HC 742 Electricity Market Reform

ESB International

The Clerk 6 January 2011

Energy and Climate Change Committee

7 Millbank




Dear Clerk,

New Inquiry: Electricity Market Reform

1. ESB International (ESBI) welcomes the opportunity to provide views in response to the Committee’s inquiry on electricity market reform. The challenges facing the energy markets over the forthcoming years are significant and the structure of those markets will play a major role in achieving Government policy objectives. The points raised in the Committee’s call for evidence are therefore timely and particularly pertinent.

2. This response provides a brief introduction to ESBI and a summary of our views, followed by more detailed responses to the specific questions posed by the call for evidence.

ESB International

3. ESBI has been a developer and operator of independent Combined Cycle Gas Turbine (CCGT) generation projects in the GB market for over fifteen years. We currently have equity interests in Corby power station and in the 850MW development at Marchwood, which commissioned late last year. We are highly advanced with our latest 860MW development at Carrington which is intended to become commercially operational in 2014. We are also developing further large-scale CCGT developments at other locations across GB.

4. In addition to increasing our conventional generation fleet, we continue to grow our position in the UK wind market. We operate the 24MW West Durham Wind Farm in Northern England, as well as the 20MW Hunters Hill and 15MW Crockagarron projects in Northern Ireland. We are currently also constructing what will be England’s largest onshore wind farm, at 66MW, at Fullabrook in Devon. Further, we expect to start construction of our 38MW Mynydd y Betws Wind Farm in South Wales later this year. We are also active in the tidal energy sector.

Summary of views

5. This section is a high-level summary of the views expressed in the more detailed responses to the Committee’s specific questions.

· The proposals contained in DECC and Treasury’s consultation documents comprise fundamental changes to the operation of the GB electricity market. The introduction of a package comprising of a FiT, EPS, carbon price support and a capacity mechanism will support the delivery of the Government’s energy policy objectives, however the success of the package will depend on its specific structure.

· The delivery timescales are challenging and come at a time when investment needs to be made, if environmental and security of supply targets are to be met. In order to limit investor uncertainty, Government must provide clarity on the intended solutions at the earliest opportunity, clearly define transitional arrangements and must demonstrate consistency of purpose over the long-term.

· There remain questions as to how the new arrangements would work in detail and also interact with existing market mechanisms. In particular, we are uncertain as to how the tariff levels would be set under a new FiT mechanism and how any new mechanism would interact with a grandfathered RO mechanism in support of low-carbon generation technologies.

· ESBI welcomes the Government’s commitment to maintaining competitive wholesale markets and its recognition that the market reform proposals need to be underpinned by significant improvements in wholesale market liquidity. We would seek for Government or Ofgem to publish further thoughts and proposals at the earliest opportunity.

· Any market intervention must be introduced to remedy specific market deficiencies. Each element of the package must be developed and introduced as a compatible and complementary suite in order for the high-level objectives to be achieved. For example, capacity mechanisms should be used to ensure future security of supply and should not be used to drive low-carbon generation development.

Responses to questions

This section provides ESBI’s views on the specific questions raised in the Committee’s inquiry.

What should the main objective of the Energy Market Reform project be?

6. Energy market mechanisms should be designed to facilitate the achievement of Governmental policy objectives. As such, the aims of the Energy Market Reform (EMR) project should be consistent with Government’s stated objectives of affordably meeting the legally binding carbon reduction targets, whilst ensuring security of supply. We are strongly of the view that, wherever possible, this should be done within the context of competitive markets which provide opportunities for independent and new entrant players, hence minimising the overall cost to consumers.

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

7. Capacity mechanisms, in varying forms and to varying degrees of success, have been used in electricity markets across the world and are generally adopted on the premise of securing supply. This is by providing specified price and/or investment signals to generators to provide appropriate levels of capacity in the future. The Committee’s question suggests that it is perhaps of the view that a capacity mechanism could be used to deliver a range of policy objectives, rather than focus on security of supply. We strongly believe that the purpose of each policy intervention should be well-defined and focused. The call for evidence discusses other market interventions such as Feed in Tariffs (FiT) and Emission Performance Standards (EPS) which are more appropriate tools for reducing carbon intensity.

8. The low carbon generation technologies that will deliver the required reduction in carbon emissions will be primarily renewable (in particular onshore and offshore wind), new nuclear and carbon abated forms of thermal generation. Although these technologies are low carbon, they are all also inherently inflexible and therefore unable to react to demand variations. An effective capacity mechanism could ensure that sufficient flexible generation is available to meet peaks in system demand in a market providing significant support mechanisms to low carbon technologies. By this role, an effective capacity mechanism can facilitate the objectives of lower carbon generation, security of supply and affordable prices.

What is the most appropriate kind of capacity mechanism for the UK?

9. Were a capacity mechanism to be introduced, it must provide appropriate signals for capacity that is required to meet peak system demand in the future market containing significant amounts of inflexible, low-carbon generation; the signals would need to be sufficient to support investment in new capacity as well as for retention of relevant current capacity. As such, we are strongly of the view that any mechanism must recognise fully the value of flexibility, as well as capacity. Further, it must provide sufficiently long-term and secure financial returns to generation developers. Investment decisions would be affected if the signals were short-term or if the signals contained any inherent instability. As a company with existing generation and development projects, we would be particularly concerned if the capacity mechanism eroded the vital role that flexible, high efficiency, lower-carbon, gas-fired generation plays in the generation mix now, and in the future.

10. The GB energy markets are some of the most liberal in the world. We believe that any GB capacity mechanism should be complementary to the current liberalised bilateral market arrangements and, wherever possible, better promote liquidity in the wholesale energy markets.

11. We welcomed the Government’s initial proposals in the EMR consultation regarding its preferred option for a future GB capacity mechanism. In general, given the current GB market design we see merit in the Government proposals for a capacity payment mechanism that:

· is targeted, rather than offering payments to all generators;

· is based on a market derived price for a given volume of capacity, rather than a price established by a regulatory body; and

· contains a volume for capacity that is derived by a coordinated administrative process.

12. In order that a competitive, bilateral wholesale market can thrive, we welcome Government’s preference to keep the generation contracted within the capacity mechanism separate from the existing wholesale and balancing markets. We recognise that this option will require careful market design but believe that it could be a workable option. The Government’s EMR consultation does not specify what types of plant the mechanism would incorporate. We are of the view that the mechanism should be open to both new and existing generation plant and would seek for Government to provide clarity on this point at the earliest opportunity.

13. The so called "last-resort" model, whereby the capacity mechanism is only called upon when all other market options have been used, would preserve market-based investment signals and would produce more efficient, economic outcomes. To this end, we very much welcome Government’s recognition of the existing problems with liquidity and its requirement for Ofgem to address them in timescales consistent with the EMR. We would, however, seek that Ofgem or Government provide proposals as soon as possible, in order that respondents to the EMR consultation are able to take a more informed view on the full range of possible reforms.

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

14. In our view, Feed-in Tariffs (FiTs) should contain technology differentiation. The level of each FiT should be determined by the costs specific to each type of low-carbon technology being supported by the subsidy. They should not, however, be further differentiated by location as this could result in less efficient outcomes by promoting yet higher cost generation at the expense of more economic outcomes.

15. In setting the FiT for each technology, we would seek that Government undertakes a transparent and robust process. We are concerned that an opaque process for determining the FiT, undertaken between Government and generators, could lead to inefficient and costly outcomes whereby the FiT produces inappropriately high rewards for certain technologies or for specific projects. This is particularly the case for technologies in which there is currently uncertainty in the development and operational cost bases, due to the nascent nature of those technologies (such as the next generation of nuclear plant and offshore wind generation).

16. Whilst the EMR documents contain some information on the Government’s views of which FiT it believes would best suit the requirements of the GB market, there is a further level of detail required before industry is able to decide on the most appropriate model. In particular we look to Government to further elaborate on how the FiT strike price or premium will be set. In particular we would recall the experience of the later rounds of contract auction under the Non Fossil Fuel Obligation process, which led to undeliverable projects securing contracts and hence precluding deliverable projects from securing contracts. We would therefore seek for the Government to give careful consideration to the methodology for deriving the strike price or premium for whichever FiT model is chosen.

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

17. We envisage the changes to be delivered by EMR to be wide-ranging and fundamental. If the goals of the reform are to be met (ie the delivery of an affordable, secure and lower-carbon generation mix), the changes must be completed as soon as possible, in order that investors have the clarity and stability they require. As such, we would seek that the EMR be introduced in one go or at the very least against a clear and defined timetable which matches the requirements of Government and industry. If phased, Government could choose to recognise the build processes and timings for new technologies, such as the new nuclear fleet and deployment stage of carbon capture and storage. However, Government must ensure that an expeditious timetable does not compromise the integrity and rigour of the final model.

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

18. If political risk is to be defined in terms of political intervention in the market, then EMR has introduced material, albeit hopefully short-term, political risk. As previously stated, we would seek that Government introduces any reforms quickly and for those changes to be robust and able to deliver the challenges the energy markets face over the forthcoming years. If these requirements are met, we would expect the risk of future political market intervention to be significantly reduced.

19. We note, and welcome, that there are elements of the Government’s proposals that (if implemented) would reduce the amount of risk associated with investments recently and currently being made. In particular, statements made on the grandfathering of RO arrangements for existing and soon-to-be developed projects and the non-retrospective application of EPS provisions were especially welcomed.

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

20. The package is both wide-ranging and fundamental. The proposals have the scope to deliver sufficient change to facilitate the delivery of Government’s goals for carbon reduction and security of supply. We are uncertain, however, whether they will result in a more affordable energy future. The amount of investment required to deliver the carbon reduction necessary to achieve Government’s objectives, is significant. It consists of both generation and infrastructure investment, which will have to rise to unprecedented levels, widely estimated to be in the region of £200billion. Coupled with this are the support mechanisms proposed within the EMR, which will result in increasing wholesale prices resulting from additional energy taxation and consumers having to fund various direct subsidy payments. We are of the view that Government should further address affordability as the EMR process continues through its various stages.

21. For the package to deliver its goals, Government must state what its intentions are for each element of the EMR and ensure that those intentions are not confused or diluted. Each element of the package (carbon price support, FiT, EPS and capacity mechanism) must be developed and introduced as a compatible and complementary suite in order for the high-level objectives to be achieved. We would seek that Government ensures this happens as a priority.

22. Further, there is a significant level of detail that must be developed before we are able to judge whether the reforms will deliver the intended outcomes. We welcome Government’s commitment to implementing changes by April 2013 but would urge for more details of the mechanics of the proposals to be published at the earliest opportunity, along with well-defined implementation timescales. This will reduce uncertainty investor uncertainty and ensure help ensure there is no investment hiatus.

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

23. As discussed previously, we strongly support the maintenance of the liberalised, competitive wholesale market. Government rightly raises liquidity in the wholesale market as an issue that must be addressed for its proposals to be successful. As an independent generation company, we are acutely aware of the impacts that low liquidity brings and welcome Government’s statements on improving it within the timescales of the EMR. The "FiT with contract for difference" mechanism that is favoured by Government relies on a transparent and robust wholesale price, driven by generation cost. We would support any initiatives that help deliver this and believe it is a key interaction/requirement of the Government’s proposal.

24. We welcome Government’s intention to grandfather the arrangements for existing and current development projects that are accredited under the RO. However, for this to work, thought needs to be applied to how projects receiving support under the RO interact and are kept "whole" relative to those that will be supported under a future FiT. It is essential that these arrangements are clarified as quickly as possible to ensure that uncertainty is minimised for projects negotiating, and entering into, power offtake agreements now.

25. The carbon price support proposals (based around the removal of Climate Change Levy exemptions currently applied to fossil fuel generation) must be compatible and consistent with the existing EU ETS arrangements. We would seek that Government ensures that the levels of taxation within the new levy on fossil fuel generation are consistent with the price of carbon being targeted.

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

26. The proposals for supporting the carbon price contained within in the Treasury consultation published alongside the EMR appear feasible.

27. It is for Government to determine the level of carbon price support that will encourage investment in low-carbon technologies. It is crucial, however, that the aggregate level of support from all the reforms is considered, in order that inappropriate levels of financial support are not granted to developers. We would also seek that the process for determining the level of support is transparent and robust.

28. We note Government’s proposal to introduce carbon price support through taxation, by removing existing exemptions from the Climate Change Levy, and as such will impact generation in both GB and Northern Ireland. Northern Irish generation participates in the Irish Single Electricity Market and we will be monitoring Treasury’s proposals with interest to better understand the consequent impacts on both UK and Irish generation.

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?

29. We welcomed Government’s recognition of the possible role that increased interconnection could play in the future generation mix. Interconnection between markets has been shown to deliver significant benefits to other European markets. These benefits relate in particular to security of supply in areas of high renewables penetration and economic price discovery as price arbitrage occurs between the markets. As a company with generation assets in other European markets, we are particularly interested to explore how interconnector flows into and out of the GB market will be treated under the envisaged GB capacity mechanism.

30. I hope the Committee finds these comments useful. Should you have any questions or wish to discuss any of the issues raised in more detail, please do not hesitate to contact me

Yours sincerely,

Martin Read

UK General Manager

ESBI Investments

Email: martin.read@esbi.ie

By e-mail

January 2011