HC 742 Electricity Market Reform

Memorandum submitted by the Department of Energy and Climate Change (EMR 01)

1. What should the main objective of the Electricity Market Reform project be?

The reforms aim at driving the growth of clean energy industries in the UK, and ensuring the best possible deal for consumers.

Electricity market reform is about ensuring that the right long-term signals are in place to enable cost-effective investment in all forms of low-carbon generation while maintaining security of supply.

2. Do capacity mechanisms offer a realistic way of achieving energy security, low-carbon investment and fair prices?

A capacity mechanism is intended to achieve security of supply, and will be designed to do so at lowest cost. The other instruments in EMR are intended to achieve low carbon investment.

The Government believes some form of capacity mechanism is necessary to ensure security of supply in future. Analysis suggests that as levels of low carbon generation increase, the price signal alone may not be sufficient to incentivise adequate levels of the additional flexible backup capacity required to run for only a few hours operation a year. Such a mechanism could also be designed to reward demand-side response and to encourage the development of energy efficiency and other ‘smart ‘ technologies.

3. What is the most appropriate kind of capacity mechanisms for the UK?

Government has undertaken qualitative assessment of a variety of capacity mechanisms, as well as commissioning Redpoint to undertake quantitative assessment as part of the analysis of EMR policy options . Government’s detailed rationale is explained in the Consultation Document.

In summary, based on this initial analysis, the Government is proposing the following design preferences for a capacity mechanism:

- a centralised system (i.e. an obligation on a single central body such as the system operator) rather than decentralised system;

- an approach in which volume is set rather than the price of capacity;

- a targeted approach, rather than offering payments to all generators

This is based on the Government’s objectives of decarbonisation, security of supply and affordability and key criteria of cost-effectiveness, durability, practicality and coherence.

It is worth noting that this configuration is an initial preference only and that the consultation is inviting views about alternative configurations.

4. Should the system of Feed-in Tariffs be focused on particular technologies or maintain a wider technology-based view?

The proposed feed-in tariff with contract for difference would apply across all low-carbon technologies, although the levels may vary between technologies to reflect different technology maturities.

5. Will it be feasible to deliver EMR in one go, or will regulations and implementation be spread over time?

A timetable for the implementation of the EMR proposals will be set out in the White Paper later this year.

The Annex to the EMR consultation document sets out proposals for ensuring a smooth transition from the current support mechanism for renewables – the Renewables Obligation (RO) – to the proposed new mechanism for low carbon.

We propose closing the RO to new accreditations from 1 April 2017, and during the period from the introduction of the new mechanism until 31 March 2017 the two mechanisms would run in parallel. We are consulting on whether to offer renewables generators a choice between the mechanisms during that period. The aim of this timetable is to ensure a smooth transition between the two support mechanisms.

6. Will market reform increase political risk for investors or create certainty?

Market reform will give greater long term certainty, because the proposed ‘contract for difference’ Feed In Tariff (CfD) means the Government will agree clear, long term contracts that guarantee revenue to generators: a CfD contract would be commercial and binding, and could therefore lower policy risk.

This FIT should deliver support for renewables at a lower cost than the RO, and integrate the policy framework with that for other low carbon technologies. Both aspects will be important for the long term political viability of the renewables programme.

7. Will the Government’s proposed package of carbon price floor, EPS, FITs and capacity mechanism provide sufficient transformation to achieve goals on climate change, security of supply and affordability?

Analysis done by the Committee on Climate Change shows that decarbonising the power sector by the 2030s is the most cost-effective way of meeting the UK’s carbon reduction targets.

Our analysis suggests that all four of the packages are capable of delivering this rate of decarbonisation if the incentives are set at the right levels. However there is more investment sooner with the packages that include the fixed payment and CfD options because the lower risks and consequent cost of capital means that low-carbon projects are economic earlier in the period (given a rising carbon price).

The impact on security of supply would also depend on the targets or levels of the capacity mechanism set. In all of the reform packages, the risks to security of supply are low as the targeted capacity margin of at least 10% is maintained throughout the period to 2030.

The impact of these reforms on household bills to 2020 will be broadly in line with existing plans as set out in the Annual Energy Statement. In the longer run to 2030, while no targets or trajectories have been set for this period yet, the Government believes the lead package of reforms would deliver an effective pathway to 2050, security of supply and consumer bills that are lower than continuing with existing policies.

With an illustrative decarbonisation benchmark of 100gCO2/kWh in 2030, the lead package of reforms would result in a period of higher investment in the 2020s and household bills would then be 4% (around £29/year) lower in the five year period up to 2030 than continuing with existing policies despite delivering a higher level of ambition.

The actual level of impact depends on the rate of decarbonisation among other things and since this has not yet been set it is not possible to be more definite at this stage. The key conclusion the Government draws from the modelling is the trend in bill impacts: small impacts on bills in the near term, but in the longer-term bills are expected to fall by 2030, despite delivering more low-carbon investment.

8. What synergies and conflicts will there be between proposed mechanisms and policies already in place?

The Annex to the consultation document sets out our proposals aimed at ensuring a smooth transition from the current renewables electricity support mechanism (the Renewables Obligation (RO)) to the new support scheme for low carbon. The consultation document sets out our intention, subject to consultee views, to enable a choice between the mechanisms during the period of dual running from the start of the new scheme until the proposed end final date for new accreditations under the RO of 1 April 2017. The aim of this is to minimise any hiatus in investment due to uncertainty while the new scheme is being introduced.

The Annex to the consultation document also sets out our proposals to ensure that even after it is closed to new accreditations, the RO can continue to run smoothly alongside the new scheme. It includes proposals to ensure existing generators accredited under the RO are confident that it will continue to function until its end date of 2037.

Owing to the length of time the RO has been running there are a number of lessons which have been learned about how the renewables market works which will be transferable to the new scheme. These include issues around bioenergy sustainability and the interaction with other support schemes among others.

9. Will a carbon floor price be feasible in the context of EMR and at what level should it be set?

To enable a secure low-carbon transition in the UK power sector, the Government believes there is a strong rationale to provide greater certainty and support to the effective carbon price faced by the sector. Introducing a carbon price support mechanism could help the UK to meet its decarbonisation objectives, as part of a wider package of reforms.

The carbon price support commitment is being considered as part of an HM Treasury and HMRC-led proposal to reform the climate change levy (and fuel duty) and is the subject of a separate consultation.

As a tax matter, and in line with previous public statements, decisions on the carbon price support mechanism will be taken at Budget 2011.

10. What effects will EMR have on the development of capacity for electricity storage and the development of interconnectors between the UK and other electricity markets?

Currently the GB market is primarily dependent on fossil fuel generation to provide the flexibility to respond to changes in demand or supply.

Technologies such as storage, interconnection and, in addition, demand side response, offer the opportunity to have a greater diversity of technologies, which should help achieve EMR aims of improving security of supply as well as reducing emissions.

As with generation investments, investments in storage are made on commercial terms. Reform of the cash out price will improve the economic case for storage, by making the costs of imbalance higher and more cost reflective. Greater penetration of low short run marginal cost plant on the system will drive low prices at times of low demand. This should make storage a more attractive investment, because it increases the opportunity for arbitrage between periods of high and low demand. Another factor in the development of storage is the technological readiness of storage technologies (today, the only market-ready technology available for large-scale deployment is pumped storage [1] ). Going forward as technologies mature, the costs will reduce, making them more economic and lower risk.

The GB electricity system is currently relatively unconnected to the electricity systems of other countries [2] . Under the current arrangements, investments in interconnection are made on commercial terms, i.e. where developers identify an opportunity for arbitrage between markets then such investments take place. However, the nature of the investments make them high risk. As a response, Ofgem is developing a new regulated approach to interconnector investment which will be consulted on early in 2011. There is widespread industry support for Ofgem’s consultation.

February 2011

[1] There is currently approximately 3GW of pumped storage in GB, a significant proportion of which is used by National Grid to fine tune the system in the balancing mechanism.

[2] There is currently about 2.5GW of interconnection capacity in the GB system, with links to the French and Irish markets.