Why is Ofgem looking to reform residual charges?

Why is Ofgem looking to reform residual charges?

Ofgem is reviewing the way residual charges in the transmission and distribution of electricity are calculated. The regulator wants to make the charges more evenly distributed across different customer groups.

One of a number of options for changes currently being assessed is the introduction of a fixed capacity charge. Adopting a fixed capacity charge will make residual costs more predictable. However, they will also reduce incentives for consumers to lower consumption. Users will still benefit from other time-of-use elements within network charges. However, the move detracts from a more dynamic use of the energy network which will help promote long-term structural change in the energy system.

What are residual charges?

Residual charges are top-up costs set to ensure network companies can recover their allowed revenue under Ofgem price controls. One major problem with the current residual charging system is that some groups of users can benefit from paying lower transmission and distribution charges when adjusting their consumption. These users will also pay less towards residual charges while the costs to other users increase to make up the shortfall. Residual charges represent around 80% of overall transmission charges. At a distribution level, residual charges will vary between the different Distribution Network Operator (DNO) companies, but can make up as much as 50% of distribution network costs.

 Why is there a problem?

Developments in the makeup of the electricity network as energy transitions towards a more flexible, cleaner and technology-driven system is expected to cause problems for residual charges, if left unchanged.

The development of electric vehicles mean the technology functions as a form of domestic storage. Battery storage and behind the meter generation make a positive contribution towards smoothing energy consumption over longer periods of time, flattening peak consumption and reducing the strain on generation during high demand periods.

As technology develops and becomes more cost-effective, an increased adoption of electric vehicles and battery storage will lead to greater demand side behaviour. Adopters of such new technologies will, under the current system, receive lower residual charges compared to non-EV or storage users who are not taking advantage of time of use tariffs. This incentivises consumers to adopt a more dynamic and flexible approach to electricity demand, as those who do not adjust their consumption are hit with higher charges. Introducing a flat fixed charge would level the playing field but deter flexibility in Demand Side Response (DSR) from consumers. Ofgem is carrying out a Targeted Charging Significant Code Review (SCR) which is looking into means of minimising the impact to those consumers who are not able to adjust their consumption.

Making residual charges ‘fair’

Work is currently underway towards a more dynamic pricing model, under which the price changes by time of day. Furthermore, market-wide half-hourly settlement will allow for all consumers, including domestic and small businesses, to install and use a smart meter. This will enable greater demand side response from those groups and increase their likelihood to change and reduce their consumption. Adoption of a fixed residual charging would reduce the benefit from DSR intended by the introduction of smart meters.

Transmission and distribution price controls will need to evolve to meet the needs of a changing energy system. Ofgem needs to focus on delivering tougher price controls in the future. The regulator has promised lower returns on upcoming price controls with a reduced level of residual charges. However, it is imperative the new model of recovering residual charges does not hinder the smart energy transition. The adoption of new smart technologies will incentivise a growing number of consumers to adjust their consumption. Customers will be more engaged in their energy use, develop a deeper understanding of the system, and be more receptive to participating in initiatives that reduce their energy consumption.

DNOs and other parties are looking to optimise the costs of developing networks to meet future changes. In particular, to address the expected growth in electric vehicles, as they will be faced with tougher price controls going forward.

We can help review your consumption

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Ross Moffat

Posted by on Friday, the 6. October at 8.00

Ross Moffat has been a part of the Market Intelligence team at Utilitywise since early 2014. His responsibilities include delivering Market Intelligence reports to clients and managing the Utility Insights Twitter account. Ross has a first class Honours degree in Business and Marketing from the University of Stirling.