Electricity Market Reform - Energy and Climate Change Contents

Examination of Witnesses (Questions 116-157)



  Q116  Chair: Good morning and welcome. Thank you very much for coming in. We've quite a lot to cover and about an hour to do it, because we have a second set of witnesses, whom we expect to move on to at about 10.45 am. We will try to reflect that sense of urgency and time pressure in our questions, and we would obviously much appreciate it if you did the same in your answers. You can by all means all respond to the questions, but don't feel you have to each time if you don't have a burning view you want to get off your chest.

  Let me start with a general question. Is it your view that this whole electricity market reform process is necessary if we are to achieve more secure and more low-carbon electricity generation?

  Dr Riley: The short answer is yes.

  Dorothy Thompson: I would strongly agree.

  Juliet Davenport: I think that there are definitely parts of the current market that will not allow the significant changes that we need to see, and they are not fit for purpose to precipitate that change. It is not all broken, but if you really want to get to the low-carbon economy, quite a lot of things need fixing.

  Q117  Chair: We will get on to some of the details of it in a moment, but are there any omissions—any big elements—that should have been in the consultation that are not there?

  Darren Braham: It is important to have a co-ordinated approach, so we have a lot of work on the generational and supply side, but we need to focus on the demand side, and to bring in the work that Ofgem is doing on liquidity, which is a big piece that is missing from this area of work. Unless you free up the wholesale market and generate liquidity, it is very difficult to encourage competition at the retail level.

  Dorothy Thompson: I strongly agree on the liquidity point. I would also suggest that, in terms of capacity, the consultation looks only at peak capacity and does not consider the problem of intermittency.

  Dr Edge: We are quite disappointed that the benefits of continuity in the policy that is out there, particularly the renewables obligation, are not reflected in the consultation. As an industry, we will work with what is on the table, but we would have preferred the option of keeping that mechanism, which is working. It should have been kept in the mix, and it should have been meaningfully assessed in the consultation process.

  Q118  Chair: Right. You all come from quite different businesses, so you are likely to have divergent views on some questions. Do you think that what is proposed offers enough improved support for small and decentralised generation and for other low-carbon electricity sources?

  Juliet Davenport: What is interesting about the document is that it does not seem to consider size in its conversation. We discuss three types of FIT mechanism, but not how those are implemented, which depends on the size of technology that you are talking about. We currently have two FIT mechanisms: a fixed FIT for very small; and a premium FIT for slightly larger. The size of the technology is quite important, so something like a CfD will be very hard for small generators to manage, and potentially the administration costs will be significant. We represent quite a lot of small generators—we have about 10% of the microgeneration market—and from our point of view, the document does not consider the impacts depending on the size of technology being considered.

  Dr Edge: From our point of view, having a single support mechanism for all low-carbon generators is a little bit problematic, because "one size fits all" means that it does not fit everyone, because not everyone is the same size. That is particularly the case with smaller onshore wind developers, who perhaps have a small portfolio of projects, as opposed to 1,600 MW nuclear power plants at the other end of the scale. The system is supposed to work for the entire spectrum, and it is very difficult to see how something could be designed to fit everyone. The proposals about auctions are particularly problematic at the smaller end of the scale, and we are not very keen on those.

  Dorothy Thompson: I suspect, though, that this subject is all about the detail of implementation, because a lot is to do with the concept of whether you are going to have a market to which all have access openly, or a market that you have to access through the supplier. That is the difference between having a feed-in tariff and an obligation through the supplier. We strongly support open market access because that is better for new entrants and independents. On size, I know that the Government are considering whether to differentiate between large and small biomass stations. There is no reason in a FIT structure why you cannot do the same. I think that this is in the detail of the implementation.

  Q119  Sir Robert Smith: One of the concerns raised about the working of the market is the potential for new entrants and the domination by large generators. What sort of capacity is provided by the smaller players, and what would be the benefits of increasing the number of smaller players?

  Dr Riley: There might be an issue of definition around the smaller players as well. I would like to think that International Power is a large generator. The independent generators as a whole are about 20% of the market in the UK. It is important that the outworkings of the energy market review provide the right incentives and encouragement for the independent generators to invest, because the amounts of investment are huge. The key outcome for this, particularly for an international company, is to get the regulatory framework right so that we are encouraged to make investments in the United Kingdom rather than in some of the other countries that we can choose for our capital.

  Q120  Sir Robert Smith: What sort of incentive?

  Dr Riley: A good outcome for us would be if the energy market review took a holistic view. We have talked about low carbon. There are a lot of incentives in the proposals to incentivise low-carbon generation, but we must maintain a viable system going forward not only from 2030 onwards, but between now and then, so some of the other things—capacity mechanisms to make sure that there is reliable security of supply in the market and responsive plant, which will be needed when base-load nuclear and intermittent wind resource are rewarded—will continue to play an important part in the system going forward. A lot needs to be taken into account in the whole review.

  Dorothy Thompson: We at Drax have been working for two years on a joint project with Siemens Project Ventures to build three large new biomass plants. One of the key challenges in putting together that project is finding some way to get security of income over time against our fuel sources. It is not possible in the current market, because the ROC is a short market and the power market trades only two and a half years forward, whereas the build takes three years. A structure like a CfD, which effectively gives stability of income, is a very good basis to go about financing and raising capital to build new stations.

  Dr Edge: I think you need to be clear about which new entrants you are trying to encourage. We see a lot of new entrants into the generation market with renewables, because that gives a low barrier to entry, and there are lots of independent developers in our membership. The Government want to encourage both that and new entrants in the form of large institutional investors, but they are different things. You need to be clear about who you are trying to entice into the market and what it is you are offering them.

  Juliet Davenport: The other thing is that people already in the marketplace will try to offset their risk, so if you increase the risks in the market, such as by increasing buy-up prices so they are spikier, you will have investment from incumbents. If you are looking at encouraging new investment, you must have a look at giving certain returns—that is really the difference. If you are looking to get new investment in, you need to consider what they will look at, and they will not be trying to offset the risks of the existing incumbents.

  Q121  Sir Robert Smith: Does anyone have views on getting new entrants into the retail side?

  Juliet Davenport: We are not that new any more. We have been around for about 10 years, but we are probably one of the smaller retailers in the electricity side of the marketplace. Having more generators to trade with is an important part, as are the credit terms you can establish. When you come in as a small supplier and talk to very large generators, they will look at you and say, "We're not that interested," whereas if you talk to generators of a similar size to you, they will offer you much better credit terms. A real diversity of generators coming in place is a really positive thing to bring in new retail.

  Darren Braham: Liquidity and, probably, the lack of independent generation have a big bearing on the development of retail competition. In our experience, there were a limited number of people to talk to.

  Q122  Ian Lavery: Liquidity has been mentioned on numerous occasions from the beginning, so it is obviously very important. It will have a huge influence on competition. With regard to liquidity, will the electricity market reform improve the risk-reward outlook for new entrants in the supply and generation market?

  Darren Braham: The risk with some of the measures is that they remove liquidity further down the curve. What might end up happening, particularly with the CfD approach, if renewables trade out at the spot market, is that you are left with lack of liquidity further down the curve. An issue for us as a supply business is that we need to hedge out 18 months to two years. It is thinly traded today, so anything that aggravates that position will be to the real detriment to an independent retailer.

  Dorothy Thompson: We are all agreed that the principal driver of low liquidity in the UK is the fact that roughly 80% of generation is actually owned by companies that control 90% of the supply. Vertical integration in itself does not necessarily mean you have low liquidity, but the fact that there is no action, need or requirement to put larger percentages of generation capacity or generation output through the market causes the low liquidity.

  Q123  Ian Lavery: Will Ofgem be able to create sufficient liquidity to support new entrants?

  Darren Braham: It is within its gift to take the requisite action, but that is really a question for Ofgem. It is something that we have made representations about in the past three or four years since we went to the market.

  Q124  Ian Lavery: Do you believe that it will be able to?

  Darren Braham: As I say, it has the capacity to do it. One of the key solutions is a requirement on the integrated players to offer their power on a wholesale market.

  Q125  Ian Lavery: Has anybody else got a view on that?

  Dr Edge: If DECC wants it, DECC will have to do it itself. Ofgem has powers to try to take this, but this way lies perhaps a lot of litigation. I would use the example of the transmission access review, in which there was an industry process, with Ofgem in the lead, to try to work out what the arrangements should be for connecting to the grid, and it ground to a halt. Ofgem said, "Can't do it," and handed it over to DECC, and it had to legislate to make it happen. I suspect that this is exactly the same kind of situation. Unless DECC grasps the nettle, it could take a very long time to do it.

  Juliet Davenport: Some fundamental changes are needed to the balancing and settlement code. I do not think that you will achieve that through the current change processes that we have, so I agree that it would possibly need legislation to push it forward, because I don't think that you can achieve it through a normal change process.

  Dr Riley: There are two ways in which you could try and improve liquidity in this market. You could do what I think you're suggesting, which is to use the regulator to intervene in the current market arrangements and try to put in some measures that will improve liquidity. On the other hand, we have a great opportunity now—through getting the energy market reform right and through putting the right incentives in place to encourage independent generators into the market—to encourage that part of the market to grow. You would hope that liquidity would improve on the back of that.

  Q126  Ian Lavery: How much capacity will be contracted in the proposed capacity market, and how will that affect liquidity in the wholesale market?

  Dorothy Thompson: As I understand it, the current forecast is that you'd have about 5 GW capacity contracted in the capacity market—I hope that my memory is right. But it is a complicated number, because what you're actually taking is a very big number for the demand forecast and a big number for supply, and then looking at the difference and trying to work out the gap. We would say that that isn't really the capacity issue; the capacity issue is on a more regular basis. Intermittency is the biggest issue. Do you realise that every winter morning our demand goes up by about 50% between 5 am and 9 am? That is just today; add in more wind intermittency and more inflexible plant and we've got another problem. The capacity market that is being proposed is way out—probably at the end of the decade—and for a very small element of the market for a relatively limited amount of time. I think it will have an impact on liquidity, because it will take out some of the demand and some of the supply of the market, but it is actually only a small amount.

  Juliet Davenport: I think there is a missed opportunity to talk about increasing transmission interconnectability and looking at capacity trading between countries as well. Significant capacity trading already exists between Italy and some of the northern states, and obviously between France. We have quite limited interconnectability at the moment, and I think that that could provide us another route to providing more security going forwards.

  Dr Edge: There is also an important confusion in the security of supply and capacity mechanism proposals. DECC seems to want to cover the fact that we need enough capacity to manage supply and demand overall, but also flexible capacity to deal with a lot of variable generation like wind down the line. There are two distinct things, but it seems to want both at the same time.

  A couple of colleagues have been talking to EirGriD in Ireland, where it has a capacity mechanism. Its advice was, "Don't have a capacity mechanism, but you need a lot more ancillary service markets," so more frequency control and voltage control. That is the kind of thing that the National Grid already contracts for in the short-term operating reserve market. Perhaps that is what we need to do the flexibility bit, and the capacity bit can take care of itself. There is the important message that DECC needs to work out exactly what it wants in this area and then work out the right mechanism to get that, rather than confusing the two.

  Q127  Dan Byles: For some time, I have been quite interested in, and a bit concerned about, the potential medium to long-term impact on consumer prices. I often get the feeling that industry, DECC and the Government—everyone—are sitting around with a consensus that this is the way forward. We are building structurally high consumer prices into the system, but who has had that conversation with consumers? The EMR consultation document has suggested that prices could rise from £80/MWh to as much as £150/MWh. Do you agree with that analysis? Is that the sort of impact on consumer prices that we will see?

  Juliet Davenport: When trying to make long-term forecasts for the impact on consumer prices, you have to look at a range. It is very hard to get precisely the right number, because there will unexpected consequences as a result of some of the market coming in. The document in the EMR talks very much about gas setting the marginal price. Obviously, as you bring in significant amounts of renewable energy, you begin to see that it will not always be setting the marginal price. You might have the marginal price being set by wind at some point in time, which I know sounds rather odd to some people.

  We are seeing that, potentially, you could see certain reductions in cost, depending on the impact of external world market prices. That really is not taken into account within the considerations that we have seen so far. I think that you have to look at the risk around future prices, as well as what the actual future price might be. The investment ideas behind EMR are about trying to reduce those risks going forward. Although we could see some initial price increases, the long-term risk might actually be reduced.

  Dr Edge: The issue is that prices will rise and we will need to have investment. We have been behind for a long time and we need to put a lot of investment in, but the prices as they are now are below the level that you would need to support the investment, so prices are going to rise.

  A high level of low-carbon generation should be a lower risk. It might be a higher price, but the chances of that moving around are a lot lower, because you have high capital costs and low running costs—you know essentially what the up-front costs are from day one. If you go down a high-fuel route with a lot of gas and coal, however, you are exposed to a lot of price volatility, so it is important to put that into the equation.

  Dorothy Thompson: We have set ourselves, as a nation, some very clear climate change objectives, and we need to recognise that, at least through the electricity market, there is going to be a price for that. On the other hand, the nation believes there is a benefit from that as well, so it is a price we have to face.

  As for the specific proposals, in terms of the FIT, the market is designed to be more competitive than the current renewables support we have, so that should deliver a better price to the customer. In terms of the carbon floor, I find that a little more challenging, because you already have the FIT to support low-carbon generation—I don't quite understand why you have the two. I think the general commentary is that there is less confidence in the carbon floor as an indicator for investment, so it is less clear that it will drive through the value through the investment. What is clear is that if you do have a carbon floor and that is introduced now, it will provide a windfall to existing renewables, to existing nuclear and, to an extent—until coal has shifted in the system—to existing gas. That windfall will be paid for by the consumer, so I think it's a bit mixed.

  Q128  Christopher Pincher: I agree that we certainly need to focus the challenge, but if you are asking certain constituents of mine in Tamworth to face that challenge and pay that price, they might balk at the prospect, so we need to demonstrate that we have consumer interests, as well as our climate change objectives, at heart. Do you feel that the green deal and its pay-as-you-save proposals are an opportunity to offset some of that risk that we are shifting away from the providers of energy to the consumers?

  Dorothy Thompson: There is no question but that the more we can improve energy efficiency, the better we are at delivering a reduced total bill to the customer. The challenge is how to get consumers to change their behaviour; people seem to like more and more flat-screen televisions, or whatever it might be. I believe in the green deal, but I think it is a big challenge.

  Juliet Davenport: May I add to that? I think that one of the areas where EMR could go a little further than it has is in looking at what demand-side response individual consumers could start to bring to this marketplace. What is interesting in the microgeneration area, particularly with solar PV—we are working with a lot of social housing in which solar PV has been installed—is that behavioural change is driven by having generation in situ. The green deal is great, but it doesn't address some of the other sides where you could get significant behavioural change by incentivising people to use power at different times of the day.

  Dr Edge: If I can widen that a little bit, there is a wider economic bonus if we get it right. We may be paying more through our bills, but we may get more economic development. I am thinking particularly of the manufacturing opportunities in offshore wind, but there are also other employment opportunities in the renewable energy industry more broadly. If we can get that benefit for the price we are paying, that is an equation that would allow people to see that it is a price worth paying, but we have to ensure that we capture that. It is very disappointing that in the market reform consultation, there was no recognition of that as an opportunity for the UK economy—it was purely focused on the electricity sector and its market, which I think was an opportunity missed.

  Q129  Sir Robert Smith: I appreciate the importance of energy use and the potential for renewables, especially in my constituency, but when it comes to Government electricity policy, shouldn't it be about the lights being on in a low-carbon way that is as affordable as possible for the consumer?

  Dr Edge: There needs to be a wider cost-benefit analysis that says, "We could go down this route, which might cost us a certain amount, but the wider economic benefit is very limited; or we could down another route, which might cost a little bit more, but you get a lot more from it." That kind of judgment is absent from this, and there does at least need to be recognition that one of the reasons we are doing this is that we think there is a wider benefit to the UK economy.

  Q130  Christopher Pincher: We were talking earlier about liquidity being a key element. Do you not think that increased liquidity in the marketplace is another element that could drive down price for the consumer? Surely we don't want to give the impression to the consumer that this has to fall solely on their back. Their behavioural change is the only way that prices can be reduced for them.

  Dorothy Thompson: We would connect increased liquidity with increased efficiency, a better relationship between generator and supplier, and more open opportunities for suppliers. We believe, therefore, that it would have a positive impact on prices.

  Juliet Davenport: As a result you may have a lower cost of credit, too. That is one of the key issues for suppliers. One of the barriers to growth for suppliers is how much they have to spend on having credit lines in place to be able to deal with generators.

  Q131  Barry Gardiner: Whichever way we look at the figures, there will inevitably be a huge amount of investment over the next 10 years. How much of that investment do you think can come from the independent sector, if I may call you that? What investment plans do you have? How much are you going to bring to this party?

  Dr Riley: I guess the answer to that largely depends on the outcome of this energy market review, because at the moment I don't think any of us would have serious plans to invest very much. The market signals just aren't there. If you look at the often quoted £200 billion that is needed over the next decade or so, perhaps £100 billion[1] is in low-carbon technology. The independent generators represent some 20% of the market, so if the framework is right, there is no reason why they couldn't invest their fair share.

  Dorothy Thompson: We're actively looking at two sorts of investment. I shall first tell you a little about Drax. Drax is the largest coal plant in the UK. It produces 7% of UK power, but we burn a lot of biomass. We have made a major investment over the past two years, and we can now burn an eighth of our capacity in biomass. That was a large investment, and last year we were, plant-wise, the largest renewable generator in the UK. With the right policies, there is an opportunity to change our coal station into a renewable station. To do that, we would need the right support from our equity investors as well as debt providers.

  As I mentioned earlier, we have also been looking at new-build plants, which we have found challenging. What we have not found challenging is finding access to capital when we can put the right structure in place; we have found it challenging to find the right structure to make it financeable.

    Juliet Davenport: We deal with about 1,700 renewable generators in the UK. In terms of recent policy changes, it has been really interesting to see the difference in attraction of external capital. There is significant debate around the current feed-in tariff, but it has very successfully pricked up the ears of various equity investors to make them come into this marketplace; it has done that very successfully. From our point of view, it has also been interesting to talk to investors and find that many are still very interested in renewables post-planning, but not pre-planning. So it depends what you are talking about; there are things other than electricity market reform that still affect incoming equity.

  Q132  Barry Gardiner: What effect will the instruments that have been proposed in the consultation have on the different types of risk that you are facing?

  Dr Edge: If I may jump in, from the figures that I have seen, of that £200 billion only about £45 billion is possible, via the Big Six's balance sheets. Other forms of finance, such as conventional project finance, are only going to take that up to, perhaps, £105 billion, so a large chunk—£95 billion—must come from somewhere else. Obviously, the big ones that everyone points at are the institutional investors—the pensions fund and insurance companies—but to get them in, you need more simplicity and ease of understanding. People say that the renewables obligation that they are being offered is complex, difficult to understand and unique to the UK, so we are not sure how that will appeal to those new institutional investors.

  Dorothy Thompson: We are owned by institutional investors, and we have had some dialogue with them. The message that comes out to me is concern that the EMR document itself does not think hard enough about investors. The situation is ultimately value versus risk versus return, and any institutional investor will say that there are many different places in which they can put their investment; they will only invest in this sector if it is attractive, relative to the opportunities. That is about return as much as risk.

  Certainly, the investors that we have been talking to recognise the attraction of the stability, and contract nature, of a contract for differences, as opposed to the current regime, in which there is—I don't like to say this in the UK—an element of political risk. I strongly agree with Gordon that the real key is to keep it simple. The more you do that, the more investors can understand and money can be attracted.

  Q133  Barry Gardiner: So how will what is proposed in the EMR affect the cost of capital for your investment?

  Dorothy Thompson: There is no question but that our analysis shows that if there is a contract for difference with the right level of return in it, there will be a lower cost of capital for us to create an investment, when compared with the RO, where we had risk on both the electricity price and the final ROC value.

  Juliet Davenport: At the smaller end of the market, however, a CfD instrument may have the opposite effect. It may drive investment upwards into much larger projects and away from some of the smaller ones because of the transactional costs that are related to the proposed instruments.

  Dr Edge: It has been well proven in a number of markets that when there is a lot of wind on the market, the price goes down. With the CfD, because variable generators such as wind are price takers, there is a risk that you will not get the index against which the CfD would be judged. You will not, therefore, get the strike price—it will be at some level below that, which you may not be able to predict with much accuracy, so although it promises price stability, it may not deliver that fully, which is a key risk for us.

  Juliet Davenport: Which I think is a big dilemma full stop, because we need to have that pricing signal right at the end, at the dispatch. Otherwise, we will not have cost-effective dispatch, which will not be cost-effective for consumers. The only way to have efficient dispatch is to have the market price in it, and then you are left with the problem of how generators deal with that. At the moment, under the ROC regime, there is no protection, and the only way to get it is to go to a large supplier who will buy the risk. Under a CfD, you will be in exactly the same position—the only way to get protection for that last-minute dispatch risk is to go to a large supplier.

  Q134  Sir Robert Smith: We have already touched on carbon price support in one review of those proposals. How do the rest of you see carbon price affecting your business?

  Dr Riley: I think the important point is that if there's a feed-in tariff of some sort that's going to be used to incentivise investment in low-carbon generation, there is a question mark around why the carbon floor price would be needed at all, because you've effectively then got two different mechanisms incentivising. If you've got a capacity mechanism as well, you've got a third, maybe, so there's a question as to whether it's needed at all.

  Q135  Sir Robert Smith: I was thinking you've got the EU ETS.

  Dr Riley: Yes, okay, so you've got a carbon price already—potentially a carbon floor price; it depends on the level at which that's set. But if it's already incentivised by a feed-in tariff, then why is it necessary? To the extent that it's decided that it is necessary, again we would make the same comments that were made earlier: it should only come into force when the generation that it's trying to incentivise is actually on the bars and generating, and not earlier—and at a sensible level that doesn't put too much of a burden on the consumer.

  Darren Braham: Our concern would be a straight pass through to the consumer's electricity bill. Some of the numbers that are being talked about would imply a 25% or 30% increase in electricity retail costs.

  Dr Edge: In general terms, we think that having more certainty in the carbon price would be a good thing. Our preference would be for some kind of EU-wide mechanism to do that—perhaps a reserve price on EUA auctions—but at the moment we're a little bit agnostic around this one. As Steve said, if there is a CfD it's a bit irrelevant, in terms of what our members actually see as their income at the end of the day.

  Juliet Davenport: Can I come in on that? I must admit that I came at this a slightly different way round, and maybe my thinking was just slightly back to front, but I felt that the reason for the CfD was the carbon price. Given the fact that you were putting a long-term price indicator into the market on carbon, the CfD mechanism was there precisely to make sure that you didn't overcompensate some of the technologies. If you don't have a carbon price, I'm not entirely sure why we're having the CfD, but maybe that's just me misreading it. I felt that a long-term price indicator that gently ramped up and gave long-term indication in the market would be a good thing, finally, and some kind of translation mechanism between the existing mechanisms we've got and a carbon price in the future would be the way that we should go eventually.

  Q136  Sir Robert Smith: Do you think the UK can go it alone with its own carbon price floor when it's got a trading mechanism for emissions and is also about to, possibly, have more interconnectors with other countries?

  Juliet Davenport: No, I think it has to be negotiated at a European level, and I think it has to be brought into a European type. There are already forms of carbon taxation across structures, across Europe, and I think considering how those interact would be an important part of it.

  Q137  Sir Robert Smith: Just one thing—a slight red herring: Professor Dieter Helm put it to us that the gas supply was becoming almost infinite and that a way of going quickly to a low-carbon situation would be to close all the coal-fired power stations and build lots of gas-fired stations, and then mothball the gas-fired power stations when future technologies become available. Does his analysis strike any chords?

  Dr Edge: I can't see how anyone would want to invest in a gas-fired power plant on that kind of basis—that at some time in the 2020s they would forcibly shut it. It does seem like a very odd way of going on.

  Q138  Dan Byles: I think his logic was that investing £100 billion in offshore wind in nine years is so staggeringly expensive that even turning a gas-fired power station off in 10 years would be cheaper.

  Dr Edge: But then you would get no benefit, in terms of all the things I was talking about—in terms of the industrial side—and you would be wide open to the gas market. Okay, there may be some kind of global glut at the minute, but there's no guarantee of that. It may be that shale gas turns out to be so environmentally horrific that you just can't rely on it and we're back again at square one with dependence on Gazprom.

    Darren Braham: Yes, I think you are moving the risk somewhere else, and in the absence of creating more storage, I think it's a very risky way forward.

  Q139  Chair: Going back to FITs, do you support the Government's view that FITs with a CfD is the right way to do it?

  Dr Edge: We think that's a slightly higher-risk strategy than the premium FIT, which is their back-up. We see there are a lot of details that need to be got in there with the CfD for it to be a fully workable system. At the moment, we are trying to work through those details and see if we, internally, in our industry, can come up with a system, within the parameters that are set out, that we think is fully workable. We have not, however, got to the end of that process. At the moment, we are not saying yea or nay to that option. The premium FIT is lower risk for us. The transition to that would be less disruptive.

  Juliet Davenport: The CfD is interesting. The examples that are given within the document relate to a one-sided CfD, as far as we can see, and particularly to ensuring that there is no downside to the investment, rather than to trying to pay back some of the upside. They particularly look at large-scale technology such as offshore wind. I come back to the point that CfD is not workable for smaller-scale generation. My feeling is that we have two types of FIT already, fixed and premium. Perhaps you could go with three types of FIT: a fixed, a premium for the mid-sized generators and a CfD for the very large ones. That would allow the trading teams that you require to manage a CfD. The overhead of that would match the larger-scale sites. You could have the review on a CfD-type basis for the premium side.

  Q140  Chair: The CfD FIT gives predictability on income, doesn't it?

  Juliet Davenport: It is not about the predictability; it is about the transaction costs of managing that predictability, and about being able to get the strike price, as was mentioned earlier, for the smaller generators in a marketplace at the rate that is perceived by the market index.

  Q141  Chair: When you say "transaction costs", what do you mean?

  Juliet Davenport: I am referring to the fact that under the consideration—admittedly, there is not much detail here yet—you would need to be trading on a regular basis, whereas generally, a smaller generator tends to put a 10-year PPA in place, does one trade and allows somebody else to take that over. The CfD proposal is expecting a much more active trading position. Therefore, if you are asking for that, you will have to carry another overhead or pay somebody else to be able to do that.

  Dr Riley: From International Power's perspective, the preference would be for a premium FIT. While a straightforward, full FIT would give absolute certainty for that investment, we would not support that because it does not take account of the impact that would have on the market as a whole, once you are looking at the amount of renewables likely to be on the system. We have a preference for the premium FIT over the CfD because it is simpler.

  Q142  Chair: Even though it takes away the certainty?

  Dr Riley: We would argue that investors in the energy market should be prepared to have some degree of energy market risk that they are willing to manage. I do not want to confuse looking for a risk-free investment with looking for a lower-risk investment that should be managed. It is important to maintain a liquid wholesale market and, therefore, a transparent wholesale price. The premium FIT would be more likely to do that.

  Q143  Chair: But almost every prospective generator of low-carbon energy says to me, "The reason we are not investing is that there is no certainty about the price." You're saying that you want the choice that doesn't give you that certainty.

  Dr Edge: I think it is fair to say that people are investing against the RO, which supposedly does not have that certainty of price, but it has the familiarity of the mechanism, which allows people to make a judgment on whether it is an investment worth making. People have been investing, particularly in wind power, in this country.

  Q144  Chair: But nothing like enough.

  Dr Edge: That's not the fault of the RO. It's because we have not been able to get enough through the planning and grid connection systems. The fact that 20,000 MW of onshore wind has entered the planning system since the start of the RO in 2002 says to me that the mechanism works.

  Q145  Chair: This is not about onshore wind. I see that there is a planning problem with onshore wind, but onshore wind is virtually a marketable technology anyway. We are looking at the other ones that are not marketable without some help. You are all saying that the one system that you want to choose is the one that takes away the thing that everyone else says they want, which is predictability on the price.

  Dorothy Thompson: Excuse me, but I am not saying that. We support the CfD FIT. The premium FIT also works, but the problem is the cost to the consumer. To encourage investment, the investors will have to assume a certain power price. They will have to look for a safe enough power price, relative to the volatile power prices, to be confident of their income. Please excuse me if I'm getting too complicated. If you think the power market will be at one level, you will have to assume it to be at a lower level to make your investment, which means more support will be needed. We think it is a consumer issue, but from an investor point of view, it's all about the level of support. In terms of the small dispatch, it is definitely the case that it will be difficult for the small generators to manage. It's exactly like the RO today; under the RO today, the small generators have to go to a supplier and say, "Give us a contract." Under the CfD, we'll be in the same position; if they don't want to face the transaction cost, they will have to go to a supplier and say, "Give us a contract."

  Juliet Davenport: I agree that the CfD, in principle, is a good mechanism for the larger generators, but I see it as a transactional cost for the smaller generators.

  Dr Riley: May I have one more go? If this was a single-issue review, and you just wanted to incentivise low-carbon generation to a particular level, a straightforward feed-in tariff would do that; that would give absolute certainty for those investments. What it wouldn't do is take account of the market as a whole. We had a conversation earlier about the importance of liquidity in the markets and thinking about a viable system going forward. That's why we'd like to think—to answer your question about why we don't go for something that gives absolute certainty for a particular investment—that the system will consider the market as a whole.

  Q146  Barry Gardiner: Is either of the two proposals for emissions performance standards worth the paper it is written on? Dr Riley, you had something to say on this in your submission.

  Dr Riley: I think we're already on record as saying that we think the emissions performance standard is an unnecessary regulation. Certainly, existing coal plant has enough constraints on it through the large combustion plant directive, the industrial emissions directive and the emissions trading scheme to ensure that there's a fairly low level of generation unabated going forward. Given the level at which the emissions performance standard is set in this document, it's very much a back-stop and probably an unnecessary piece of legislation.

  Dorothy Thompson: We would completely agree.

  Q147  Barry Gardiner: Would anybody disagree?

  Juliet Davenport: I don't know enough about it, but in principle, I would agree as well.

  Q148  Barry Gardiner: Let's imagine a scenario where the level was brought down from 600 or 450 grams per kWh to something that might seem to have a bit more teeth and that might actually bite into gas as well. What would the effect be? Might it be worth having that?

  Dr Edge: Philosophically, our view would be that you'd want something in the short to medium term that incentivises the low-carbon, while in the longer term you have something like the EPS to squeeze out the rest of the carbon in the system. I'd have thought, as part of an overall mix, an EPS that does indeed bite down into unabated gas eventually is what you'd want. Certainly, from our point of view, for the low-carbon, we're much more focused on the carrot bit of this than on the stick of the EPS, which may be necessary in the longer term.

  Q149  Barry Gardiner: In a sense, the carrot and the stick are just the obverse of each other, aren't they? If the EPS is biting down, it is increasing the attractiveness of the investment proposition for your sector.

  Dr Edge: That would be, to mix metaphors, a bit of a blunt carrot; it would be an incentive, but it would be rather indirect.

  Q150  Dan Byles: I just want to come on to capacity mechanisms. A number of respondents to the Committee have suggested some uncertainty about exactly what the capacity mechanism is supposed to achieve. Is it supposed to achieve a certain amount of capacity of any type, a certain amount of capacity of particular types or something else? I would welcome your views on that.

  Dr Riley: If the capacity mechanism is there to ensure security of supply, that means you need a wide range of technologies in the system. It should, therefore, be a broad mechanism that ensures you keep the capacity in the system for reliability and security of supply.

  Q151  Dan Byles: A technology-blind system?

  Dr Riley: Correct.

  Dorothy Thompson: And also supply and demand blind.

  Juliet Davenport: Yes.

  Dr Riley: I'm sorry, but I have one more point on this. We have seen this effect in some of the other markets in which we operate. Clearly, demand-side participation would be an important part of the market going forward, as well, but that also needs to be real. In some of the other capacity markets in which we operate, demand-side bidding is there and participates at the auction stage. However, it isn't necessarily there when it's intended to be, and the penalties for non-performance aren't that great. There is a lot of devil in the detail around thinking through capacity mechanisms where demand-side participation is used as well.

  Q152  Dan Byles: Do you think it's possible to design a system that will reward both generation and demand-side measures?

  Dr Riley: Yes, there are systems around the world. There's the PJM[2] in the US, where there is a functioning capacity market, and I thought the all-island market[3] was quite a good capacity market as well, in contrast to the comments made earlier. The markets exist, and it is possible to learn lessons from some of the detail of those markets as they've operated.

  Juliet Davenport: Bringing in the demand side is very important. Part of that needs to look at how the settlement system brings in the demand side and what the opportunities are for aggregating the smaller-scale demand, not only the larger scale. It is also about looking at the technology links into that. We talk about smart metering and smart grid, but we are not really talking about connecting it to a smart settlement yet. I think you need all of those aligned, and a bit more creativity and imagination could go a long way towards bringing in other areas.

  Q153  Dan Byles: Do you have a view on the level of capacity mechanism that we would require? Pöyry Energy Consulting did some modelling that threw up the idea that we might need up to 40 GW of back-up or demand-side measures. Do you have a view on what level might be required?

  Dr Edge: It rather depends on the rest of the mix. It also depends on how much you can bring in on the demand side and how much interconnection capacity you can build with the rest of Europe. I am afraid such estimates are a little like asking, how long is a piece of string?

  Q154  Dan Byles: Do we not need an idea, or at least a working ballpark figure, if we're going to design a system that will generate the capacity required?

  Dr Edge: I certainly think that we need to focus much more on post-2020 scenarios. Our industry has been very focused on 2020 because we have a very hard target to meet, but beyond that is a really important debate that we are only just starting to have, which those questions would come out of. DECC has been trying to do it through its 2050 pathways work; we can argue about the usefulness of that, but we need to have the conversation and we're not really down that path.

  Q155  Dan Byles: Do you think it's too early for DECC to be looking at trying to create a capacity mechanism?

  Dr Edge: No, but knowing how much it wants to deliver is another debate that may have started but certainly has not finished.

  Dorothy Thompson: There are two different time frames here. I strongly agree on 2050, but the thing to remember is that our new nuclear plant will probably be load following. The profile of what our plant can do will change, and that will be a big advantage if we achieve what we want to achieve in nuclear by 2050. There is a risk in the transition. We read recently that it is estimated that by 2020 the hourly swing will go from 5 GW in 2009 to 17 GW in 2020—that is if we achieve what we expect to achieve on wind and so on. It is an enormous figure; 17 GW is like every household in the UK going from no power to almost full power within an hour. It is a major swing.

  I think we have to worry quite a lot about what the transition will be. There is no question but that by 2020 most of our coal plant will come off the system. Our coal plant is providing an awful lot of that flexibility. We are a very strategic asset, so I see it day by day. We spend a lot of time providing frequency response and balancing support services, and on special contracts to National Grid just for that support. The coal will go, or a large part of it. That is simply a feature of the industrial emissions directive. You will also find that some of the older plant will go, which is also providing some of the flexibility, and we will have much less fossil fuel plant to balance the system. I don't know what the answer is, but I believe it is something we should worry about. As you said, people should be trying to estimate exactly what the problem is so we can work out how to solve it.

  Juliet Davenport: Just to add to that, one small thing is that we're quite mute about electric vehicles at the moment and consideration of what that load may do to the system. I am concerned that there is no consideration at the moment for restricting electrical vehicles, and when they can charge and how they can charge—we are talking about speed charging. Those types of loads could make much bigger swings than we are talking about in this context. So, I think that needs to be considered to make sure that we don't add to the problem that may be coming towards us.

  Q156  Chair: We touched on interconnections earlier—some of us were at National Grid yesterday, as it happens, and they are very keen on seeing more investment in interconnectors. Do you think that there is a limit as to how much we should regard interconnection as part of the answer? I know that it is a two-way process; obviously, we are supplying them sometimes as well. However, do you have a view about the theoretical maximum?

    Dr Riley: I am sure that there is a limit, but I wouldn't have a number. Again, I would have thought that there is evidence from some of the interconnected markets in continental Europe, where the peak in demand is actually coincident, and therefore, the effectiveness of an interconnector may be more limited than its nameplate capacity. As long as that sort of effect is taken into account, interconnection has an important role to play.

  Juliet Davenport: I think renewable resource interconnection is quite interesting. If you look at the disperse of weather systems across Europe, when you are generating, you look at your generating capacity. When we buy power in the UK we try not to buy it in one region; we buy it across the UK. So, our 1,700 generators are spread, because that spreads our weather risk. Essentially, if we are going to move to a much windier portfolio, which we will, having larger interconnection means that—although I agree with the point about demand—in terms of wind, you will get spread.

  Dr Edge: You might estimate some kind of limit, but by the time we get towards that, technology will have advanced, so the limit will have extended further. So, in some ways, you might regard it as essentially infinite, although I cannot predict the future. It is always difficult.

  Q157  Chair: The other point that was raised right at the start was about coherence of the package. There are several elements in it, but do they all fit together? Are they all necessary? Do you need a carbon price mechanism if you have a feed-in tariff, and so on? Do you think that those elements are not really consistent?

  Dorothy Thompson: I echo what Steve said. If you are supporting your low-carbon generation through a feed-in tariff, I would question the role of the carbon floor.

  Dr Riley: Again, the devil is in the detail. It would be quite easy, with some of these measures, to not think about the impact that a single measure has on some other important attributes of the market. At the same time, however, with enough considered thought, it is possible to bring this package together so that it is coherent and protects the good elements of the market that we have so far, as well as improving it and encouraging the right investment.

  Dr Edge: I would have concerns about the reliability and security of supply measures, and the low-carbon support measures. It is possible that, through the capacity mechanism, you could really affect the wholesale price of power and that would impact on your low-carbon support mechanism. So, those bits need to fit together.

  Chair: Okay. We have reached the end of our allotted time. Thank you for coming in, and I am sure we shall see you again individually or collectively on other matters before long.

1   Note from the witness: "actually about £130 billion" Back

2   Note from the witness: "Pennsylvania, Jersey, Maryland" Back

3   Note from the witness: "all-island (Irish) market" Back

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Prepared 16 May 2011