Whether in equities, property or commodities like electricity, there are plenty of people who will confidently assure you that they can help you beat the market. They will insist that they have the experience, insights and insider knowledge to ensure that – in exchange for a modest fee – you will pay less or earn more.
I’ve spent long enough trading and advising on commodity hedging and in particular electricity markets to know that, on average, the textbooks are right: the future price of a commodity is a function of all the information currently in the public domain, and anyone who tells you they know with certainty whether a market will go up or down is either a liar or an insider trader.
This means that a commercial or industrial (C&I) consumer of power will, despite what a lot of advisors say, on average pay the market price over any reasonable period of time. Sometimes hedging forward will save money; sometimes that power could have been bought for less in the day-ahead market.
Certainly, there is considerable value in smoothing out power price volatility and ensuring predictability in input costs. But it’s highly unlikely that any sort of hedging programme, forward purchasing strategy or complex options trade will, over the medium term, enable the buyer to beat the market.
Beating the market with flexibility
However, many businesses have an asset that can enable them to pay less than the average market price for their power: the ability to alter when they consume. By shifting demand from expensive peak times to periods when prices are low – as we have discussed in a previous blog – C&I consumers can potentially make considerable savings on their power bills.
Historically, however, it has been incredibly difficult for them to take advantage of any flexibility they might have. The structure of the market and the nature of supply contracts have disincentivised so-called demand-side response (DSR) solutions, to the detriment of consumers and the system as a whole.
Managing this flexibility is best undertaken by electricity suppliers. However, changing the volumes of power they supply to large customers at short notice creates balancing risk, requiring them to pay potentially expensive charges to compensate the system operator for putting supply and demand on the grid out of balance.
In addition, providing flexibility to customers is administratively complex. An electricity supplier may need to make a handful of wholesale market power trades to fulfil a typical customer’s supply contract. But enabling that customer to dynamically consume more or less power in response to near-term price signals will require the supplier to trade much more actively – creating complexity in trade processing and billing that suppliers are unable or unwilling to take on.
Inserting flexibility into the system
The status quo was not just bad for the consumer – it was also bad for the system. The failure of suppliers to enable their consumers to respond to price signals leads to price spikes that are higher and longer in duration than would otherwise be the case. A less price-responsive market needs more generation and transmission infrastructure to meet demand peaks, adding to overall system costs.
In response, Ofgem introduced BSC Modification P415, which came into force last November. It essentially allows third parties – known as virtual lead parties (VLPs) – to manage a consumer’s flexibility assets and trade that flexibility on the wholesale market, while allowing the consumer to continue its electricity supply relationship with its supplier.
P415 creates what is known as “deviation volumes”, which represent the difference between a site’s expected consumption – it’s baseline – and actual metered energy use.
When flexibility is triggered, the VLP becomes responsible for the change in consumption by the site compared to its expected consumption. A perimeter correction takes place, to ensure the supplier isn’t out of balance (and thus subject to balancing costs). The VLP is then able to trade that deviation in the same way that any supplier or generator would trade an amount of generation.
However, if the consumer has responded to high prices by trimming its consumption, the supplier is out of pocket because it has sold less power than anticipated (power that it will have contracted to buy in advance through a forward contract). To address this, P415 provides a financial compensation for the supplier, based on the Ofgem price cap and socialised across the network.
Good in theory…
While P415 does, in theory, address the problem of supplier inaction regarding their customers’ flexibility, it is far from ideal in practice, introducing several complexities and inefficiencies. These include:
- Challenges over setting baselines: Defining baseline power consumption levels is complex and imperfect. If baselines are set too high or too low, the deviation volumes calculated could misstate the flexibility delivered, risking under- or overcompensation to suppliers, VLPs and consumers.
- Interactions with other flexibility schemes: A number of other schemes and markets are in place that allow owners of flexible assets to provide flexibility services. These include flexibility markets run by distribution system operators and the Balancing Mechanism, operated by the National Energy System Operator. P415 allows VLPs to ‘stack’ wholesale trades with other services, but doing so requires sophisticated data systems and verification processes to avoid double-counting.
- Risk of supplier cost pass-throughs: P415 is unpopular with suppliers, who face significant new burdens adapting their systems and processes for those customers who contract with VLPs. They have also raised concerns that the compensation mechanism will not adequately reimburse them for forgone revenues from customers who curb demand (rather than shifting demand from one period to another). Suppliers may choose to treat P415 as another cost that they aggregate and pass through to customers, making the market less transparent.
- Adding another supplier to the mix: The new mechanism introduces complexity into the relationship between the customer and its electricity supplier – essentially inserting another supplier into the picture. This means the consumer will need to ensure that their contracts with the supplier and the VLP don’t conflict, and that there is clarity and seamless communication between the two parties over billing and compensation during flexibility events.
- Questions over likely uptake: All this means there are very real questions around the likely uptake among C&I consumers. It remains to be seen how many will be convinced to insert an additional service provider between them and their existing supplier. For many companies, this will be a leap in the dark, potentially risking interruption to their very ability to do business, and they are likely to need some convincing from VLPs who are unlikely to be familiar to them.
A simpler solution
Make no mistake: encouraging the uptake of demand-side response is good for consumers, good for grid operators and good for policymakers and regulators as they promote the net-zero transition. It promises to make electricity grids more efficient, dramatically reducing costs and avoiding billions of pounds of additional investment.
But there is a simpler solution than P415, and one that would have avoided the need for its introduction in the first place. Those entities best placed to provide integrate flexibility services – the electricity suppliers themselves – could step up and offer a seamless experience to existing customers where both parties profit from exploiting whatever flexibility the customer can offer. That incumbent suppliers have proved reluctant to do so does, we believe, provides an opportunity for disruption in the UK electricity supply market.