Emissions Performance Standards

Memorandum submitted by Ofgem (EPS 21)

About Ofgem

1.1. Ofgem welcomes the opportunity to provide evidence to your inquiry on Emission Performance Standards (EPS). We are the Office of the Gas and Electricity Markets. Protecting consumers is our first priority. We do this by promoting competition, wherever appropriate, and regulating the monopoly companies which run the gas and electricity networks. The interests of gas and electricity consumers are their interests taken as a whole, including their interests in the reduction of greenhouse gas emissions and in the security of the supply of gas and electricity to them.

Executive Summary

1.2. The evidence we have gathered suggests that there are many ways of designing an EPS in order to achieve different objectives, but that any EPS has to be designed very carefully in order to:

· complement existing and future policies in reducing CO2

· manage any effects upon EU wide CO2 emissions and the carbon price

· limit its effect on the level and volatility of domestic energy prices

· encourage the development of carbon capture and storage (CCS) technology

· minimise the costs associated with reducing CO2

· manage its impact on security of energy supply and investment, especially with regard to flexible capacity.

Designing an EPS which addresses all of the above will be difficult and it is inevitable that there will need to be some trade-offs throughout the policy development process.

What are the factors that ought to be considered in setting the level for an Emissions Performance Standard (EPS) and what would be an appropriate level for the UK? Should the level be changed over time?

1.3. Before discussing the factors to be considered in setting the level of an EPS, it is important to clarify what is meant by an EPS. In essence an EPS is a limit on the amount of CO2 that can be emitted during the generation of electrical energy. Within this basic definition, an EPS can take a variety of different forms according to what the EPS is attempting to achieve and what the existing policy and market framework is like.

1.4. Firstly, there are options for the timescale over which the emissions are measured. An EPS could be designed such that the amount of CO2 per unit of electrical energy generated is restricted on a half-hourly basis, which is the approach currently being used in California1. Alternatively, it could be applied on an annual basis (an emissions "bubble"), which was adopted in the UK to reduce other gas (SO2 and NOX) emissions from large power plants during the 1990s2.

1.5. Secondly, there are options for how an EPS is targeted across the power sector. One possibility is to apply the EPS to every plant (or even generating unit), which would effectively prohibit the construction (or constrain the running hours) of particular types of power generation that emit relatively large amounts of CO2 for each unit of electrical energy they generate. A further possibility is to apply an EPS across a company’s fleet or across the whole of the UK’s power fleet. This would allow high emitters to operate for limited periods, provided that the average emissions over the year are below the EPS level.

1.6. Thirdly, an EPS can also be applied to either new or existing plant (or both), which could have implications that are discussed later on.

1.7. Finally, these limits can be static or change over time. While the CO2 limit in California is fixed at 500 kilos of CO2 per megawatt hour, the SO2 and NOX limits under the European Large Combustion Plant Directive (LCPD) became tighter throughout the 1990s.

1.8. Each of these designs imply very different flexibilities for both Government and energy companies, with a range of associated benefits and costs. Therefore, before setting any EPS design or level, it is important that clear objectives are considered. Possible objectives include:

· The limiting of CO2 emissions from new, existing or all plant

· Preventing the construction of certain types of generation plant (e.g. specific technologies such as unabated coal)

· Encouraging the development of low carbon technologies, such as CCS

· Encouraging more carbon efficient plants within existing technologies – e.g. designing an EPS to make all gas plants meet a certain EPS for gas plants.

Once the objectives are set, it is then possible to consider the other factors to be considered when setting the EPS. These include:

· The effectiveness of the EPS for achieving emissions reductions – there could be unintended consequences as a result of generators’ decisions and through interactions with other policies

· The need for new flexible plant on the system and security of supply issues – see sections 1.22 to 1.26 for further information

· The existing policy framework for emissions reduction and the interaction of the EPS with these policies - see sections 1.9 to 1.14 for further information

· The future policy framework, such as a carbon price floor

· The availability of technology to operate within the EPS – the EPS has to take account of what is technically possible or should be designed to drive technology development

· The costs associated with meeting the EPS – see sections 1.27 to 1.36 for further information

· The effect of the EPS on investment decisions

What benefit would an EPS bring beyond the emissions reductions already set to take place under the EU ETS?

1.9. Before discussing the extra benefits of an EPS beyond EU ETS it is important to highlight the overlap between the two policies. As the EU ETS is primarily designed to reduce the quantity of CO2 emissions over time, any sort of EPS that does this too will clearly overlap with it. For an EPS to reduce CO2 emissions in the UK by more, it will have to set limits on generators that are stricter or more specific than those implied by the EU ETS.

1.10. However, a UK based EPS will not necessarily reduce total emissions across the EU unless further steps are taken. Because total EU power sector emissions are capped at the EU wide level, and the EU ETS allows trading of carbon across member states, any emissions reductions undertaken in the UK could still be emitted elsewhere in Europe.

1.11. This ‘waterbed’ effect could, however, be mitigated if suitable quantities of EU Allowances (the currency of EU ETS representing the right to emit) are removed from the system. The Government could ‘retire’ or ‘purchase’ EU Allowances but this process is complex to get right. It should also be noted that the auctioning of EU Allowances brings in substantial Government revenues which would be forgone. Further, the legality of the UK government effectively reducing the quantity of EUAs available within an EU-wide agreed cap and trading scheme would have to be explored.

1.12. There is also the question of how widely an EPS could be applied. For example, as noted above, a UK applied EPS could reduce UK emissions, but would have little wider impact on EU emissions. For an EPS to have a significant impact on EU emissions, it would also have to be implemented by a number of European countries either independently or co-ordinated together. However, this would imply that two schemes are in place with similar purposes and possibly working against one another in certain areas.

1.13. The overall impact of an EPS upon EU Allowance availability and the CO2 price is unclear since this depends on the interaction between lower demand – generators wanting fewer EUAs because they cannot emit as much carbon – and reduced supply – Governments retiring EUAs to prevent the waterbed effect. However, it is possible that an EPS could reduce the price of CO2, which would act as a disincentive for investment in low carbon technology.

1.14. However, if an EPS helps to force a technological breakthrough in CCS or other emissions performance innovations in generating plant then this could encourage cheaper ways of decarbonising the power sector than those that would otherwise have emerged as a result of the EU ETS. This could mean that the cost of using these technologies is reduced in future relative to what they would have been had an EPS not been introduced and could also mean that the EU ETS cap could be further tightened to take advantage of this technological development in order to reduce emissions further.

1.15. In addition, an EPS could ensure that there is an insurance policy against the construction of higher carbon plant that could occur if the EU ETS were to be weakened in the future. We understand that there is some stakeholder concern that once higher carbon plant have been built, their developers may have some "bargaining power" with which to later broker a way to run for more hours with future Governments.

1.16. Lastly, an EPS that affects existing coal plants might also encourage further switching to biomass, which has started to occur due to the subsidies offered by the RO. For example, the Drax and Tilbury power plants have both moved from pure coal-firing to biomass co-firing, with plans to increase the amount of biomass that they use as their fuel source1. This should reduce emissions in the short-term, with the provisos about the EU ETS cap that were noted earlier, but as the use of biomass increases so does the importance of sustainable sourcing and life cycle emissions.

How effective is an EPS likely to be in driving forward the development of CCS technology? Should the UK’s CCS demonstration programme cover gas-fired as well as coal-fired power stations?

1.17. There is no simple answer to this question as different types of EPS have varying impacts on the development of CCS.

1.18. If an EPS means that power generators using fossil fuels cannot operate without CCS, this may provide an incentive for them to invest in this technology.

1.19. However, at present, CCS technology is unproven at a large scale both technically and economically. Correspondingly, a developer may choose to make an alternative investment decision to meet the EPS, rather than necessarily explore CCS. For example, if an EPS rules out unabated coal plants, a developer may choose to invest in a gas plant (assuming that would meet the EPS) rather than a coal plant with CCS.

1.20. There is an additional risk that some EPS types may actually deter investment in CCS. For example, a developer may not invest in a new plant with CCS fitted if it believes that it will be left with a stranded asset in the eventuality that CCS does not work and the station cannot meet the required EPS.

1.21. All in all, most EPS variations are unlikely to provide a sufficient incentive by themselves to push a developer towards CCS.

Could the introduction of an EPS pose any risks to the UK’s long-term agendas on energy security and climate change?

1.22. Once again, there is no simple answer to this question as different types of EPS have varying impacts on energy security and climate change.

1.23. In the energy market there is always a requirement for flexible plants to be able to be switched on quickly when energy demand is high, or when output from other forms of generation is lower (e.g. when renewable output is low or when base-load plants fail). Flexible capacity is likely to become of greater importance as increasing amounts of variable renewable generation, such as wind power, comes onto the power system. Currently fossil plants provide a lot of this flexibility.

1.24. If an EPS ensures that fossil plants are to be restricted in some way then flexibility will be needed to be provided from somewhere else. This could be provided by increased use of sustainable biomass and through innovations in electricity storage and demand side response, as well as extra interconnection. However, these possibilities face a number of current challenges. Correspondingly, any EPS will need to carefully consider what impact it would have upon peaking and balancing plant during the time before these alternative options can be developed and deployed.

1.25. For example, if an EPS prevented the construction of any new coal-fired plants, then alternative generation (e.g. new gas plants) would need to be built in their place. We have analysed in the "Discovery analysis tool" the most extreme case, i.e. the impact of building neither any of the coal-fired plants that we had projected would be built between now and 2024-25, nor any alternative plants. Although this is a crude analysis as it is likely that the market would invest in alternative generation (e.g. new gas plants), the tool showed a potential shortfall in generation capacity. If this shortfall is filled primarily by gas plant, then the UK will lose some diversity in its generation capacity, which could pose a risk to security of supply if there are gas supply blockages.

1.26. Further, it is possible that if an EPS is focused on banning new fossil plants from being built, it might encourage existing fossil plants that are less efficient and ‘dirtier’ to run harder and longer than would have been otherwise been the case. Under some circumstances this could perversely lead to increased carbon emissions (although this effect would be limited by the EU ETS cap). This incentive would be created if an EPS drives higher prices for electricity (mentioned below) and a lower carbon price.

What is the likely impact of an EPS on domestic energy prices?

1.27. Once again, there is no simple answer to this question as different types of EPS have varying impacts on both the level and volatility of the price of energy.

1.28. However, an effective EPS will affect the level and volatility of domestic energy prices. This is because any effective EPS will restrict the choices available to generators, which is likely to lead to higher costs that will ultimately be passed onto energy consumers in the form of higher prices.

1.29. The most obvious source of an increase in costs is generators having to use lower carbon forms of generation to provide the energy needed in the UK. Existing lower carbon energy (at current carbon prices) is generally more expensive than using coal or gas, and the fitting of CCS to fossil fuel power stations would also clearly increase the cost of generating the electrical energy.

1.30. In addition, generators under any sort of running hours restrictions will only want to use their running hours at the point where they can make the maximum possible returns. This means that the generators will want to sell their energy at peak times when the electricity price is highest e.g. winter demand spikes. Correspondingly, generators will not want to use their hours at times of lower demand, when prices are generally cheaper. If their generation was required at those times of lower demand, then they would demand a higher price to generate, in order to factor in the opportunity cost of them not being able to use their hours when they can take advantage of higher prices. The result would be that the price at those times of lower demand would increase, thereby increasing the costs to consumers.

1.31. When restricted plant is able to demand a higher price for its electricity, unrestricted plant can also increase its price in the knowledge that it will still be purchased. Therefore the price making behaviour of restricted plant to maximise their profits also presents opportunities for unrestricted plant to become more profitable. Unrestricted plant includes low carbon and renewable generators, and increases in these generators’ profitability could extend their planned operational life, or increase the incentive to invest in these technologies.

1.32. We would like to draw the Committee’s attention to an interesting example of how plant running restrictions can affect the prices that these plant charge for the electricity that they produce. We would like to stress that the example is only dealing with the price of the energy produced by the specific restricted plant mentioned below and that we are not drawing any firm conclusions on the more complicated effect of these plants’ behaviour on other plants’ pricing behaviour. While overall electricity prices did increase during this period, there were other contributory factors affecting the wholesale market price at that time.

1.33. The example here is the effect of the Large Combustion Plant Directive on plant pricing behaviour. The LCPD introduced measures to control the emission of nitrogen oxides (NOX), sulphur dioxide (SO2) and particulates (dust) from combustion plants. These plants must meet Emissions Limit Values (ELVs) for the three pollutants.

Large combustion plant had the option to either:

· Opt-in: comply with LCPD’s ELVs, with existing plants being able to use a national cap and trade system that reduces the amount of their emissions over time;

· Opt-out: existing plant could agree by 30 June 2004 not to run the plant for more than 20,000 operational hours between January 2008 and December 2015.

1.34. Existing plant which would not run for more than 2000 hours a year until the end of 2015, and/or 1500 hours a year from 2016, could apply for derogation from the LCPD. These were subjected to a fixed ELV for SO2.

1.35. From the graph below it can be seen that the more restricted plants (opt-out and derogation) became more expensive than the plants who fully complied with the LCPD’s emissions limits. This is mostly visible from December 2007 onwards, where the differences between the prices asked for by plants which have opted for the different LCPD compliance options diverges. This is because they put a premium on their energy, factoring in the opportunity cost mentioned in 1.30.

Prices for coal-fired generation, 2007-08, £/Mwh

Conclusion

An EPS is a policy intervention with good intentions but many potential repercussions. It is not just a case of introducing a simple intervention to ban higher carbon forms of electricity generation.

The policy intent of any EPS needs to be clear, then the EPS can be appropriately designed to meet its intent.

Whatever EPS is chosen, it must be well designed in order to ensure that it actually results in carbon emissions reductions, while preventing security of supply threats or increases in the price of energy.

I hope that this evidence is of use to you and I am happy to provide additional evidence if required.

September 2010