The end of the line: assessing the impact of reform to the arrangements for connection to the GB grid

The end of the line: assessing the impact of reform to the arrangements for connection to the GB grid

For at least the last couple of years, there has been a lively policy debate relating to the evolution of the GB electricity market.

The Government’s Review of Electricity Market Arrangements (REMA) consultation is considering major changes to the market design, such as locational pricing, reform to CfD support arrangements and changes to the capacity mechanism. ESO’s Beyond 2030 document has suggested a need for massive network build, and the move from ESO to NESO will see the implementation of new strategic planning processes, looking across energy vectors and at both national and regional level.

Given this context, it is easy to miss changes which appear more technical in nature but which may still have very significant implications for the cost and speed of our net zero transition. One such change might be that proposed for the connections process. While it is difficult to pinpoint a specific starting point for the debate about the right approach to connections, a major milestone was the ESO kicking off its connections reform process. In December 2022, it published a “Case for Change” report. Following that, it embarked on a process of solution design, issued a consultation in summer 2023, and published final recommendations in December 2023. Ofgem then published an open letter on the topic in April 2024.

As with any reform, the proposals (and any variants put forward as part of the next phase of the reform process) will need to be assessed by Ofgem prior to implementation. While the changes appear technical in nature, given the nature of the potential ramifications, it will be important that any such assessment is holistic and robust.

In this note, we:

  • discuss the drivers for reform, and summarise the proposals themselves;
  • consider how the proposals might be evaluated from a societal viewpoint; and
  • consider some broader options in relation to the issues

The issue and the reform proposals

Ultimately, an ideal connections process would ensure that projects which are the most privately profitable and societally beneficial are clear that they can connect to the network
quickly. One of the major concerns which Ofgem, DESNZ, ESO, and others have in relation to connections at present is the “queue” of projects at transmission and distribution level.

According to Ofgem, this stands at over 700GW, more than four times the volume of generation that the UK is predicted to need by 2050.

The queue of projects is ordered by the date which each is given for its prospective firm connection to the network. And the concern stems from the (realistic) assumption that the queue contains a mix of projects with good prospects for eventual development, and projects which are less likely to come to fruition. Any new project which comes along, whether it itself has good or bad prospects, joins the back of the queue, or put another way gets a date for firm connection which is a long way off.

This means that projects with good prospects, which are important for our transition to net zero, might end up waiting a long time to connect, delaying or raising the costs of the transition.

This situation stems from the fact that projects face relatively low barriers to entry into the queue. A project can apply to secure a position in the queue (i.e. a firm connection date) at a relatively early stage in its development, and so having incurred relatively little financial outlay. And while payments to the network owner (so-called “user commitment” payments) do increase as the date of firm connection nears, for projects with firm connection dates which are some way off (which is by and large the case for any new project applying), these payments remain low for a long time.

ESO’s proposals, to which Ofgem appears to have given some degree of blessing, have now been formalised as modifications to the Connections and Use of System Code, the document which sets out the process for connecting to the network. The proposals envisage requiring projects to be significantly more advanced (and hence to have spent significantly more) before they can secure a firm connection date.

Specifically, the proposals would see:

  • the introduction of an annual application window for connections (rather than the present continuous process), with the introduction of two formal gates through which projects have to pass as part of the overall process to securing a firm connection date (Gate 1 and Gate 2);
  • relatively light eligibility criteria for Gate 1, at which projects will receive an indicative connection date; and
  • much stricter criteria at Gate 2, the point at which projects will be given a firm connection date and location.

The criteria to proceed through Gate 2 are proposed to be that (i) the developer has secured land rights on the planned site and (ii) the developer is ready to submit an application for planning consent within certain timelines. The option to introduce “financial instruments” (i.e.some form of additional cost or fee associated with maintaining a firm connection date once it has been issued) is being kept under consideration.

Last but by no means least, this arrangement is proposed to apply to new projects and, retrospectively, to the existing queue. In other words, projects previously issued with firm
connection dates would need to pass the Gate 2 criteria by a certain point in time in order to retain the right to connect at that date.

Requiring projects to be further advanced in order to secure (or retain) a firm connection date will almost certainly result in some projects dropping out of the queue before Gate 2. Projects will have to incur costs to meet the new, tougher criteria. Some may simply not have the funds (or be able to secure additional third party equity or debt financing in time) to enable them to progress sufficiently. Others may not yet be sufficiently certain of the likelihood of making a return on the additional investment, and may simply let their projects lapse.

While GB almost certainly doesn’t need 700GW of projects to meet our net zero goals, we do need significant investments in renewables, low carbon flexible production and in electricity
storage. Given this, securing a date for firm connection to the network is likely to remain an important milestone in a project’s development. At this point, a major risk associated with a project (i.e. securing a long dated connection) is removed, meaning that projects (i) can secure finance at a lower cost, and (ii) have a larger pool of potential financing options open to them.

So while connections reform may appear to be a largely technical question, because it may increase barriers for projects seeking to access larger and lower cost pools of finance, it is important that it is subjected to a robust cost benefit analysis (CBA) by industry and Ofgem.Ofgem recognises this explicitly in their open letter.

Components of a CBA

This naturally leads to the question of what such an assessment would involve.

Economically, a firm date in the queue is an option. It gives developers the ability (but not the obligation) to take a project forward. Given the long queue, securing this option is valuable, as without it a project has little or no certainty as to when it can connect and start to earn revenue. Once it has secured the option, project sponsors can decide whether and when to progress to acquire land, secure planning consents, secure a supply chain, and ultimately secure finance to take a final investment decision (FID).

However, as we set out above, it is an option with a relatively low option fee (until the firm connection date draws near). That means many developers expect the option to be profitable even if there is only a small chance of the project proceeding.

In theory, the option fee also secures a right to take the place of projects which drop out of the queue (for example, because they conclude they will not be needed and hence will not be profitable). If projects drop out, their position is typically offered to the next project(s) in line.

However, because the cost of retaining a position in the queue remains relatively low until projects near the date of their firm connection, few projects drop out at an early stage. This
means that by the time drop outs become more significant, the projects behind them are more likely to have already optimised their delivery planning (e.g. through contracts with their supply chain). It can be difficult or risky for them to try to accelerate their progress: if they accept an earlier firm connection date and then deliver their project “late” (relative to the new date), they will incur costs to the network company but have no offsetting revenue.

Compared to today’s counterfactual, the proposals increase this option fee, in that developers have to spend more money before securing (or maintaining) a firm connection date.
Importantly, however, the scale of increase is:

  • unknown to policymakers, because it is based on additional requirements to be met (rather than, for example, a set fee to enter or stay in the queue); and
  • variable across projects, because for some projects, acquiring land rights and being ready to submit a planning application might come at a lower cost than for other projects. It is not necessarily the case that the projects who will face the lowest additional cost to comply
    with Gate 2 requirements will be those which are the most privately or societally beneficial.

Again, other things equal, this means that:

  •  the cost of capital for projects will increase – projects have to incur more spend:
    •  further ahead of the point at which they start to earn revenue;
    • under conditions of higher risk; and
  • there is likely to be reduced competition in developing projects, because in effect barriers to entry to the market will have been raised. This is particularly likely to affect non-balance sheet funded developers.

Both will mean investors require more revenue from consumers in order to build a given volume of new capacity:

  • the first effect will increase investor financing costs, meaning that more revenue is required to achieve a given hurdle rate; and
  • the second will mean that the marginal investor hurdle rate is likely to be higher (because there is less competition driving down investor returns).

These effects are likely to manifest in higher prices in either the capacity mechanism in relation to non-supported capacity or the CfD auction (or other support scheme prices) for supported capacity.

However, other things are almost certainly not equal. Because the proposal will apply prospectively and retrospectively, it is likely that some existing projects will drop out of the queue. These might be the projects for which the private and societal benefits are lowest. However, there is a risk that the attrition includes beneficial projects. For example, this might be the case for projects with more complex planning applications. Equally, since capital markets are not perfect, it may also be that some more beneficial projects drop out because their developers cannot find the right sources of finance.

Projects dropping out of the queue will also have a number of effects:

  •  the above impacts may be partly (but not entirely) mitigated:
    • the impact on cost of capital should be lower, as the delay period between the initial (higher) outlay and eventual connection should be shorter;
    • to the extent that today’s long queue disincentivises some developments, some more competition (perhaps with a greater likelihood of proceeding to FID) may come
      forward; and
  • beneficial projects should be able to connect sooner, reducing costs to customers, because the price impact of greater supply of electricity should be felt sooner in wholesale markets.

Separate from this, there may be a benefit in terms of efficient network planning (i.e. ensuring the networks develop the right capacity in the right place at the right time). Given the time taken to develop network infrastructure, networks may benefit from seeing an early “long list” of projects under development (even if they know some may eventually not take FID), because it gives them an early indication of reinforcement needs (e.g. if they see a cluster of projects
under development). They will also clearly benefit from better information as to which projects are most likely to proceed. In this sense, the two gate process is well designed to secure some early information which then improves over time.

Beyond these efficiency considerations, it is likely that any CBA will have to consider some broader effects.

In their open letter, Ofgem already suggests that whether proposals ensure “equitable outcomes across all generation, demand and storage projects” is an important consideration.
As we note above, some aspects of this may be difficult to gauge given the nature of the proposals. It is perfectly possible that there are privately profitable and societally beneficial projects for which the cost of land rights and planning is very high, and conversely some less profitable and less societally beneficial projects for which the land and planning costs are low.

This might imply a differential impact of the proposals across projects. As we noted above, it may also create a risk that more beneficial projects drop out of the queue, while less beneficial projects remain in it.

Developers of some technologies will be involved in other administrative processes which have specific timings associated with them (e.g. Crown Estate sea-bed auctions, the Scottish Government’s INTOG process, Ofgem’s own interconnector windows). For projects involved in such processes, the interaction of milestones linked to either payments or enduring rights to develop might impact project risk, and so the likelihood of projects proceeding. This will
need to be assessed both from an overall efficiency perspective, and in terms of the extent to which the proposed arrangements secure equitable outcomes.

All of this means that a robust CBA of the reforms will be complex:

  • the change in cost of securing and maintaining a position in the queue is unknown, and the lowest change in cost may not correlate with the most beneficial projects;
  • the reform will change levels of risk and competition, but in a complex way. The greater the impact, the more the queue is likely to reduce; but the more the queue reduces, the more the impact is mitigated; and
  • the reforms to the connections process need to be seen in the context of a wider landscape of processes relevant to developers, meaning their impact may vary by technology and by project.

However, complexity of the effects does not justify failing to consider them properly. If reform is progressed, the industry and Ofgem should be clear as to their expectations from it, and why these can be expected to be in the interests of consumers.

A broader perspective

The ESO’s proposals start from the presumption that the long queue is a problem in and of itself. And if the queue contains beneficial and less beneficial projects, and the most beneficial
projects are not able to connect quickest, it is highly likely that this presumption is correct. But this analysis points to two possible solutions to the problem: either raise the cost of entering and maintaining a position in the queue, or allow greater movement within the queue.

As we have discussed above, the ESO’s proposals take the first route. They raise the cost by requiring projects to reach a certain stage of development prior to securing a firm connection date.

There are, of course, other options to increasing cost, for example:

  • raising the cost of securing and maintaining a firm connection date by a known and controllable amount, for example by introducing an annual fee to maintain a queue
    position (the fee could be increased or decreased to achieve the “desired” length of the queue); or
  •  use price to ration the length of the queue, for example by auctioning a defined volume of connection capacity by period.
    An auction regime is likely to be too complex to consider at this point in time (though we note that DESNZ does refer to the potential to auction rights to the network in its second REMA consultation). In contrast, raising the cost by a known amount (in addition to the other proposals) is being kept under consideration as part of the discussions on CMP434/435. It remains to be seen whether there will be appetite to consider a simplification of the proposals,
    by only including such a charge (i.e. by removing the Gate 2 eligibility criteria in ESO’s proposals). While the effects of such a reform would remain complex, greater transparency as
    to the additional costs being visited upon projects may be seen as a positive.

Equally, while the proposals change the risk profile of projects, it is notable that they do not consider the broader conditions of connection offers. At present, the liquidated damages in some connection offers are set to zero. This means that for a project with a firm connection date, if the network moves this date backwards and that has knock on implications for the project (e.g. delaying its first cashflows), the network does not have to provide compensation. If the connection process is leading projects to incur greater costs early on in their development programme under conditions of highest uncertainty, it may be appropriate to consider their risk position in the round.

But what about the second route? This would involve solutions which aim to ensure projects can trade their positions in the queue, meaning that the projects which are most profitable and societally beneficial should be able to secure earlier connection dates through trading, even if
they are initially provided with firm connection dates well into the future.

This would involve transfers of value between projects. Less beneficial projects that have secured early firm connection dates would be able to monetise some of the benefit of their
valuable option by selling to more beneficial projects. And while the existence of ticket touts capturing value from a secondary market evokes strong emotions in the context of football matches and Taylor Swift concerts, in the context of the connections queue, value transfers may be less of a concern, and such trading should deliver value to customers.

At present, there may be barriers to efficient trading. For example:

  • while information on generation projects that have accepted an offer is made public, this is not the case for demand customers (which, given demand growth from LCTs and
    datacentres, and the bidirectional nature of storage assets, may be increasingly
    important);
  • connection offers are technology specific, adding cost and complexity to trading. For example, ESO’s agreement would be required to allow a grid-scale storage facility or an offshore windfarm to make use of a connection offer originally made to an interconnector; and
  • since a connection offer is essentially a contract between a specific project sponsor and a network, novation of that contract is only possible with the network’s agreement. 

Just as it is difficult to gauge the impact of the ESO’s proposed reforms, it is difficult to know how effectively an option based solely around facilitating trading would be. Trading is never likely to be perfectly efficient: connection offers are far from a standardised commodity. The question is whether it can be made efficient enough.

More than that, however, reforms that reduce friction in trading should be considered no regret. They will help to ensure the most profitable projects come on line first irrespective of the broader approach and hence the length of the queue. While the industry develops and assesses the proposals put forward by ESO and actions in Ofgem’s Connection Action Plan, perhaps there is also scope to give some more attention to flexibility within the queue.