HC 742 Electricity Market Reform

ENERGY AND CLIMATE CHANGE COMMITTEE

ELECTRICITY MARKET REFORM: A CALL FOR EVIDENCE

A RESPONSE BY DRAX POWER LIMITED

JANUARY 2011

EXECUTIVE SUMMARY

· Meeting Government’s policy objectives on security of supply, the decarbonisation of electricity generation and affordability to end consumers should be the focus of the reform package;

· Drax believes that these objectives are best achieved by maintaining adequate generation capacity margins, promoting adequate investment in low carbon generation technologies, addressing the relative competitive positions of the various market participants and promoting greater wholesale market liquidity;

· Drax believes that specific measures raised by the Electricity Market Reform (EMR) consultation have the ability to achieve these objectives, such as a capacity mechanism and a Contract for Difference (CFD) Feed-in Tariff (FIT);

· An appropriate capacity mechanism would:

o ensure there are adequate returns for making capacity available to the market, thereby avoiding early closure of existing plant; and

o provide medium-term signals for investment in existing and new flexible plant, which ensures the most efficient investment prevails, lowering the cost to end consumers;

· However, there are a number of considerations that must be addressed when designing a capacity mechanism in order to avoid unintended consequences, such as the premature closure of existing flexible plant to the detriment of security of supply;

· Drax advocates a capacity mechanism that rewards the provision of flexibility services, particularly in the light of the anticipated high penetration of intermittent and inflexible generation capacity over the next decade;

· A serious shortcoming of DECC’s preferred approach is that it focuses purely on extreme peak demand, neglecting the importance of flexibility in securing supply;

· Drax supports the CFD FIT approach to renewables support as it provides investors in such technologies with greater revenue certainty by agreeing a contracted strike price, whilst avoiding windfall profits for generators and ensuring excess revenue due to high market prices is returned to end consumers; and

· Drax believes that the carbon price support mechanism is unnecessary as it is an economically inefficient tool that supports specific technologies whilst simultaneously distorting the wholesale market; in particular, there is a concern over the conflict that would exist between the proposed GB specific Carbon Price Support and the existing EU Emissions Trading Scheme (EU ETS).

INTRODUCTION

1. Drax is predominantly an independent power generation business responsible for meeting some 7% of the UK’s electricity demand. The Company also owns Haven Power, a small electricity supplier serving the needs of business customers.

2. As the owner and operator of Drax Power Station in North Yorkshire, the largest, cleanest and most efficient coal-fired power station in the UK, Drax is committed to reducing the carbon footprint of UK power generation. To this end, in summer 2010 the largest biomass co-firing facility in the world was commissioned at the power station, providing the capability to produce 12.5% of the station’s output from renewable and sustainable biomass – equivalent to the output of around 600 wind turbines. In addition, the largest steam turbine modernisation programme is underway at the power station and is now just over two-thirds complete. Together these two initiatives will reduce emissions of carbon dioxide by over three and a half million tonnes a year, which is a reduction of 17.5% compared to 2006 levels.

3. Drax is pleased to have the opportunity to participate in the Committee’s inquiry on EMR. As a provider of flexible generation to the System Operator and an investor in renewable electricity generation from biomass, Drax believes it is well placed to comment on the key issues of a capacity mechanism, Feed-in Tariffs for renewable technologies and a carbon price support mechanism. Drax is still assessing the benefits and risks of the EMR proposals, however, it is encouraged by the holistic approach taken by DECC.

A CALL FOR EVIDENCE

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

4. The EMR project should focus on reform of the GB electricity wholesale market arrangements in order to ensure that the correct framework is in place to deliver the Government’s key policy objectives, namely security of supply, the decarbonisation of electricity generation and affordability to end consumers. This can be best achieved by:

· maintaining adequate generation capacity margins to ensure security of supply;

· ensuring there is an adequate level of investment in low carbon generation by providing investors with a greater level of certainty over their investment returns;

· addressing the competitive imbalance between vertically integrated and independent generation and supply companies; and

· promoting greater liquidity, competition and tenure of contracts within the wholesale electricity market.

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

5. It should be recognised that significant investment is needed to meet future peak demand and flexibility requirements, despite relatively low forecast demand growth over the medium-term. The closure of 20GW of flexible plant and 7GW of nuclear plant is scheduled by 2020, with the connection of 25GW of intermittent wind capacity expected over the same period.

6. When designed correctly, capacity mechanisms do offer a realistic way of achieving greater energy security. This is best achieved by:

a) ensuring there are adequate returns for making capacity available to the market, thereby avoiding early closure of existing plant; and

b) providing medium-term signals for investment in existing and new flexible plant, which ensures the most efficient investment prevails, lowering the cost to end consumers.

Neither of the above is provided by the current energy-only market arrangements.

7. In addition, reduced availability of existing flexible plant is also expected over the next decade, due to environmental legislation and more onerous operating regimes. However, it should be noted that the need for flexible plant has not diminished because:

· typically, demand increases by up to 50% on a winter morning between the hours of 5am and 9am; and

· by 2020, the most extreme hour-to-hour change in demand net of wind output could be as much as 17GW [1] , which is a significant increase from the maximum variation of 5GW in 2009.

8. In order for capacity mechanisms to be successful, they must address the risk of flexible plant closing prematurely. Early closure could be caused by:

· the reduction in wholesale market liquidity as the volume of capacity that is subsidised increases in a market that already suffers from low liquidity:

o this increases the risk of the market not valuing flexibility in the power price;

· reduced load factors for thermal plant as they fulfil a "flexibility" role, rather than the traditional baseload generation role; and

· increased hour-to-hour variation in output due to the incentivised growth of intermittent (i.e. wind) and inflexible (i.e. nuclear) generation.

9. A well designed capacity mechanism would ensure that the value of both capacity and energy is transparent to all investors in the market, promoting a competitive and efficient wholesale electricity market.

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

10. In order to deliver efficient investment in flexible capacity, thereby creating the least cost to the end consumer, the capacity mechanism must provide signals to the market that allow both new and existing plant to compete. DECC’s preferred approach to a capacity mechanism, as set out in DECC’s EMR consultation document, does not provide existing plant with the appropriate signals to deliver security of supply services. The proposal could force existing flexible thermal capacity to close prematurely, when such plant could be the most efficient investment option to provide peak demand and flexibility services.

11. DECC’s preferred solution appears to only focus on a peak demand scenario, neglecting to address the looming issue of flexibility in low demand periods. Given the Government’s policy to incentivise investment in a large volume of intermittent (i.e. wind) and inflexible baseload (i.e. nuclear) generation capacity over the next decade, it is essential that the capacity mechanism addresses both capacity demand extremes and flexibility requirements. The technical characteristics of certain plant (e.g. the ability to quickly increase or decrease output) makes them more suitable for providing flexibility services than others; it will be crucial to maintain a sufficient level of flexible plant to respond to sudden changes in demand or intermittent plant output.

12. The preferred approach outlined in the EMR consultation    document requires a central body to determine the difference between a capacity demand forecast and a capacity availability forecast, in order to determine the volume of capacity for which the mechanism will contract. These figures are notoriously difficult to forecast, which, in turn, makes forecasting the difference between the two particularly difficult. The longer the term of the contracts in the proposed capacity mechanism, the less likely it is to be accurate.

13. In addition, the options suggested in the EMR consultation are the two extreme solutions, i.e. a targeted approach that is limited to a small volume of Open Cycle Gas Turbine (OCGT) plant and an all inclusive (i.e. all plant) approach based upon a fixed capacity payment value. Whilst the consultation document critiques the difference in cost between the two approaches, it fails to recognise that there is the potential for models that fit between the two extremes that could deliver greater security of supply at an acceptable cost to the consumer, i.e. an approach that is open to all flexible generation plant, but takes an auctioning approach in order to contract with the most cost effective provider.

14. In Drax’s view, the capacity mechanism should be a centrally administered scheme, where a central body takes a decision on the total volume of capacity required (i.e. the forecast total capacity requirement; similar to DECC’s proposed solution). To meet the forecast total capacity requirement, the scheme would be open to all plant (new and existing) and should be based upon two to five year contracting periods. This would allow the mechanism to focus on a range of plant types, providing a solution to both peak demand and flexibility requirements.

15. It would also reduce the risk of over or under contracting by making the forecasting of future requirements more straightforward (i.e. calculating the total requirement only). This would mean that rather than there being a focus on investment in a new generation of OCGT plant, market participants should continue to take decisions on the most appropriate investment option, such as whether to invest in new plant or to upgrade and decarbonise existing plant.

16. Drax believes it is potentially inefficient to build a capacity mechanism around an assumption of the type of plant required. For example, the traditional "last resort" peaking plant in the UK has been OCGT, which run for around 30 minutes on a few occasions per year; however, this was against a background of coal and gas fired generation, whereas the future generation mix will be dominated by wind and gas. This raises a number of questions including:

· are OCGT (gas or oil) plants appropriate to provide this service given their low efficiency and high level of carbon emissions?

· will the high volume peaking capacity (currently supplied by large oil fired plant) still be required? and

· will GB, in fact, need a greater volume of total capacity?

17. A capacity mechanism that is available to all types of plant capable of providing reliable flexibility services, and is based upon clear investment signals set by a central body, would allow the market to provide the most efficient and flexible solution to issues encountered by both extreme demand periods and changes in intermittent generation output in low demand periods, at the lowest cost to the end consumer. Government policy objectives will ensure that such plant is incentivised to decarbonise, in order to continue to be competitive and remain on the system.

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

18. Drax believes that FITs should be available to all types of renewable generation technologies. Drax believes that all support models, whether for renewable and / or low carbon generation technologies, should be designed in a way that promotes wholesale market liquidity. It is essential that all generation technologies continue to participate in the wholesale electricity market in order to ensure that all plant continues to respond to fundamental market signals and to avoid perverse actions from generators that are immune to the consequences of their actions.

19. It is essential that the chosen subsidy model provides renewable generators with the support they require when prices are low, but avoids providing windfall profits to both new and existing plant when prices are high. The design of the CFD FIT approach (the preferred option in DECC’s EMR consultation) provides both of these benefits by recouping windfall profit from generators and passing the benefit straight back to consumers via their bills.

20. Furthermore, Drax supports the movement away from the current support mechanism (the Renewables Obligation (RO)) to a mechanism that provides greater revenue certainty and ensures that the full value of the subsidy reaches the investor, removing a significant investment barrier currently faced by independent generators and new entrants.

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

21. Whilst it is tempting to take a "big bang" approach to reform, there are a number of issues that must be taken into account, such as the complexity of the current arrangements, the nature of industry contracts, commitments already made to investors (such as grandfathering or guaranteeing a level of support under the RO) and the fact that differing types of plant may require support at differing points in time (e.g. new nuclear capacity will not be delivered until around 2020 at the earliest, therefore only requires certainty of support before that time, not support itself).

22. Drax supports a transitional approach that ensures:

a) urgent fundamental market reform occurs sooner rather than later:

o provision of greater certainty over renewable generation investment returns;

o a capacity mechanism to ensure the network retains much needed flexible reserve capacity;

o the need to address the balance of competition between different types of energy company (i.e. those that are vertically integrated and those that are independent); and

o measures to improve wholesale market liquidity;

b) support is provided / introduced in line with investment timescales:

o investment support mechanisms are required now to support technologies that can be deployed and utilised now; and

o investment support mechanisms for low carbon plant that cannot be deployed now should be put in place in line with delivery timescales (i.e. CCS and new nuclear is expected to arrive around 2020);

c) transitional arrangements are put in place where contracts and commitments currently exist:

o the current RO must continue alongside FITs for those investments that are operational / under construction;

o the transition process between schemes should be notified as soon as practicable in order to avoid a detriment to investor confidence; and

o consideration must be given to the nature of the market:

§ trades may be contracted a number of seasons ahead; and

§ industry participants may have existing contracts in place that span multiple years, where it may not be possible to pass on new costs.

23. The implementation approach taken by DECC must provide certainty of longevity and allow sufficient time for the relevant industry codes to be modified.

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

24. Whilst Drax advocates stable and enduring market arrangements, there are a number of major issues that exist in the current market structure that must be tackled now.

25. Market reform measures must concentrate on creating a competitive and liquid wholesale market, with a renewable subsidy regime that provides certainty to investors and their financiers. It is essential that the market arrangements in place over the next decade encourage investment in low-carbon technologies, whilst maintaining a sufficient level of efficient, flexible thermal capacity to ensure security of supply.

26. If market intervention does not occur now, it is highly likely that inefficient investment decisions will be taken and regulatory uncertainty will remain. Drax believes that change to the current market arrangements is unavoidable if the Government is to encourage greater levels of investment to achieve its policy objectives.

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?

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

27. Drax believes that the Carbon Price Support is unnecessary; it is an economically inefficient tool that supports specific technologies whilst simultaneously distorting the wholesale market. Drax is concerned over the conflict that would exist between the proposed Carbon Price Support and the existing EU Emissions Trading Scheme (EU ETS). The Carbon Price Support is a unilateral measure taken by the Government on a European-wide market, where there is currently a mechanism in place to support the price of carbon allowances (i.e. the EU ETS cap). Drax continues to believe that the price level of carbon allowances should continue to be determined by the market, which in turn is driven by the EU ETS cap.

28. As the level of interconnectivity increases between GB and other EU Member States, it is imperative that those investors that have sites in GB are not placed at a competitive disadvantage to those sited in mainland Europe. If such a competitive disadvantage were introduced, this could lead to investment being redirected to other Member States, with GB becoming more reliant upon imports of energy in order to meet national demand.

29. There is a further conflict between the proposed Emissions Performance Standard (EPS) and current European directives that have been put in place to tackle exactly the same issues. The EPS is an unnecessary layer of legislation that will be introduced alongside the existing Large Combustion Plant Directive (LCPD) and Industrial Emissions Directive (IED); each of these directives define emissions standards for electricity generation plant.

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

30. A carbon floor price will only be feasible if it:

· only benefits new low carbon investments, i.e. it does not provide a windfall to plant that is already operating;

· only applies when the new plant that the mechanism is attempting to incentivise begins to generate electricity and not before;

· is set at a level that provides ‘certainty’ and not subsidy; and

· it does not dissuade the much required investment in GB.

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?

31. If the separate elements of the EMR project are carefully designed, the final package could have the potential to:

· create a competitive and liquid market that encourages new entry and innovation;

· place all generators located in GB (and partaking in the wholesale market) on the same footing as those generators located in mainland Europe; and

· promote greater consistency between European wholesale markets, thereby encouraging market linking, interconnectivity and competition.