Reputation built on results

Scottish IndependenceIssues for the Power and Gas Markets

Insights and opinions from Baringa Partners

Viewpoint

Scottish IndependenceIssues for the Power and Gas Markets

2 Scottish Independence – Issues for the Power and Gas Markets

Power and Gas Today

Secure, reliable, stable and affordable energy supply is critical for any country. The UK has progressively moved towards developing and managing provision of power and gas on a GB-wide basis. In September 2014, voters in Scotland will be asked the question “Should Scotland be an independent country?” If the outcome of this vote is “Yes” then this will raise fundamental issues for the power and gas markets of the newly separated nations of Scotland and Great Britain without Scotland1.

While, in a post-“Yes” vote world, a wide ranging set of discussions will follow between governments out of which a spectrum of approaches to policy and implementation of independence will likely emerge, it is useful and instructive to consider some of the key power and gas market related issues. This viewpoint sets out some initial thinking on key issues to be considered, and challenges to be addressed.

Policy and RegulationToday policy and regulation is split between the Department for Energy and Climate Change (DECC), who lead on policy, and the Office of Gas and Electricity Markets (Ofgem), who regulate the licensed participants and the power and gas markets. Both DECC and Ofgem operate across all of Great Britain for both markets sectors. In addition, the Scottish Government has the ability to set aspects of energy-related policy within Scotland, for example, the Scottish Renewables Obligation and the planning regime.

The UK has legally binding obligations on climate change abatement and the use of renewable energy to meet total energy demand, some of which are specific to the power and gas sector such as targets on renewable energy. The obligations, which the UK has agreed with the EU are based

1 We use “Britain” to refer to England, Wales and Northern Ireland without Scotland

Transmission lines

Beach Terminal/Interconnection Point

Interconnectors

LNG facilities

Storage facilities

Figure 1: Gas Transmission

3Scottish Independence – Issues for the Power and Gas MarketsIssued 2014

on the current UK situation, are UK wide obligations and are enshrined in national law. Furthermore, Scotland itself elected its own non-binding targets on renewable electricity.

Gas Infrastructure and Market

For decades England, Wales and Scotland have had a single gas transmission network, originally developed by British Gas and now owned and operated by National Grid.

There are six major beach terminals in GB, five located in England and one located in Scotland. About 25 per cent of gas flows into the GB transmission network through the Scottish St Fergus terminal annually.

Continental markets are accessed through the England-Belgium and England-Netherlands interconnectors. Another interconnector runs from Scotland to both Northern Ireland and the Republic of Ireland, making Scotland a key gas access point for all of Ireland.

All the current and planned gas storage and LNG facilities are located in England, Wales and Northern Ireland.

Gas has traded as a single GB market since the introduction of the gas market in the mid-nineties with trading predominately taking place around the national balancing point (NBP) hub. Under the Uniform Network Code (UNC) National Grid is responsible for the balancing on a GB-wide basis and recharges these balancing costs to shippers. The UK NBP is the most actively traded gas hub in Europe.

Electricity Infrastructure, Generation and Market

Ownership of the electricity grid in Great Britain is split between National Grid (England and Wales), Scottish Power (southern Scotland) and Scottish and Southern Energy (SSE) (northern Scotland). Each network owner is responsible for connections to and development and maintenance of their network. The transmission use of systems tariffs are developed

on a GB-wide basis and recovered by National Grid (as system operator), who redistributes to the network owners.

In comparison to gas, the electricity network and market arrangements have only been integrated for a short period of time. Until 2005 the Scottish grid and trading market were separate from England and Wales with the two markets interacting through a cross-border interconnector. This changed in 2005 when British Electricity Trading and Transmission Arrangements

Scottish electricity transmission system

English & Welsh electricity transmission system (National Grid)

Interconnector

Figure 2: Electricity Transmission

58%16%

4%

11%5%

5%

4 Scottish Independence – Issues for the Power and Gas Markets

(BETTA) merged the system operation and market into the England and Wales arrangements forming a single GB market and single grid operation undertaken by National Grid. Electricity is balanced on a GB wide basis and the cost of balancing recovered from generators and suppliers in proportion to their market share.

About 67 per cent of generation capacity in Scotland is owned by Scottish Power and SSE on a roughly even basis. The remaining capacity is predominately EdF Energy baseload nuclear generation (~18 per cent) and wind generation. Production by both capacity and controllable plant is dominated by the two incumbents. Scotland is currently a net exporter of electricity to England.

Retail SupplyLicensed electricity and gas suppliers have a wider role than just supplying the product to the customer’s meter. The government discharges climate change abatement actions through suppliers and also recovers costs of renewable subsidies through suppliers. This means that a significant part of a customer’s energy billl is made up of fixed regulated costs (eg network charges) and government obligation costs (eg renewables subsidies, VAT).

Similar to electricity generation, supply to non-industrial consumers in Scotland is dominated by the two incumbents. On the gas side, Scottish Gas (part of British Gas) as the pre-privatisation incumbent retains a significant presence.

Wholesale energy, supply costs and profit margin 58%

Distribution charges 16%

Transmission charges 4%

VAT 5%

Environmental changes 11%

Other costs 5%

Figure 3: Electricity Household Bill Breakdown

Ofgem Factsheet 98

5Scottish Independence – Issues for the Power and Gas MarketsIssued 2014

Power and Gas Independence IssuesSecure, reliable, stable and affordable energy supply is needed for business and industry to develop, and for people to have a minimum acceptable standard of living. These factors always predominate in the mind of a government when mapping out energy policy. These priorities will remain for all governments in the event of a “Yes” vote as they do today for the devolved administrations and central government across the UK.

The remainder of this document considers issues specific to the Power and Gas sectors which will need to be addressed should there be a “Yes” vote for Independence.

Policy and RegulationEnergy policy is driven by the specific needs and situation of a country. Under an independent Scotland scenario, over time there could be a divergence in the energy policy of the two nations, role and authority of regulators and the obligations of market participants.

In terms of the regulator itself, it seems plausible (perhaps even likely) that an independent Scottish Government would wish to appoint its own independent energy regulator. The new regulator would need to tackle similar issues now facing Ofgem, namely the level of competition in the retail and wholesale markets, and how to recover the costs of expanding electricity networks. The separate regulators would need to work

together, indeed the EU trend is towards market alignment and regulator cooperation, but there may well be different priorities and issues for these regulators to consider.

A key policy ‘unknown’ is what would happen to the UK’s binding 2020 renewables target should independence occur. The UK target on renewable generation agreed with the EU is based on the UK as a whole and is agnostic to the location of the generation within the UK. Much of the UK renewable generation is based in Scotland and is a combination of unsubsidised large scale hydro and subsidised renewable generation. If Scotland becomes a separate country various issues arise. Firstly, distinct renewables targets would need to be established for the two countries and Britain, in particular, would need to determine how to meet the target. Secondly, it is uncertain what would happen to the provision of subsidies to Scottish renewable generation or whether the Carbon Price Support Tax would continue to be imposed on Scottish generators.

The first issue cannot be resolved by Britain and Scotland between them as the target is an EU obligation. Re-negotiations of EU targets following splitting of a country has not happened before and it is not clear how such negotiations would be conducted. A further complication is the EU membership of an independent Scotland in itself; views differ on what would happen in practice and over what timescales Scotland could become an EU member.

In addition, would a future independent Scotland, continue the range of policies which impact on the domestic and non-domestic retail sector from an energy efficiency perspective?

Infrastructure AssetsInfrastructure assets can be split into regulated and unregulated assets. If, following independence, each country’s networks are regulated separately then to ensure efficiency in network development and minimisation of costs for consumers, the two regulators will need to work together to plan and optimise network development, particularly offshore, through the definition of clear roles for the transmission system operators and owners and revenue control and charging arrangements. The recovery of costs of ‘shared assets’ will need to reflect the relative costs and benefits in the two countries. In addition, the efficient and economic operation of a network which spans Great Britain today will need to be considered.

Non-regulated infrastructure of interconnectors, LNG facilities and gas storage are not subject to regulated returns which means they cannot be assured of income. For these asset owners, earnings are exposed to wholesale prices within the markets that they operate, the market arrangements for which will be determined by national regulators within the guidelines established for the European Integrated Energy Market.

6 Scottish Independence – Issues for the Power and Gas Markets

GeneratorsThe mix of generation capacity in Scotland differs from that of England and Wales, and is likely to diverge further in coming years. Figure 4 (right) shows the generation mix in 2012, for Scotland and England and Wales. Scotland has a large proportion of generation from baseload nuclear plants at Torness and Hunterston (34 per cent of generation), hydroelectric schemes (11 per cent) and onshore wind (17 per cent). Following recent closures of fossil fuel fired plant Scotland has comparatively little fossil fuel fired generation (33 per cent) when compared with the rest of the UK (73 per cent), and only two major Scottish generators remain – Longannet (coal, 2.3GW) and Peterhead (gas CCGT, 1.2 GW).

The Scottish Government has ruled out any further nuclear plant in Scotland, following the expected closures of Torness and Hunterston in 2023. It is highly likely that this policy will remain whether or not Scotland leaves the UK. Longannet is currently bound by the EU Industrial Emissions Directive, and is expected to close in the early 2020s as a result. Assuming that an independent Scotland remains part of the EU, or independently enforces the emission regulations consistent with regaining membership, it is expected that Longannet will close whether or not Scotland leaves the UK.

While Scotland is currently a net exporter of electricity, these thermal closures represent a very large proportion of capacity which must be replaced if Scotland is to ensure electricity security. The Scottish Government has targeted a large expansion in renewables, primarily onshore wind, reaching 100 per cent of electricity demand by 2020. As part of the UK, the cost of financial support

to Scottish renewable generators is shared amongst all UK consumers – should Scotland become independent, questions remain about the willingness of consumers in Britain to pay this support, and the ability of Scottish consumers to pay this on their own.

Similar questions surround the future of Peterhead, currently sharing £100m from the UK Government as part of a Carbon Capture and Storage (CCS) FEED study. Up to £1bn may be available to Peterhead to convert to CCS from a UK government, should Scotland leave the UK, a GB government may choose to withdraw funding.

Trading Market Arrangements

EU energy policies are pushing towards more integrated power and gas market integration. This is to support security of supply and cost efficiency which is being progressed on an EU-wide basis. This is demonstrated through greater market coupling between trading hubs across Europe, making it easier for wholesale market participants to flow energy across Europe. In the

Nordic area and Ireland, integration has progressed further to single cross-border markets, though there are still some transmission area-based aspects in the Nordic area such as transmission and energy balancing prices.

In this area, views expressed to date have been divergent between those favouring continuing with the single markets and those of the opinion that the current arrangements cannot continue as now if the countries separate. In our view, any splitting of the GB electricity market is more likely to reflect the underlying network topology than the result of the Scottish independence vote. For example, it could be argued that the push towards bidding and price zones means some de-coupling of England and Wales and Scottish power prices might be inevitable (albeit as part of an integrated market).

If markets were to be fully separated, the sudden changes to market structures and trading arrangements could risk stranding assets, adversely impacting market liquidity and causing wholesale market prices to increase.

Figure 4: Generation mix in 2012

Biomass

Wind

Hydro + PS

Oil

Gas

Nuclear

CoalScotland

Share of generation 2012

England & Wales

100%

80%

60%

40%

20%

0%

7Scottish Independence – Issues for the Power and Gas MarketsIssued 2014

Summary If Scotland does vote for independence the actual date for independence is not known, although the Scottish Government has proposed a date of 24th March 2016, 18 months after the independence vote. Furthermore, a wide spectrum of outcomes in terms of the degree of separation between Scotland and Britain are possible even in the event of political and border independence of a “Yes” vote. Similarly, even after a “No” vote, a range of further outcomes in terms of the devolution of powers and policy-making are plausible.

In the window between the vote and independence day, the day-to-day operation and functioning of the power and gas markets is likely to continue as now. It will be commercial decisions with longer-term horizons, such as asset investment or signing up to long-term contracts, which could be impacted by the lack of medium to long-term clarity. In particular, investors and contracting parties may feel the return on their investment or contract will be affected by the government negotiations. This means securing funds or getting authorisation to enter long-term contracts will not be possible or that higher returns are sought to reflect the perceived increased risks.

The two governments will need to balance the mutual dependency between geographically proximate and well connected energy markets with the desire to ensure each of the nations retains control over vital energy policies. There is recognition that there is a need to provide longer-term clarity for investors and investments in the sector as soon as possible, but this must be balanced against seeking clarity on the best direction for their country and the trade-offs they are prepared to make. We suspect that renegotiation of renewables targets could be one of the toughest areas for discussion.

The coming months hold great uncertainty for these sectors, uncertainty that may continue for some time after the Scottish independence vote and which, as noted above in relation to the political outcomes, could be along a spectrum of possible degrees of power and gas market “independence”.

per cent objective and so the existing rollout programme would be unlikely to show significant change. However, even without EU membership, it seems probable that the rollout would continue given that future energy policy is at the core of the independence debate and that smart metering is seen as a key enabler of a lower carbon economy.

Consumers and Retail SupplyThere has been much speculation over the impact of an independent Scotland on consumers. Retail energy prices are a key political agenda item in the UK currently and the perception by voters over the possible impact is likely to be an influencing factor for a “Yes” or “No” vote. Significantly, the implications for Scottish and British consumers may be different. For example, Scottish renewable development is currently subsidised by all GB consumers (as is generation in other parts of the GB subsidised by Scottish consumers) and so these single renewable support schemes and a common levy to pay subsidies across GB may no longer exist post-independence. This could, in principle, drive prices higher in Scotland, particularly if the Scottish government maintains its commitment to renewable generation. On the other hand, Scottish consumers may avoid having to subsidise the proposed new generation of nuclear plant in the future. Furthermore, the surplus of generation in Scotland at times of high renewables output may drive lower prices should the wholesale markets be split, and these benefits may offset some of the potentially higher subsidy costs for Scottish consumers. In practice, there are many factors at play which will drive retail energy prices in the short to medium-term, some of those related to independence and others not. It will likely be difficult to truly isolate the impacts of independence verses wider market dynamics.

Another issue in relation to retail supply is the rollout of Smart Metering. The current UK mandate, which is being driven by DECC and which is written into the licence conditions of UK energy

suppliers, is to have smart meters installed in all residential and small business customers of both gas and power by 2020. This is, at least in part, being driven by an EU mandate to install smart meters in at least 80 per cent of all power customers by 2020. Were Scotland to be granted EU membership, it would have to comply with this 80

For more information please contact:

energy_advisory@baringa.com

+44 (0)203 327 4220

Baringa Partners LLP, Dominican Court, 17 Hatfields, London SE1 8DJT +44 (0)203 327 4220 F +44 (0)203 327 4221 W www.baringa.com E info@baringa.com© Copyright Baringa Partners LLP 2014. All rights reserved. This document is subject to contract and contains confidential and proprietary information.

About BaringaBaringa Partners LLP is an award-winning management consultancy that specialises in the energy, financial services and utilities markets in the UK and continental Europe. It partners with organisations when they are developing and delivering key elements of their business strategy, as well as working extensively with government and regulators to provide policy and advisory services. Baringa works with its clients either to implement new or optimise existing business capabilities that relate to their people, processes and technology.

Baringa is recognised both in the UK and internationally for its unique culture, which has been acknowledged by a number of awards and accolades and continues to reaffirm Baringa’s status as a leading people-centred organisation.