Rt Hon Alex Salmond MSP First Minister of Scotland ~ St Andrew's House, Regent Road, Edinburgh EH13DG The Scottish T: 08457741741 Government

The Rt Hon Chris Huhne MP Secretary of State Department of Energy and Climate Change 3 Whitehall Place London SW1A 2AW

)t))- March 2011

Dear Chris

Project TransmiT: Academic Reports

I am writing following the roundtable review on 4th March of the draft reports from the Project TransmiT academic teams who are providing views on the optimal approach to transmission charging in the GB system. As energy economists, we both recognise and appreciate the temptation to produce charging models based on pure economic principles. But as Ministers, we both equally appreciate the pressing reality of the need to develop charging models that will deliver our shared policy outcome of a low carbon generation mix in both Scotland and the UK.

I appreciate the challenge of academic and economic modelling within the policy reality of what Governments want to achieve. But I am concerned that some of the views emerging from the academic work could undermine the overarching policy aims of Project TransmiT: to put in place charging arrangements that facilitate the timely move to a low carbon energy sector, and provide safe, secure, high quality network services at value for money to consumers.

I am disappointed, but not wholly surprised, the draft study from the Electricity Policy Research Group at Cambridge University again reflects their long held views on locational marginal pricing. This model, with potentially significant locational targeting of both short and long run costs would exacerbate the existing locational imbalance facing renewables generators in locations of highest resource. I suggest locational pricing can also compound complexity and variability in charging. As with locational charging, locational pricing can give perverse pricing signals to more remote parts of the networks, especially where large scale investment has been made or is required (e.g. the planned east and west coast offshore HVDC links between Scotland and England). I am disappointed the academic team from US Universities is suggesting further compounding locational imbalances through a combination of locational marginal pricing with an additional element of targeting constraints costs at generators behind constrained grid network boundaries. I think we are both clear the review of transmission charging must be carried out against the reality of the "Connect and Manage" solution to grid access delivered by the UK Government in August 2010 and it is unhelpful to seek to revisit the principle of socialisation of constraints costs that is now helping to connect new renewable generation. I was, however, interested in some of the US thinking about a "plan and price" approach. This envisages a long term planning approach to required future generating mix, supported by limited use of locational signals where appropriate to deliver this. I think this is one idea worth exploring further.

I note that the Strathclyde University study also favours a locational element in the future charging regime. I also note it is the only study that assesses charging methodologies other than locational marginal pricing. It is also the only study that identifies the need to consider a future locational approach in the context of the wider policy framework within which the future charging regime must work and the wider regulatory and market reforms currently underway in the Electricity Market Reform.

I appreciate and understand the arguments for a locational element in a transmission charging methodology. But the need for renewable generators to locate in areas of highest resource must be a significant mitigating factor. I am firmly of the view that the locational element should not be the extreme - and arguably penal - locational signal the current system delivers for generators in Scotland. I believe the effectiveness of the charging signal to generators where to locate must also be considered alongside a signal to encourage low carbon generation in the areas of highest resource. As I have argued before, if there is a locational signal in the charging methodology, it must be more equitable. An effective approach could be to smooth the locational variance through a banded approach to charging through a lower "collar" of -£5p/KwH and an upper "cap" of +£5p/KwH. I would suggest more detailed consideration be given to this option.

I am concerned the proposed charging models from the Cambridge and the US studies would compound the high transmission costs and prolong the system constraints faced by developers in Scotland. Both models would primarily favour generation close to centres of demand or where the network does not need reinforcement. Both models would fail to address the scale of the challenge Scottish, UK and EU Governments have set in meeting renewable energy and climate change targets. Both models would slow down, rather than accelerate diversification of the generating mix and security of electricity supply by acting as a barrier to renewables deployment across the GB system.

The complexities and possible consequences of each of the academic workstreams need to be understood in much more detail. They are lacking in evidence of the practical outcomes of the different charging regimes, locational marginal pricing in particular. I understand there are arguments that locational marginal pricing may contribute to significant underinvestment in grid development (as has proved to be the case in the United States), be a brake on renewable energy deployment, and have a significant adverse impact on security of supply in some areas (again, the United States' record of blackouts does not support a compelling argument for locational marginal pricing).

The academic reports are a useful contribution to the academic debate, but there is a disconnect between the academic debate and the policy reality of making the transition to a future low carbon generating mix. Before any of these proposals is considered in detail, we must have a more robust assessment how the suggested models would actually work in practice and with particular emphasis on what, as policy makers, we want them to deliver.

Like you, I am keen the review of transmission charging is thorough, open minded and delivers fundamental change capable of supporting our overarching policy goals on security of supply and renewable energy delivery. I am also keen that our review of transmission charging delivers a more transparent and less complex charging methodology.

I therefore remain to be convinced that some of the academic teams have given sufficient consideration to tackling this complexity, the realities of the future low carbon generation policy aims of Governments, and the regulatory frameworks and charging mechanisms needed to deliver this.

I am sending a copy of this letter to Alistair Buchanan and the review team at Ofgem.

ALEX SALMOND