Offshore transmission: the licensing regime explained

12 July 2013



In January 2013, several aspects of the regulatory regime underpinning the connection of offshore wind assets to the UK's onshore electricity network were criticised by the UK's Public Accounts Committee.


In January 2013, several aspects of the regulatory regime underpinning the connection of offshore wind assets to the UK's onshore electricity network were criticised by the UK's Public Accounts Committee. This article seeks to outline the background to the regime, highlight the key current issues, and explore its wider implications for the industry and the public.

By James Phillips, partner, Burges Salmon LLP*

Offshore wind will play a significant role as part of the UK's energy generation mix over the coming decades. However, the challenges faced by developers remain significant, in what has been, and continues to be, a rapidly changing commercial, technical and regulatory landscape.
Over recent years, one of the significant uncertainties with which developers have had to grapple is the evolving regulatory regime underpinning the connection of offshore wind assets to the onshore electricity network. In January 2013, this regime was given a higher public profile through the reporting in the national press of the conclusions of the Public Accounts Committee, which has been critical of several aspects of the new offshore transmission licensing regime ("the Regime").
Outside the offshore wind industry, the Regime remains poorly understood. This article seeks to outline, in an accessible form, the background to the Regime, highlight the key current issues arising from it, and explore the wider implications of the Regime for the industry and the public.


Background
For much of the early rounds of offshore wind development, each developer was responsible for consenting, licensing, constructing and maintaining all of the grid connection assets required for its project, from the offshore turbines to the onshore substation. For those early projects, there was nothing to prevent developers from operating the offshore cables and other connection infrastructure required to connect into the onshore electricity networks and, in practice, there was no alternative option available to them.
Looking ahead to the anticipated vast expansion of offshore wind, the UK?government considered that the existing system would be incapable of delivering cost effective and timely connections. The UK?government was also very mindful of the gravitation, at a European level, towards encouraging the unbundling of ownership of transmission assets from generation and supply assets1. This requirement now forms part of The Third Package of legislation on the liberalisation of the internal electricity and gas markets ("The Third Package"), which was adopted by the European Commission on 19 September 20072.
As a result, the government first began consulting on the design of a new offshore transmission regulatory regime back in 2005. The Regime was finally implemented in 2009, using powers afforded to the Secretary of State by the Energy Act 2004, through the enactment of the Electricity (Competitive Tenders for Offshore Transmission Licences) Regulations 2009 (SI 2009/1340) (the "2009 Tender Regulations") and through a series of changes to the existing system of licences, codes and agreements that governed onshore electricity transmission.


Key principles of the Regime
The key principles of the Regime are as follows:
all offshore connections to shore at 132 kV or more from the Renewable Energy Zone and from the territorial sea adjacent to Great Britain require an offshore transmission licence to be in place;
an offshore transmission licence must be obtained through a competitive tender process in accordance with the relevant Tender Regulations;
the competitive tender process allows companies to bid for a licence to be the Offshore Transmission Network Owner (OFTO) of particular offshore networks, which entitles them to earn a regulated rate of return on the costs of building and operating those networks;
the generator cannot be the OFTO, ie there must be separate ownership of generation and transmission assets once projects are operational (with some very limited exceptions).
The OFTO Regime was designed in two phases: the Transitional Regime, which applies to those projects which could achieve (or demonstrate that they would achieve), a prescribed stage of development by 31 March 2012, and the Enduring Regime which applies to all other projects.
Under the Transitional Regime, developers construct the necessary transmission assets, with the completed transmission assets being transferred to an OFTO appointed through Ofgem's3 tender process at a price set by the Authority based on the costs which ought to have been incurred following a costs assessment. Therefore, for transitional projects, the role of the OFTO is to finance, own and operate an asset that has been or will be constructed by the developer.
Ofgem has run two tender rounds under the Transitional Regime, with an amended version of the Tender Regulations being introduced in 2010 (SI 2010/1903) to reflect lessons learned from the first round. For each tender round, Tender Rules are published which prescribe the tender process in detail.
The transitional tender rounds have been open to "qualifying projects", which either obtained, or demonstrated to Ofgem that they would obtain by 31 March 2012, the following:
a grid connection agreement with National Grid Electricity Transmission plc ("National Grid");
an agreement for lease of the seabed with The Crown Estate Commissioners (introduced in the 2010 Tender Regulations);
all necessary consents and property rights for the transmission assets to be constructed and maintained;
completion of construction or completion of all necessary contracts for the construction of the transmission assets; and
financing to construct the transmission assets.
The Transitional Regime has proven to be fit for purpose. The first transitional tender round commenced on 22 June 2009 and included nine projects - Robin Rigg, Gunfleet Sands, Sheringham Shoal, Ormonde, Greater Gabbard, Thanet, Walney 1 and Walney 2. An additional four projects - Lincs, London Array, Gwynt y Mor and West of Duddon Sands - have been included within the second transitional tender round (being held in two tranches), the first tranche of which commenced on 17 November 2010.
To date, each tender process has attracted sufficient interest from bidders for the process to be regarded as competitive. A feature of the OFTO bidding process has been the formation of consortia to participate in the bidding process, which is unsurprising given the value of the assets being transferred4. This trend will almost certainly continue into the Enduring Regime.


Enduring Regime
When originally designed, it was envisaged that under the Enduring Regime an OFTO would need to be appointed to design and construct offshore transmission assets as well as finance, operate, own and maintain them. It was considered that introducing a competitive process into the design and build stage would encourage innovation and provide scope to attract new sources of technical expertise and finance to the sector, thereby providing best value to consumers. That policy was hugely unpopular with developers, who were concerned that they would lose control over a critical component of their projects, resulting in risks to project timescales, leading in turn to increased borrowing costs and difficulties in obtaining positive investment decisions.
As a result, and in light of offshore wind's being key to the government's meeting its 2020 Renewable Energy Directive targets, DECC (the UK's department of Energy and Climate Change) and Ofgem revisited the original policy. On 31 December 2012 changes to the Connection and Use of System Code (CUSC) and the Grid Code took effect, introducing the "generator build" option on an enduring basis. Subsequent changes have also been made to the System Operator/ Transmission Owner Code ("STC") to fully implement the policy.
Under the Enduring Regime, offshore developers will have the flexibility to choose whether they, or an OFTO, design and construct transmission assets. Regardless of the party who constructs the offshore transmission assets, an OFTO will be responsible for the ongoing ownership and operation of the assets.
DECC and Ofgem are still enthusiastic about the OFTO-build model, and significant attention has been paid to trying to devise a regime which may work for developers. The two main variants are the "Early OFTO-build" and "Late OFTO-build" models. The diagram (Figure 1) shows where the tender would be likely to occur in each of the OFTO-build and generator-build models.
Under an Early OFTO-build model, the OFTO would be responsible for all aspects of pre-construction, consenting, procurement, construction and operation of transmission assets. Under a Late OFTO-build model, the OFTO would deliver the procurement of the transmission assets and construction phases of the build programme, after a generator had obtained the necessary consents for the transmission works.
Despite the best efforts of Ofgem to make the OFTO-build model a viable option for generators, it appears unlikely that many (if any) developers will opt for an OFTO-build approach in the near future. Despite the OFTO-build option reducing the initial capital requirements of the developer, the cost of the transmission assets might typically only equate to 10-20% of the capital cost of the whole project, and therefore this advantage is unlikely to outweigh developers' concerns of potential revenue loss if there was to be a late delivery of the transmission assets by the OFTO.


The Enduring Regime tender process
On 22 February 2013 new Tender Regulations 5 (the "2013 Tender Regulations") came into force, aimed at ensuring the Enduring Regime is suitable for future projects. The first tender round under the Enduring Regime is expected to commence later in 2013. Under the 2013 Tender Regulations, the tender process for the Enduring Regime will comprise the following stages.
Developer requests Ofgem to commence a tender exercise, specifying whether it will be a generator-build or OFTO-build and providing evidence that the relevant "qualifying project" requirements (see above) have been satisfied.
Ofgem notifies developer of the fee and the level of security required to be placed to cover Ofgem's costs of running the tender and the entry conditions that must be satisfied (including the provision of project details for a data room and a draft transfer agreement to be entered into between the developer and the successful bidder).
Ofgem publishes a notice of its intention to commence a tender exercise for all qualifying projects. Detailed Tender Rules and the costs recovery methodology detailing the payments to be made by bidders at each stage of the process are published by Ofgem before the commencement of the tender round.
Pre-qualification ("PQ") stage to determine the qualifying bidders. Bidders sign a confidentiality agreement and project information is then made available to them by Ofgem.
Qualification to tender ("QTT") stage to determine the bidders that will be invited to participate in the Invitation to Tender ("ITT") stage. Ofgem has discretion as to whether to hold a QTT stage for transitional or generator build tender exercises.
ITT stage to determine which qualifying bidders will become the preferred bidder or reserve bidder for each qualifying project. For OFTO-build tenders, the developer may be required to make a payment to cover bidders' costs if the tender is withdrawn in certain circumstances.
Best and final offer ("BAFO") stage, although Ofgem may dispense with the need for this.
Preferred bidder stage in order to determine the successful bidder to whom the transmission licence is to be granted for a qualifying project. Ofgem will publish a notice specifying the identity of the preferred bidder and will inform the preferred bidder of the steps required to be taken for the preferred bidder to become the successful bidder. In practice, this will include the entering into by the preferred bidder of a Transmission Owner Construction Agreement ("TOCA") with National Grid and the accession of the preferred bidder to the STC.
Developer enters into an agreement transferring the transmission assets (in the case of generator-build) or the preliminary works (in the case of OFTO-build) to the preferred bidder when it becomes the successful bidder. The successful bidder is granted an offshore transmission licence.


Key issues under the Enduring Regime
Aside from the changes to the Tender Regulations, the sector has been grappling with some significant practical and policy considerations over the last few years. Some of the main issues are highlighted below.


Commissioning
The concept of generator-build has presented a practical issue concerning the commissioning of generating stations. Ofgem recognises that the OFTO will want to see the transmission assets working prior to taking ownership of them. However, section 4(1)(b) of the Electricity Act 1989 ("the Act") currently prohibits the transmission of electricity to any premises without a licence at any time, whether before or after the completion of commissioning.
To address this issue, the Energy Bill currently before Parliament6 proposes amendments which would amend section 4 of the Act to allow a generator to transmit electricity without a transmission licence for up to 18 months from when the wind farm is first capable of exporting electricity, in certain circumstances. The aim of the 18 months' grace period is to give time for the commissioning to be completed before the assets are transferred to the OFTO. When the Energy Bill is enacted, this issue should therefore be resolved, provided that the European Commission is satisfied the solution is consistent with the requirements of the Third Package in respect of ownership unbundling.


Staged and phased projects
Many Round 3 projects are taking place within large zones, where developers will seek to develop projects on a phased basis. Ofgem has been keen to try to understand how developers will go about structuring the development of these large zones and how investment decisions will be made, so as to develop rules on whether transmission assets should be tendered within the same tender round, and if so, whether these assets should be bid on separately or as part of the same package.
In May 2012 Ofgem consulted on how "staged projects" and "phased projects" should be treated under the enduring regime. The policy position announced in September 2012 was that the scope of a tender exercise would normally be limited to a committed project phase, but that where that committed phase is being built out in more than one stage, all of the stages within that phase should be included within a single tender exercise. Ofgem has stated that it will work with developers to consider variations in a limited number of project-specific circumstances.


Co-ordinated networks and investment
In March 2012 Ofgem and DECC published a joint conclusions report aimed at tackling potential barriers to the co-ordination of offshore transmission assets, citing potential costs savings of £3.5 billion by 2030. Ofgem has sought to allow for a more holistic view of long term network planning across onshore and offshore needs, to avoid a scenario in which all offshore projects connect to shore via radial links. To help system planning, an amalgamation of the Offshore Development Information Statement (ODIS) and the Seven Year Statement (SYS) is seen as an important step.


The solution to developing a co-ordinated and efficient network is highly complex, given that the most efficient offshore network would potentially involve the shared use of offshore transmission infrastructure by different offshore developers and the integration of these networks with onshore reinforcements taking place offshore (such as the East Coast and West Coast 'bootstraps').
Ofgem is still working on removing the barriers to co-ordinated networks, and seeking to clarify how best to facilitate offshore infrastructure investments which have a wider onshore or offshore system benefit. In doing so, it has identified three main categories of potential anticipatory investment ("AI") which may be required.
Offshore generator focused AI - to support more efficient connections for later phases of generation.
Wider network benefits AI undertaken by a developer.
Wider network benefits AI not undertaken by a developer.
National Grid has already started to propose integrated solutions in its grid connection offers to developers for phased projects. However, whilst developers are likely to be in favour of oversizing their transmission assets on the first phase of zone development to facilitate a more efficient connection of additional capacity within their zone at a later date, they will understandably be concerned at the prospect of being asked to carry out transmission works for wider system benefit. Ongoing work is being carried out to identify whether there are appropriate incentives for developers to construct assets providing wider network benefits. It is recognised that the Transmission Network Use of System Charging and User Commitment Methodologies will need to appropriately cater for these arrangements if developers are to be asked to do this.
In instances where the developer is not best placed, or does not have the appetite to develop infrastructure for wider system benefit (for example where the wider benefits are not key to the generation project in development), Ofgem has indicated that it may be appropriate for a separate competitive tender to take place whereby an OFTO would be appointed to construct and own the assets. Ofgem is currently working on providing further clarity as to how AI would be treated when Ofgem assesses the asset transfer value during a tender process. This will be a crucial issue to understand for both developers and prospective OFTOs.


Generator-build
Since December 2010, all developers making a connection application at 132 kV or above, or already having such connection agreements in place, have been asked to confirm whether they will be pursuing the generator-build or OFTO-build approach. All agreements issued pre-December 2010 were drafted on the basis that an OFTO would construct the assets, therefore most (if not all) of these agreements will have been revised to reflect the generator build approach. The obligations of developers under these generator-build connection agreements put the developer in a novel position of being a quasi-transmission owner (albeit without being a signatory to the STC) which has created some interesting new practical issues for the developer to manage.


Costs recovery
Pursuant to the 2013 Tender Regulations7, Ofgem must assess the economic and efficient costs which ought to have been incurred by the developer in connection with the development and construction of the transmission assets. Under the Transitional Regime, various reports have now been published on cost recovery issues for individual projects. While certain trends can be identified, Ofgem has recently published some additional guidance on costs assessment principles to assist developers8. It is already clear that in addition to keeping an accurate and full audit of costs incurred, it will also be important for a developer to be able to justify why particular transmission-related decisions have been taken (for example in respect of the acceptance of contractual risks and the settlement of any disputes which arise during the construction process).


OFTO SPVs
To date, under the Transitional Regime, the transfer of transmission assets has taken place through an asset purchase agreement entered into between the developer and the successful bidder. Many developers are exploring the option of setting up a special purpose vehicle to own all of the relevant transmission assets from the outset (an "OFTO SPV"), which could also enter into all of the relevant contracts relating to those transmission assets. The main perceived advantages are that (a) it may assist with the separation of generation and transmission costs from a costs auditing perspective and (b) it may simplify the asset transfer process by allowing a sale of the shares in the OFTO SPV to the successful bidder. Ofgem is currently neutral as to which option should be chosen. The decision as to whether to have an OFTO SPV will depend upon the preferred approach to development and procurement adopted by each developer and it is expected that both options will be chosen under Round 3.


Opportunities and risks
While no public funds are directly involved in paying for and maintaining transmission assets, OFTOs receive their income via National Grid, which in turn recovers its costs from electricity suppliers and generators. In practice, these costs are passed onto consumers through electricity bills, which explains why there is significant pressure politically for the margins payable to OFTOs to be no higher than is necessary.
The balance that the Regime is seeking to strike is delivering value for money for consumers whilst still maintaining an attractive environment for investment. The stinging criticisms of the Public Accounts Committee this year have been that, to date, the terms of offshore transmission licences have been "heavily skewed towards attracting investors rather than securing a good deal for consumers."
If the Transitional Regime tender processes had failed to attract interested bidders, it would have been extremely damaging for the offshore wind industry as a whole, potentially leading to a complete hiatus in investment by developers until confidence in the Regime could be restored. Given the importance of onshore wind in helping to meet 2020 Renewable Energy Directive targets, it is perhaps unsurprising that the Regime has so far erred on the side of generosity.
Prior to the publication of the Public Account Committee's report, Ofgem had already issued a consultation on its policy towards the contents of offshore transmission licences for future tenders9. Whilst this consultation does not contain many concrete proposals, it does highlight that Ofgem may be prepared to reconsider (and in fact has already been reconsidering) some of those features of current offshore transmission licences which were so heavily criticised. A summary of the Public Accounts Committee's criticisms are set out in Table 1, together with Ofgem's latest published position relevant to that criticism.

Conclusions
When introduced in 2009, the OFTO regime was met with significant concern from developers nervous as to whether offshore projects could be delivered under an enduring regime which insisted on an OFTO-build approach. The successful operation of the Transitional Regime and the emergence of the generator-build option have done much to restore confidence in the Enduring Regime, although significant issues and uncertainties remain to be resolved, particularly for those projects which are likely to form part of co-ordinated offshore networks.
DECC and Ofgem have responded on several occasions to criticisms of the Regime from within the industry. At a crucial time in the deployment of offshore wind, it will be interesting to see whether the Public Accounts Committee criticisms, or indeed Ofgem's current consultation process, result in any significant changes to the commercial terms applicable to those taking ownership of offshore transmission assets. Prospective bidders and developers alike will be following the situation closely.

 

James Phillips may be contacted on +44 (0) 117 902 7753, and [email protected]

 

Footnotes
[1] In its Resolution on Prospects for the internal gas and electricity market adopted on 10 July 2007, the European Parliament expressed strong political support for this, considering that "transmission ownership unbundling is the most effective tool to promote investments in infrastructures in a non-discriminatory way, fair access to the grid for new entrants and transparency in the market"
[2] The Third Package has been implemented in the UK through The Electricity and Gas (Internal Markets) Regulations 2011 (SI 2011/2704)
[3] For simplicity, Ofgem is used to refer to Ofgem, Ofgem E-Serve and the Gas and Electricity Markets Authority in this article.
[4] The estimated asset transfer value for London Array (the largest of the transitional projects) is £428m
[5] The Electricity (Competitive Tenders for Offshore Transmission Licences) Regulations 2013 (SI 2013/175). The 2010 Tender Regulations will continue to apply to those projects which qualified under the 2010 Tender Regulations and in respect of which Ofgem has issued a notice to all qualifying bidders of the payment they need to make in respect of the ITT stage.
[6] Clause 127 in Bill 135 2012-3 dated 8 February 2013 (as amended in the Public Bill Committee)
[7] Regulation 4
[8] "Offshore Transmission: A Guidance for Costs Assessment" (ref: 183/12)
[9] "Offshore Electricity Transmission: Consultation on licence policy for future tenders" published by Ofgem on 30 November 2012

 

 

Table 1 PAC criticisms
London Array, the world’s largest operational offshore wind farm
Figure 1. The OFTO tender models.


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