HC 742 Electricity Market Reform

Electricity Market Reform

Submission by Welsh Power Group

Introduction

1. Welsh Power Group (WPG) is a privately owned energy company with a strong track-record in development, in both conventional and renewable energy.  In August 2009 Welsh Power submitted an application to develop Wyre Power, an 850MW CCGT (combined-cycle gas turbine) power plant near Fleetwood, Lancashire, with an investment of some £600 million.  In January 2009 the Company commenced the development of a 49.9MW biomass plant at Newport Docks through its wholly owned subsidiary Nevis Power Limited.  We also own and operate an OCGT, Leven Power, on a STOR contract to NGC.

2. Formerly, WPG owned and operated Uskmouth Power until its sale last year to SSE. It also developed Severn Power, a new 850MW CCGT plant in South Wales, which it subsequently sold to DONG Energy. WPG also started its own retail business, Haven Power, in 2007, but this has subsequently been bought by Drax.

3. WPG has significant experience of the problems experienced by small independent players trying to operate in the GB electricity market and we welcome the Committee’s inquiry into the proposed reforms. Outlined below are our comments on the areas outlined in the terms of reference, along with a few other observations. We would be very happy to talk to the Committee about any of these issues if that would be helpful

Issues Not Addressed by Electricity Market Reform Proposals

4. WPG believe that the GB electricity market is fundamentally broken with illiquid markets, dominated by six large, integrated companies, and significant barriers to entry to each part of the market. WPG has significant experience of the problems caused by the illiquid GB power and they have shaped the way that our business has developed. It is extremely disappointing that the DECC document pushes resolving the problems back to Ofgem, who have been ignoring the issue for years.

5. Concerns about market liquidity have been raised by traders and suppliers for years, and Ofgem’s own corporate strategy in 2005 recognised that vertical integration needed further consideration. The Select Committee on Business and Enterprise in December 2008 said: "We welcome Ofgem's decision to take action to improve liquidity in the wholesale electricity market." We therefore feel that Ofgem must have recognised 2 years ago that action was required and they should now be seen to do something rather than focus on monitoring and reporting.

6. As there is now wide recognition that the market is not liquid action is required to fix it. DECC outlines proposals Ofgem has put forward, but progress needs to be made. Ofgem’s "wait and see" attitude is simply not likely to deliver timely changes to the market. Furthermore Ofgem seems to push ahead with projects that the smaller players do not value, such as a full review of transmission charging, rather than concentrate efforts and resources on key problem like market liquidity.

7. In terms of some of the claims made by the big 6 about their level of trading, we would be interested to know if Ofgem has audited the trading of one or two of those companies to see who they trade with and how. We would be concerned that their "trading" is very limited, in terms of volume, products and counter-parties.

8. WPG believe that Ofgem should also ask to see the financial models that justify some of the new build projects (notable new nuclear) proposed by the big 6, as we cannot see how with current prices, and no liquid forward curves, these utilities are justifying any new investment. As developers ourselves we know that the forward curves make justifying new projects extremely difficult, so is it that the big 6 can hedge the power price risk directly into their supply business?

9. Ofgem seems very focused on cash-out prices, with a proposal to undertake a significant code review in this area (see comments below). We do not believe that there is any evidence that cash-out causes any greater problem than incentivising the suppliers to be long to manage their cash-out risk. The wholesale market does not reflect the cash-out prices, nor should it, and the market does not want to use cash-out as an index to trade around. There is no easy answer to cash-out calculations and compared to the lack of liquidity in the market it is a minor issue. Ofgem needs to be careful not to tinker with balancing rather than address the more fundamental, structural issues.

10. WPG would like to see the government or Ofgem refer the big 6, or the sector as a whole, to the Competition Commission for a full structural review. The only way that the generators will bring more power to market is if they do not own supply business or they are not allowed to sell to any supply businesses with which they have any shared ownership. We believe a licence condition to stop generators selling directly to their supply businesses would be a quick and easy step towards changing trading requirements. WPG would propose that Ofgem bring forward draft licence changes with their remedies document later in the year or the government could implement changes with the legislation that is likely to follow this market review.

The Objectives for Reform

11. WPG recognises that the government’s drive to low carbon electricity market does require some consideration to be given to the way the market is structured and operates. We feel that there are specific elements of the market that face new challenges with the emergence of increasing amounts of intermittent generation and new, larger, nuclear power plants. That said we are not convinced that the main problem is the structure of the rules so much as the existence of dominant players who create barriers to entry and gain commercially advantage from their integrated nature. We are extremely disappointed that structural remedies are being left with Ofgem to pursue at their leisure.

12. The objectives of the reform should be:

· To address the dominance of the big 6;

· To check that the current rules (Balancing and Settlement Code and Grid Code) will treat all plant equitably while facilitating the roll out of lower carbon generation;

· Not create further complexity unless it alters the incentives on players to significantly change their behaviour;

· Put in place a stable market framework for the future where the regulator will not push for further radical change in the medium term;

· Better define the role of Ofgem and government in setting future energy policy; and

· Stop yet another cash-out review until Ofgem can demonstrate there is a problem.

Capacity Mechanisms

13. WPG believes that the GB market already has a mechanism for delivering new capacity in the form of the National Grid STOR contracts [1] . These contracts, now they are being made for longer periods (up to 15 years), offer the market a way to encourage new build at competitive prices via an open tender process. WPG agreed with National Grid that there is a longer term requirement to increase the reserve on the system. But in terms of a supply demand balance the market should be competitive enough to respond. There is significant evidence [2] that enough capacity will be built to meet general demand levels, replacing aging plant, what seems to be missing is the reserve element in the market.

14. National Grid needs reserve to manage the pick-ups in demand where fast response is required, for example at lighting up time, when wind farms lose the wind, or a large plant has a technical problem and drops off the system. The increasing amount of intermittent generation requires additional capacity be held in reserve to manage these real time system issues. The larger nuclear plants will also mean National Grid requires additional reserve as the new plants will be the largest plants on the system, so back-up must exist for when they trip off. These two factors are combining to require additional reserve is held by the system operator.

15. WPG will therefore be supporting the tender for targeted resource (TTR) option proposed by DECC which can operate just like STOR. We believe that any other form of reserve market creates the risk of the customers being forced to buy and pay for capacity that the market should deliver in a competitive manner. Customers at the last electricity market review in 2000 argued strongly against any mechanism that paid generators simply for being available. This was because all generators got paid, even if the system did not need them, and it could be argued that this lead to the excess generation capacity seen at NETA go-live in 2001.

16. This type of reserve capacity must be fast responding, but will only run for limited periods. The nature of the plant with low running, high wear and tear costs through peaking, and the only counter-party being National Grid, will not simply be built by the market backed by these long term contracts. Even if suppliers were required to show they had contracted for enough generation to meet their customers’ demand, they would not purchase these reserve style generators output. It is only the system operator who requires such services and it is more economic that they are purchased centrally as their benefit is spread over all customers.

17. National Grid in trying to extend the length of STOR contracts has recognised that without these longer term agreements financing such new build will be extremely difficult. However, the development of these longer term reserve contracts needs some further work. Notably:

· National Grid must structure a long term contract that works in the context of energy markets that will change in future years, i.e. they must be flexible;

· National Grid must outline what capacity it requires for reserve purposes and where it wants stations to locate, so the tenders are more likely to deliver the capacity that the system operator wants;

· Ofgem must agree with National Gird that the prices the capacity is bought at will be passed through in the years to come, i.e. a commitment to allow cost recovery in future price control periods/incentive schemes;

· If the government only wants capacity of a certain type (for example gas rather than fuel oil) for environmental reasons it needs to place that statutory requirement onto National Grid in a transparent manner; and

· National Grid needs to better understand the costs of this type of generation to ensure fair treatment of small providers facing a monopsony.

18. WPG would note that DECC believes that increasing customer participation in the market (as "negawatts") would be beneficial. While WPG welcomes all forms of competition in the market, the government must be realistic about how much demand wants to participate. Large customers currently respond to the TRIAD system, where their consumption in the three winter peak half hours dictates their transmission charges. This is an extremely effective mechanism and should be maintained. However, more active customer participation was one of the NETA design criteria. The customers do not seem to want to participate in the type of market created. This may be overcome with changes in market design, but we suspect the problem of managing their primary production while participating in the market will be extremely difficult to overcome.

Feed-in-Tariffs

19. WPG supports the introduction of feed in tariffs (FITs) as a more efficient mechanism that the current RO regime. However, it is the level of the FITs that will determine if it is a mechanism that will deliver larger amounts of renewables in time to meet the various government targets.

20. The technology banding has been a relatively successful way to try and reward renewable generators enough to get their technologies off the ground and to build up experience on the capital and operating costs of some cutting edge technologies. What matters most to developers however is the stability of the support mechanisms.

21. There was a hiatus of investment while DECC put out a decision on grandfathering ROCs for some technologies last year, notably biomass, and now there is concern that the banding review will alter the RO support in 2013. So developers who waited for the grandfathering decision may now have left it too late to ensure completion of a build by April 2013, so have to wait to see what support levels will be in 2013. While DECC have announced they will bring forward the banding review, such indecision and lack of understanding about the nature of these investment decisions is clearly hampering the roll out of additional capacity. The market will then move towards the FIT regime and again developers will want more details on FIT levels, cut over policies, grandfathering, etc. before progressing projects.

22. WPG would also note that we see no reason why Ofgem run these types of schemes. We recognise that Ofgem has ended up with the role of administrator, or delivery agent, of various policy tools such as the Renewables Obligation and FITs schemes. In the case of the FITs scheme we were disappointed that there was no competitive tender to select the most efficient and cost effective administrator. We believe such roles are best done by an organisation that delivers high quality IT solutions and government could consider hiving the E-Serve function off for sale, into HMRC or another existing body.

Delivery of New Market Rules

23. Experience with NETA suggests it is perfectly possible to deliver a whole new market in one go if the political will is there. The personal involvement of Ministers in pushing NETA forward was instrumental in forcing players who did not support change to go along with it. That said there may be some system changes that would be best phased in, notably any larger systems changes.

Market Risk

24. WPG believes that the government’s announced reforms could easily be seen as largely incremental changes. It has been unfortunate that so much has been made of the scale of change as this has clearly created uncertainty for developers and investors. The lack of detail in the policy proposals is also adding to risk, so the sooner the proposals are worked up the better.

25. WPG feels that the reviews being carried out by Ofgem, while getting less press coverage, actually represent a bigger market risk. The changes we are most worried about are:

· Project TransmiT [3] , with the potential to change all transmission charges and connection fees;

· The still yet to be implemented EDCM [4] charges in the distribution networks and the associated treatment of pre-2005 generators;

· The proposed review of cash-out prices; and

· The new powers to alter industry codes that Ofgem have given themselves [5] .

26. We are therefore very pleased that DECC is reviewing the role of Ofgem. WPG feels that it is right that government can propose change to the policy framework, but the role of Ofgem has become so unfocussed that it is now probably the greatest risk to our business.

27. WPG believes that Ofgem’s remit today should have three key roles:

· The management of the price controls and associated price regulation of the monopoly networks;

· The awarding of licences; and

· The administration of the codes that under pin the technical rules associated with the market operations and associated dispute resolution.

28. WPG believes that the government should abolish the GEMA (the Authority) style of governance. The Authority members have created several problems:

· Direct accountability of the CEO of the regulator has been eroded;

· Decision making is opaque (with Authority minutes being anodyne and published late and no papers available); and

· Costs have increased for no perceived benefit.

29. A good regulator acts in an open, transparent and engaging way, with all interest groups.  A strong and constructive partnership with those being regulated would be helpful and the Authority is too far removed for this to be possible or practicable. 

30. We hope that DECC will ask questions about how regulation of regulators is achieved and by whom. This is fundamental to a better structure of regulation going forward. Independence is one thing, but a regulator that is unchecked simply creates regulatory risk, thereby adding to costs and limiting market entry. Witnesses to the House of Lords Select Committee investigating Regulators stated that "there is a crucial need for greater parliamentary oversight … over regulation bodies". We recognise that the government needs the regulator to be independent, but that is not incompatible with rights of appeal and accountability of regulators to elected members of Parliament.

31. Once DECC has set out the details of the new regime in the power market and a new regulatory regime then the reforms could provide greater certainty than we have experienced in recent years. However, while Ofgem can continue to undertake policy reviews without any demand for change (from the market players or the customers) then significant risks remains.

Synergies and conflicts

32. Of the policies announced the government some pose more problems than others. Taking each in turn:

33. Floor price for carbon – this does represent a major change in taxation, but its implementation does not look obviously problematic. There are some definitional issues that need to be considered, such as where generators are not supplied fuel by "suppliers" who are meant to collect the tax. The government must also brace itself for the price rises that will follow the new tax. The HMT figures (based on no a nalysis, but market knowledge) look low given it is the marginal generators (coal and gas) that will face a significant increase in their costs.

34. Feed-in-Tariffs – This is a significant change, but the timescales look achievable and the use of FITs rather than ROCs is likely to deliver efficiency gains in the longer term. The conflict will arise when parties are unclear how the move to FITs will occur. Some questions we would have are: can we elect to go to FITs not ROCs; how will the supplier obligation work as ROCs phase out ; what are the support levels; is there going to be grandfathering; etc… The sooner these details can be worked out and communicated to developers the better.

35. Of the design options outlined , WPG believes that the CfD related FIT will offer the best value for money. We will need to wait and see the details of the strike price and how the scheme will be administered, etc. before we will know how difficult the implementation will be. As the RO will be maintained until 2017 there is no obvious rush to get the FITs in place, though most developers may welcome an early rather than late introduction.

36. Capacity Payments – As noted above, WPG believes that a mechanism could be delivered that simply builds on the existing market arrangements. This would be the TTR mechanism in the DECC consultation. If the government goes further, for example dictating the quantity , or even the specific types , of generation to be built there are far greater changes and the concept of free, open markets is being abandoned.

37. Obligations on Suppliers require licence changes and then some time for compliance. A capacity payment on all would require changes to, we assume, the BSC to create the payment and that will need significant system changes.

38. Emissions Performance Standards (EPS) If we assume that this is a mechanism that will operate under the environmental regulations and be overseen by the Environment Agency, it would seem to fit into the current regulatory regime. While the setting of the EPS itself may have significant impact on investment decisions , implementation of the regime itself would appear to work with current monitoring and reporting.

39. WPG is concerned that the EPS principle will be applied to large plants initially and then to smaller plants later. If this is the government’s intention, then it needs to say so now. As noted above, the types of generation that best act as reserve capacity often run on fuel oil and therefore have relatively high emissions, though only for short periods, when compared to say a gas plant. While there is debate around what emissions levels of all plants should be that creates uncertainty for investors. If smaller plants, such as reserve plant , needs to be gas plant the government should state that clearly . It will cost consumers dearly if new fuel oil plant is built that must later been abandoned. That said, we note the government’s intention not to apply the EPS to existing coal plant, so similar rules could be outlined for any future change in emissions standards.

40. Further proposals – WPG has serious concerns about the review of cash-out. This is an exercise that has been undertaken by Ofgem on a number of occasions. There have been numerous changes to the BSC altering cash-out since 2001 and endless industry meetings on the subject . There are two conflicting problems that Ofgem has raised and DECC mentions:

· The level of cash-out – is it cost reflective? T he issue being how to allocate the cost of energy and the system service (frequency response, STOR, etc.) costs.

· The impact on competition – with suppliers claiming the price is penal and therefore they are likely to buy more power than they need to limit cash-out risk.

41. WPG feels that there is no "correct price" for the imbalance prices. The cash-out regime we have today has been subject to much review and the possible regimes outlined by DECC (single cash-out, marginal, change in reserve cost allocation, etc.) have all been considered. We can see no evidence that the prices are wrong unless DECC wants to set different incentives on the players. For example , a marginal price is likely to be higher so make suppliers go longer into each balancing period.

42. WPG is concerned that there is some misconception about the role of cash-out in sending investment signals. We have heard Ofgem say that the prices are not high enough to encourage investment in reserve p lant . However, reserve is not built based on cash-out. Plants being built to provide STOR type reserve are built based on their contracts with National Grid . C onventional , usually larger scale, plant is most often backed by longer term sales contracts. It can be argued that the cash-out feeds into the forward curve, which is the price that should underpin major capital expenditure on new build. But the forward market is so illiquid that there is no robust forward curve for cash-out to impact .

43. WPG feels that the latest cash-out review looks like job creation by Ofgem. Unless they have something new to discuss then the market has been round these arguments enough times to have well informed opinions. It is then a matter of policy choice if you want the design to result in, on average, higher or low prices. We would recommend that a review of cash-out is not undertaken unless evidence of the "incorrect" prices can be provided. Cash-out prices in any given half hour can vary widely, but do they allocate cost in a way that incentivises balancing? Yes.

44. On balancing services, while we have sympathy with the idea of better cost allocation, the costs are so small in relation to delivered prices that the work may not be worthwhile. It may simply be easier to make cash-out more penal if it is energy shortfalls the system operator wishes to discourage . Reserve costs may not relate specifically to a supplier being short of energy, but the way the energy is consumed . F or example the reserve used to cope with a pick-up in demand from a TV event. Within a half hour the supplier may have enough generation being delivered, but the shape of the delivery profile may not meet the shape of demand.

45. It is a regular mantra from Ofgem that all costs must be correctly targeted. WPG supports this principle, but believes that it is general thrust of the incentives that market players respond to. The rules of electricity trading are already very complex. Changes could shift costs between players, but if the general incentive is to balance that is what they will do. Changing systems and adding complexity simply drives up costs and creates barriers to entry. Government should urge Ofgem to remember the 80:20 rule; if 80% of the incentives target costs correctly players will respond.

Carbon Floor Price

46. WPG believes that the proposals from HMT provide a good basis for setting a carbon floor price. The issue is how to link the new "CCL carbon price support rates" to the price of the EUAs under the EU ETS scheme such as to achieve the desired price of carbon. We do not believe that linking the price on a daily or weekly basis is either feasible or desirable given the volatility it will add to generation costs for marginal plant. Such volatility is highly likely to feed into electricity prices as generators seek to hedge the carbon risk.

47. WPG believes that setting the new CCL rate annually, while creating some stability, risks over or under achieving on the target price. A fixed escalator may lead players to believe that the government is highly likely to alter the costs if they can see their target value is going to be missed. It may be better to set the target rate and adjust the CCL rate annually to meet the rate. With a forward price for carbon generators should have clearer idea of what the CCL rate will be if they know the target price.

48. As a generator we would prefer to have a rate that we know is fixed (with the known escalator). However, the political risk would appear to be less with a fixed target rather than an escalator as there would be less chance of sudden change if the rate set ended up a long way off target . If the government goes with its proposed CCL start rate and known escalator it should commit to hold to that formula fo r say the life of the Parliament.

Storage and Interconnectors

49. WPG does not have any specific views on these two technologies. However, we would note that it is vital to maintaining a competitive market that any new technology, additional capacity (located in the UK or imported power) is treated in a non-discriminatory way . While the government subsidi s es specific fuel types, in terms of market rules, transmission access arrangements , etc. all players should be treated equitably.

Conclusions

50. WPG continues to believe that it is structural reform of the market to create a competitive, transparent and equitable market for all players that will deliver the greatest benefit to customers. The signals that the FITs regime, carbon floor price and EPS will send should help the market to move towards low carbon generation.

51. However, WPG remains concerned by how much of the market is up for review and how the focus is not on the big picture issue of structural reform. We also continue to believe that Ofgem is simply piling regulatory risk on the market by undertaking work that simply does not need to be done. The majority of the government’s proposal can be made with incremental change, and adapting policy instruments already in place, but it is vital they set out some long term principles and policy details as soon as possible.


[1] Short Term Operating Reserve – and Ancillary Service

[2] See National Grid Transmission Entry Capacity Register

[3] Ofgem has already announced the hiring of three sets of academics and another set of consultants for this project (Ofgem letter 10/10/2010) . If they cannot resource the work we are not sure how small players are meant to participate.

[4] The charging methodology for customers connected at extra high voltages (22kV or more) in the distribution networks – due 1 April 2010.

[5] Significant Code Reviews are to be conducted by Ofgem where they appear to act as judge and jury.