APPENDIX 3
Memorandum from The Office of Gas and
Electricity Markets
ENVIRONMENTAL APPRAISAL
SUMMARY
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.
INTRODUCTION
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).
THE PROPOSED
NEW ELECTRICITY
TRADING ARRANGEMENTS
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.
FALLING ELECTRICITY
PRICES
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.
ESTIMATED IMPACT
ON EMISSIONS
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:
| 2010 |
| 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.
REMOVAL OF
MARKET DISTORTIONS
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.
PAYMENT FOR
FLEXIBILITY
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.
IMBALANCE CHARGING
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.
CHP AND RENEWABLES
GENERATION
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.
CHP—OVERVIEW
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.
EXISTING CHP SITES
WHICH IMPORT
ELECTRICITY
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.
CHP SITES WHICH
EXPORT ELECTRICITY
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.
NEW CHP INVESTMENT
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.
RENEWABLES—OVERVIEW
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.
RENEWABLE PLANTS
WITH A
PREDICTABLE OR
FLEXIBLE OUTPUT
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.
NEW RENEWABLES
INVESTMENT
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
SUMMARY OF ENVIRONMENTAL AND SOCIAL IMPACTS OF THE NEW
ELECTRICITY TRADING ARRANGEMENTS
| Category | % effect
| Environmental effect | Other action
|
| Electricity prices | Wholesale 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 flexibility | New 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 charging | Incentive to predictable output
| Increased risk for plant with unpredictable output. Should benefit base load generation—nuclear, gas
| |
| CHP—existing | Lower 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 investment | Lower 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—existing | Lower 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—new | Lower 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 http://www.detr.gov.uk. Back
| 
