HC 742 Electricity Market Reform

Electricity Market Reform inquiry – SSE response

 

SSE understands the reasons and motivations for Electricity Market Reform and the need to accelerate investment in the electricity sector. However, the current combination of preferred options would have the opposite effect and would be likely to deter investment.

In particular, DECC’s proposals for Contracts for Differences (CfDs) and a targeted capacity intervention would represent a very high level of central control over the electricity market. Very little scope for market decision-making and competitive differentiation would remain and policy risk would increase substantially. As a result, the motivation for the private sector to invest, particularly in the development stage of large projects, would be considerably undermined and many of the key benefits of liberalised markets (competitive pressure on costs; innovation; responsiveness to shocks and uncertainty) would be lost. The following summarises SSE’s views on the four key reform areas.

Carbon price support

SSE believes that strengthening the long-term carbon price signal is an important element of EMR. In particular, visibility on the carbon price beyond 2020 is needed, given the uncertainty over the status of the EU ETS after that date and the timing of investments. In designing Carbon Price Support (CPS), HMT and DECC need to ensure that it:

(i) increases investment but does not unnecessarily raise customers’ bills or distort the market through undue windfall gains and losses to existing generation. In practice this means CPS needs to be at a notional level (e.g. £1/tonne) until 2020, after when the majority of low carbon capacity will start operation;

(ii) is set to deliver a ‘bankable’ carbon price trajectory. This means the tax should be adjusted so the overall carbon price (EU ETS plus CPS) is never outside a narrow range, and the trajectory needs to be set for a long period in advance. This is similar to the approach suggested by the Prime Minister for the fuel price escalator and moves away from a tax which can be changed every year at the complete discretion of Treasury, which is not a viable basis for investment and is not bankable; and

(iii) does not result in UK carbon prices being substantiall y higher than prices in mainland Europe . This would place UK generators at a significant cost disadvantage and result in a sign ificant increase in interconnector imports [1] .

Providing these conditions are met, SSE believes CPS can help enhance investment and ensure the merit order favours low carbon.

Capacity mechanism

SSE believes a general capacity payment – paid to all capacity according to its availability at peak demand - is needed to secure sufficient capacity going forward. The current market framework is already deficient in rewarding investment in system reliability, as large sections of the market can effectively avoid long-term costs of providing this ‘insurance’ by contracting on a short-term basis (i.e. there is not a fully developed market for reliability). As the level of inflexible plant on the system increases (i.e. wind and nuclear), these problems will be exacerbated, with thermal plant becoming increasingly reliant on infrequent and uncertain price spikes to pay back investment. Combined with uncertainty around market reform, there are now serious concerns over whether sufficient investment in firm capacity will come forward over the coming decade.

Crucially, the mechanism must cover all capacity, including demand side resource. Any mechanism which attempts to pay only a subset of capacity (e.g. only peaking or new) will simply increase risks for all other types of investment. The ‘targeted mechanism’ proposal could be highly damaging. With the potential for centrally-tendered plant (and uncertainty around the timing and volume of this) market-based investment would be sterilised. Developers would be concerned that if they did invest this would be ‘crowded-out’ by tendered plant and hence would hold back investment or may even strategically defer investment in the hope of securing a tender. Tenders of new plant would also force premature closure of existing plant – raising the overall costs of securing an adequate capacity margin. This would all lead to a ‘slippery-slope’ - where an increasing amount of plant is tendered for and the role of the market eroded.

Conversely, a general capacity payment could substantially de-risk investment in capacity, reduce costs of finance and bring forward the most cost-effective forms of capacity. Therefore, costs facing the consumer would be limited to what is needed to pay the unavoidable ‘insurance premium’ that is needed to provide sufficient capacity to balance the system on a daily, monthly and annual basis.

Support for low carbon

The Renewables Obligation (RO) is now a well-designed and well established support mechanism and, as such, SSE does not believe there is a case for reform [2] . The difficulties in the rate of renewables deployment have been related to grid access, transmission charging, planning constraints and financing construction/operational risks (the same issues that will delay nuclear) – not the support mechanism.

It is therefore welcome that, should the RO be replaced, it will be ‘vintaged’ for existing and upcoming investments – however, the period that the RO is open for new investments should be extended until 2020 (and ‘vintaged’ until 2040), to ensure investments needed to meet 2020 targets are not adversely impacted.

If the RO were to be replaced it would be important to keep the new renewable capacity ‘in the market’, such as through a Premium FIT. Taking low carbon generation out of the market through Contracts for Differences (CfDs) would substantially undermine the basis of liberalised markets and could have a number of damaging effects:

· Loss of competitive pressure. With contracts for electricity in effect being with, and set by government, the scope for competition in supply and in contracting of energy would be heavily restricted. Moreover, market signals on when, and how much to build would be lost and competitive pressure on the supply chain would be reduced. In particular the ability to generate value through prudent risk management and by selecting the ‘right’ projects is a fundamental motivation to invest for all developers which would be largely removed with a system of CfDs;

· Limited scope for price discovery. CfDs inherently require more government involvement in fixing prices, increasing the information requirements for government and the risks of setting the ‘wrong’ price. In particular, the scope for the market to ‘self-correct’ for general movements in construction costs over time would be removed. Therefore, under a CfD, developers would require a significant premium to cover this risk, raising costs to consumers;

· Reduced development capital. With CfDs, developers would not be in control of the build decision (with this being subject to the successful award of contract) and hence the motivation to invest at this crucial development stage would be substantially reduced. This would be particularly acute if the CfD prices were determined by auction. There is a risk very few parties would be willing to commit the substantial development capital needed to submit sensible bids without any guarantee of contract. Therefore, there may be little competition for contracts. Moreover, successful bids may not be robust and include underestimated costs (so-called ‘winner’s curse’), and consequently many projects would fail to be delivered (as was the experience with NFFO auctions); and

· High transaction costs and implementation issues. CfDs would require substantial contracting, payment and cost-recovery systems which would involve high setup and running costs. Moreover, finding an appropriate price index against which to set the contracts would be challenging and, if costs are recovered through a variable levy on bills, suppliers would face substantial cash-flow risks. The increased complexity implied here would also be a deterrent to new investors on both the generator and supply side. This runs contrary to the desire to introduce a mechanism which avoids the perceived complexities with the RO. CfDs would be much more complex and, with experience, generators are now very comfortable with the RO.

Before extending support beyond renewables, SSE believes it is important to first assess the impacts of CPS and a capacity mechanism (once their design has been established) to determine what funding ‘gap’ remains. Should this remain, explicit and clearly targeted support for nuclear, such as a Premium FIT, may be needed which will need careful design. The impacts of extending subsidy coverage through a CfD scheme on wholesale markets and dispatch patterns also need to be carefully assessed and managed. The analysis so far has been at too high a level and does not adequately take account of the behavioural and perception issues which always affect markets.

Emissions Performance Standard (EPS)

An EPS on new plant as proposed can provide a useful backstop to prevent build of plant that is inconsistent with climate change goals. SSE agrees that it should be set as an annual limit (to allow build of peaking plant) and that the appropriate level is the equivalent of 450gCO2/kWh for a plant operating at baseload. The principle of grandfathering this level is extremely important otherwise investment will be heavily deterred. Moreover, any revision of this level should be conditional on successful demonstration of CCS on both gas and coal.

As a final comment, SSE has some concerns that the impacts on wholesale prices of the proposed EMR package have not been given sufficient weight and analysis in the consultation nor have the range of potential unintended consequences been fully explored.

SSE’s preferred reform package

The following summarises what SSE believes to be a workable reform package, within the options presented in the consultation, which enhances investment and minimises market distortion:

· Carbon Price Support – at very low levels until 2020 when a target price within the range £20-40/tonne should be implemented;

· A general capacity mechanism – covering all ‘firm’ capacity (and demand-side management);

· Retention and extension of the RO for renewables (and, if any reform is made, a Premium FIT is the best option); and

· An Emissions Performance Standard on new build as proposed.


[1] For example, a carbon price differential of around £5/tonne would theoretically make it more cost-effe ctive to build a CCGT abroad with a corresponding interconnector, rather than build a CCGT domestically.

[2] Since its introduction in 2002, the RO has seen the level of renewable electricity from 1.8% to over 6.6%.