HC 742 Electricity Market Reform

January 6th 2011

RWE npower response to ECC Select Committee Inquiry on Electricity Market Reform

Introduction

1. RWE npower welcomes the opportunity to submit our views on the Electricity Market Reform inquiry to the ECC Select Committee, but are still in the process of assessing the implications for our existing and future investments of the proposed Electricity Market Reform package set out in the Government consultation published on 16 December 2010.

2. The package of proposals set out in the EMR consultation represents a radical departure from the competitive market. The Government acknowledges the importance of competitive markets to deliver objectives efficiently and with minimum cost increases to consumers and states that markets should be allowed to function where effective. However, the reduced exposure to the wholesale price as a result of the introduction of a Contract for Difference (CfD), the intervention on the carbon price and the potential distortion through the introduction of a new capacity mechanism all amount to a radical move away from the competitive market.

3. We note that although all existing players have said that they are capable of and willing to manage wholesale price risk, the EMR proposals place significant emphasis on diluting wholesale price risk to encourage new entrants and new investors into the market. The proof of their success will be if they do indeed result in new entrants or new investors committing to new low carbon projects.

4. We believe that more work needs to be done to understand the synergies and conflicts between the proposed measures in the EMR package, to avoid over-design and policy redundancy and to ensure that the EMR delivers its objective of the transition to secure, low carbon electricity system at least cost to the consumer. For example, further consideration is needed with regard to the interplay between a carbon floor price and a Feed-in-Tariff with a two-way CfD.

Response to questions

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

5. We believe that the primary objective of the Electricity Market Reform project should be to assess the ability of the existing market arrangements, and what possible interventions might be necessary, to deliver a secure, low carbon, affordable electricity mix for the 2020s and beyond and, in particular, delivering the decarbonised electricity system by 2030 at the lowest achievable cost. A key outcome of the Electricity Market Reform project should be an attractive, stable and predictable investment

environment for all stakeholders in the electricity market (including generators, suppliers and customers) and should deliver value for money for customers and maintain the competitive nature of the electricity market.

Questions 2 and 3: Do capacity mechanisms offer a realistic way of achieving energy security, low-carbon investment and fair prices? What is the most appropriate kind of capacity mechanisms for the UK?

6. We do not believe that the case for a new capacity mechanism has been adequately made. National Grid operate a well managed reserve market that is understood by market participants. This market is capable of managing the increased reserve requirements to meet the renewables targets and is open to both generation and demand. There is an issue with the pricing of reserve back into the energy market that needs to be resolved as part of a cash out review. The suggestion of introducing a "strategic reserve" market needs to be carefully considered as it has implications for the energy market and is likely to dampen price signals.

7. In the current electricity market, capacity signals are provided through clear and transparent electricity prices in the balancing mechanism together with a role for the system operator that ensures there is sufficient back up or reserve generation. In the future, demand side participation in the market will be facilitated through the investment in smart metering and appropriate new tariff structures.

8. We believe that the current arrangements could be refined and extended to ensure security of supply even with increasing connection of variable renewable generation and that an explicit capacity mechanism is not required at this time. In their Future Balancing Services Requirements document, National Grid, for its Gone Green scenario, has indicated the level of positive reserve requirement per year to 2025/26 as a result of the increasing penetration of wind generation but also the increase in large unit size of nuclear. National Grid go on to say that this increased reserve can be met either by increasing the amount of STOR or from the balancing mechanism. The choice of which one to use would come down to cost. [1] We believe that this will be best achieved by an extension to the Short Term Operating Reserve (STOR) arrangements which meet the requirements laid out by DECC in the EMR consultation, in that:

· STOR is administered by a central body, National Grid

· STOR is volume based

· STOR is a targeted mechanism.

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

9. In order to deliver decarbonisation of the electricity system at the lowest cost to the consumer, we believe that all low carbon generation technologies should be able to compete on a level playing field.

10. The current renewable support mechanism, the Renewables Obligation is well understood and through its robustness has proved to deliver investment – giving strong incentives to efficient projects. In this context, we continue to believe that a Low Carbon Obligation that is fully compatible with the existing Renewables Obligation could – with minimum interruption to the market and investor confidence – provide support to all forms of low carbon electricity generation, including nuclear, CCS and renewables.

11. However, we recognise that the Government’s favoured option for low carbon generation support is in the form of a low carbon ‘Contract for Difference’. We believe this proposal may have some merits, and we are currently evaluating the proposal as part of our response to the Electricity Market Reform consultation. The CfD approach may enable investment in low carbon generation provided that there are adequate returns and sufficient long term guarantees associated with the key contract parameters.

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

12. Given the scale of the market reform envisaged in the Electricity Market Reform project we believe that it is essential that the interaction between all of the important elements is considered together. This should ensure that there is a consistent approach towards the various market interventions and a stable environment created for investment.

13. We note that the implementation of the key elements of the proposals required consideration of the associated timescales. For example, the detailed systems required to deliver the proposed low carbon support mechanism have significant lead times. Consequently we believe that as part of the implementation process a detailed plan and clear overarching guidance is required to ensure that market participants can understand the impact.

14. We would be concerned if elements of the EMR were implemented in a piecemeal basis and unilaterally without a clear overarching strategy for implementation. Equally, the implementation must have due regard for the European context. For example, the package of measures needs to be compatible with the 3rd Package, while the unilateral imposition of the proposed carbon floor mechanism needs to be considered in the context of the future development of the EU ETS to ensure it does not unduly impact on UK competitiveness.

Question 6: Will market reform increase political risk for investors or create uncertainty?

15. Any intervention in the market creates uncertainty for investors. The publication of the Electricity Market Reform consultation on the 16th December is the first step in defining the scope and scale of the proposed reform that can be expected. The development of the legislative framework and the detailed implementation rules (which government envisages will be in place by 2013/14) will inevitably create a period of time when the investment climate is uncertain. The more rapidly we can move to detailed proposals the greater the certainty of the new regime for all stakeholders. In this context, we welcome the government’s intentions to present final decisions on the market reform package in its Spring White Paper. It is crucial that there is no slippage in this timetable and that primary legislation is enacted as soon as possible in 2011. The publication of a detailed implementation road map and plan is essential at this stage.

Question 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?

16. We believe that some elements of the Government proposals in the Electricity Market Reform consultation could – subject to detailed design – have the capacity to facilitate the low carbon transformation of the GB electricity market. However, at this stage we have concerns that certain aspects of the government’s package will prove difficult to implement and could lead to some perverse incentives. We are not, therefore, convinced that the proposals are the most effective in terms of the likelihood of delivering the decarbonisation objective, or in terms of minimising the impact on consumers.

17. We are currently evaluating the details of each market intervention and considering the potential implications for GB stakeholders of the proposed package as a whole. We believe that cost-efficiency needs to be at the centre of any market reform. In order to achieve this it is important to:

· Avoid over-designing the market (ie policy package should be the minimum set of interventions required to achieve the overall objectives);

· Ensure a coherent package of measures that not only work together to complement each other, but avoid unnecessary duplication and policy redundancy; and

· Bring the efficiency of the market to bear to minimise the cost to the consumer.

18. In this regard, we have some specific concerns about the coherence and aggregate impact of the proposed interventions in the EMR package:

· The proposal for an Emissions Performance Standard (EPS) is unlikely to provide any additional certainty for investors in low carbon generation. The proposed EPS aims to prevent new coal-fired generation being built without installation of carbon capture and storage, but it is not clear that this provides any additional benefits beyond current Government policy on new coal-fired power generation. The consultation itself notes that the proposed EPS has limited interaction with the other mechanisms. It is difficult to see how the EPS will provide any additional certainty or incentive in delivering the investment needed to achieve climate change goals.

The ECC Select Committee is already aware from our evidence to its recent inquiry on EPSs that we believe that a moratorium on unabated new coal (with through a requirement for CCS demonstration or an EPS) will have the impact of stopping the development of CCS in the UK. A more considered policy with Government, for example, underwriting some of the risk if CCS were not feasible technically or economically, would be more likely to encourage the UK to develop CCS expertise.

· We agree with the Government’s conclusion that a carbon price floor is unlikely by itself to provide sufficient incentive for investment in low carbon generation. However, more work is required to understand the relationship between the proposed carbon price floor and Government’s preferred option of a two-way Contract for Difference (CfD), in particular to establish the role that a carbon price floor plays – if any – in incentivising investment in low carbon generation when set alongside a FiT.

The EU has set emissions reductions targets through the EU ETS and this should remain the central mechanism for determining carbon prices. Introduction of additional measures in the UK should not be seen to undermine the EU ETS. We are concerned that the rate of the proposed tax on the carbon content of fossil fuels supplied to generation could be decoupled from the EU carbon allowance (EUA) price resulting in an undue impact on UK competitiveness if, for example, the Commission strengthens the EU ETS or the EU moves to a 30% emissions reduction target. There needs to be a dynamic element with the EUA price.

A carbon floor price should only be introduced on the timescales where it could have an impact on investment decisions. Any benefits of certainty in the price of carbon are likely to be over the period from 2020-2030 (particularly until future carbon targets are agreed at EU level) and there are likely to be very limited benefits for investment decisions if introduced earlier than 2018. In particular, there is a danger that if it is introduced at a rate that results in higher electricity prices in the short-term it risks, resulting in windfalls for existing low carbon generators and being seen simply as a further revenue raising measure for the Government which unduly impacts on UK competitiveness.

· While a CfD may dilute market risk for nuclear and renewable plant, a two-way CfD will increase risk for fossil plant with carbon capture and storage (CCS) and is likely to deter investment in CCS further. Under a two-way CfD, plant with CCS will be unable to recover the costs of their input fuels when coal and gas prices rise significantly in the future.

· We do not believe that the case for a capacity mechanism has been adequately made. In the current electricity market, capacity signals are provided through clear and transparent electricity prices in the balancing mechanism together with a role for the system operator that ensures there is sufficient back up or reserve generation. In the future, demand side participation in the market will be facilitated through the investment in smart metering and appropriate new tariff structures.

We believe that the current arrangements are suitably robust enough to ensure security of supply even with increasing connection of variable renewable generation and that an explicit capacity mechanism is not required at this time. The review of electricity cash out prices previously announced by Ofgem is an important element in ensuring that the current arrangements can develop to respond to increasing variable generation [2] . In addition, we note that National Grid have already indicated the extent to which the current reserve market can accommodate the additional requirements identified as a result of increased connection of wind generation [3] .


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

19. There is the potential for significant interaction between the Electricity Market Reform proposals and the EU Emissions Trading Scheme and the EU Products Directive. The EU ETS sets a price of carbon through the cap on allowances that are either auctioned or issued to companies. Ideally the UK should not need to set additional limits on carbon prices through the proposed floor price mechanism as this could potentially lead to competitive impacts for the UK compared with other EU Member States. Future certainty in emissions reductions through the EU ETS would reduce the need for a carbon floor price set only in the UK.

20. The Energy Products Directive sets minimum levels of tax for energy used across different sectors and it has been suggested that this should be reformed to take account of the carbon content of the energy product. Carbon floor price proposals need to take into account any potential for reform of the Energy Products Directive.

21. There is a potential for conflict between the impact of policies that result in costs on electricity compared with other fuels, for example, gas where for some consumers there are only limited costs associated with the carbon emissions from the use of those fuels. Further analysis is needed to assess the impacts of the EMR proposals on fuel switching in the context of the broader energy market particularly if greater electricity use is seen as part of the strategy for delivering emissions reductions in sectors such as transport and heating. 

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

22. Providing the proposed mechanism (i.e. through reform of the climate change levy) meets requirements of European legislation (in particular the Energy Products Directive) and future changes to this legislation then it will be feasible to introduce a carbon floor price. However, a carbon floor price is both insufficient on its own and provides diminishing support over time as the electricity system is decarbonised and the role of fossil plant in setting price declines (particularly for investments from 2020 with more than a 30 year payback in the context of an EMR aspiration to drive the carbon intensity of electricity generation down to at least 100g/kWh by 2030).

23. Furthermore, in the context of the EMR package, it is unclear what additional role a carbon floor price will play – if any – in incentivising investment in low carbon generation when set alongside the Government’s preferred option of a two-way Contract for Difference (CfD).

24. Looking at the carbon price support mechanism on its own, it is not clear that the current proposals will set a carbon price floor or will simply act as an additional tax on electricity. There is a danger that if the level of the tax rate is set too far in advance and carbon prices under the EU ETS subsequently rise significantly (for example, if the EU moves to a 30% emissions reduction target), consumers will be paying far higher prices than necessary. It is crucial that there is a dynamic element with the EU carbon allowance (EUA) price to minimise any undue impact on UK competitiveness.

25. On the other hand if the level of the tax is set without sufficient lead time to allow the level of tax to be taken into account in forward prices, generators will need to factor in the additional risks from uncertainty in tax levels in their pricing structure. The rate of any carbon tax on input fuels would need to be set no less than two years in advance.

26. Any assessment of the level at which a floor price is set must take into account the overall impact of all proposed support mechanisms and the timescales over which new investment in low carbon generation is likely to be delivered.

Question 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?

27. The issue of electricity storage and interconnection is related to the temporal and geographical electricity price differentials that emerge as a consequence of the proposals under the Electricity Market Reform package. The extent to which price signals are impacted by the proposals through, for example, the capacity payments mechanism is an important consideration. Companies will not invest in demand management or storage if they think price signals will be undermined by government and regulators, or the operation of reserve capacity by National Grid. Given the scale of the intervention it may be difficult for the market to deliver increased storage or interconnection without understanding the interaction of all elements of policy.


[1] National Grid Future Balancing Services Requirements: Reserve, http://www.nationalgrid.com/NR/rdonlyres/55610D9A-C53A-4E28-88C6-29AE5DF72EF2/42697/Future_Balancing_Services_Requirements_Reserve1.pdf

[2] Open letter consultation: Potential Significant Code Reviews (SCRs), Ofgem, 12 th August 2010

[3] National Grid Future Balancing Services Requirements: Reserve , http://www.nationalgrid.com/NR/rdonlyres/55610D9A-C53A-4E28-88C6-29AE5DF72EF2/42697/Future_Balancing_Services_Requirements_Reserve1.pdf