HC 742 Electricity Market Reform

ECC Select Committee Inquiry into Electricity Market Reform

Centrica Response

1. Centrica plc (Centrica) is the parent company of British Gas, the UK’s largest energy supplier with around 16 million customer contacts in the domestic sector and around one million in the non-domestic sector.

2. We also own upstream gas production and power generation assets to support our supply businesses. Specifically:

- We own 8 gas-fired power stations including Langage, one of Britain’s newest and most efficient gas power stations;

- We are the largest UK supplier of offshore wind and recently won the rights to develop over 4GW of Round 3 offshore wind in the Irish sea;

- Through our Joint Venture with EDF Energy we own 20% of British Energy, the nuclear generator, and we also have the option to participate in the nuclear new build programme with EDF; and

- Finally as one of the largest installers of microgeneration including Solar PV and Heat Pumps, we also have a major interest in small scale electricity generation.

3. We welcome the opportunity to respond to the DECC Select Committee Inquiry into Electricity Market Reform (EMR). Subsequent to the announcement of the Inquiry, DECC has published its EMR consultation providing further clarity on the proposals being considered. We are still assessing these proposals and - for the purposes of this evidence - are not yet in a position to come to a final view on some of the specifics, so instead have highlighted some general principles. Noting the wide scope of the Inquiry questions we have grouped our evidence around a number of key themes as highlighted in the DECC consultation.

EMR Focus

4. We believe that the EMR is broadly focused on the right priorities.

5. The current market-based arrangements have served the UK exceptionally well and the UK has enjoyed considerable security of supply. This has been achieved through a competitive wholesale market that maximises the operational efficiency of the existing fleet and has supported new construction, such as Centrica’s newly operational Langage power station. The customer has also benefited, with UK electricity prices being on average amongst the lowest in the EU 15 over the past five years.

6. The Renewables Obligation, designed to meet the UK’s renewables targets, has also resulted in the construction of over 5GW of wind generation. The UK is now the leader in offshore wind.

7. However, the current arrangements do not provide the market signals to ensure that there is sufficient diverse low carbon generation investment to meet the UK’s carbon targets.

8. In addition, as the proportion of intermittent renewables generation from wind power increases, the electricity system will come under increasing strain at times of low wind output and high demand. We do not believe that current arrangements provide the investment signal needed to ensure flexible plant would be available to back up this intermittent generation in order to guarantee security of supply.

9. It is therefore appropriate that the EMR focus on:

a. options to encourage greater investment in all low carbon generation; being a combination of a carbon price floor and low-carbon generation revenue support

b. targeted capacity payments to ensure security of supply by rewarding flexibility in the context of greater intermittent generation

10. We strongly welcome DECC’s focus on the importance of a smooth transition in order to minimize the associated investment hiatus. This is particularly important if renewable generation investments are to continue in order to meet the UK’s renewables targets, and guaranteed grandfathering of existing rights is an important principle.

11. If implemented effectively, we believe that the key components of DECC’s EMR package will deliver a durable new market framework enabling investments needed to meet the UK’s energy policy goals. Specifically, the essential ingredients are the combination of: a meaningful carbon price floor, appropriate additional revenue support for low carbon generation, and capacity payments for flexible generation. We believe that where possible, the benefits of a liberalised market must be maintained in order to contain costs for consumers and ensure that private sector is bearing appropriate risks. Both DECC and Ofgem recognise the importance of wholesale power market liquidity and it will be important to consider any potentially adverse impacts from the implementation of EMR.

Carbon Price

12. We strongly welcome the proposal for a carbon price floor as part of the EMR package. This ensures a clear economic signal to the market consistent with the ‘polluter pays’ principle; the higher the floor, the stronger the signal. The proposed introduction by 2013 is welcome and in doing so the floor can make a meaningful contribution to lowering the UK’s short term carbon emissions and encouraging new low carbon investment. The carbon price floor encourages lower carbon dispatch, thereby lowering the UK’s carbon emissions. It also provides a long-term and durable economic signal by which to make investment decisions. While all taxes are subject to change, we believe investors would not discount the value of a carbon price floor because of this. We believe investors will see it as enhancing the economics of low carbon generation and will rely on it being in place for the long term.

Low Carbon Generation Revenue Support – Premium & Contract for Difference Feed-in Tariffs

13. DECC’s EMR consultation outlines two main options, a Premium Feed-in Tariff (PFIT) and a Contract for Difference Feed-in Tariff (CfD), with a preference for the latter. In essence, the PFIT is a top-up payment in addition to the wholesale electricity price, whereas the CfD provides fixed revenue support.

14. A Premium FIT is closest to the existing market structure and maintains the strongest market forces for all generators. It would only require modest reforms for the RO to become a PFIT and could continue to be banded so that different technologies receive different support levels. It therefore minimizes investment hiatus, given its relative simplicity and modest reforms to the RO, which is well understood by investors.

15. A Contract for Difference FIT represents a more fundamental change in the market, by removing long-term wholesale price risk from the generator. As such, there are more fundamental questions and long-term consequences we have yet to fully consider. These issues are not necessarily insurmountable, but do need to be thought through before embarking on the CfD.

16. Issues include the need to better understand the impact on market liquidity. If generators have long-term CfDs against an index (e.g. against annual average prices), they are likely to want to sell power into the wholesale market as close to that index as possible lower their risks. This could reduce market liquidity which could be a barrier to new entry and could restrict suppliers’ ability to hedge. More broadly, as increasing proportions of the generation market become largely fixed price, we would need to understand the implications for the electricity retail market: suppliers’ ability to compete on price and product innovation could be impeded. There are also important implementation questions to be answered such as who will the counter-party to the contract be e.g. Government/ Ofgem? And how will they raise revenue e.g. customers, taxpayer? And finally what are the implications for UK customers if increasing parts of generation are locked in to a CfD price set by Government, but commodity prices shift unexpectedly downwards (e.g. as a result of an expansion of shale gas)? Some of the UK’s competitors would not be locked into similar contracts and precedent has shown Government’s poor ability to predict future prices with any degree of certainty.

17. For both a CfD and a PFIT setting accurate levels of support is challenging. DECC has expressed a preference for auctioning. While this is the more theoretically appealing approach, practical experience demonstrates that Government auctioning processes can cause significant delays and be flawed in their design and implementation. [1] A more practical approach may be one that builds on the precedent of the banding process for the RO, in which Government sets the price level with periodic reviews expected. The level is set on the basis of a range of factors e.g. commodity price trends, information disclosure from participants and the supply chain, and the volume of investment Government wants to encourage. We believe that this is more appropriate given the early stage of some technologies in either their deployment in the UK or in their technical evolution.

Emissions Performance Standards

18. If a carbon floor and low carbon generation support mechanism are implemented correctly, the need for an EPS is redundant. The risk of introducing an EPS is that flexible gas-fired generation that is required to back up wind generation will not get build. DECC’s proposals is that any EPS will be limited in its application, to new coal, which we support. However, we note that some groups have already been calling for this to be extended to gas, which impacts on investor confidence.

Capacity/Flexibility Mechanisms

19. Given the potentially important role gas will play as a lower carbon transition fuel, it is important that market incentives to encourage low carbon do not crowd this technology out. Unprecedented amounts of generation plant are likely to close in the next few years to due to age or environmental regulations. It is highly unlikely that new nuclear and renewables will fill this gap in the short to medium term – and too great a risk to rely on them doing so – but new gas power stations may be crowded out in the post-EMR landscape because of the expectation of declining load factors and poor returns on investment. This would impact on security of supply.

20. In addition, as greater intermittent renewables come online, flexible plant will be required to back-up these renewables, which is unlikely to be nuclear or CCS which tend to be less flexible baseload technologies. Therefore, the economic incentives need to be in place to ensure efficient, flexible, and relatively low carbon options are available to play a back-up role, where these plants are operating at a much reduced load factor and potentially faced with depressed prices for large periods. This is not just a question of investment in new gas-fired plants, since there are also important refurbishment/life-extension decisions to be made in respect of existing stations in the coming years. Suitable backup plants could close without new plants being built to replace them, if the signals are not there to stay online, jeopardising security of supply.

21. We support DECC’s decision to introduce targeted incentives to ensure that the appropriate plant should be retained or built to ensure security of supply. We believe that the emphasis should be on flexible, relatively low carbon plant, either existing or new. A blanket capacity payment to all technologies would represent a fundamental intervention in the market which could lead to distortions and unintended consequences. Since it would reward all generation, irrespective of the characteristics desired, there may be greater value in keeping old inflexible plant on the system rather than rewarding flexible and, likely, lower carbon intensive options. We therefore support a targeted mechanism rewarding the characteristics required, specifically flexibility.

22. If designed correctly, an economically efficient capacity mechanism would encourage moderately efficient CCGTs to stay on the system beyond what would otherwise be their economic closure date /or encourage new, efficient CCGTs or OCGTs to be built. In time we believe other technologies could play a role, but they are not yet economically efficient, and the carbon benefits of disproportionately supporting them would be relatively low given their low load factor. As smart meters become more widespread in the residential and business sectors, the demand side could also contribute to providing flexible capacity (so called ‘negawatts’), as may storage. It is therefore important to design the capacity mechanism so it is neutral to the qualifying technology and focuses on the characteristics required. Ultimately, it is crucial that the mechanism is targeted and focused on rewarding the most cost-effective options, to minimise distortions in the market and therefore lower any costs to consumers.

Conclusion

23. We believe the package of a strong carbon price floor and additional mechanisms to support low carbon generation and flexible additional capacity, with incentives set at an appropriate level, will deliver the durable long-term framework needed to deliver the UK’s energy policy goals.

24. On their own, the EMR policy components represent significant changes to the market. As a package, they represent a fundamental renewal. This is appropriate, given the scale of the challenge ahead. However, given the strong benefits the UK gains from the current market structures, where possible it is important to retain features intrinsic to liberalised markets, so customers can benefit.