Select Committee on Environmental Audit Minutes of Evidence


Memorandum from The Office of Gas and Electricity Markets



  1.  The primary purpose of the New Electricity Trading Arrangements is to encourage competition in the electricity market. This will deliver lower electricity prices which contribute to the sustainability of the UK economy in which access to electricity at affordable prices is a key element. They will help to fulfil the DTI objective "to ensure the development of competitive markets in gas and electricity with prices which are below the median of EU countries while maintaining effective regulation where it is needed, security of supply and addressing social and environmental issues". The implementation of the new trading arrangements is likely to have both positive and negative environmental impacts, but overall is likely to be slightly negative. Estimates of the environmental impact of lower electricity prices are given below. Lower electricity prices will benefit the UK's industrial competitiveness and provide social benefits to the fuel poor and those on low incomes.


  2.  The Government asked the Director General for Electricity Supply to undertake a review of the wholesale electricity trading arrangements in October 1997. In the White Paper on Fuel Sources for Power Generation published in October 1998 (Cm 4071) the Government confirmed that the current Electricity Pool should be replaced by new trading arrangements. The White Paper explained that new trading arrangements were needed to remove distortions in the current Pool pricing mechanism which favoured some sources of generation over others and amplified weaknesses in competition in the electricity market. The White Paper contained an environmental appraisal. This paper builds on that work.

  3.  The new trading arrangements are part of a wider programme of reform of the electricity market which also includes the completion of the introduction of supply competition and the divestment by the major generators of some coal fired generation plant. The Government expects that the overall programme of reform will encourage a more competitive market which will reduce wholesale electricity prices by at least 10 per cent over the medium term.

  4.  Taking full account of the effect of the proposed new trading arrangements on the environment has been, and continues to be, one of the central objectives of the Review of Electricity Trading Arrangements. The relevant Reform objective (set out in the March 1998 terms of reference for the Review) is:

    ". . . what changes in the electricity trading arrangements will best be compatible with Government policies to achieve diverse, sustainable supplies of energy at competitive prices and with wider Government policy, including environmental and social issues."

  5.  Electricity generation has environmental impacts. It is the largest single source of emissions of carbon dioxide (although emissions have fallen by 29 per cent since 1970 whilst generation has increased by 39 per cent) and two thirds of sulphur dioxide emissions come from power stations (although since 1970 there has been a 68 per cent fall in the sulphur emitted per unit of electricity).


  6.  The key features of the new trading arrangements are that:

    —  Bilateral contracting is the normal method of business;

    —  Greater responsibility for delivering contracted electricity rests with market participants; and

    —  Those who do not fulfil contracts can expect to receive less advantageous terms than if they had contracted fully in advance.

  7.  The effect is to transfer the responsibility for delivering contracts to market participants. At present the risk is managed centrally by the grid operator, NGC, and the costs smeared across participants. In the new trading arrangements costs imposed on the central system by uncontracted actions will be passed back more directly to those causing these costs.

  8.  The market will consist of forwards and futures markets where participants will be able to contract bilaterally over a range of periods from a few days to a year or more ahead of real time delivery. There will be a screen-based power exchange which will operate from a day or more ahead of real time up to (initially) four hours ahead. This market will enable participants to trim their contractual positions, taking account of the latest information—such as the weather. From four hours ahead of real time NGC will take control of the electricity system. NGC will match supply and demand in real time using a balancing mechanism which will open four hours ahead. Generators will be able to offer increases and decreases in output into the balancing mechanism, and customers will be able to offer decreases in consumption. NGC will call these bids as necessary to balance the system. There will be a settlements process to arrange for the financial settlement of balancing mechanism trades, and for the settlement of contractual imbalances.

  9.  There are two main effects which are likely to have environmental consequences and are addressed in this paper:

    —  Electricity prices are expected to fall; and

    —  The removal of market distortions will change the relative competitive position of market participants.


  10.  The Government has indicated that its wider programme of electricity market reforms, which includes the implementation of new electricity trading arrangements, will result in reductions in wholesale electricity prices of at least 10 per cent over the medium term. Lower electricity prices are an important contribution to the Government's policy to encourage UK competitiveness and this is reflected in the DTI objective mentioned above. The new trading arrangements will encourage the economically efficient use of resources which will free those resources for other purposes. Lower prices are important to help address the social problems resulting from fuel poverty and assist consumers on low incomes. Lower prices will have a range of environmental consequences:

Effect on demand

    —  Effect on incentive to reduce electricity consumption by switching off. Simple energy saving measures, such as switching off appliances when they are no longer required, are principally motivated by the potential saving in the cost of electricity. Lower electricity prices will reduce the financial incentive. However, it will continue to be possible to make significant savings through these means and the effect of lower prices is unlikely to be significant. The promotion of energy saving will continue to be an important part of Government policy.

    —  Effect on incentive to invest in energy saving measures. Decisions to invest in energy saving technology will depend on the anticipated return on investment which in turn depends on the value of the energy saved. Lower electricity prices are likely to reduce the incentive to invest in energy saving measures.

  11.  On the other hand, the new trading arrangements include a more active role for electricity suppliers and, potentially, consumers. Suppliers will be able to offer balancing services to the system operator if they can encourage their customers to take steps to reduce electricity consumption at short notice. The increased incentives for demand-side participation could offset to some degree any increased consumption arising from the points raised above. Demand-side participation is explored in further detail below.


  12.  The possible long run effect on gaseous emissions of an illustrative 10 per cent fall in wholesale electricity prices, to which the new electricity trading arrangements will contribute, has been explored using the DTI Energy Model (this is basically a set of interlocking models of final user energy sectors and the electricity supply industry). This can be used to consider possible impacts on CO2, SO2 and NOx. The impacts are uncertain and will depend, for example, on what is assumed about other factors influencing the level of electricity demand. The results reported in the table below, which are based on a 10 per cent fall in wholesale electricity prices, can only give an indication of the scale of the long term impact on emissions:
CO2 (as million tonnes of carbon)+0.5
(percentage of 1990 UK CO2 emissions)(0.3)
SO2 (kilotonnes)--4
(Percentage of 1990 UK SO2 emissions)(--0.1)
NOx (kilotonnes)--2
(Percentage of 1990 UK NOx emissions)(--0.1)

  13.  The modelling suggests that for 2010 there could be an increase in CO2 as a result of the extra electricity demand. SO2 and NOx could be reduced since extra electricity demand could encourage additional gas fired generating capacity and this serves to reduce the load factor on coal and oil plants. Gas fired plants emit virtually no sulphur dioxide and much less NOx than coal or oil fired plants, per unit of output.

  14.  Overall, the effect on CO2 is rather small—a 10 per cent fall in wholesale prices increases CO2 by around a quarter of 1 per cent of its 1990 value. The same is true for SOx and NOx—the effect in 2010 is to decrease emissions by 0.1 per cent for both emission types.

  15.  The Government has a Kyoto commitment to a reduction in the emissions of a basket of greenhouse gases by 12.5 per cent below 1990 levels over the period 2008-12. It also has a domestic goal of a 20 per cent cut in CO2 emissions. The Government will consult on a draft climate change programme[4] later this year—that programme will take account of updated projections of greenhouse gas emissions which effectively allow for the impact of the new electricity trading arrangements and other measures to improve competition in electricity markets.


  16.  The new trading arrangements will have the effect of:

    —  Enabling plant that is able to flex its output in short timescales to receive full value for providing this service. This will tend to increase the market value of flexible plant as compared to inflexible plant. Customers will also be able to receive payment for reducing electricity consumption;

    —  Applying charges to those who do not meet their contracted electricity volumes.


  17.  Flexible generation plants, and customers who are prepared to shed electrical load at short notice on request, will be able to offer this service into the proposed balancing mechanism. NGC will then be able to call these bids, as required and in economic order, to balance supply and demand on the grid system. The use of generation in this way reflects current practice and is, of itself, unlikely to have any significant environmental impact. The use of demand reductions, however, is likely to increase significantly. Demand reduction would reduce the need for generation and consequently would have a significant beneficial environmental impact. Currently NGC's ancillary services contracts with the demand side for response services amount to 680MW, made up of large forms with a consumption of over 3MW. It is not possible to forecast the extent to which demand will play a role in the proposed balancing mechanism as there is little experience to draw upon. However, chapter 13 of the Ofgem consultation document on the New Electricity Trading Arrangements (July 1999) explores the potential for greater demand-side involvement in providing flexibility and concludes that it is substantial compared to current levels, in particular for smaller consumers.


  18.  The new trading arrangements will apply imbalance charges to market participants who do not meet their contracted volumes. Those requiring electricity from the system to top up their contractual position are likely to pay more than their contract price, whilst those with electricity in excess of their contract position are likely to receive a lower price. This reflects the cost of flexing plant to make the necessary system compensations in short timescales. The arrangements encourage predictable behaviour.

  19.  Unpredictable output or demand is addressed principally through NGC instructing flexible plant to adjust its output to compensate. Flexible plant used in this way is mainly (but not exclusively) fossil fuelled plant. Using plant in this flexible fashion results in a lowering of the thermal efficiency of the plant and consequently has a greater environmental impact than operating such plant with a constant output. The encouragement of predictable electricity consumption and production patterns will have a beneficial environmental impact, although it is not likely to be great.

  20.  Some CHP and renewables plant has an unpredictable output, whilst others have a predictable or flexible output. The effect of the new trading arrangements on such plant is considered below.


  21.  CHP and renewables generators are not homogenous groups. The impact of the new trading arrangements will be different for different groups. CHP and renewables generators are expected to make a significant contribution to achieving the UK's legally binding target to reduce emissions. For this reason the Government has policies to encourage generation from CHP and renewable sources. The Government has set a target of 5,000MW electrical capacity of CHP capacity by the year 2000 and is considering a target of 10,000 MWe of CHP capacity by 2010. It is working towards a target of renewable energy providing 10 per cent UK electricity supplies as soon as possible, which it hopes to achieve by 2010.

  22.  This section of the paper explores the effect of the new trading arrangements on CHP and renewable generators. However, the effect of wider Government policies on these groups also needs to be considered. The conclusion is that CHP and renewables plants will not be affected equally. Some types of plant will be encouraged by the new trading arrangements whilst others will not. It is very difficult to quantify this differential effect, but it is likely that on balance the net effect of electricity price falls and the creation of a level playing field through the new trading arrangements will reduce the market value of renewables generation and the incentives to invest in new CHP, with a resulting detrimental environmental impact. Significant measures to mitigate the direct impact of the new trading arrangements on CHP and renewables generators have been taken including the development of the concept of aggregation to reduce the exposure to imbalance charges of individual small generators, and setting a threshold below which the rules of the new trading arrangements do not apply directly. The Government continues to have an objective to ensure that 10 per cent of electricity in the UK is supplied from renewable sources. The measures that it employs to achieve that goal will have to take full account of the expected market conditions, including the effect of the new trading arrangements. This can be expected to offset the effect of the new trading arrangements. The Government is also considering the application of the Climate Change Levy to renewables and CHP. Decisions on this could also affect the competitive position of CHP and renewables generators in the market place.


  23.  There are 1,132 CHP sites in England and Wales with a total of 3,329 MW electrical capacity. There is no statistical information which enables the predictability and flexibility of these CHP sites to be quantified. To achieve maximum efficiency, and thus maximise environmental benefits, CHP plant needs to produce heat and power simultaneously. Consequently, the output of CHP plant is dependent on the requirements of the associated heat load. The heat load could be predictable and relatively uniform, for example where the heat output of the CHP plant is used for the heating of premises. In other cases it could be less uniform, such as where the heat output is used in certain industrial process applications. Because CHP electrical output is influenced by heat demand, CHP is likely to be inflexible, although it may be possible in some cases for electrical output to be raised at the expense of the heat output if electricity prices made this change beneficial.


  24.  The majority of sites with CHP are electricity importers as the CHP is sized to provide only a portion of the site electricity needs. They are in a similar position to sites with no CHP. They are net consumers of electricity and will need to forecast their demand if they self-supply, or contract with a supplier who will do so on their behalf. Such importing sites would benefit from lower electricity prices. However, importing CHP sites have the additional risk, compared to non-CHP sites, that the CHP plant may fail. This would result in the site importing much larger volumes of electricity and, in the short-term, could put the site into imbalance. There would be a cost for the site in managing this risk. The cost would depend on the reliability of the CHP plant. As with other electricity customers using a supplier, the site would benefit from being aggregated with other customers for imbalance purposes.


  25.  There are 232 existing CHP sites in England and Wales which export electricity (ie 20 per cent of the total number of CHP sites) with a total electrical capacity of 1,795 MW (54 per cent of the total). CHP sites with a predictable electricity output have a low risk of exposure to imbalance charges. Consequently, these generators should be able to obtain a reasonable market price for their output, whether they are selling directly to customers or to an aggregator. However, given the general reduction in wholesale prices expected from the new electricity trading arrangements, the position of these generators may deteriorate slightly. In general, licence exempt embedded CHP plants will be able to sell their output to local suppliers. Predictable output from embedded generation should be attractive to such suppliers because it avoids transmission charges without raising imbalance risks. The extent to which CHP plants will be able to capture these benefits will depend, among other things, on the extent of supply competition in their area.

  26.  CHP plant with an unpredictable output will be exposed to imbalance charges, either directly or indirectly. Although the proposed power exchange will remain open until at least four hours ahead of real time, very small CHP sites are unlikely to have the manpower resources available to trade actively in such short timescales.

  27.  Licence exempt CHP sites with an unpredictable output will be able to ameliorate their exposure to imbalance prices by aggregating their output with that of other licence exempt generators. The settlements process would see only the net imbalance rather than the individual imbalances of each site. Nevertheless, there would be some cost to the sites for the cost they are imposing on the system.

  28.  Licensed CHP sites with an unpredictable output will be required to sign the Balancing and Settlement Code and will therefore be exposed directly to imbalance charges. For such generators imbalance charges will be potentially volatile. When there is surplus generation on the system, generators may be paid to reduce output which could result in plants with an unpredictable output paying for any excess they may have produced above that they had contracted for. At other times, when the system is short of generation, such generators could receive high payments for their excess output. Such generators could choose to aggregate their output with that of other generators so that the combined group were exposed only to the net imbalance. This would significantly reduce each plant's risk. They would, however, bear some penalty for the cost they are imposing on the system. In general, CHP sites with unpredictable exports of electricity are expected to be the most affected by the new electricity trading arrangements.


  29.  New investment in CHP plant where the site is importing or exporting electricity will be affected by lower electricity prices. CHP Association figures suggest that a 10 per cent reduction in electricity prices (assuming no other offsetting measures, such as fiscal incentives) would make investment in new CHP less attractive (a 15.1 per cent return would fall to a projected 12.6 per cent rate of return in investment). As has been noted, lower electricity prices are a Government aim and new electricity trading arrangements are one element in achieving that goal. Improvements in technology might improve the ability of some CHP plants to have a predictable output, or even a flexible output. For example, Energy Technology Support Unit (ETSU) suggest that CHP plant with the potential for flexible operation is already planned. Such plant will be able to earn premium prices in the market.


  30.  In 1997 there was 3,372 GWh of electricity produced from renewables plants in the UK excluding large scale hydro and pump storage. Of this 665 GWh (20 per cent of the total) came from wind, 159 GWh (5 per cent) from small scale hydro, and 2,549 GWh (75 per cent) from biofuels, including landfill gas, sewage sludge, and municipal waste combustion.

Renewable Plants with an Unpredictable Output

  31.  Wind generation is the principal category of plant with an unpredictable output. The output of these plants is entirely dependent on wind speed. Low or very high wind speed prevent such plants operating. Industry studies of land-based wind generation plant suggest that wind generators are able to forecast their output accurately four hours ahead of real time with only 60 per cent confidence and will therefore have a significant exposure to imbalance charges.

  32.  All current wind generators are licence exempt. The aggregation of generation output with other exempt generators is therefore an option available to wind generators. A plant operator might aggregate the output of their plant with a number of other wind generators, or aggregate with other types of exempt generator. This would spread and reduce the individual imbalance risk of each plant and thus help to reduce the risk premium but is unlikely to offset the impact of the new electricity trading arrangements completely. Although a plant operator could also contract with a local supplier or with a larger generator to pass the risk on, it is likely that the plant operator would have to pay a significant risk premium.


  33.  Most biofuel and hydro plants have a predictable output and many will have the potential to operate flexibly. They are all licence exempt. Predictable plants should be able to obtain reasonable prices for their output for the same reasons that apply to predictable CHP Plants. Plants able to offer flexible output will have the potential to obtain a premium price for their output. Such plants could, for example, offer flexibility into the balancing mechanism. They could also, as embedded generators, contract directly with suppliers. Suppliers might be prepared to pay a premium for the ability to call on flexible embedded generation capacity to change their physical imbalance position during the four hour gate closure period.


  34.  The higher prices achievable by plant with predictable or flexible output is likely to influence the type of renewables plant constructed.

  35.  Increased generation from renewable sources remains an important part of the Government's policy to combat global warming. The non-Fossil Fuel Obligation (NFFO) scheme obliges Public Electricity Suppliers to secure specified amounts of renewable generation capacity. This scheme will substantially reduce the impact of any adverse effect of the new trading arrangements, such as lower electricity prices, on renewables generators. The Government is currently considering revised arrangements for encouraging support for electricity generation from renewable sources and will take full account of the new market conditions in developing its proposals.

October 1999

Annex 1

Category% effect Environmental effectOther action
Electricity pricesWholesale prices at least 10% lower Reduced incentive to save electricity and to invest in electricity saving. Positive effect on fuel poverty and social exclusions Energy Efficiency Standard of Performances (EESOPs), Home Energy Efficiency Scheme (HEES), Social Action Plan
Payments for flexibilityNew opportunities for demand-side bidding. Increased reward for flexible plant Reduced generation from marginal plant will reduce emissions. May extend life of coal plant
Imbalance chargingIncentive to predictable output Increased risk for plant with unpredictable output. Should benefit base load generation—nuclear, gas
CHP—existingLower prices, imbalance charges, aggregation rules, exemption thresholds CHP importing sites (80 per cent of sites, 46 per cent capacity) will benefit from lower prices. Exporting sites will continue to have market for power. Predictable and flexible plant should have increased value as result of imbalance arrangements. Unpredictable plant will face additional risks. This can be significantly offset by aggregation arrangements Government is considering the treatment of CHP under the Climate Change Levy arrangements
CHP—new investmentLower prices, imbalance charges, aggregation rules, exemption thresholds Lower prices plus increased risk for some types of plant will reduce incentive to invest. Aggregation rules should allow some risk to be offset Government is considering the treatment of CHP under the Climate Change Levy arrangements
Renewables—existingLower prices, imbalance charges, aggregation rules, exemption thresholds Existing NFFO contracts should not be affected. Ex-NFFO generation should be competitive in new market. Aggregation rules will allow some risk to be offset. Flexible renewables plant will have the opportunity to earn a premium for that service Government is considering the treatment of renewables under the Climate Change Levy arrangements. Replacement for the NFFO scheme is also under consideration
Renewables—newLower prices, imbalance charges, aggregation rules, exemption thresholds Plant with predictable output should be able to achieve competitive prices. If flexible as well, will receive additional reward. Inflexible plant will face new risks. Wind most affected. Will benefit from exemptions and aggregation opportunities. New investment likely to favour technologies which provide predictable and flexible output Government is considering the treatment of renewables under the Climate Change Levy arrangements. Replacement for the NFFO scheme is also under consideration, to be decided later this year

4   Draft UK climate change programme, published March 2000. Copies available from DETR Free Literature, tel: 0870 1226 236, fax: 0870 1226 237 or Back

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