HC 742 Electricity Market Reform

HOUSE OF COMMONS

ENERGY AND CLIMATE CHANGE COMMITTEE INQUIRY

ELECTRICITY MARKET REFORM

MEMORANDUM BY SCOTTISHPOWER

Summary

1. Electricity Market Reform (EMR) is a process of major importance to the achievement of a low carbon energy system which delivers security of supply at a price that the economy can afford. Delivery of the investment needed is a huge challenge and we welcome the fact that the Government has given the matter such serious thought at this stage.

2. Much work remains to be done. Getting the details right for each of the main policy instruments, and ensuring they work together as part of an integrated and cohesive solution, will determine whether the UK attracts investment in the energy sector against a backdrop of significant international competition for capital.

3. We are at the early stages of analysing these complex and important proposals, but our initial observations are as follows:

· Proposed new Feed-In Tariff (FIT) and Contract for Difference (CFD) system for low carbon energy

We believe this could be a beneficial approach to bringing forward investment in low carbon technologies. However, there are major complexities and uncertainties still to resolve before we can be confident that it would be workable. In the meantime, it is also appropriate to explore the "Premium FIT" approach as a back-up option.

Key issues will include providing sufficient confidence to renewables investors to enable investment to continue; ensuring that the value of renewable investments already made or in process are protected; establishing how the CFDs would actually work; and assessing how the CFDs could best be structured to promote efficient real time despatch and reduce the incidence of negative power prices.

We do not think that it will be possible to introduce a viable auction process for low carbon generation at this stage.

· Carbon price floor

We have supported initiatives to make the carbon price stronger and more predictable at a European level. Looking at the initiative for the UK alone, it is important to balance the policy benefits of a price floor against any impacts on competitiveness. We think that, for the reasons given below, that balance points toward a floor at a modest initial level with a slow rate of growth.

It is unlikely that the floor price will directly accelerate investment in new low carbon technologies. This is because the proposed FIT/CFD mechanism will effectively neutralise the impact of the long term wholesale price (including the effect of the carbon price floor) on such investments.

In setting any floor price, it is important to consider how it would interact with the EU ETS (which could negate any short term carbon savings through higher emissions elsewhere) and with the role that existing coal must play in security of supply for at least the next 15 years. It must also be borne in mind that too high a floor price could lead to substantial gains for existing low carbon generation, at the expense of consumers.

· Capacity mechanism

We support the introduction of a capacity mechanism within the market arrangements but believe that only a broadly based scheme will be effective and efficient. All plant that is technically capable of providing security of supply should be incentivised to play its part. We envisage a scheme which provides the necessary incentives for both investment in new flexible plant and retention of existing plant, as this is the most effective way to support security of supply. We think that the narrower approach suggested in the DECC consultation would fail in this objective because the tendered plant would simply replace, rather than augment, existing flexible plant.

· Emissions Performance Standard (EPS)

We believe the key principle here is to provide certainty at the time when an investment is committed. For this reason, we would advocate grandfathering arrangements so that the EPS that applies to a plant is the one in force at the time of construction. To assure security of supply, the EPS should not apply to existing plant when given environmental or efficiency upgrades. Both these points should be entrenched in primary legislation, so that investors will have the confidence they need to provide and maintain the fossil fuelled plant that will be needed to deliver security of supply for at least the next 15 years.

4. In all these areas, getting the detailed design right will be critical. For example, we think that the carbon price floor and EPS will have little direct impact on investment in low carbon plant. But they could, if too ambitious, result in significant additional costs for consumers and adverse security of supply implications. Thermal generation will continue to have an important role in the medium term, both in facilitating a secure and efficient transition to a low carbon future, and in the early demonstration of CCS.

5. On the renewables side, it is important to note that the Renewables Obligation (RO) is working and has already brought forward billions of pounds of investment. First and foremost, we need to do everything we can to avoid a hiatus in renewables deployment. This will require providing clarity on the forthcoming RO banding review and demonstrating how the new system will protect new and existing renewables investments. Any new system will need to be at least as effective as the RO if the level of investment is to be maintained and indeed accelerated. While the FIT/CFD system could have some technical advantages, they are yet to be demonstrated in the detailed design. Given the other risks for renewable energy, we do not see a major reduction in the cost of capital for renewable investments as being an outcome from the proposals.

6. We are committed to working with the Government to ensure that the final package delivers the progress that we need on renewables, nuclear and carbon capture and storage whilst keeping the interests of consumers firmly in mind.

Response to issues raise by the Committee

7. ScottishPower (SP) is one of the six large integrated electricity and gas utilities in the UK, with some 6 GW of electricity generation capacity, significant electricity transmission and distribution networks and supplying some 5.2 million gas or electricity services to customers in Great Britain. ScottishPower Renewables (SPR) is a major developer and owner of renewable energy, with over 930MW of onshore wind plant currently installed in Great Britain and Ireland. Both companies are subsidiaries of Iberdrola SA, which is itself developing plans for a new nuclear power plant adjacent to Sellafield, in consortium with GDF Suez and Scottish and Southern Energy. References to "we" and "us" refer to all or any of SP, SPR and Iberdrola as the context requires.

8. As mentioned in the summary above, we are still developing our overall views on EMR and digesting the detailed information the Government has put forward. It will be particularly important, in considering the matters we and others have raised, that the importance of the market in governing the electricity industry is maintained. Not only is the market the best incentive to efficiency along the production chain – from designing and building plant through to fuel procurement and the supply business – but it provides the best approach to efficient real time despatch.

9. A significant challenge from this market review is ensuring that the suite of reforms, when considered in totality and alongside the existing competitive market dynamic, delivers a sustainable return for investors in low carbon generation that is sufficient to bring forward the investment, in a world where capital is constrained and subject to strong competition. Companies will make their own assessments on the relative risks and rewards of investing in the UK energy market, but it will also be important for DECC to satisfy themselves that the necessary investment will indeed be forthcoming before reaching final conclusions.

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

10. The main objective should be to bring forward sufficient investment in new low carbon generation to ensure the UK is placed on a trajectory to achieve our long term renewable energy and decarbonisation targets, in a way that ensures that energy security is not jeopardised and energy costs remain competitive in a European context.

11. This will require a set of market interventions to allow investors in low carbon generation projects greater revenue certainty, but at the same time providing existing generation the opportunity to remain economic and play a role in delivering affordable, secure energy. A balanced and diverse energy portfolio is highly desirable to manage technology and fuel price risks.

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

12. The purpose of a capacity mechanism is to help achieve energy security, and help mitigate wholesale electricity price spikes, against a background of intermittent or relatively inflexible low carbon plant. A capacity mechanism does not therefore directly promote low-carbon investment (which can be promoted by other instruments), but can make it feasible by helping to ensure security of supply [1] . Provided that the mechanism does not incentivise inefficient solutions for the provision of capacity, the overall impact on prices should be limited, as the cost of the mechanism is largely offset by reduced price spikes as the incidence and severity of power shortages is reduced.

13. Whilst an "energy only" system can in theory deliver effective market operation, this market design has a number of limitations in practice. The most notable is that, where there is sufficient plant available, the price tends to be insufficiently above the Short Run Marginal Cost (SRMC) to provide a clear return for investment. Meaningful capital returns normally only occur when the system is short of electricity and the price rises sharply – such events may be both difficult to predict and perceived to be a possible subject for regulatory intervention. For this reason, we agree with the Government that a well-designed capacity mechanism should be positively considered for the UK market.

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

14. It must be recognised that it is difficult to design a capacity mechanism that works as intended. A key question is whether the mechanism should be tightly targeted or whether it should support any plant, existing or new, that is technically capable of providing security of supply.

15. Our assessment is that the latter approach is much more likely to support security of supply. A targeted approach is likely to cause replacement of plant that provides security but does not meet the target specification with plant that does. This creates additional cost but little if any additional security. The Government’s modelling assumes that this displacement effect can be cured by design but does not say how. We think it is unfortunately inherent in any targeted approach to a capacity mechanism.

16. A broad scheme which rewards existing thermal assets and new CCGT developments that are technically capable of providing security of supply, is in our judgement most likely to promote security of supply at minimum cost because it avoids the risk that subsidies are spent on replacing existing plant that could perfectly well provide the security requirement. A good first step in further evaluating this argument will be to assess the security requirement and in particular the time periods over which backup power is likely to be needed. The ideal plant might be very different if the resilience sought is for days or perhaps a week as opposed to an hour or two.

17. Consideration should be given as to the eligibility of wind power and other non-firm renewables for a capacity mechanism. This is important because the mechanism would reduce average wholesale prices (by mitigating spikes) and existing projects under the RO would be adversely affected if they did not receive capacity payments. However, the system of payments must reflect firm/flexible capacity actually delivered if it is to work. It may be possible for such generation to receive a partial capacity credit, reflecting its contribution to security of supply. Alternatively, renewable generation could be exempted from the levy that would support the capacity mechanism.

18. As well as the scope, there are a number of other factors in capacity mechanism design. A key issue is determining the amount that the mechanism should pay out. This should be stable and predictable, and depend on the amount of capacity provided rather than the nature of the plant providing it or whether it is in fact called to run. The payment level will need to take account of the fact that increasing wind on the system is likely to drive down the actual load factor of the backup plant needed for security of supply.

19. In arriving at a specific design for the UK, we believe it will be possible to extract the successful elements of the various schemes in operation globally, whilst discarding those elements that have not worked well in other markets.

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

20. In principle we believe the proposed FIT/CFD approach could be workable, both in terms of bringing forward low carbon generation and integrating it in the market. Critical to achieving these dual aims will be getting the design of the scheme correct.

21. To achieve the legally binding Government targets the UK will need to deploy a diverse range of technologies, as outlined in DECC’s excellent 2050 Pathways work. Against this backdrop it is difficult to envisage how a non-banded structure could operate, as the FIT would need to be set at a level to bring forward the most expensive low carbon technology, resulting in all other technologies being over-rewarded. For this reason, the FIT design should focus on the revenue requirement of technologies on a banded basis, similar to the operation of the current RO scheme.

22. We believe there is no alternative at this stage to administered price setting, as practised in the current RO and banding reviews. Low carbon investments will require a clear market to bring them through the development stage to fruition; they cannot meaningfully be auctioned ahead of the planning stage and the costs of development are too high for their recovery to be subject to an auction outcome. Given the current position where a limited number of offshore wind and nuclear sites have already been allocated to developers, we do not in any event see how any meaningful price discovery could emerge from auctions.

23. There are a multitude of considerations around the detailed design of the FIT/CFD scheme, including important questions around the duration of the FIT, whether the CFD operates on a capacity or commodity basis and how the reference price against which the CFD is indexed is set. The FIT/CFD system should be engineered so as to preserve the despatch efficiency of the market and avoid the occurrence of uneconomic negative pricing. We are continuing to work on these issues.

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

24. We and other market participants stand ready to invest considerable sums in the UK energy market – billions of pounds each over the next ten to fifteen years – and much of this investment will need to be committed over the next 12 to 36 months. In our case, we are planning to take important investment decisions during calendar year 2011 – life extension at Longannet and a major offshore wind development being two specific examples. Other developers will soon be taking nuclear investment decisions.

25. It will therefore be important for DECC to be able to state policy intent very clearly as we move through 2011, with sufficient detail on substance and timings, for the entire EMR package. Indeed, it will also be necessary to have similar certainty about issues such as transmission charging, which could affect a number of key investments.

26. It is likely that many aspects of EMR will need to be implemented simultaneously because they interact strongly with each other, but it is possible that others could be implemented separately. So long as there is an overall design, with a clear road map and set of timings sufficient to allow investment decisions to be taken, we would support a pragmatic approach to implementation.

27. While renewables certified up to 31 March 2017 will have the ability to proceed under the RO, we think there is a positive benefit in providing developers the option to proceed under the FIT/CFD regime from an earlier date – say 2013, when hopefully most of the rest of the package will be able to go live. We note that the Treasury’s proposals on the carbon price floor also envisage a 2013 start.

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

28. It will not be possible to answer definitively whether the proposed reforms will increase political risk or achieve greater investment certainty until much more of the detail is developed. Issues which will affect this balance include:

· The full details of the FIT/CFD system or any premium FIT alternative. The CFD system could promote certainty because of the legal status of a contract, but much will depend on how the strike price will be set and the other CFD terms.

· The proposed capacity mechanism, which could clarify investment decisions for flexible thermal plant if applied broadly to all technically capable plant, but could create additional risk if targeted at a subset of the relevant plant.

· The proposed EPS, which is likely to increase investment and political risk unless effective grandfathering at the point of the final investment decision for a new plant is entrenched in primary legislation.

· The carbon floor price, which will impact investment decisions around thermal plant (though not low carbon plant because of the CFD system). Risks could increase if its trajectory ultimately depends on fiscal considerations and/or any competiveness impacts rather than any plan set in advance.

· The effectiveness with which the RO is honoured for existing and pipeline projects and the timeliness with which clarity is provided for the new system.

· Whether investors interpret the decisions (especially on the capacity mechanism and honouring the RO) as stranding past investments and therefore increasing the perception of regulatory risk for the future.

29. Subject to these issues, we believe that EMR has the potential to provide additional certainty for investors.

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?

30. It is too early to give a definitive answer to this question. Not only are we continuing to study and consider a complex package of proposals, but the outcome is likely to depend significantly on detail that has not yet been finalised. Subject to that detail, we think that the proposals could help to move Britain toward meeting these objectives and we will be working with the Government to help achieve this.

31. We believe the RO as designed today provides effective incentives for renewable development and provides sufficient long term signals to attract investors, enabling the UK to work towards the challenging targets set. The transition to a new FIT/CFD mechanism will have to ensure investor confidence throughout, so that delivery at pace can continue at all times. This is necessary if the UK is to have any chance of achieving its 2020 renewables target.

32. It is clearly vital that the package of measures promotes security of supply. It will therefore be necessary to ensure that the reforms do not inadvertently accelerate the closure of existing thermal generation, which remains the mainstay of system stability and security. It would be particularly inefficient for such generation to close prematurely and then have to be replaced. In this context, it will be important to consider the scope of the proposed capacity mechanism, the level of the carbon price floor, and ways to prevent or limit the emergence of negative prices at times of high renewable output.

33. It will also be necessary for Ofgem to set rates of return for network investments at a level that brings forward the infrastructure investment needed to achieve the vision.

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

34. There is an inevitable conflict between any measure aimed at domestic action within the traded sector and the wider EU ETS. This is because, to the extent that the domestic action reduces UK CO2 emissions, somebody elsewhere in Europe will be able to emit more at a lower cost. In the short term, the result could be a zero sum on CO2 with a cost to UK consumers. However, the UK wishes to show leadership in terms of action on climate change and there are two longer term reasons why domestic action may be desirable:

(a) inevitable tougher targets in the longer term mean that it is sensible to make progress with investments now; and

(b) progress with domestic action will allow tighter targets to be set at EU level in the future.

35. In managing this conflict, it may make sense to focus domestic action at measures that encourage investment in low carbon energy sources, as the UK will benefit from this in future years when carbon targets tighten. It is less clear that actions like the carbon price floor (which in the FIT/CFD model has little impact on low carbon investment) will be as successful, and this may lend weight to arguments from consumer interests that the floor should start low and be increased only slowly. Existing coal plant is also likely to be important for security of supply for at least the next 15 years and for demonstrating CCS – too ambitious a carbon floor, too early, could prejudice this.

36. There is also a potential conflict between the impact of EMR measures on the wholesale price of electricity and the existing renewables obligation. To the extent that EMR actions, including the proposed capacity mechanism, lead to a reduced wholesale price, this would be reflected in the returns to existing and new renewables projects that are supported by the RO. It may be that this impact could be ameliorated by exempting renewables from the levy needed to fund the capacity mechanism and/or designing the FIT/CFD system to reduce the incidence of negative prices. This could be achieved with a strong capacity element in the CFD payments or by limiting the amount of energy from each plant falling under the CFD (and increasing the unit rate accordingly).

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

37. A carbon floor price will have limited impact in incentivising low carbon investment if the EMR is implemented through a FIT/CFD mechanism. This is because the CFD ensures that (leaving aside despatch incentives) low carbon investments are remunerated according to the CFD strike price and not the prevailing wholesale market level. As a carbon floor price is intended to support low carbon investments by raising the wholesale power price, its effect is largely nullified by the CFD.

38. Given that the policy benefits of a carbon floor price may be reduced by EMR, it will be important to take careful note of the potential impacts on UK industrial competitiveness of setting the floor at too high a level. We would therefore advocate a cautious approach – starting low and rising slowly.

39. In its recent consultation, HM Treasury outlined three carbon price scenarios (£20, £30 and £40 / tonne by 2020, rising to £70 / tonne by 2030). We would suggest that the low scenario is appropriate given the limited policy benefit. Any 2020 carbon price in excess of the middle scenario is likely to lead to a significant deviation from alternative EU and global price mechanisms. In addition to the obvious concerns for UK competitiveness, this could have a damaging impact on energy security by impacting the business case for the environmental compliance investments needed at some 18GW of existing thermal plant, including the power station at Longannet which is intended to host the UK’s first CCS demonstration.

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?

40. Whilst most methods of electricity storage remain either expensive in terms of capital intensity or unproven at commercial scale, we continue to analyse this group of technologies to assess whether a viable investment proposition can be developed. It would be appropriate for electricity storage and its contribution to security of supply to be recognised in the EMR context.

41. Given the current high cost of storage, the market may choose to deliver flexibility either by building conventional or peaking fossil generation or by retaining older plant for a time. Some of these options, backed by appropriate support mechanisms, will create time to allow a more complete understanding about the effects and uses of smart metering and the real potential for demand side management in the UK.

42. A high carbon floor price could in theory encourage carbon intense generation flows into the UK market. If, for example, the floor price is causing UK power prices to be higher than those in the EU, it is conceivable that EU coal generators could generate in another country to supply the UK. Policy makers should be aware of this risk and take account of it in setting and monitoring the carbon price floor.

ScottishPower January 2011