is today. In essential respects, competition, regulation and industry organisation all reflect development of the market paradigm established with the privatisation of the power sector in 1990. This was based on unbundling of the different parts of the power sector – generation, transmission, distribution and supply. Generation is a competitive activity, while transmission and system operations (as well as distribution) are natural monopolies that are granted to a private sector business in return for being subject to price regulation controlling the return they can make for their shareholders and the quality of service they provide.
First principles of regulatory economics dictate that there potentially serious conflicts of interest arise if a business is allowed to operate in both a regulated and a competitive business at the same time. A business permitted to operate this way could, under these conditions, try to do a number of things to promote its own interest to the detriment of both its competitors and the public interest. These include:
· moving costs from the competitive business (the interconnection assets) to the regulated monopoly, thus allowing their recovery as costs necessarily incurred to keep the system going. This ends up as a subsidy to its own competitive activities to the detriment of competing generators.
· operating the system in such a way as to advantage its own assets, thereby increasing its revenues to the detriment of competitors and the public.
· determining its investment programmes in such a way as to advantage its own (interconnection) assets.
· investing excessively in transmission assets – “gold plating”- in order to increase the asset base on which it is allowed to earn its regulated rate of return (although this can arise even for a transmission only business).
The Select Committee did not find any evidence that National Grid is abusing its position in any of these respects. Indeed a prime function of Ofgem, the regulatory body, is to monitor these activities and prevent abuse. National Grid says it has put safeguards in place to keep competitive and monopoly functions separate. Even so there is is a case for separation of activities, in order to eliminate even the possibility of abuse, and it this argument that underpins the Select Committee report.
The Counter Argument
There are however some powerful counter arguments. The drive to a low carbon economy is going to bring profound changes to the power sector. These start with questions of technology and scale but they have huge ramifications. Conventional assumptions about markets, regulation and governance are coming under increasing pressure. Some of these challenges sit at the heart of the Oxford Martin Programme on Integrating Renewable Energy, and it is worth rehearsing a few of them, drawing on some particular challenges for energy markets already identified within the programme.
1. First it is increasingly governments that take the key decisions on investment. This is for some very powerful reasons that we identify and which reflect both climate policy imperatives and wider policy and market uncertainties. Given that governments lack any technical competence in the power sector, the role of organisations like the National Grid is more and more important.
2. Second, traditional divisions between businesses are increasingly difficult to sustain. Generation and transmission investment have always been substitutes to some degree. To that we can now add storage of electricity. Storage has traditionally been viewed in relation to its generation potential (ie the competitive part of the sector) but is increasingly seen as an instrument in managing the networks, both transmission (high voltage) and distribution (low voltage). Segmenting what might or might not be a competitive activity will be increasingly difficult.
3. Third, conventional wholesale market structures, designed for fossil fuel generation, are not really compatible with the technical and economic characteristics of low carbon power generation. Inflexibilities, intermittency, zero marginal cost and other factors render the old merit order an inappropriate basis for efficient dispatch of generating plant. Without major re-design these markets will provide neither a signal for the right kinds of new investment, nor a basis for efficient and secure operations. National Grid sits at the centre of this issue.
4. Fourth there is still a great deal of uncertainty around the scale or scales at which the key operating and investment decisions in the power sector will be made. One plausible direction is a move towards much greater decentralisation of generation, storage and system control, combined with much more emphasis on the consumer as an active participant in energy markets. We may see much more localised approaches to network management. But the benefits of capturing diversity, in consumer loads, storage options and intermittent generation, are such that interconnection within national systems is likely to remain of fundamental importance. This will not eliminate the role of the Grid; it may well enhance it. And the technical expertise embodied in the current structure is not an asset we should put at risk.
5. Finally, there is always a balance to be struck in industrial organisation between the benefits of specialisation/ unbundling/ competition on the one hand, and coordination and the minimisation of transaction costs (between unbundled entities) on the other. Nowhere is that more important than the power sector, where real time balancing of loads requires strong elements of control at different voltage levels. The nature of the low carbon economy tilts that balance towards coordination, and a strong role for the National Grid.
For these reasons I believe that a cautious approach is justified in looking at the future of the public service and utility functions carried out by the National Grid. This is not to dismiss the concerns of the Select Committee. Indeed we know that, to meet the challenge of a low carbon future, there needs to be a fundamental overhaul of the system architecture for the energy sector as a whole and the power sector in particular. But to embark on a re-organisation of National Grid, in the absence of a clearer vision of where we need to get to, and focusing on what are in a sense problems of the old paradigm, may be a mistake. To do so without a clear direction of travel will simply add to the policy uncertainties that are a major problem for new investment.
This opinion piece reflects the views of the author, and does not necessarily reflect the position of the Oxford Martin School or the University of Oxford. Any errors or omissions are those of the author.