HC 742 Electricity Market Reform

RES Response to the Energy and Climate Change Committee’s call for evidence for its forthcoming inquiry into Electricity Market Reform Response

1. RES (Renewable Energy Systems) is a privately-owned British renewable energy project developer, active across Europe, North America and Asia-Pacific. We have been in the renewables sector for over 25 years and have built more than 5GW of wind energy capacity worldwide. We seek to retain as many of the projects we develop as possible. In the UK we retain around 50% of the projects we develop. We therefore have strong interests in the long term viability of projects and the market for renewables more broadly.

2. The RES Group works in a range of technologies: onshore and offshore wind: solar PV and solar thermal; biomass power and on-site biomass heating; and ground source energy; and offers strategic advice to businesses on carbon reduction.

3. Despite the current economic situation, we continue to expand, with staff numbers rising sevenfold since 2002. We now employ over 300 in the UK and Ireland and almost 900 worldwide. With a broad portfolio of renewable technologies, RES is a good example of a successful British company in the international renewables sector, supporting UK industry and skills growth.

4. We welcome the opportunity to provide written evidence to the Committee’s forthcoming inquiry and will respond to each of the questions posed in turn.

Executive Summary

5. We consider that the Government’s preferred proposals as set out in the Electricity Market Reform (ERM) consultation in December 2010 are unworkable and undermine the position of renewable electricity generators and developers. Our key concerns are:

a. The removal of the obligation on suppliers to source renewable electricity removes one of the key drivers for increased deployment. It is likely that the contracting terms renewable generators will be able to negotiate will deteriorate if the obligation is removed.

b. The Contract for Difference (CfD) does not benefit wind generators as they would remain exposed to short term price risk. Wind generators are likely to realise substantially less than the contract ‘strike price’, yet this lower level of realisable revenues would be largely hidden.

c. The proposal to use auctions to set support levels is unworkable and would increase development risk significantly.

6. We believe that the Government’s alternative proposal for a premium type feed in tariff for all low carbon generation could, however, be made to work. Under such a scheme it would be vital that suppliers were incentivised to source renewable generation. Under current premium FIT proposals suppliers would not have any incentive to source low carbon generation. This is likely to lead to deterioration in Power Purchase Agreement (PPA) terms and negatively impact low carbon generators’ position within the market.

7. RES has developed an alternative feed in tariff mechanism which we believe addresses the government’s objectives for reform and, crucially, does not undermine renewable generators’ position in the market. The alternative proposal, and a paper outlining our concerns with the EMR proposals, is included as an annex to this submission. We have circulated these papers widely within the industry.

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

8. Meeting the carbon and renewables targets should be the primary objective of the EMR. A second but important objective of the EMR should be to ensure that these commitments can be met at least cost whilst maintaining secure supplies.

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

9. A capacity mechanism is one way of achieving energy security.

10. Recent developments in Germany have shown, however, that the market alone can deliver secure supplies without dedicated capacity payments. In Germany there is 26,000MW of wind capacity installed, 17,000MW of solar, of a total system capacity of around 150,000MW. In 2009 there were 140 negative price periods in the market. Negative prices occurred when generation was greater than demand, usually during time of high wind and solar output. By 2010 there were no negative price periods. The reduction was largely due to nuclear plant being operated much more flexibly than had previously been anticipated. Nuclear stations are now turned down in periods of high renewable output. This demonstrates that the market can react rapidly to new market conditions and deliver robust and low cost solutions. Plants operating more flexibly could reduce the amount of highly flexible peaking plants required to complement variable generation at much lower cost than a capacity mechanism.

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

11. Initially a capacity mechanism is likely to be needed to support the continued operation of existing fossil fuelled plants rather than the investment of new capacity. The mechanism should enable such an outcome.

12. In the longer term, if a capacity mechanism is pursued it must be able to deliver a long term signal, upon which investment decisions can be made, if necessary.

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

13. Low carbon technologies are at very different stages of maturity. It is therefore not appropriate to have a single level of support. The level of support should be set so as to get the most low carbon generation at minimum cost.

14. If a system of FITs is introduced it is vital that incentives remain on suppliers to source low carbon or renewable generation. One of the key drivers in renewables deployment to date has been the obligation on suppliers to source renewable output. As a result renewable generators have been able to secure PPAs with supplier relatively easily. There is a very real risk that if suppliers were no longer incentivised to contract with renewable generators, that the terms of PPAs would deteriorate, threatening projects’ finances.

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

15. We believe that EMR should be delivered over a number of years. This would enable sufficient visibility of the changes to occur. The current EMR, combined with Ofgem’s proposals on improving liquidity, have not been sufficiently thought through, and nobody appears to have a full understanding of how the changes will interact. This exacerbates the risks facing investors and will lead to a investment hiatus until the regulations have come into effect and shown to work.

16. Additionally, the scale of the changes proposed risk undermining existing investments by opening up their contracts under change of law provisions

17. Spreading the reforms over a number of years will also allow policy makers to establish whether the market can deliver the requirements of the industry, or whether reform is necessary. For example it is not clear that the market can’t deliver the flexible and responsive generation and demand required to complement variable generation.

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

18. Market reform is likely to substantially increase political and investment risk.

19. Replacing the Renewables Obligation with another support mechanism such as a FIT would substantially increase political risk associated with renewable investments in the UK. The RO is working, there are mechanisms in place to ensure that the level of support awarded to new projects is kept in line with their needs, and there is very little uncertainty over the long term value of support. The RO already operates in a way which is very similar to some premium FITs and achieves the same outcome as a premium FIT. There is therefore little benefit to be gained, but substantial damage to investor confidence to be incurred.

20. It is therefore important to minimise the level of change introduced, such as moving to a premium FIT.

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?

21. RES is broadly supportive of the Carbon Floor Price, EPS and capacity mechanism proposals.

22. We believe a carbon floor price is feasible in the context of the EMR. With a carbon floor price and EPS the level of additional support some low carbon technologies will require will be substantially reduced.

23. Currently there is insufficient information to judge whether the proposed CfD can be made to work, and we have a very low confidence in it.

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

24. There is substantial potential for synergies between the proposed mechanisms, but there is also substantial risk that such synergies will be missed due to the various mechanisms being poorly implemented.

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

25. We believe a carbon floor price is feasible as it will enable low carbon technologies to more rapidly reach a point of economic independent. We believe that the level should be set so as to send a clear and decisive signal to investors as early as possible, ie rising to £40/tCO2 in 2020.

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?

26. It is not currently possible to know the impact of the EMR on electricity storage. We would hope that the reforms enable energy storage to be developed within the market. Energy storage could play an important part in delivering the security of supply objective.

Annex - RES Briefing Note: Electricity Market Reform

The Electricity Market Reform (EMR) proposals published by the Government on 16th December have the potential to cause substantial difficulties for the UK renewables sector. Given the scope of these changes RES feels it is very important for the renewables industry to respond decisively to the proposals. In this paper we present our main concerns. The aim is to help provoke and progress a full and informed debate within the industry. We believe that any move away from the Renewables Obligation (RO) could undermine the sector at a point at which deployment and the supply chain are reaching a critical mass. However, there is very strong political pressure for the RO to be replaced with another mechanism. We therefore outline a possible structure for a premium type feed in tariff which could form the basis of a workable replacement to the RO and support all low carbon technologies.

Our fundamental concern is:

The reforms are needed to bring on new nuclear, but do so to the detriment of renewables

The Government states that new nuclear investment is difficult under the current market framework. Whilst we acknowledge these difficulties, we firmly believe that, because they are specific to nuclear investments (and possibly Carbon Capture and Storage (CCS)) but not renewables, they should be addressed in a way which does not negatively impact the renewables sector. We strongly disagree with the headline claims that the reforms will benefit renewables. The cost and disruption to the renewables industry of the reforms will far outweigh any perceived benefits. This is supported by the impact assessment that acknowledges that many of the benefits outlined for renewables are unlikely to materialise, are likely to have been overstated in the modelling or will be outweighed by far larger risks and market barriers.

Other important concerns include:

The reforms remove suppliers’ obligation to contract for renewable electricity

Under the proposals suppliers would no longer be obligated to contract for renewable electricity. This undermines the strategy of utilities that have supported Government policy in pursuing renewable development as well as fundamentally undermining competition in the renewable energy market. The PPA market is reasonably liquid at present due to the demand from utilities. If suppliers no longer have an obligation or target to purchase renewable electricity then they will be less inclined to contract. There is a very real risk of the PPA market becoming much less competitive with higher discounts applied to PPA terms. This loss of revenue is likely to significantly offset any notional gains from a reduction in hurdle rates and will increase the overall cost to the consumer. Whilst it is vital that that existing projects are properly grandfathered, we believe this is possible. Our concern is for new projects.

Auctions are fundamentally flawed as a price discovery mechanism

The auction structures mentioned in the EMR will not lead to reliable price discovery. In competitive market segments there will be a tendency to bid over-enthusiastically, impairing project delivery whilst in uncompetitive markets there is the potential to abuse market power. In order to mitigate these risks the Government has proposed to enter all low carbon technologies into a single auction and hints at penalties for non-delivery. Neither of these options works. The single auction approach overlooks the fundamentally different financing, operational and investment characteristics of different technologies. Whilst the penalty for non-delivery is not suited to the UK’s protracted planning and grid development regimes and significantly increases the risk adjusted development cost as well as acting as a barrier to entry to new market players.

We do not see how an auction system can be effectively implemented, and an ineffective auction system will seriously undermine the ability to deliver the Government’s carbon and renewable objectives

Contracts for Difference (CfDs) are unworkable and will provide no benefit for renewables

As it is proposed, CfDs will pay the difference between the contract ‘strike price’ and a market reference price (this could be an annual or perhaps monthly price index). Any difference between the renewable generator’s outturn PPA price and the market reference price will not be covered. The CfD does not, therefore, substantially increase revenue certainty for renewable generators as the headline proposal might suggest. Rather generators will remain exposed to short term market price risk (e.g. as a result of intermittency) and any discounts applied within the PPA as a result of suppliers’ market power. We see substantial difficulties with basing the CfD reference price on either half hourly or annual prices, making both approaches unworkable. CfDs as proposed are untested. Their complexity will further add to the development hiatus as the increased regulatory complexity is understood by the renewables industry.

CfDs transfer substantial risk to electricity consumers

It is proposed that the CfD will transfer price and over-investment risk from low carbon generators to electricity consumers (via a Government agency). The Government appears to be relying on its gas price assumptions to justify the CfD proposal. If gas or carbon prices (and therefore wholesale electricity prices) were low, the amount paid to low carbon generators through the CfD mechanism would increase. This represents a substantial liability faced by consumers which the supporting analysis does not explicitly quantify. The Treasury recently announced that it considers the cost of the Renewables Obligation (RO) to have implications on the UK Government’s ability to raise taxes, even though the cost is not borne by tax payers but electricity consumers. Given that the CfD is expected to cover over 50% of the market in 2030, the potential liability could therefore have serious implications for the Government’s ability to raise taxes. This impact has also not been quantified.

There are fundamental flaws in the supporting analysis

We fundamentally disagree with a number of the assumptions made in the consultation and supporting analysis. Our key concern is that the justification for reform hinges on the reduction in hurdle rates brought about by CfDs, and in particular the way that this applies to nuclear. Nuclear investments are assumed to have a higher hurdle rate than all other technologies in the current market (including R3 offshore). Nuclear then benefits from a 2% reduction as a result of the CfD. This assumption reduces the cost of nuclear, allowing it to be built sooner than would otherwise be the case; the primary benefit of the CfD proposal. We think that the initial hurdle rate for nuclear is too high and as a consequence the potential gains have been significantly overstated. The reduction in the hurdle rate for wind is less extreme, but it ignores the substantial development and regulatory uncertainty created. In reality these are likely to increase rather than decrease return requirements for renewables. There are a number of other issues which we fundamentally disagree with including the assumed inability of investors to forecast carbon price more than five years out and the assumption that nuclear is inflexible.

We agree that both nuclear and CCS have a central role in the movement towards the low carbon economy alongside further renewable development. Our concern is that the proposals support nuclear to the significant detriment of renewables. As it stands the RO is working well. The level of support is transparent and, as acknowledged in the proposals, it now has many of the characteristics of a premium feed in tariff. The proposed reforms threaten to derail the renewables sector just at the point when deployment, and the supporting supply chain, is scaling up to really significant levels.

Possible Structure of a Premium Feed in Tariff

Our immediate preference is to retain the RO as it stands and to support nuclear as a separate low carbon technology. However, the Government is opposed to creating a specific subsidy for nuclear and is keen to replace the RO. Other reforms of the electricity market are also likely to necessitate changes. In order to constructively engage with the EMR process we are putting forward a mechanism we believe could be workable and deliver the Government’s objectives. In developing this proposal we consider the following to be essential:

· Suppliers must have some requirement or incentive to source low carbon generation.

· The level of support must be determined through independent analysis and consultation with industry; auctions can’t produce stable market signals and must not be used to determine prices.

· The level of support should be transparent.

· Low carbon generators should benefit from the carbon floor price with the expectation that the required level of support will be reduced for new projects as wholesale prices increase.

· The new arrangements should ensure a smooth transition for existing projects

The proposal:

· A premium type feed in tariff for all low carbon generation

· Projects would receive the Premium FIT based on, but separate to, their output. Generators would continue to enter into PPAs with suppliers for their output, and the Premium FIT would be paid according to metered output by a central agency.

· The cost of the Premium FIT would be recovered from suppliers according to the proportion of electricity that they supply from non-low carbon sources.

· By charging the Premium FIT according to non-low carbon supply, suppliers would be strongly incentivised to source low carbon generation to minimise the cost to their consumers.

· The reporting structures for this have already been established with Fuel Mix Disclosure.

· The Premium FIT would be complemented by a carbon floor price, targeted capacity payment mechanisms and emissions performance standard as proposed.

· The level of the Premium FIT would be differentiated by technology maturity (e.g. established, developing and pre-commercial). Our expectation is that they would last for 20 years and be indexed linked.

· At the end of a project’s eligibility for the Premium FIT, the electricity generated would still be considered low carbon in the cost recovery mechanism.

· The level of the Premium FIT would be reviewed periodically, with technologies being able to move down to lower bands as the level of deployment increased. Once operational projects’ premium levels would be grandfathered.

· If needed, projects could opt to enter into a long term fixed price PPA or CfD for their electricity. Under this proposal there is already an incentive to enter long-term PPAs to protect suppliers from a higher cost burden in later years. Additional measures should be enabled through Ofgem’s proposals for improving the liquidity of the electricity market.

Next Steps

RES feels very strongly about the proposed EMR and we have prepared a more detailed critique of the proposals which we would be very happy to share it with you. However our objective is to move rapidly to establish an industry position around an alternative proposal. Our view is that it would then be useful to employ external advisors to develop this proposal further and evaluate the benefits relative to the Government’s preferred option. If you would like to discuss further any of the points raised in this paper or opportunities for co-ordinating responses to the Government’s consultation then please contact either Sarah Merrick (t: 01923 299 448, e: sarah.merrick@res-ltd.com) or Gordon MacDougall (t: 0141 404 5503, e: gordon.macdougall@res-ltd.com).