HC 742 Electricity Market Reform

Energy and Climate Change Committee inquiry into Electricity Market Reform

RenewableUK evidence

January 2011

Market reform is needed to reflect the challenges of security of supply, decarbonisation and affordability; we are not sure that Government’s proposals live up to this challenge.

We are disappointed that the benefits of policy continuity in support of renewable generation have not been given any weight in DECC’s thinking; we believe that change brings disruption and a potential hiatus in delivery. This risks the UK’s ability to establish a thriving renewable manufacturing base.

Some key issues of immediate concern regarding the proposals set out by Government have been raised by RenewableUK members, and these must be urgently addressed; these are reduction in incentive on suppliers to buy renewable power, the role of auctions in setting support levels, and the proposals for change to the Renewables Obligation system in 2013.

RenewableUK is the leading trade association for the renewable energy industry, with over 650 corporate members from right across the wind, wave and tidal stream sectors. Our membership will be key in delivering the investment required to meet challenging renewable and climate change targets.

The need for market reform

The combination of about one-quarter of our generating capacity being due to retire in the next decade and the need to decarbonise the electricity sector by 2030, as recommended by the Committee on Climate Change, is providing the drive for market reform. RenewableUK agrees that one of the key priorities is the need to massively increase investment in new low-carbon generation, but it is also the case that such investment is only encouraged through the whole policy environment being supportive. Government must not let efforts to make planning consents simpler, and grid connections affordable and timely, be given lower priority while it turns its attention to the market arrangements.

When approaching major reform of the market, it is beneficial to look at the elements of the current policy mix that are working, and consider whether it is best to continue these or move to alternatives. Consequently, RenewableUK and its members are frustrated that Government is not considering retention of the Renewables Obligation (RO) as a serious option. The RO has been responsible for massive developer activity, particularly in wind power on- and offshore: over 20GW of onshore wind projects have entered the planning system since 2002, and high developer appetite offshore has driven award of 48GW of sites by Crown Estate. Any failure to translate this activity into more capacity in the ground or water should be blamed on difficulties in gaining planning consent and grid connection. Even so, the UK leads the world in offshore wind deployment and is also a significant market for onshore wind. Consequently, renewable energy is the only low-carbon generation sector that has current delivery that could be disrupted by major policy change. Greater care must be taken with our technologies to ensure that the confidence of current players to invest is not damaged in pursuit of new investors.

One of the justifications used by DECC for this major reform is to make investing in the UK power sector more attractive to new entrants. Given that the most successful part of the current policy mix in bringing new players to the UK is the RO, including private equity and some institutional investment, it seems somewhat perverse to sweep it away without attempting to understand in depth what drives existing investors and how these may be kept on board while reaching out to new sources of money. Despite making these points to Government, however, DECC has opted to propose completely new systems of support, and we discuss some initial points about them now.

Proposals for change

Given the radical nature of the changes that DECC is consulting on, It will take some time and the clarification of key details before RenewableUK can come to a fully considered position on the proposals as a whole. In particular, there are many questions that need to be answered about the Contract for Differences (CfD) proposal for support of low-carbon generation. Consequently our views and those of our members are likely to evolve as the key questions are answered. There are some key issues that we are concerned about, however.

First amongst these is power offtake risk under the new arrangements. Under the RO, suppliers are incentivised to sign power purchase agreements (PPAs) with renewable generators, as they wish to secure the Renewable Obligation Certificates that go with this electricity. Under the CfD, or the premium feed-in tariff that is DECC’s back-up option, there is no such direct driver for suppliers to buy renewably-generated power: the contract for support is signed with a third party tasked with paying generators additional financial assistance, not with buying the power itself. With no other reform, the risk that projects may not be able to secure PPAs could deter investment in development, thus threatening targets. Alternatively, PPAs may be available but with much greater discounts to the market price than PPAs under the RO, which would impact on the financing terms available to such projects. If other action to increase wholesale power market liquidity is successful, then these risks may be offset to a greater or lesser extent, but this could require substantial changes and presents a significant challenge in its own right. It is at the moment unclear if the work that Ofgem has in train on this issue will result in enough additional liquidity to reduce offtake risk sufficiently. If this work on market liquidity is unsuccessful, then the reform process would have increased this key risk for developers. It is vital that this issue is addressed.

The second key issue that RenewableUK members have identified is the proposal to set the level of support under the new, single mechanism through an auction or tender process. The experience of the renewable sector in the 1990s should give Government pause for thought. A great deal of the wind capacity contracted under later rounds of the Non-Fossil Fuel Obligation system never materialised due to the failings of that tender process, and we do not wish to see that experience repeated. We believe that auctions could have an important deterrent effect on companies investing in the development phase of projects: before entering an auction, there would be no clarity on the economics of the projects and thus investing in development would be riskier.

Trying to run a process that includes both large organisations bidding in nuclear stations and small developers trying to build a handful of wind turbines could also be difficult, given different capabilities and attitudes to risk: for instance, significant penalties for non-fulfillment of a contract may deter developers of smaller projects at a time when more of the onshore wind capacity that needs to be delivered going forward is likely to come from such developments. We also see it to be almost inevitable that auctions will require Government to be specifying volumes of capacity to be supported in each bidding round. This seems incompatible with any idea of free markets being able to bring forward appropriate mixes of power from the decisions of multiple players as opposed to ministers making judgments on limited information.

At this time we would much prefer reward levels under the new support system to be set by an open, evidence-led process, as the banding levels for the RO are set now, and would need much persuasion that any auction or tender process could be better.

Thirdly, any transition from the RO to a new system of support needs to be handled with extreme care if delivery is not to be disrupted in the short term. Such disruption would be extremely damaging to the ability of the UK to capture the manufacturing industry for the UK in offshore wind, and the jobs and economic development that would result. It is important to note that delay would not mean that investment in the UK happens later, it will instead go to other countries such as Germany, and the significant economic benefit of the UK’s offshore wind programme will be felt elsewhere. In putting in place grandfathering provisions and other transitional measures, it is not just the level of support under the RO that needs to be protected, but the overall position of projects, and in particular the contracting terms of existing or near-term projects. Other parts of the EMR package could result in deterioration of the terms available for the power side of the contract, and this is not reflected in the grandfathering principles set out by DECC.

In this vein, we find the proposal from DECC to move the RO into a system of ‘fixed ROCs’ in 2013 difficult to understand, since it risks precisely the hiatus in short-term delivery that DECC purports not to want. Any project seeking financial close now for delivery after April 2013 may have to be suspended until the details of this proposal are worked out and/or it is rejected, as it is essentially a new system that needs to be fully understood before investment decisions can be made. Moving the RO to a fixed version also risks significant disruption of existing contracts with a consequent diversion of management time to making good existing project positions. This will militate against new project development.

In order to avoid the risk of hiatus in the short term, DECC may have to remove this option from the table immediately. It is possible that such a proposal could be implemented in 2017, when the RO is closed to new entrants, which would avoid the immediate disruption that earlier introduction would cause. There would still be difficulties in terms of lack of supplier incentive to sign PPAs as noted above, as well as disruption of existing agreements.

Security of supply

Another area of high interest to RenewableUK members is the consultation around security of supply issues, and in particular proposals for a capacity mechanism. It is important that new arrangements here are fully transparent to participation by the demand side, enabling all the possibilities opened up by smart grid functionality to be exploited commercially. This will be vital as the proportion of variable renewable generation in the mix increases.

Another key tool in managing the UK power system in future will be much larger amounts of interconnection with the rest of Europe. The consultation has relatively little to say on this subject, which is puzzling, given the large changes being introduced in the management of cross-border power flows and trading that the EU’s third power liberalisation package mandates. We would urge DECC to consider strongly how the Electricity Market Reform proposals will work in the European context.

January 2011