Electricity Market Reform - Energy and Climate Change Contents

Examination of Witnesses (Questions 92-115)


25 JANUARY 2011

  Q92  Chair: Good morning. Thank you for coming in. You will have heard what we have discussed already, and we will be dealing with some of the same issues again. Just looking at the time, we have got a maximum of about an hour before we start to lose a quorum, so we will try to be concise.

  Can you start with a general comment about whether you think the overall electricity markets reform package is ambitious enough to achieve what are clearly some quite challenging goals?

  Simon Skillings: One of the particularly refreshing things about the session you have just had is that nine tenths of it was talking about what you might call energy policy—exactly what the goals are, and perhaps what they should be—rather than the details of market rules and the tool box to deliver them. So, my answer to your question is that I don't actually know what the objectives are. They are implied in the consultation documents, but they are certainly not explicit.

  What are the objectives with regard to carbon reduction in the power sector over the next two decades? What are the objectives with regard to technology deployment? We all have views, but we do not actually know what the objectives are. If they are as challenging as a lot of people think, we need a fundamental electricity market reform package built around long-term contracting, as Dieter mentioned, and therefore they would be appropriate. If we are not going to be ambitious, we certainly do not.

  Simon Less: I echo some of those points. On the face of it, one of the three objectives is the carbon objective—the 2050 target. But in fact this is interpreted far more narrowly. It is interpreted as a target in one sector of the economy—electricity—for one particular level of carbon at 100 grams per kilowatt hour and at one particular date. This narrowing down of a wider carbon objective to that very narrow intermediate target leads to much of the shape of the package, which, in my view, moves very much into a central planning role.

  Another objective, which is not in the tripartite objectives but is clearly driving some of this, is the renewables target, and Dieter has already talked about that. That is a different objective from carbon. It is not in the tripartite, but it is driving this. The third tripartite objective on affordability and cost-effectiveness is again narrowed. It appears not to be applied to all aspects of the electricity market. It is narrowed to looking for cost-effectiveness in the operation and construction of generation, but not cost-effectiveness in the choice of different generation technologies and the timing of when we build them. To summarise, there is a lack of clarity in the objectives.

  Q93  Chair: Accepting that, if we were to say that there has to be a significant reduction in the carbon element of electricity generation, and that it seems inevitable that electricity demand is going to rise as the economy grows and we gradually decarbonise heating, buildings and surface transport, whether it is 100 grams per kilowatt hour by a specific date or not, there has to be a substantial downward trend over the next 20 years or so. Given that that is an objective, if not terribly well defined in the document, do you think that the general approach and the chosen or suggested interventions in the market are the right ones?

  Simon Less: If we interpret the objective in that more general way—we do not need all elements of this package—the Treasury document that sits alongside the DECC consultation document, which consults on carbon price support, does some modelling that shows that a £40 per tonne carbon price in 2020 and £70 in 2030 is sufficient to deliver, on central assumptions, 105 grams of carbon dioxide per kilowatt hour in 2030. But there are risks around that. If you pay a different gas price, that might change to 160 grams if you happen to have a low gas price, so that in broad terms that policy alone will deliver the outcome that you want. Yet DECC brings forward a whole set of other policies, because it appears to be driven to target, to have certainty around this timed target of 100 grams.

  Simon Skillings: Can I comment on that? I am not sure that it does say that. I think it says that if you believe that investors are going to be very confident about the length of time that that carbon price signal lasts, and if you maintain an extremely aggressive renewables obligation package, believe that gas prices will not become too low, and are not worried about maintaining security of supply, it is okay. However, I think it fails in all other measures, and the modelling clearly demonstrates that.

Tim Tutton: Between ourselves, we have previously talked about one of the key ambiguities. It was echoed in some of what Dieter said in that it is not absolutely clear throughout the document whether the objective is to hit a volume target and try to minimise the price of achieving it, or to spend a certain amount of money and chuck it out the system, and the volume is whatever comes out of it. Let us look at the FITs chapter, for instance. Essentially, it starts with price, like the carbon price stuff. When you move to the implementation section of the consultation paper, it introduces the concept of auctions, which is a volume concept. You set the volume and you try to get the volume at least cost.

  The paper as a whole is handicapped by an ambiguity. It is interesting because when it comes to talk about capacity mechanism and security of supply, rightly in my view and, I think, in Dieter's, it starts with volume. It says that we will need a certain amount of volume of flexible plant, or whatever, to keep the system running, so we should go out to competitive tender to secure that volume. I got the impression from reading the paper that it was written in one sense starting from price and seeing what happened on volume and, at some point quite late in the drafting, it was felt that perhaps it was better to start with volume because that was the objective. Things were therefore put in at the end of the paper that completely unbalance it.

  Are you trying to get volume or to constrain how much you pay for all of it? That is the primary question in many ways, and it does not really surface in the paper until quite late, implicitly through the capacity mechanism, which is a different issue, and through the discussion of having an auction mechanism for implementing FITs. When you talk about the ambition of the paper, what is it? As Simon says, it is ambiguous.

  Rachel Cary: It is interesting to talk about the objective being decarbonisation. I have argued that setting it out as quite a clear objective is key. It has not come out of nowhere. If we are thinking about affordability to consumers across the whole economy of decarbonising, the Committee on Climate Change has said that if we are to meet our 80% reduction, pretty much the simplest and the cheapest way is for consumers to go for rapid power sector decarbonisation. If we take that as given, it is then interesting to look at the four policy tools to see whether that will achieve the objective. We would welcome long-term contracts in real low carbon generation. Equally, the capacity mechanism is the sort that fits well in a low-carbon world. It gives an equivalence to demand and supply sides, and reflects the need for flexibility.

  What is interesting is whether we need a carbon price and an EPS to drive the high-carbon stuff off the system, and whether the EPS as it is set does anything additional to existing planning. We could do it for a carbon price, but as the Treasury document clearly sets out, because it raises the wholesale price of electricity, it is actually a high cost for consumers. We suggest that a far more intelligently targeted regulation could be more effective at driving high-carbon plant off the system.

  Dieter covered whether we want to be proactive and, for example, go with CCS deployment. If we want to do that, we need to think ahead. As with the supply chain for nuclear, we need to think about developing a UK supply chain for CCS. Relying on a price signal that will take a long time to materialise and will be far less significant than fluctuations in the gas price is a risky strategy. If we want people to start thinking about where they base their fossil plant and making sure that it is near clusters and things like that, some sort of targeted regulation that makes it clear by which date they need to start thinking about changing the technology could be much better. That is the bit of the package that we would have questions about.

  It was bizarre that the modelling done to accompany the consultation considered only an unrealistic EPS, which would drive up all coal and some gas. We need modelling done on a more intelligent EPS that would actually be far less dramatic, but bring forward investment in things like CCS.

  Chair: We will pursue some of those individual matters.

  Q94  Dan Byles: To take up your EPS point, you heard my question to Professor Helm about the current two options. They have been criticised from various directions. One suggested that it would not make any difference to the current system. The other said that, as a result, it would effectively lock in gas and fossil fuels for the long term. Do you have a view on that? How would you see a more intelligent EPS working?

  Rachel Cary: One of the things you want to do is reward early movers. So, for example, you might have an EPS that is set at a higher level for plants commissioned up to a certain date, with a lower level after that. That would really encourage people, because we are asking them to go forward and trial out quite risky technology in terms of CCS and deploying the full supply chain, and I do not see how the current proposals do that. Also, because you are covering only coal, how you are suddenly going to drive unabated gas out of the system in a 10-year time frame in the 2020s is a worry.

  Q95  Dan Byles: You wouldn't be talking about grandfathering, so new plants that come online between now and 2020, for example, would know that from a certain date in future they would need to retrofitted. Basically, you are building retrofitting into the system.

  Rachel Cary: Yes, exactly.

  Tim Tutton: One of the good things is the paper's recognition of the importance of grandfathering—it is crucial. As the paper points out, huge damage was done in terms of policy changes failing, which changed the rules of the game not only for new plant coming on, which would have been less disruptive, but for existing plant. In the paper, grandfathering is rightly regarded as simply a cost that you have to bear.

  It may be that you find you have brought stuff on that is expensive—that will happen—but that was the deal at the time. If people do not think that that is going to be the deal, and there is not an effective long-term contract underpinning what they are going to do, it will discourage them from bringing stuff on.

  Simon Skillings: I think that's right. However, Rachel's point about the supply chain is very important: grandfathering does not help those who are sitting in the supply chain and are, we hope, developing that capability. You might be a manufacturer who is developing high-efficiency gas turbine technology now. You are right that the EPS proposals don't do anything at the moment, and they say they are not trying to do anything other than back up what is already there. However, they also say, "We might change this in future and tighten it up, and, if you are already built, or have reached financial close, it won't affect you." That is not helpful from a supply chain perspective, because those in that chain are interested in the orders coming down the road in the next few years.

  That seems to be an unhelpful way in which to put EPS in place. I believe that the EPS is an important instrument, because it creates a clear long-term market volume signal and is, therefore, something that the supply chains can go at. It should be established clearly over time scales to which the supply chain can respond. The current incarnation, in which it is not doing anything, but might do so in future, fails on all counts.

  Q96  John Robertson: Professor Helm was not very complimentary about EPS. However, I still cannot believe that you could just do away with it yesterday, rather than even tomorrow. How do you view his line on gas—that we should just start building a lot of gas-powered stations and that we would eventually be better off doing that than investing in renewables?

  Simon Less: I broadly agree with what he said and with the calculation that he highlighted of saving perhaps £90 billion if we were to build gas and then scrap it, rather than building offshore wind.

  Another point, which Professor Helm did not make in support of his argument, is that the offshore wind that we build this year has a lifetime of about 20 years at best. We do not know much about the lifetimes of wind turbines that we have put in harsh environments; we only know about the past 20 years. That means that by the time we get to around 2030, we will need to replant this offshore wind in any case. That puts the need into context—even if we were to have to scrap the gas turbines early.

  Q97  Laura Sandys: Going back to feed-in tariffs, what lessons can be learned from FITs in other countries? How could they be integrated into our reform programmes?

  Tim Tutton: One of the lessons from other countries is that having very generous feed-in tariffs produces a big effect. In several countries that have applied them, especially those with more capability of having onshore wind than the UK, there has been substantial supply response.

  The question that Dieter was asking was about whether that was the cheapest way of doing it, as well as actually producing the response. His answer, which I agree with, was that you start from the other end. You say, "This is the volume we want. Now come and bid for the long-term contracts to build that." Assuming—it may not be the case in nuclear—that there is a reasonable degree of competition, that will deliver it cheaper than the other approach, which is explicit in the consultation paper. That says that the other alternative is that we do some modelling and decide what these things will cost and offer up a price that we think will deliver the volume that we need. You are not using the market to discover whether that price is right or not.

  Simon Skillings: I think the idea that auctions are some panacea is rather false. We are looking at technologies where for nuclear it is absolutely inconceivable that you will have a competitive situation and for CCS it is probably inconceivable that you will have a competitive situation. You either have that situation, where auctions are clearly inappropriate—you need to have a bilateral negotiation—or you have a situation where there are many providers of the technologies, and where you pretty much know the costs. The question there is whether the administrative burden of the auction is worth while compared with the benefits you can create.

  I echo the point that volume is key. It is about volume, and returning to the point on technology, it is so important that we move this away from a yah-boo-sucks, "I like this technology, I don't like that technology" debate. It is about how we manage the risks of delivering our climate security objectives. Different technologies have different cost and deployment risks. Some of them might cost a bit more, but are more reliable in deployment. Some of them may cost a bit less, but have huge deployment risks. We have to have that debate and discussion before we can get into this "Is it gas? Is it nuclear?" debate and move on from the rather superficial debate we have at the moment.

  Q98  Laura Sandys: This is for the others to answer as well. Do you not feel that we have a situation with many different mechanisms—all of which will have to be stress tested by the investment community—such as the technology, our potentially failed projects, successful projects and the affordability issue? If you have an auction mechanism, there will in some ways be much greater transparency and clarity than all those different levers, which might create very different behaviours when they are out there in the marketplace. Is this system too complex to deliver clarity and transparency?

  Simon Skillings: Two quick answers. I agree that we are spending too much time dabbling around in the tool box. It is not until you are clear what you are trying to deliver that you know whether the tools are right. The CFD instrument they describe is clearly not appropriate for all the technologies. The main answer to your question is that the technologies are all very different. If we believe that we have such a challenge that we need to draw on all technologies, including the demand side, the cost characteristics, the timetable and the investment risks are all so different. I cannot imagine what a technology-neutral auction would look like. It is bound to favour one or the other. We have to be clear, therefore, on the volumes that we are looking for from these technologies, perhaps just as a minimum, which can then form the basis of those long-term contracts.

  Simon Less: I agree with Simon's point. I cannot see how auctions could be technology neutral, although I draw a different conclusion. They will inevitably draw the Government—the central planner—into making a whole range of decisions, which, hitherto, have been made by the market. The Government will need to decide what overall capacity we need, what technologies we need, what the timing of those technologies is, and make a whole range of other decisions, including on the price, assuming, as Simon sets out, that the auctions cannot reveal those prices in an efficient way.

  We should not be under any illusion that the CFD element of this package is a major step towards central planning and away from market decision making, because of what we are saying here. The conclusion that I draw is that that's a step we should not be taking—we should certainly not take it lightly—and we should, therefore, be looking first and foremost at how to strengthen the carbon pricing framework. How do we get a long-term credible carbon price, within which system the market can operate flexibly to take decisions about technology types, the timing of technology and the order in which we put in technologies? For example, making such decisions as in Dieter's example—do we do gas first and offshore wind later, rather than doing offshore wind very expensively now? Let the market decide these things.

  Can I pick up a point Rachel made earlier: the problem with that approach being that we can't be certain—or, rather, market players can't be certain—about the level of the carbon price in the future? As Dieter said, it is the level of the carbon price in the future that is most important. One important option has not been considered in the package, as far as I can see: instead of having a contract for difference around the electricity price, leading to all the central planning, why not have a contract around the carbon price, if the problem is certainty in what the future of the carbon price will be? So, the Treasury is saying that it will target a certain carbon price at some point in the future. DECC could then simply write a contract with all generators to say that the Treasury will stick to its word, and if it doesn't they have this contract to come back to us on. In that way, we can extend the horizon of confidence that investors have in relation to the carbon price, making it a more tenable policy on its own in driving the carbon targets.

  Q99  Sir Robert Smith: On that carbon price support, the Treasury's own analysis suggests that nuclear would be the big winner, so it wouldn't necessarily be neutral.

  Simon Less: Saying that one technology under the modelling would be a winner is not necessarily saying that it is not neutral. I have not looked at the modelling, or seen it, but I presume that the reason that it brings support to nuclear is because, in part, the cost characteristics of nuclear make it favourable. That is applying a neutral criterion of cost. It is saying that offshore wind is more expensive than nuclear, therefore offshore wind—logically—ought to come further down the line.

  Q100  Sir Robert Smith: But would carbon price support risk being dead weight in rewarding existing renewables?

  Simon Less: You would need to make an adjustment to, say, the banding in the renewables obligation if you introduced carbon price support, to mitigate windfall to those renewables already in receipt of it.

  Q101  Barry Gardiner: Turning back to capacity mechanisms, do you think that the case is unequivocal? Do you think we should wait and see what the demand side will do? Basically, the same question you heard me ask Dieter.

  Simon Less: On capacity mechanisms, I am in the wait and see camp. I don't think that the evidence put forward is convincing and that we need to make this intervention in the market now. The projected difference between what we think capacity will be and what we would like capacity to be is quite small—between 5% and 11% projected, with 8% to 12% being optimal, according to the consultation. There is not a huge gap. There are a number of changes, such as sharpening up, balancing prices, and indeed the carbon price itself, which would help to close that gap.

  Then, there is the uncertainty. We don't know how much intermittent wind will be built, and that is a big driver of the problem. We don't know how fast and how smart metering and other demand-side response technologies will come in, and how effective they will be—storage as well. There is a whole set of unknowns. The problem, in any case, is largely in the next decade; it doesn't seem to be very large.

  Also, introducing a capacity mechanism is not without risk. The document itself goes into a number of the risks: the risk that you dampen pricing and therefore choke off demand-side responses; what is called a slippery slope risk, in which investment doesn't come forward because it would prefer to be inside the capacity mechanism, so, gradually, the capacity mechanism has to grow; or the risk that we overpay for a level of certainty that we don't need. Because of those risks and because the case isn't made, my preference would be to wait and see what happens. In the end, to build the sorts of peaking, back-up plant that would solve any problem that did arise, the lead times are not very long—they tend to be low-capital and high-operating-cost plants.

  Tim Tutton: It depends—

  Barry Gardiner: Can we let Rachel in? She has tried a couple of times.

  Rachel Cary: I would say there are risks in "wait and see" both on the supply and demand sides. On the demand side, we can put up some gas turbines very quickly if we have problems with intermittency, but we know that the demand side solutions will save us money. A targeted capacity mechanism, where the system operator starts going out and contracting with the demand side, trialling those new commercial arrangements and new technologies, will benefit the innovation. We are more prepared and we have our inevitable high proportion of intermittent wind. Equally, on the supply side, if we say we will wait and see which technology is developed and do not go for a degree of central planning, whereby we develop things such as CCS, we will not develop offshore wind, certainly not in a strategic way. That would be a real shame, because the UK has fantastic geographic resources. There is a risk to the UK economy in just waiting until you have to bring in lots of nuclear plants, or missing your opportunity to develop new industries.

  Tim Tutton: Echoing Dieter's comment earlier, what is the question to which the capacity mechanism has an answer? The capacity mechanism in the consultation document is used in a very specific way. In other words, capacity over the system as a whole, in terms of volume and megawatts, is actually being sold by FITs in this paper. You are throwing money at it and bringing forward capacity. In the process, you are skewing the type of capacity that is out there. You are skewing it towards intermittent and inflexible capacity, and you are then creating a problem—a lack of flexible plant in the system. So, in the consultation paper's case, it is using the capacity mechanism as the answer to a much narrower question. It is a bit like a medical diagnosis—you start with the ideal. As Simon says, you could, ideally from a market point of view, just fix the carbon price. But the paper does not like that. It therefore says, "Well, no, it's going to be too expensive and it's going to cause too much intermittent plant", so you have FITs, which try to solve the first problem, and the capacity mechanism, which tries to solve the second.

  Back to, "Do you do it now or wait and see?" The point about the consultation paper—to the extent that it is successful and to the extent that FITs and the other policies produce loads of intermittent and inflexible plant—is that you will need, probably, a capacity mechanism in the narrower sense in which the paper defines it.

  Dieter would probably say, "Well, that's the wrong question." And the question is, "Should you be looking at the global capacity and long-term contracts if you are looking at some sort of central planning approach?", which is his energy agency route, in which case you do not need the local capacity mechanism to solve the flexible plant, because it is being dealt with as part of the global mechanism. If the paper is right in saying that we are going to offer huge incentives to build intermittent and inflexible plant, you probably will need an additional side-effect countering mechanism, which encourages flexible plant to be built. I agree with Simon—the slippery slope means that you will probably end up with all flexible plant actually being contracted to that capacity mechanism.

  Simon Skillings: Can I add one last dimension to that argument? If you are funding large amounts of low-carbon generation with long-term contracts, they effectively have a capacity payment in them. If you want to avoid shortages and very high prices, it is absolutely essential to have a capacity payment. I do not perceive "wait and see" as credible. The key point is, we are moving to a very different world from the traditional way of looking at the electricity market. The products and services we need in that residual part of the market are going to be different. There will be much more of a requirement for flexibility of different sorts. An exploration of that is the key thing that we have to tackle here. As Rachel says, we have the opportunity to drive an innovation policy, which not only, though very importantly, includes the demand side. It is an opportunity to lock the smart grid piece in to deliver some of the market developments that it is there to deliver. Technologies such as storage can be hugely important, as well as the flexible generation that exists now, so I think that that is a very important dimension.

  Q102  Albert Owen: Can I ask about some of the limitations of this market reform? The objective of EMR is to produce low-carbon, affordable, secure electricity, but is there not a danger that we are focusing too much on new generation and not on reducing demand?

  Simon Skillings: Yes, absolutely. The principle of equitable treatment between the demand side and the supply side is important. That is talked about with the capacity mechanism, which is fine, but it looks at demand response. Traditionally, there are three elements to the demand side—demand response, demand reduction and distributed generation. We would expect demand reduction and distributed generation to be potentially cheaper alternatives to low-carbon generation. It seems to me, therefore, that the demand side should have a fair crack at the FIT side, as well as the capacity payments side, of the equation.

  Rachel Cary: I agree with Simon. On reducing demand, we should make sure that energy efficiency is not only part of the contract for difference mechanism, but something that is really pushed. Whether or not it is the agency that determines those volume contracts, on which they are scrutinised, are you really doing as much as you could to go out and contract on things that are going to reduce long-term energy demand? It is also the wider piece, and Dieter mentioned, as, indeed, does the consultation, that you talk about reducing demand across the whole economy, but you are mainly focusing on the green deal. While that is still in play, there are so many other measures and instruments that we will need to use to target different sectors of the economy to reduce demand. The first thing that we should do is to make all this affordable for the consumer. There are other activities that need to take place, in addition to EMR.

  Simon Less: The key thing to drive demand reduction is to price carbon properly, by pricing in the environmental externality. On the CFD proposal, I find it hard to get my head around how the Government would go and contract with demand that then does not happen. They are contracting for something not to happen in the future—for that demand not to materialise. I fear that under the CFD mechanism, the supply side will have an advantage and that all the focus will be on the make-up of the generation capacity. To the extent that CFDs are part of the package, which reduces the focus on pricing carbon properly, that will be detrimental to the demand side.

  Can I also say something that is relevant, when we are considering the carbon price driving demand, about the effect on prices? Clearly, putting on a carbon price drives up prices. That is its purpose—to create energy efficiency, so that the lower-value uses for energy are driven out. But the flip-side of the way that it is being proposed is that there is a tax receipt. The proposal is to support the carbon price using a taxation mechanism, so there will be receipts. So the overall effect on customers depends on how the Government choose to use those receipts. They could return them to customers through having lower taxes elsewhere, or they could return them directly to energy customers. The overall impact can therefore be mitigated, but you still have the sharp incentives not to use energy that you do not need to use.

  Rachel Cary: Can I respond to that? I would agree with the hypothecation point that some of the revenue should really be spent on energy efficiency measures and such things. But on the idea that the demand side is not reliable, I just think that evidence from US markets with capacity mechanisms shows that that is not true. It is a perception issue. If you have both energy efficiency and demand-response measures, while some in a portfolio will not deliver, some will over-deliver, and they have been shown to be 90% reliable. That is one of the hurdles—I have talked about why we need to start thinking about contracting the demand side earlier rather than later, because there is a perception that it is unreliable, but it is not, as if it is aggregated it can be really reliable.

  The second point I wanted to argue is that we know with energy efficiency that price signals are one of the things that do not work. There are lots of disincentives. Everyone knows that they can save money saving energy. There are often so many other barriers that just saying we can price the carbon adequately and that will be our solution to energy efficiency is a fallacy.

  Q103  Albert Owen: There might be a difference. You are all of the opinion that reducing demand may be sidelined. We need to deal with it. Other issues not in the EMR are planning and grid connections. Do you think that there should be? Should they all be in one market reform Bill or are you comfortable with how this Government and the previous Governments proceeded with planning first? How do you feel about grid connection? Do you think that it should be part?

  Tim Tutton: The combination of the so-called transmission access review—the main Government initiative in that area—is probably the solution that most easily underpins the volume objectives underlying decarbonisation. In other words, it effectively concerned whether there were real physical constraints—mainly planning constraints—on building the grid. The question was always whether you stopped people then connecting if there was no good there or let them connect, accepting that there will be transmission constraints and that some will have to pay for them. That solution was adopted. It says that, if you are a wind generator in Scotland and can literally get a physical connection to the system, you will be allowed to connect. You will be allowed to generate and, if you are constrained, you will be compensated for that and everyone will pick up the cost of the constraint.

  A pure economist would have a few issues with that position and say that it would cause inefficient connection, but from the point of view of hitting a volume target, it is probably the right solution.

  Simon Skillings: The one element of the grid side that is most obvious as an omission involves the interconnection agenda with Europe. One the one hand, we have a programme looking at building a North sea grid and improving interconnections, yet the EMR is in the context of an island system. It is hugely important and it actually reinforces the importance of long-term contracts. One thing that will become obvious is that there is no right answer in market arrangements, balancing rules, capacity payments, carbon pricing, renewable subsidies and so on. As we begin physically to interconnect the European market, you will find that everybody is in a different place on those issues, and that gives rise to perverse assumptions.

  We mentioned earlier the single electricity market in Ireland as a result of the carbon price underpin meaning that southern Ireland generators were very happy with the carbon price because of the perverse incentives it created. You know that an integration agenda means that we will have to change all such things going forward. We shall have to harmonise balancing rules, renewable subsidies, capacity payments and carbon pricing to avoid perverse incentives. The only way in which we can drive forward investment against that sort of uncertainty is by locking it out through long-term contracts. I believe that contracts are absolutely key if we are going in this direction, and I do not know anyone who thinks that it is not a bad idea to integrate the European market.

  Rachel Cary: I think that interaction with planning is interesting. The UK has a lot of objections, for example, to onshore wind, which is very cost-effective and perhaps one of the reasons why we are having to go so much offshore. How we set up the support mechanisms for low carbon, how simple it is, how much community ownership and how much local buy-in we can get to renewables is really important. I feel for DECC, but one of the things that it tried to do by moving away from the ROs was to go for something more simple. I am not sure how a contract for difference with a complex auctioning process would be that simple or that easy, for example, for community groups to engage with, so you might want a two-tier approach to expand the threshold for FITs bits and make it simple up to say, 25 MW. That might be one approach. You are really going for the auction approach—the contract for difference approach, certainly, whether it is an auction or not—for the more complex, bigger players, because I think that is key in the UK.

  Q104  Chair: On the question of interactions, which is clearly extremely complex, do you think that the Government's document has paid enough attention to the possible interactions? We are dealing with a sort of water bed here—if you do something here, it produces a consequence over there, which might not be immediately predictable.

  Tim Tutton: It will always be messy to some extent when you are trying to hit multiple objectives, but yes. One of the ways of tracing the line through as a medical analogy is saying that you start with one solution and you are then for ever putting sticking plaster over the problems that each of those solutions will create. Putting words in Simon's mouth, he would probably say that he preferred to see much more of the heavy lifting done by the carbon price alone, for that reason in part.

  Simon Less: It's a complex package. As I was outlining earlier, it will take the Government into making an awful lot of decisions, and things will happen that neither we nor the Government can predict. There will be unintended consequences, and the risk of that will create a lot of regulatory uncertainty. That itself will drive up the cost of capital and the risks for investors, so there is merit in a package that is simpler than this. I have set out what I think that should be.

  Rachel Cary: I think one of two processes going on—it will be interesting to explore the connection—is the networks development, as well as the market reform. We have talked about grid connections for transmission scale, but there are things like the low-carbon network fund, which is all about deploying all these smart technologies on the distribution networks. The capacity mechanism—FITs, this targeted, flexible mechanism—should give us business revenue for those sorts of technologies, so it will be interesting to see how the two connect and how we go from pilots of smart growth and demand-side response through to bringing them to market. That is an interesting crossover.

  Q105  John Robertson: Thinking of the costs and getting back to the professor's points about gas and how much investment should be in gas, I know we have invested a lot of money in renewables, but my worry is that the cost of connection of all these renewables, which are obviously on the periphery of the country in relation to the grid, is suddenly not cost-effective any more. Should there be another process, therefore, for localised electricity feeds from these areas, rather than connections to the national grid? Should it be treated as completely separate from what we could call the core-type energy that is supplied?

  Tim Tutton: One of the problems is that, just as the UK system has traditionally exported electricity from the north to the south, for coal-type reasons in the past, so it is with the wind distribution and with the availability of sites because of planning permission, which mean that the wind generation is quite a long way from the demand. As long as you have got that, and as long as you effectively see offshore wind as the core technology doing most of the lifting for renewables, then it is hard to see how you can afford heavy transmission investment to get that electricity to customers.

  John Robertson: So that brings us back to whether we should actually be investing in renewables.

  Rachel Cary: The thing to think about is that, whatever we do, the transmission network requires a lot of upgrading—a lot of it is coming to the end of its life. In a way, we have got a bit of a blank slate to start with. Another thing—for example, we talked about nuclear fleet—is that it costs a lot to upgrade the transmission network to accommodate a new nuclear plant, so it is not just renewables that raise that issue. I think you are right about the issue of distributed generation, and it shows how difficult it is. We think about supporting generation based on the costs of supply, but we have then got to think about the network costs. When we are thinking about how these proposals support distributed generation, it is very tricky, because the contract for difference is very much about bringing on the big stuff—CCS or offshore wind.

  Q106  John Robertson: My problem is that if you look at any line that has been on the go for 10 years—it is still nowhere near being completed—the cost 10 years ago was a lot less than it will be in the next two or three years, or whenever it is actually completed. Should we even be thinking of investing in that extension of the grid to peripheral areas, where we will hit the same kind of problems that we have had in the major line?

  Simon Skillings: This is one of the key values of the North sea project. We are not talking about major onshore lines; we are talking about identifying how to put together an offshore grid and how to land that effectively into the onshore infrastructure—I am sure that we will need some form of infrastructure. I do not know the answer to your question, but it seems to me to be one of the very important questions that the North sea project should explore, which is exactly how efficiently we can tap the North sea resource and what the appropriate infrastructure is to deliver it.

  Tim Tutton: One of your key points was the question you posed just a moment ago. Grid costs reinforce Dieter's argument, basically. Effectively, if you are looking at power station costs, his argument for gas now, wind later is reinforced, when you add in grid costs.

  Q107  John Robertson: So how are the feed-in costs going to be developed? Whereabouts does this appear in the system? Who pays?

  Tim Tutton: Everyone pays.

  Q108  John Robertson: How is it paid?

  Tim Tutton: It goes into transmission network use of system charges, which are charged to all generators and suppliers.

  Q109  Chair: In terms of the interactions, what effect will all this have on our attempts to couple our markets with neighbouring markets in France, Holland, or even Ireland, and trying to promote interconnection? In that respect, there will be some interactions that will not be entirely helpful.

  Simon Skillings: Having spent a bit of time recently in Brussels trying to explain it to them, the first thing to say is that they are very interested. The UK is definitely seen as a country in which other countries want to know what is going on with our market. They want to understand the direction we are going and they want to understand how that fits with their own context and what it may mean going forward.

  My second point is just to reinforce my earlier point that if you believe in physical interconnection, you also have to believe in harmonisation of rules, because it becomes absurd otherwise. In Europe they are beginning to toy with the question, "If the UK is doing this, while facing an investment issue, and other countries are facing that over the coming years and will need to start thinking about these problems, how do we, as Europe, identify the need for harmonisation and the progression of harmonisation in these rules, such that we get the benefits of a unified single European market?" That question is just beginning to be asked in Brussels.

  Q110  Dan Byles: I have to go in a moment, so I apologise for asking the question then possibly rushing off. Everything seems to come back to the phenomenal levels of investment that are required—some £200 billion over the next 20 years. Professor Helm referred to £100 billion in nine years on offshore wind. There will be a nuclear power station coming online every nine months from 2017. We are talking two channel tunnels a year for ten years. That is a phenomenal amount of investment from a very limited number of companies in a limited industry, which is already at capacity and highly leveraged and which is also being asked to build new nuclear power stations in China, Japan, France and Germany. Do you think that this package of reforms will do what is needed to bring the investment that we need here in the time frame that we need it?

  Simon Less: There are lots of large numbers here, but the total amount of money, getting on towards £100 billion in generation to 2030, is small, compared with the global pool of capital. The global pool of capital is so much larger than that and it will go where the risk-reward ratio is attractive. That is what we need to focus on. Does this package—both in terms of the financials and the risk-reward, but also in terms of non-financial factors such as the planning regime and grid access, which have already been discussed—stack up to a favourable prospect? I think that an important part of trying to incentivise low-carbon investment is having a long-term credible carbon price into the future, because that can be plugged into calculations of risk and reward.

  Simon Skillings: Can I add that I agree with that? There's plenty of capital; it's about making sure that it fits the risk-reward appetite. We must not forget the significance of the green investment bank proposal, because EMR de-risks the earnings stream from operational assets. It does not help to take away construction risk, which is very significant for many immature technologies. It is extremely important that the green investment bank is established in such a way that it can raise capital and that that is secured by the Government. Interestingly, in a very similar way to the CFD proposals that are in the EMR, it is very important that consistent thinking is applied so that the green investment bank can be used to de-risk those parts of an investment that EMR cannot.

  Q111  Sir Robert Smith: The green investment bank has to be a bank, not just a fund.

  Simon Skillings: Absolutely. That is critical.

  Q112  Sir Robert Smith: Finally, on trying to take all this forward, a number of the energy companies have been keen to see some kind of road map for its implementation. Do you see stages through which the reform has to go to achieve the goals?

  Simon Skillings: Shall I have a quick stab? We haven't talked about institutions in this section; I know that it was talked about in the earlier session. It is so important that we clarify the policy objectives, and set in train the institutions that need to be established, which could take some time. Who is going to be the contracting body? What is the governance under which it will operate? Where are the regulations under which it will operate? That will take time, and it is very important to set it in train. I would prioritise that rather higher than continually refining the tool box, because until you are actually clear about what people are trying to do and what degrees of freedom they have, it seems a little pointless to go in to shine the tools that they will be using.

  Q113  Sir Robert Smith: How soon would you need to do that to meet all our obligations?

  Simon Skillings: I actually think that it is already too late to say, "Well, let's just put everything else on hold and wait until we've got this in place." What is essential is that we have dual policies: one in which we establish the enduring situation; and the other that is focused on ensuring that investments continue to flow through. We need to ensure that we have transitional arrangements in place that ensure that investors know that they are not going to be any better off by waiting. It is absolutely critical that no investor sitting here thinks, "If I wait a couple of years, I might be better off." That option has to be taken off the table.

  Simon Less: In terms of meeting all our obligations, I have hardly met anyone who believes that we can meet our contribution to the EU renewable energy target. I don't think that this package, or anything similar, can enable us to meet it, because the factors against us are physical and practical in the remaining nine years that we have. This package will not help us meet that target, and nor will any other that is realistic.

  On the longer-term goals on decarbonisation, as I have already said, I think the key reform is the carbon price, which is something that could be put in place relatively straightforwardly, compared with some other aspects of the package.

  Q114  Sir Robert Smith: So, the message is almost, would you say, that trying to achieve the goal is distorting?

  Simon Less: Trying to achieve the renewable target is distorting and incredibly costly, as Dieter illustrated earlier, but it is legally binding. Between now and 2020, there will come a point when it is absolutely obvious to everyone that we won't meet it. The question then is what do we do—do we try to renegotiate it? That may depend on how many other countries are not meeting it. How much money are we going to put into trying to meet it in the meantime?

  Q115  Sir Robert Smith: One final question. How is the target legally enforced?

  Simon Less: In theory, we can be what is called "infracted" and fined by the European Commission for not meeting it. I am not a lawyer, so I cannot tell you what all the ins and outs of that are. There is, however, a question over the limit to the fine, which I cannot quote off the top of my head, so that even if we were fined at that limit every year for a very long time, it would probably still come to less than £90 billion.

  Simon Skillings: What the law tells you is that this is not a binary decision—that we are going to meet it, so we should plough ahead; or that we are just going to fail, so we might as well give up. It is clear that whatever penalties there are will very much depend on the extent to which we have tried to achieve the target. Therefore, I don't see this idea that somehow or other views on whether or not we are going to deliver it affect our efforts in delivering it. It is those efforts that will affect the fine more than whether we achieve a particular number.

  Chair: I think we have run out of time and almost of a quorum here; although three is a quorum. Thank you very much for your attendance and comments, as well as for your patience, which we much appreciate. This is a very important subject for us, and I am sure that we will benefit a lot from what you have said.

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Prepared 16 May 2011