HC 742 Electricity Market Reform

Energy and Climate Change Committee’s call for evidence on
Electricity Market Reform
Submission by International Power Plc

(I) About International Power plc

IPR welcomes the opportunity to contribute to the Energy and Climate Change Committee’s call for evidence on the Electricity Market Reform (EMR). HMT and DECC published formal Consultations on EMR in December 2010 so our response to the questions posed in this Inquiry may change following detailed analysis of the Government’s proposals.

International Power Plc (IPR) is a global independent power generation company with interests in over 34,000 MW of generation capacity in 21 countries. This includes approximately 5000 MW of plant in the UK market where, in partnership with Mitsui & Co., it owns and operates the coal fired station at Rugeley, Deeside Power CCGT, Saltend Cogeneration Plant in Hull, First Hydro Pumped Storage Stations at Dinorwig and Ffestiniog in North Wales, and Indian Queens peaking plant in Cornwall; the company also has a share in Derwent Cogeneration plant. These assets represent a 7% market share, making IPR one of the country’s largest independent power producers.

IPR is one of the world’s top 10 owners and operators of wind farms with an installed capacity of 1340 MW, much of which is in Europe. The company is keen to develop its renewable portfolio further and is involved in a range of projects in the UK as part of this strategy.

(II) Summary key points

§ Market reform must focus on delivering a viable electricity system in 2030, and on maintaining the system during the intervening period; it is also vital that a competitive framework is retained.

§ The UK’s electricity mix should evolve in concert with that in other European countries to maintain economic competitiveness.

§ On the creation of a carbon price floor – bearing in mind there are specific market reform proposals to subsidise all low carbon generation, the priority must be a mechanism that delivers the least extra cost to the sector and the consumer.

§ On the adoption of Emission Performance Standards – in light of existing and new emission reduction regulation, Emission Performance Standards are an unnecessary regulation.

§ On low carbon support mechanisms – If the objective is to deliver a mix of low carbon technologies, each with its own cost structure and benefits, it will be necessary to offer different tariffs for different technologies.

§ The significant reduction in risk for all new low carbon generation may well deliver the carbon savings being sought by Government, but at a higher cost to the consumer than might otherwise be the case, and to the possible detriment of the rest of the electricity sector.

§ On capacity payments – such a mechanism will be required to provide sufficient plant availability and flexibility at all times to ensure security of supplies, particularly in a sector that has a very high penetration of intermittent renewable, and large inflexible nuclear plant.

(III) On the Questions posed in the Call for Evidence

Q1: What should the main objective of the Electricity Market Reform project be?

1. The main objectives of the Electricity Market Reform process must be to maintain security of supply and help the UK meets its climate change obligations, both at a cost the country can afford.

2. The UK has led the way on electricity and gas liberalisation in Europe over the last 20 years. The main driver for this transformation was a desire for greater efficiency across the industry and cheaper bills for consumers - it is fair to say that the market has delivered on these objectives and it is important that a competitive framework is maintained in the future.

3. With time, a number of other objectives beyond competiveness have also become more important - the need to address climate change, maintaining security of supply, and the renewal of an ageing infrastructure. In the current austere times, the need for investment, and maintaining and creating new jobs is also high on the agenda.

4. Today, there is a view that Government interventions in the market are needed, primarily to ensure decarbonisation of the electricity mix. IPR believes there should be emphasis on the market as a whole, and on establishing all the attributes needed for a viable industry and competitive framework. Armed with this knowledge it is possible to determine the market structure that can best deliver these attributes, and at the same time ensure the ‘health’ of the industry in the interim period to 2030 and beyond.

Q2: Do capacity mechanisms offer a realistic way of achieving energy security, low-carbon investment and fair prices?

5. Yes - a capacity mechanism is essential to facilitate the integration of around 30GW of wind generation needed to meet the 2020 renewables target and this conclusion is based on the following observations:

§ As new, subsidised low carbon generation capacity is commissioned, wholesale prices are likely to be more volatile in the short term and depressed in the longer term. Price spikes have traditionally occurred at times of high demand but as wind penetration increases, the relevance of a demand peak to the market will be diluted, with prices being driven more typically by the prevailing amount of wind generation. It will therefore also be increasingly more difficult to predict pricing patterns and anticipate capacity needs.

§ As noted by the Climate Change Committee in their Fourth Carbon Budget Report "decarbonisation will also increase the level and the variability of demand, through the electrification of heat and transport. In particular, demand for electricity from the heat sector could add significantly to the need for flexibility by increasing the variability, seasonality, and peakiness of electricity demand".

§ The risk profile surrounding the profitability of fossil generators will change significantly. Fossil generators will potentially have to recover their costs and a sufficient return over a much shorter period of running [1] . It will be very difficult for flexible plant to fully capture the unpredictable price ‘spikes’ and earn a sufficient return to cover fixed and variable costs.

§ Whilst the current energy-only market has delivered significant investment over the last 20 years, it was not designed with these increasing levels of subsidies and intermittency in mind. There will be a fundamental shift in the relationship between capacity and energy across the energy system, with a very significant tranche of capacity operating at very low load factors.

6. IPR’s view, supported by a number of industry commentators, is that a capacity-based mechanism will be required to provide sufficient plant availability and flexibility at all times to ensure security of supplies. This capacity mechanism is distinct from a low carbon support mechanisms or carbon floor price, both of which provide incentives to address the Government’s low carbon investment agenda.

7. DECC favours a targeted capacity mechanism - IPR does not believe this is appropriate. The Brattle Group undertook an extensive study of worldwide capacity market designs [2] and noted that:

….administratively, limiting payments to new plants…. constitutes an out-of-market mechanism….. The additional capacity maintained through such payments will create or prolong the "missing money" problem for all resources that are not receiving the special payment…. the need to extend such payments to existing generation will quickly grow as the suppression of energy market prices forces existing resources into retirement unless they too receive the additional payment.

In essence a targeted payment will create a "slippery slope" as referred to by DECC in the EMR consultation; the central body has to procure ever more generating capacity. Whilst in the short term a targeted mechanism has its attractions, in the long term costs are likely to be higher due to the market distortions a targeted mechanism will create.

Q3: What is the most appropriate kind of capacity mechanisms for the UK?

8. IPR believes a capacity mechanism should have the following basic characteristics:

§ to avoid picking winners, it should be universal; the RO/FITs, support for CCS, and the carbon floor price, if implemented, will each provide a ‘targeted’ subsidy;

§ it should avoid exacerbating the current level of vertical integration. This criterion rules out a supplier based capacity obligation as under this mechanism, suppliers would self-contract first and only go to market to meet their residual capacity need;

§ it should provide a forward price for the value of capacity and reward availability at the ‘net demand’ peak (i.e. demand net of wind generation);

§ it should allow for genuine demand side participation;

§ it should provide an appropriate and common penalty mechanism for non-availability. This would encourage the required flexibility and reliability; and

§ the costs of the capacity mechanism should be paid for by end consumers since they are the beneficiaries of incentivising security-of-supply.

9. To meet the above criteria, a long-term centrally administered capacity mechanism is most appropriate. Such capacity mechanisms have been in operation elsewhere – IPR believes two could be suitable: the Pennsylvania, New Jersey and Maryland (PJM) market in North East USA and the capacity mechanism within the All Ireland Market (AIM). Both could form the design basis for a GB capacity mechanism. Of the two, the AIM mechanism is the simpler and can more readily be adopted alongside the existing BETTA arrangements.

Q4: Should the system of Feed-in Tariffs be focused on particular technologies or maintain a wider technology-based view?

10. Government proposals in the DECC Consultation are for a mechanism that subsidises all low carbon generation: renewables, nuclear and in time, fossil with Carbon Capture and Storage. If the objective is to deliver low carbon generation at least cost to the consumer a single FIT is the most appropriate. If there is a desire to deliver a mix of low carbon technologies, each with its own cost structure and benefits, it will be necessary to offer different tariffs for different technologies.

11. However there are some potential unintended consequences in providing subsides for all low carbon generation. The complete removal of risk from new low carbon generation may well deliver the carbon savings being sought by Government, but at a higher cost to the consumer than might otherwise be the case, and to the detriment of the rest of the electricity sector - e.g. by reducing the wholesale power price - perhaps leading to early closure of valuable UK generation.

12. Item (4) above stresses the importance of ensuring that all attributes associated with a viable electricity system are incentivised - this does not necessarily require the same mechanism across all technologies, rather a package of economic instruments that best suit the range of attributes needed, whether it is low carbon, stand-by generation, flexible plant, or fast-response facilities. Feed-in Tariffs have a role to play but so do other mechanisms including capacity payments.

13. As indicated earlier the Government has indeed proposed a package of measures in its recent Consultation documents on the creation of a Carbon Price Floor and Reform of the Electricity Market. The only concern at this stage is the question of whether more than one economic instrument is needed to support the low carbon sector as is being proposed by Government.

Q5: Will it be feasible to deliver EMR in one go, or will regulations and implementation be spread over time?

14. The Emission Performance Standard (EPS) is independent of the other pillars of the EMR and could be implemented at any point in the future. If an EPS is adopted then it should only apply to new coal plant.

15. The remaining parts of the EMR can be implemented separately although the regulations need to be delivered at the same time or at the very least developed in parallel to ensure they work together and minimize costs to consumers. For example, setting the level of any FIT will need to take account of the level of the carbon floor price and the carbon floor price will need to take into account the prevailing wholesale price and the income being earned from a capacity payment mechanism.

16. With ROCs/FITs providing the necessary subsidy for renewables, a carbon floor price is clearly targeted at nuclear generation and potentially CCS. On the expectation that the first nuclear power station is realistically not generating until around 2020, a carbon floor price is not needed until then. If brought in before this date, the floor price will merely create windfall profits for existing low carbon generation. However, its introduction could be signaled far in advance in order to provide the appropriate investment signals, and some stability, for all types of generation. There is nonetheless the question of whether, in light of the proposals to subsidise nuclear through a FIT mechanism, a carbon price floor is needed at all.

17. By the start of 2016, 12GW of plant opted-out of the Large Combustion Plant Directive (LCPD) will have shut as well as Wylfa and Oldbury nuclear stations. The remaining coal plant will be subject to reduced operating hours unless they fit Selective Catalytic Reduction to reduce NOx emissions to comply with the Industrial Emissions Directive [3] . Also, over the next decade or so some of the AGR nuclear power stations may close. Introducing a capacity mechanism would aid investment decisions at this point when capacity shortfalls are expected to become apparent. Again the introduction and design of the capacity payment should be well signaled to aid investment decisions.

18. Replacing ROCs with FITs could happen at any time but needs to be signaled well in advance to allow renewable developers to know at project financing stage which mechanism will be providing the renewable subsidy. The linkages between a new scheme and the RO also need to be clearly defined in order that grandfathering for existing projects is made effective.

Q6: Will market reform increase political risk for investors or create certainty?

19. Regulatory risk is arguably one of the most important considerations for market participants, not only for new investment decisions but also for existing assets where financial decisions were taken in the prevailing regulatory regime. Existing and new investments must be considered when assessing risks associated with potential new market arrangements.

20. Government interventions such as those being proposed in the EMR are likely to transform the market and as such create considerable uncertainty for all stakeholders. This will remain the case until the Government delivers its new market arrangements.

21. The way in which the new arrangements will be implemented and, in particular, the potential for further interventions will also increase uncertainty. Government must decide, with all the market participants, what is needed for the market over the long-term, and then implement the changes in a timely and predictable manner.

Q7: 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?

22. International Power agrees that a package of measures is needed to meet the goals on climate change and security of supply – the difficulty will be to ensure the measures being proposed deliver at least cost to the consumer. This is best achieved if:

§ duplication in measures, such as the creation of a carbon price floor and CfD/FiTs mechanisms to reduce risk for low carbon technologies, are avoided;

§ unintended consequences, such as ‘windfall’ profits for existing low carbon generation that would occur from a broad based ‘carbon tax’ on fossil fuels, is avoided;

§ unnecessary regulation such as Emission Performance Standards is avoided;

§ market solutions continue to be promoted in order to deliver efficiencies, maintain equilibrium with other European markets, and deliver improved levels of competition.

23. IPR believes the EMR should also address liquidity - healthy levels of liquidity are highly desirable in the market, and will in any case be needed to ensure a robust reference price for the CfD FITs mechanism being proposed to incentivise new low carbon generation. Since each of the six Vertically Integrated (VI) companies have a broadly balanced generation and supply position, there is currently little imperative to trade in the market, resulting in low liquidity.

24. IPR would like to see a significant improvement in longer term market liquidity, particularly for less standard products such as peak and off-peak, as these markets are particularly ‘thin’. Improved price formation and market access are, for instance, important to independent generators looking to ‘hedge’ output forward at a fair price, and on timescales that are more consistent with availability of fuels.

Q8:  What synergies and conflicts will there be between proposed mechanisms and policies already in place?

25. The current ROC mechanism has a headroom calculation to ensure that the target is always ahead of the build rate. If new renewables receive their support via a FIT and existing renewables continue with ROCs, the headroom mechanism will need to be modified so that it can work alongside the FITs mechanism.

26. It is worth noting that the creation of a carbon price floor as described in the recent Treasury Consultation will deliver ‘windfall profits’ for all existing low carbon generation such as nuclear and renewables due to higher than anticipated wholesale prices.

27. There is also the potential for windfall profits for existing and new low carbon generation if gas prices and therefore wholesale prices rise (since gas generation tends to sets the marginal price) beyond that assumed when the carbon price floor was set. The level at which the carbon price floor is set then, should also take into account the prevailing wholesale price for electricity i.e. the carbon price floor should be linked to the wholesale price such that the former declines to the market price for carbon as wholesale prices rise.

28. The support being proposed for all low carbon generation, and the creation of a carbon price floor will undermine confidence in the EU Emissions Trading Scheme, the Government’s declared principle instrument for emissions reduction.

Q9: Will a carbon floor price be feasible in the context of EMR and at what level should it be set?

29. The Governments original reason for the creation of a carbon price floor was to reduce the risk of a low carbon price (and therefore a low pass-through to the wholesale price) for nuclear and other low carbon generation. In the event, the Government now proposes to establish a mechanism in the Contract-for-Difference or a premium Feed-in Tariff to subsidise the economics of nuclear and other low carbon generation; in light of this, the economics of low carbon generation is assured and we believe it is no longer necessary to create a carbon floor price.

30. Also, the creation of a carbon price floor will undermine the EU Emissions Trading Scheme in the UK, the Government’s declared principle instrument for emissions reduction. Further, a carbon price floor is unlikely to be adopted elsewhere in Europe putting UK industry at a competitive disadvantage.

31. However if the Government chooses to go ahead with the creation of such a mechanism:

§ it should only apply when new low carbon plant begin operating, thus minimising the potential for windfall profits to existing nuclear and renewable generation;

§ the carbon price floor should be set at a level that provides ‘certainty’ and not subsidy, and minimises the chances of ‘windfall’ profits. This could be achieved by delaying its introduction to align with the expected commissioning of the first new nuclear power station;

§ The carbon price floor needs to be linked to the wholesale price, again to avoid ‘windfall’ profits to new low carbon generation as discussed in item 27 above.

32. Bearing in mind there are specific market reform proposals to subsidise all low carbon generation, the priority must be a mechanism that delivers the least extra cost to the sector and the consumer. The priority must be a mechanism that delivers the least extra cost to sector and the consumer.

Q10: 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?

33. IPR owns and operates Dinorwig and Ffestiniog pumped storage power stations in Snowdonia, representing 2088 MW of capacity in the GB market.

34. There are no specific proposals on storage in DECC’s consultation, nor any detailed assessment of the economic value that it can provide for a low carbon plant mix. Notwithstanding this, the natural synergies with intermittent generation tend to support the view that there is some long-term potential for economic development of new storage schemes, perhaps with more significant energy backing than the existing schemes which were primarily built for rapid response services rather than wind-related storage.

35. There are however conflicting pressures on storage emerging from the EMR process:

§ the viability of storage is driven by the value in price arbitrage in peak to off-peak, taking account of the inherent cycle efficiency of the storage technology. If the EMR is successful in delivering new low carbon investment, the traditional pattern of prices in these periods is likely to change significantly, with less certainty over the timing and extent of peak and off-peak periods and more day-to-day volatility. Whilst storage can benefit from price volatility, the uncertainties over the nature and price impact of market interventions may undermine some of these benefits;

§ currently, low load factor pumped storage plant faces large capacity-based costs (e.g. business rates, Transmission Use of System charges) and needs to earn revenues via an energy-only market (alternatively contracts for reserve can be tendered via the system operator.) The potential introduction of a capacity market has the potential to improve the economics of storage, and bring forward new development initiatives;

§ the introduction of a carbon floor price is a negative factor. It is likely to directly reduce the energy margin available to storage technologies.

36. These schemes typically entail high capital costs, long lead times, and significant construction risks. It is therefore important the future pricing environment is well understood in order to establish whether any additional development is needed from an economic standpoint – for example, as implied in the question, any requirement for storage can be reduced through increased interconnection, particularly with Europe. The EMR will be helpful in providing more certainty on the future shape of the market and therefore whether there is an economic case for more storage. International Power intends to undertake more work on this issue.

For further information please contact:

Dr Steve Riley

Executive Director - Europe

Telephone: 0207 320 8682;

Email address: steve.riley@ipplc.com

January 2011