| Pumped storage
and they are unlikely to recover the value of their investment within the 25-year cap and floor support window. However, Ofgem is considering a mechanism where post-regime revenues can offset past consumer-supported floor payments. Whilst this approach ensures that consumers who provided investment support through floor payments can benefit from the continued operation of assets beyond the 25-year regime period, if designed correctly it could ensure that developers do not ultimately record a negative return for their overall investment.
Risk of competitive distortions The cap and floor design is uniform across all LDES technologies, but PSH has higher upfront investment costs and a longer payback period. So if the floor level is set too low, project financing may be difficult for PSH and investors/funders may look at other LDES technologies with lower CAPEX values but also lower asset lifetimes (e.g. lithium-ion with longer discharge) as being a more attractive investment opportunity. The current model also disadvantages
projects with much longer lifespans due to their longer development cycles, potentially leading to longer-term financial inefficiencies. However a potential solution is that there are calls for technology-specific financial structures to avoid distorting investment incentives.
Financing risks despite revenue certainty Debt financing is crucial for PSH projects, but the existing scheme: Treats all projects with a standardised cost of debt, rather than using actual borrowing costs for each project; may not offer sufficient flexibility for highly leveraged PSH developers who need longer- term debt. So a lack of tailoring for actual debt and equity requirements makes it harder for private sector financing to work under the scheme. Ofgem is exploring a hybrid floor mechanism, where project-financed PSH developers could set their floor based on actual cost of debt rather than a notional benchmark.
Regulatory complexity and monitoring burden The multi-stage assessment (eligibility, cost-benefit analysis, final award and post- construction review) creates a significant administrative burden. This means that PSH developers will need to continuously demonstrate ongoing financial viability and system benefits, adding to the complexity of project planning. However, developers are lobbying for a simplified regulatory process for proven technologies like PSH.
Restrictions on revenue stacking and ancillary services PSH typically operates by stacking multiple revenue streams (arbitrage, capacity market,
frequency response), but the cap and floor model does not incentivise seeking additional revenue streams. So if revenues hit the floor level too frequently, PSH may be forced to rely more on the cap and floor mechanism than market-driven income. It remains unclear whether PSH can fully participate in ancillary service markets while under the cap and floor scheme. However a potential solution is in the form of a revenue-sharing mechanism above the soft cap, which is being trialled to maintain market-based incentives. Although it’s a complex but potentially investable framework for pumped storage, the LDES cap and floor scheme provides some much-needed revenue certainty. And it is a step in the right direction but further adjustments are needed to make pumped storage investments more viable under this framework. Several unresolved challenges remain for developers: Mismatch between contract duration and asset lifespan. Unclear post-regime revenue mechanisms. Risk of competitive distortions with shorter- duration LDES technologies. Difficulties in securing appropriate project financing under a notional debt model. Regulatory and administrative complexity. Approach to revenue stacking which could impact market participation.
These challenges can be addressed by: extending contract durations; allowing post-regime revenue-sharing mechanisms; introducing a tailored floor rate for project- financed PSH; and encouraging projects to generate ancillary service income.
Inertia value
Another issue for pumped storage schemes under this mechanism is the difficulty in valuing inertia. Under Ofgem’s CBA framework for LDES, inertia-related benefits are likely to be assessed within the “Other System Impacts” category. However, given the challenges in quantifying inertia’s value, how Ofgem integrates these benefits into decision-making will be key.
Inertia as an essential grid service but a hard-to-monetise benefit Grid operators currently need inertia to maintain system frequency stability but, unlike energy arbitrage or capacity payments, there is no widely accepted market mechanism for valuing inertia on a consistent basis, making its financial inclusion complex. Ofgem will likely assign an indicative value
to inertia benefits but not give them direct financial weighting in the cap and floor mechanism, instead ensuring that system needs are factored into the application process. It should be noted that not all LDES technologies can provide inertia services and so recognition of inertia value may be a key differentiator between projects.
Likely methods for considering inertia in “Other System Impacts” To account for inertia within the CBA framework, Ofgem may use the following methodologies: 1. Shadow pricing based on NESO stability contracts - Ofgem could reference existing NESO procurement prices for stability services (e.g. synchronous compensation contracts). This will provide a benchmark for assigning indicative inertia value, though it may not be a direct financial component of cap and floor payments.
2. System security weighting factor in CBA applications – Ofgem may assess inertia qualitatively by applying a weighting factor to LDES projects that provide clear stability benefits. It ensures that projects like PSH, which offer inertia services, are not disadvantaged in cost-benefit rankings against storage technologies that do not provide inertia services.
3. Minimum stability contribution criteria for eligibility – LDES projects could be required to demonstrate inertia contribution potential as part of the cap and floor approval process. This can help by recognising the strategic system value of inertia-providing systems like PSH without needing to assign a specific monetary value; and preventing over-reliance on inverter-based storage that do not inherently provide inertia.
Potential gaps and future market development for inertia valuation While Ofgem’s existing cap and floor model can indirectly reflect inertia benefits, the lack of an explicit inertia market outside of NESO contracts remains an issue. Future considerations for improving inertia recognition are: Developing a structured market for inertia payments at NESO to support fair valuation. Forming a regulatory “stability incentive” mechanism in new LDES application rounds. Exploring long-term system planning models to credibly and reliably evaluate the continued need for inertia to maintain grid stability.
Strategic consideration Under the LDES Cap and Floor CBA, inertia
benefits from PSH will likely be considered but not directly monetised. Ofgem’s best approach will involve:
Using NESO contracts as a valuation proxy but not a direct funding mechanism. Applying a weighting criteria for projects contributing essential system stability. Avoiding market distortions by ensuring non- inertia-providing assets do not undermine grid resilience in LDES project selections. Encouraging future market mechanisms to formally recognise and compensate inertia in a structured way.
While inertia may not yet be explicitly factored into cap and floor calculations, its current strategic system importance should be an influential factor in final assessments.
www.waterpowermagazine.com | July 2025 | 11
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