Understanding interconnectors

Understanding interconnectors

11 September 2019

David Haverbeke, Lis Blunsdon and Yohanna Weber

Channel: Innovation, technology & operations, Strategy & management

With post-Brexit energy trading arrangements still unresolved and Europe's connectivity lagging expectations, Fieldfisher energy experts David Haverbeke, Lis Blunsdon and Yohanna Weber, discuss why more attention needs to be focused on critical power infrastructure.

Interconnectors - the physical structures that enable energy to flow between networks - are among the least visible and consequently least talked about constituents of the EU's energy sector.

Effectively managing the complex network of cross-border interconnector cables and pipelines that make up Europe's highly integrated energy network is a major challenge for EU regulators.

The regulators' job is to ensure that Europe's energy market operates as efficiently and sustainably as possible and in the best interests of EU consumers - and interconnectors are vital to achieving these aims.

But, due to a combination of adverse investment conditions, regulatory ambiguity and a general lack of incentives, interconnection levels in Europe are lagging behind targets.

This matters, because it threatens to jeopardise Europe's ability to meets is clean energy goals, set out as part of the EU Commission's Clean Energy Package.

Launched in November 2018, the package's chief objective is to provide clean energy for all European citizens, mobilising up to €177 billion of public and private investment per year from 2021 to reduce carbon emissions and generate economic growth.

Cross-border electricity cables are seen as the lowest-cost route to decarbonising EU energy supply, as they reduce the need for (often inefficient) local generation, by allowing energy to be transmitted from where it can be most economically produced to where it is most needed.

The European Council wants to achieve interconnection of at least 10 per cent of each member state's installed electricity production capacity by 2020, rising to 15 per cent by 2030.

As things stand, just 17 of the 28 member countries are on track to reach the 2020 target.

The European Council admits its interconnection goals are "ambitious" (although non-binding), but says they are necessary to help achieve a 45 per cent reduction in the bloc's emissions against 1990 levels by the 2030 horizon.

In order to meet its interconnection targets, it seems likely that the European Commission will need to rethink its approach to how these projects are approved and financed, as current models do not appear to be working.

 

The interconnector disconnect

Despite their importance, interconnectors are largely unheard of outside power and energy regulatory circles.

This could change, as the EU comes under pressure to meet its interconnection targets and connect growing renewable generation capacity with the grids that supply energy consumers.

Interconnectors cost billions to build, but should theoretically pay for themselves in a properly functioning energy market.

They generate income from congestion revenues, derived from the price difference between the power seller, at one end of the interconnector and the power buyer, at the other.

Congestion revenues are therefore dependent on the existence of energy price differentials between markets, with electricity (or gas) ideally flowing from lower priced to higher priced markets.

The difference is paid to the owner/operator of the interconnector, often a transmission system operator (TSO), in return for "managing" the congestion.

TSOs are also compensated for assuming other regulatory responsibilities, such as liability management, organising third party access to power supply and setting regulated tariffs.

 

Managing the market

One issue that needs to be addressed by any future reforms of the EU interconnector sector is the tension between publicly funded and so-called "merchant" interconnectors.

European legislation includes specific conditions on how congestion should be managed and how revenues derived from interconnectors can be used, which vary depending on whether an interconnector operator is designated as a TSO.

A TSO is entrusted with transporting energy (natural gas or electrical power) on a national or regional level, using fixed infrastructure (which could include an interconnector) - a function defined, certified and monitored by the European Commission.

As TSOs are often wholly or partly owned by national governments and have a natural monopoly over energy transmission in their region, they are subject to state regulation.

TSOs must provide grid access to other electricity market players (i.e., generating companies, traders, suppliers, distributors and directly connected customers) according to non-discriminatory and transparent rules.

Article 16 of the Commission Regulation (2017/2196) states that TSOs are obliged to use the revenues of congestion management to guarantee energy availability and, if practical, re-invest in increasing the interconnector's capacity.

Additional layers of obligation may be added to an interconnector operator, public or merchant, if they decide to apply for various other certifications, such as project of common interest (PCI) status (governed by the 2013 Trans-European Networks - Energy (TEN-E) regulations), state aid funding and certain exemptions from various regulatory requirements.

 

TSO or no?

A clutch of recent and pending certification decisions from the European Commission, the Agency for the Cooperation of Energy Regulators (ACER) and various national regulatory authorities (NRAs) have provided some clarity on when an interconnector operator will be considered a TSO or a merchant operator, but the matter is still unclear for some projects.

If an interconnector is not a TSO, in theory the operator is free to pay this revenue to private investors, but also needs to set aside some of its income for possible fines from NRAs (if, for example, the operator fails to guarantee the required capacity) and other expenses.

The regulatory framework established around the interconnector industry is designed to favour TSOs and consequently makes it difficult for merchant interconnector projects to get off the ground in the first place and compete in the market once they have.

Despite pledging to mobilise both public and private investment to meet its clean energy objectives, the EU Commission is nervous about entrusting the operation of critical energy infrastructure to profit-seeking businesses.

While TSOs are important investors in private interconnector projects, they are potentially conflicted, as competition from additional interconnectors is likely to reduce congestion rates, and therefore revenue, on existing interconnector capacity.

The gap between current capacity and interconnection targets suggests that TSOs are unable or unwilling to make the necessary investment required by the EU Commission to meet interconnection objectives.

TSOs can also face restraints on the flexibility of their financing and may lack the bandwidth to deal with at least two sets of stakeholders in different jurisdictions linked by interconnectors, further curtailing their ability to drive progress.

These are among the reasons why some argue that a greater role needs to be handed to merchant interconnectors.

 

Certainty and simplicity

For merchant interconnectors, legal certainty and security of investment need to be satisfied before a private investor, or a consortium of investors, will commit to funding a project.

To date, the experience of merchant interconnectors seeking to develop EU projects has generally been a struggle.

There are good reasons why the European Commission might be ambivalent to merchant interconnectors.

For one thing, regulated energy links are more transparent and easier to monitor and manage than privately funded projects - an argument that carries some weight considering the strategic importance of large energy infrastructure.

There is also a policy issue, centred on the idea that congestion revenues should be used to fund more investment in interconnectors, rather than private sector returns.

Some are worried that merchant investment will crowd out regulated investment, causing TSOs to lose control of vital infrastructure to benefit of financiers and the detriment of consumers.

However, cheerleaders for private sector interconnectors point out that merchant operators can potentially build bigger and more innovative projects faster than TSOs can, so it seems counterproductive not to encourage this approach, albeit within firm parameters.

Application and approval procedures for interconnector projects also need to be streamlined to encourage more projects to be built - especially by private investors, who are less willing to wait for extended periods to get their money back.

Lots of interconnector projects get stuck in the permitting process, which takes a minimum of 3.5 years to gain consent.

Projects seeking PCI status take even longer to get from application to approval, commonly taking in excess of five years for gas interconnectors and more than 10 years for electricity.

An ACER report published in July 2018 on the progress of PCIs found that almost half of electricity and gas projects were delayed or rescheduled, with permitting the most commonly cited reason for electricity project rescheduling.

Gas projects were delayed due to finance and other market issues, but permitting was also high on the list of stumbling blocks.

To break this impasse, both the public and the private sector need to come up with new ways of bringing more finance and expertise into the interconnector market and consider how merchant assets can be aligned with public policy goals.

 

Brexit

Since the UK missed its original Brexit deadline of 29 March 2019, politicians have failed to demystify what any future EU-UK relationship will look like.

While there has been much discussion about potential trade relationships, scarcely any attention has been paid, before or since the Brexit referendum, to energy trading or the UK's long-term energy security.

Opinion is divided on how disruptive Brexit will be to the UK's energy market, but most agree the UK is likely to come out of it on less favourable terms than it has currently.

Few outside the interconnector industry realise that the UK is physically connected to Europe by a series of cables and pipelines, which supply a significant proportion of the country's energy.

While fears that these transmission lines might be "switched off" in the event of a "no-deal" Brexit are unfounded (not least because this would be almost impossible to do), if and when the UK becomes a third country, these cables and pipes will no longer be treated as EU interconnectors.

This means that both merchant interconnector operators and UK-based TSOs - including National Grid - will have their certifications revisited and their status amended to reflect the less favourable trading terms afforded by the EU to third countries.

In the event of a no-deal Brexit, the UK will almost certainly be excluded from the EU's Internal Electricity Market (IEM) market-coupling system.

This cross-border allocation mechanism designed to integrate EU wholesale power markets by making capacities implicitly available on exchanges, rather than explicitly auctioning them to users, greatly reduces or even removes price differences in electricity across borders.

As a net importer of energy, if the UK moves outside the coupling system and is forced instead to engage in bilateral energy trading with Member States, the chances are that UK domestic energy prices will increase noticeably.

Being excluded from the day-ahead coupling mechanism will also mean the UK is likely to have to conduct more intra-day trading, which is much less efficient, even if it does not prove obviously disruptive.

For most energy companies, including a handful of merchant interconnectors, the short-to-medium term burdens will be mostly administrative, but the longer-term outlook is uncertain and depends largely whether the UK remains in lockstep with the EU in areas such as network codes.

How and to what extent the UK implements codes to maintain some degree of alignment with the EU remains to be seen, particularly with respect to the EU's Clean Energy Package.

 

What next for interconnectors?

Under the EU's Clean Energy Package, each EU Member State is required to draft integrated national energy and climate plans for 2021 to 2030, outlining how they will achieve their respective targets.

Not all of the package's final text has been enacted and what remains to be finalised - including the new Electricity Directive and what is anticipated to be an expanded role for ACER - will likely have important implications for the interconnector industry.

If ACER's powers are enhanced, this should lend more uniformity and certainty to decision-making on interconnectors, leaving less to the discretion of NRAs.

These measures, coupled with a renewed impetus to reach the EU's interconnection targets and emissions goals, should create a positive support framework for the interconnector industry.

However, work still needs to be done to level the playing field between public and private interconnector projects, if transmission capacity is to be expanded fast enough to meet policy targets and consumer energy demand.

Regulatory adjustments will also be needed, including a potential overhaul of the TEN-E regulations, which have not been amended to reflect recent shifts in energy policy and energy generation mixes.

In particular, there needs to be realignment to make sure money is going to right places promptly to fulfil policy - something which is currently under review by the European Commission although it is unclear when this will result in updated regulations.

David Haverbeke, Lis Blunsdon (regulatory) and Yohanna Weber (planning) are partners specialising in energy projects and infrastructure at Fieldfisher.

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