Entry Capacity Substitution Workshop 5 – 5 th December 2008 Review and Options for Development.

Entry Capacity Substitution Workshop 5 – 5th December 2008

Review and Options for Development

Agenda

Recap of substitution benefits and impacts

Impact on entry capacity charges

Reserve prices

Incremental step prices

Potential options for substitution

Substitution Benefits

Maximise use of existing Transmission network assets for the

benefit of consumers.

Avoid both capacity sterilisation and unnecessary infrastructure

investment while accommodating changing flow patterns.

Substitution Impacts

Substituting capacity to recipient ASEPs to meet incremental

capacity requirements will impact on prices paid for capacity at

those recipient ASEPs in exactly the same way as if requirements

are satisfied through investment (i.e. in the absence of

substitution).

Substituting capacity away from donor ASEPs will reduce the

reserve price at the donor ASEP (all other things being equal).

Substitution Impacts

To trigger incremental capacity at an ASEP where capacity has been substituted away will have minimal impact on the prices that would have to be paid. Therefore the main impacts are:

For long term capacity projects that are economically able to trigger incremental capacity, the potential default lead time of 42 months and the need to provide the necessary User Commitment.

For short term players there may be a greater reliance on the 10% of baseline capacity that is held back to the shorter term. However, this is supplemented by availability of additional capacity through Transfer and Trades and discretionary release.

For marginal gas fields, there may also be a greater reliance on the 10% of baseline capacity.

Substitution Example – Prices

Reserve Prices (and step prices for incremental entry capacity) are a function of the obligated capacity level.

Hence, substitution will generally decrease the P0 price at donor ASEPs; and

Release of incremental entry capacity will generally increase the P0 price at recipient ASEPs.

Revised obligated levels / prices apply from the applicable quarter/month, i.e. from month 42.

The assessment undertaken is highly simplistic and ignores all other effects, e.g.

• substitution may impact supply / demand scenarios which could in turn affect prices,

• other, non-substitution, issues may cancel out the effects shown,

• similar substitutions at different ASEPs may have different outcomes.

At Substitution Workshop 3 on 11th June 2008 National Grid gave an example of the possible impact of substitution on entry capacity reserve and incremental step prices. An update of these prices is provided in the following slides.

In this example 10mscmd of incremental capacity is allocated at Easington. This is achieved by substituting capacity from other ASEPs:

• All available capacity from Hornsea, Hatfield Moor and Theddlethorpe;

• Some of the available capacity from Bacton.

Substitution Example – Prices (Sept 2008 basis)

ASEP

Initial Prices

p/kWh/dayChange in obligated

level

mscmd

New “post-substitution”

Prices

p/kWh/day

P0 P10 P20 P0 P10 P20

Easington 0.0092 0.0110 0.0134 + 10 0.0095 0.0127 0.0141

Hornsea 0.0090 0.0101 at P8 - 0.9 0.0090 0.0101 at P8

Hatfield Moor 0.0028 0.0033 at P5 - 0.8 0.0030 0.0035 at P8

Theddlethorpe 0.0082 0.0110 0.0120 - 49.2 0.0063 0.0078 0.0088

Bacton 0.0084 0.0110 0.0141 - 41.7 0.0062 0.0079 0.0106

NB – P10 and P20 step prices relate to an incremental capacity of 25% and 50% of the obligated level. Hence, with the exception of Easington, the “new” prices relate to a smaller incremental quantity.

Substitution Example – Prices

Where capacity has been substituted away from a donor ASEP, such that the obligated capacity level is reduced, Users can only be allocated capacity to the initial obligated level by triggering, in a subsequent QSEC auction, the release of incremental entry capacity. This may be subject to a 42 month lead-time.

In general the step price is driven by the obligated level. Hence, following substitution we would expect the prices at equivalent capacity levels to be the same pre and post substitution for any particular ASEP.

However, the IECR methodology requires a minimum increment at each step so the step price required to return to the initial obligated value may, for some ASEPs, be above the initial P0 price as in the given example.

Substitution Example – Prices

ASEP

Initial obligated

level

mscmd (GWh/d)

New obligated

level

mscmd (GWh/d)

Step Price to trigger release of

incremental capacity needed

to return to initial obligated

level

p/kWh/day

Theddlethorpe 56.4 (610) 7.3 (79)0.0088 (P20)

(Initial P0 = 0.0082)

Bacton 164.7 (1783.4) 123 (1333)0.0087 (P14)

(Initial P0 = 0.0084)

In the example the obligated capacities at Theddlethorpe and Bacton are reduced significantly.

The step price to return to the initial level is slightly higher than the initial P0 level.

Substitution Example – Prices

ASEP

Initial

obligated

level

mscmd

(GWh/d)

Step Price to

trigger release

of incremental

capacity

p/kWh/day

Project

value

£m

New

obligated

level

mscmd

(GWh/d)

Capacity

obtained for

50% NPV

GWh

Average Unit Cost

p/kWh/d

Theddlethorpe 7.3 (79) 0.0088 155 56.5 (611) 15082290.006876

(Initial P0 = 0.0082)

Bacton 123 (1333) 0.0087 141 166 (1798) 13213350.007040

(Initial P0 = 0.0082)

In order to return to the original obligated capacity level Shippers will need to place capacity bids at the next QSEC auction at a level that passes the NPV test, i.e.

Bids must have an NPV of at least 50% project value

Earliest “incremental” bid placed at Q15 (42 month lead time) at the relevant step price.

•The bidding strategy was designed to maximise the quantity of [capacity * Days] having triggered the incremental quantity. •Ignores cost of capacity up to the initial (post-substitution) obligated level.•No profiling (winter / summer variations) of bids.

Substitution Analysis Timeline

National Grid governance

QSEC auction closes

Incremental Obligated Entry Capacity

proposal submitted to Ofgem

Substitution analysis

Ofgem governance28 day veto period defined in Licence

Allocations to be made

2 months – as defined in UNC section B2.6.7

Indicative Timeline

Analysis of alternative investment

option

Challenge & Review. Audit of results

Value of projects can be several £100m.

Sanctioning at senior level required.

Ofgem response may impact proposals requiring further analysis / governance

High Level Choices – Substitution Decision

In the draft Methodology Statement, shipper bids are the only determinant of shipper interest.

Constraints could be applied to the draft MS e.g. an economic test or exchange rate cap.

Non-market information could be used to determine how much should be reserved at each donor ASEP, this opens up the party making the decisions to challenge and lobbying – it also begins to challenge the value of the User commitment process other than as a mechanism for providing funding.

New mechanisms could be developed to enable shippers to prevent capacity from being substituted away from a donor ASEP, probably by requiring payment of a nominal fee.

“Condition” Incremental

ASEP

Donor ASEP Comment

Current Bids Absence of bids Bids required to hold capacity

at donor ASEP

Current + constraints Bids Absence of bids +

test

Bids required + tests need to

be passed

Non-market (NG or

Ofgem decision)

Bids Non-market info

(e.g. TBE)

Subjectivity required

New market based

process

Bids Reservation

quantity

New (low cost) product

required

Option Assessment Criteria

Each option has its advantages and problems; so how do we assess the most appropriate methodology?

National Grid considers the following criteria are key: Does the option maximise the potential substitution benefits?

Does the option provide sufficient risk mitigation against unintended consequences?

How easy is the option to implement

Is the process transparent and predictable with minimal scope for challenge?

Can processes be undertaken within allowed timescales? Impact on systems, Licence, UNC etc

Each option to be rated on a scale of 1-5, where:

“5” fully satisfies the criteria and

“1” does not satisfy the criteria

Evaluation of each Option against Criteria

Option

Assessment Criteria

TotalSubstitution

benefits

Risk

mitigationImplementation

1) Draft Methodology

2) Limits on Quantity

3) National Grid Discretion

4) Ofgem Discretion

5) Simple Economic Test

6) Exchange Rate Cap /

Economic Test Combination

7) Option to Buy

8) Sub-Reserve Prices

9) Early Warning System

10) Two Stage Auction

11) BGT Proposal

All obligated entry capacity remaining unsold after the QSEC auction allocations will be available for substitution.

No restriction on substitutions e.g. exchange rates / zones.

Advantages Concerns

Simple to undertake.Transparent - limited scope for challenge.Consistent with Licence obligation. Minimises unnecessary investment.

Unlimited loss of capacity at donor ASEPs.May impact on price driven marginal supplies – impact on security of supply.May not be economic and efficient

Option 1: Literal Interpretation of Substitution Obligation – as

discussion draft

Option 2: Limits on Quantity Available for Substitution

As Option 1 but with additional capacity withheld from substitution. Could be based on % of baseline / obligated or historic flows

or TBE forecasts.

Additional withheld capacity to be agreed with Ofgem in advance of the auction.

Advantages Concerns

Simple to undertake Transparent – if values published in advance.Balances substitution and “economic” obligations.

May result in unnecessary investment being undertaken (forecasts could be wrong).Could undermine TBE process: potential for disputes over values used. Does not encourage User commitment.

Option 3: National Grid Discretion

This option can be developed in several ways; based on Option 1 but with National Grid rejecting certain potential

substitutions.

A loosely defined methodology allowing National Grid discretion to apply/vary exchange rates or limit substitutable capacity from donor ASEPs.

Advantages Concerns

Maximises substitution whilst offering some protection to donor ASEPs.Simple to apply (subject to challenges).Allows factors in addition to TBE and bookings to be taken into account.

Absence of transparency could lead to dispute and challenge creating uncertainty and delay, requiring extension to the 42 month leadtime.Calls for methodology to detail when / how discretion will be applied will undermine the ability to use discretion.May not encourage User commitment.

Option 4: Ofgem Discretion

Based on Option 1. National Grid will submit incremental capacity release proposals to the Authority identifying proposed substitutions. Ofgem may reject certain potential substitutions even if the published methodology has been followed.

Advantages Concerns

Maximises substitution whilst offering some protection to donor ASEPs.Simple to apply.Allows factors in addition to TBE to be taken into account.Decisions not influenced by National Grid commercial interests.

Increased uncertainty for TO potentially leading to buy-back costs and wasted investment.Absence of transparency could lead to Ofgem decisions being disputed and challenged creating uncertainty.Calls for Ofgem guidelines on when / how discretion will be applied.National Grid / Ofgem iterations will significantly extend capacity allocation / release timelines.

Option 5: Simple Economic Test

As Option 1 but with each substitution confirmed subject to an economic assessment.

This assessment could be applied to restrict substitution in several ways; e.g. if

a) Recipient ASEP bids < Donor ASEP reserve price * exchange rate

b) Donor ASEP value (to the pre-auction obligated level) > [50%] Recipient ASEP value.

a) Based on incremental capacity project values from the Transportation Charging Model

b) Based on revenue drivers

c) Donor ASEP value (to the TBE level (or other criteria used in option 2)) > [50%] Recipient ASEP value

These tests are intended to measure and compare the value of capacity substituted from the donor ASEP and released at the recipient ASEP and preventing substitution where the value at the donor ASEP is higher.

Option 5: Simple Economic Test (2)

Advantages Concerns

Values capacity at the donor ASEP

Can prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost.

TBE options may not apply the test to capacity in excess of forecast. Hence do not place added restriction on unneeded capacity.

Places a value on capacity at donor ASEPs even where that capacity is unwanted: assumes unsold capacity is wanted.

Substitutions are likely to be multi-donor to single recipient and part substitution / part investment. The process could therefore become highly complex particularly to determine exchange rates.

Increased post-auction analysis required. Could lead to requirement to increase default leadtimes.

More complex options could require UNC / Licence changes.

The value placed on capacity is not the market value.

Option 6: Exchange Rate Cap / Economic Test Combination As Option 1 but with each substitution confirmed subject to:

Exchange rate cap: close 1:1

Economic assessment: project value at donor ASEP to recover TBE peak forecast capacity must be less than the project value for the incremental capacity at the recipient ASEP.

Advantages Concerns

Values capacity at the donor ASEP and makes comparative test to recipient ASEP value.

Providing some protection short term players and marginal gas fields

Will prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost.

Maximises substitution without providing total protection to donor ASEPs.

Prevents aggressive aggregate capacity loss.

Mechanical process – transparent, limited scope for challenge.

Places a value on capacity at donor ASEPs even where that capacity is un-booked: assumes TBE forecast capacity will be wanted so may prevent otherwise logical substitutions.

Low exchange rate cap combined with economic test only facilitates substitution for low to high priced ASEPs for capacity below TBE level.

Will not always prevent TBE forecast capacity needs being substituted away so Shippers may still have to commit earlier than they feel able to.

Additional post-auction works required.

Option 7: Option to Buy

A Shipper can place a value on non-incremental capacity at an ASEP for an option price.

To comply with the Licence fees need to be cost reflective.

Advantages Concerns

Shippers can signal future requirements at lower exposure than with full commitment in QSEC auction.

Shippers will need to commit to costs before decisions on whether capacity is truly needed.

Options may block out other Shippers wanting obligated capacity at the same ASEP.

Option prices need to be high enough to prevent spurious reservations but lower than reserve prices. Not feasible at all ASEPs.

Regulatory treatment of option fees needs to be considered.

Potential systems implications.

Potentially does not address the concern with price driven marginal supplies.

Option 7: Option to Buy – Issues for Consideration

What does the Option provide? Does the Option prevent capacity from being substituted?...or

Does the Option put the capacity to the back of the queue for substitution?

What is the Option price (i.e. the price paid to create the Option)? Subject to question above.

Same for all ASEPs or linked to ASEP specific reserve price?

Is there an Exercise for the Option? If so, how is it effected? Automatic if ASEP identified as a donor ASEP for substitution?

Only if Shipper gives consent at the time that the ASEP is identified for substitution?

What is the Exercise price (i.e. the price paid to be allocated the capacity)?

Reserve price at the relevant ASEPs?

What duration does the Option cover? Default lead time plus 1 year?

What is the life-time of the Option? For one year from one annual QSEC auction to the next?

Option 8: Sub Reserve Prices

Donor ASEP shippers can reserve capacity through capacity bids at below reserve price. In effect a variant on the Option to Buy model.

Where substitution is identified, capacity will not be substituted if the donor ASEP bid value exceeds the recipient ASEP bid value (bid price * quantity * duration).

Advantages Concerns

Values capacity at the donor ASEP and makes comparative test to recipient ASEP value.

May prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost.

Potential lack of transparency / complexity could lead to challenge.

Would require UNC / charging methodology / Licence changes.

Increased post-auction analysis required.

Minimum reservation price and revenue treatment to be considered.

Potential systems impact.

Reduced auction income will impact commodity charges.

Does not address the concern with price driven marginal supplies.

[When] is the capacity allocated and if so as what?

Option 9: Early Warning System

Based on Option 1 but publication of TBE data on new projects ahead of auction

Shippers will be able to bid for capacity at “vulnerable” ASEPs.

Advantages Concerns

Shippers will be able to make more informed decisions as to obtaining capacity to protect it from substitution.

No impact on post-auction timeline.

Highly subjective – potentially misleads markets. Recipient ASEP bids may not materialise.

Confidentiality at recipient ASEPs may be compromised.

Additional (substantial) pre-auction analysis works required.

If Shippers respond by obtaining capacity at identified donor ASEPs the issue may just cascade to other ASEPs.

Option 10: Two Stage Auction

Based on Option 1. Several variations where QSEC is run in two parts.

Baseline and incremental capacity can be obtained in the first phase.

Only baseline capacity can be obtained in the second stage. This allows donor ASEP Shippers to respond in the second stage if they feel that capacity at their ASEP is vulnerable.

Advantages Concerns

Maximises substitution by allowing substitution except where capacity has been sold.

Identifies incremental capacity bids, allowing donor ASEP response.

Cannot predict outcome – leading to late delivery of pipelines (standard 48 month lead time required)

Complex – could add significantly to timelines.

Shippers maystill have to commit earlier than they feel able to,be incentivised not to bid in first auction round, andbe unable to accurately identify donor ASEPs prior to stage 2.

Major change to QSEC auction (UNC) – could impact on systems.

Options 11: Previous BGT Proposal

Based on Option 1 but Shippers at donor ASEPs can recover substituted capacity at the next QSEC auction at reserve price.

Essentially this is Option 10 (two stage auction) with an extended period between stages.

Advantages Concerns

Allows Shippers to recover capacity without needing to trigger incremental capacity i.e. no NPV test.

Shippers may still have to commit earlier than they feel able to.“Recovered” capacity will only be available from 42 months after the second QSEC, i.e. 12 months reliance on availability of short term capacity.Does not fund investment (SO/TO revenue issue).

Other Options?

Option Shortlist

…………….

Next Steps

By 12th December - Industry options to be put forward Forward to Joint Office

cc [email protected]

7th January - Workshop 6 Location to be confirmed

Review industry options; narrow down for further development.

Detailed assessment of preferred options.