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The UK is at a critical juncture in the way we use energy. A quarter of our generation capacity will close in the next ten years and must be replaced. Electricity Market Reform (EMR) presents a once in a generation opportunity to shift our energy usage to a low-carbon, energy-secure and affordable future.
The Government is right to aim to attract investment in low-carbon generation and to create adequate rewards for flexible capacity. However, the proposals presented in the consultation are over-complex, potentially expensive and fail to recognise the urgency of the transformation that needs to take place. The proposed reforms would not do enough to attract the £110 billion investment needed in the electricity sector in less than a decade and they miss the chance to put the UK at the forefront of innovation and competition. Without that investment, the UK will not meet its decarbonisation and energy security targets. In this Report, we recommend a number of ways that the Government must improve its proposals in order to make the UK an attractive place to invest in low-carbon electricity.
First of all, the Government needs to be more explicit about its ambitions. In line with the recommendations of the Committee on Climate Change, the Government should design the market reforms in order to achieve a carbon intensity in the range of 40-60gCO2/kWh by 2030 for electricity generation. It should set out an intended pathway of gradually reducing carbon intensity toward 2030.
Current electricity trading arrangements have been moderately successful in achieving energy security at reasonable cost, but the electricity market must now be adapted to deliver decarbonisation and new capacity. Low-carbon technologies have very different economic profiles and operational characteristics from the gas and coal plant that has sustained us in the past. There is a need for much better balancing arrangements, interconnection and new technologies like electricity storage to deal with greater intermittency, as well as new generation to cope with increasing volatility and demand. In the future the UK could benefit from much more interaction with EU electricity markets.
The big omission from the Government's proposals is a plan for reform of the wholesale electricity market. The core of the electricity market—the wholesale market—would not be changed by the measures proposed. The consultation document proposes a number of "bolt on" measures that reform the subsidies and structures around the market, not the market itself.
Wholesale electricity market reform will be needed to break the dominance of the Big Six energy companies in order to allow new entrants to invest in the UK's low-carbon future. The Big Six will be key contributors to the low-carbon transition, but they cannot meet our investment needs alone. Currently, the Big Six are almost unchallenged in the sector, as they control both generation and supply, and there is little room for independent or decentralised generation. The lack of liquidity in the market makes it hard for potential investors to have confidence in the prices they will receive. An illiquid and opaque wholesale market poses serious difficulties for new entrants to the sector, threatens the effectiveness of the Feed-in Tariffs proposed by the Government and undermines competition, so that consumers are likely to pay more than they need to. The Government must bring forward a plan for reform of the wholesale and balancing markets—a real electricity market reform.
The measures proposed in the package are designed to encourage large amounts of investment in low-carbon generation, while maintaining enough flexibility to meet demand. The first "pillar" of EMR is a kind of long-term contract—a Feed-in Tariff. If long-term contracts are successful in reducing risk, this should reduce the cost of capital and deliver billions of pounds in savings over the life of capital investment projects. In a global market, where investors have opportunities to invest in any sector in any country, this will be vital for making the UK competitive and attracting the massive sums of new capital required.
However, the Government's "one size fits all" approach will fail to bring forward the low-carbon investment we need. The model of contracts proposed may be appropriate for some generators, such as nuclear and biomass, but could increase costs and risks for intermittent generators such as wind and technologies like carbon capture and storage and electricity storage. A Feed-in Tariff with Contract for Difference may be an effective way to expedite an extremely rapid rollout of nuclear energy if that is the option the Government wishes to pursue, but alternative kinds of long-term contract should be designed for other kinds of low-carbon generation. The Government must create an independent expert institution to design these contracts as soon as possible, or instruct an existing body such as Ofgem to do so.
The second pillar of EMR is a Carbon Price Support (CPS). A realistic carbon price could internalise the cost of greenhouse gas pollution and help to make low-carbon technologies competitive. The EU Emissions Trading Scheme (EU ETS) has so far failed to deliver prices that encourage a long-term technological shift and is unlikely to do so soon, but any UK attempt to create an effective carbon price unilaterally is potentially costly. CPS is being put forward as an element of EMR, but delivered by HM Treasury on a different timetable from the rest of the package. It introduces political risks with little evidence of the supposed benefits.
Third, the Government has put forward an Emissions Performance Standard (EPS) as a backstop against the most polluting electricity generation. The EPS proposed in the consultation document would have no material impact and is therefore pointless. The prospect that the EPS will be tightened by unannounced amounts later on introduces additional political risk.
The fourth pillar of EMR is a capacity mechanism, which may be necessary to ensure energy security. In the short-term, new capacity is required to fill the gap when present generation shuts down, but the capacity mechanism proposed may not be available soon enough to create that supply. In future, however, we are likely to have much more inflexible and intermittent generation and some premium payment may be needed to ensure that enough flexible generation is available to meet demand.
The money we invest in decarbonisation today must be weighed against the benefits for consumers now and in future generations. Demand reduction ought to be a primary focus of the Government's decarbonisation agenda, as the most cost-effective and environmentally effective method of climate change mitigation. Demand reduction should be placed at the heart of EMR and the Government's climate change policy. The Government also has a responsibility to ensure that the potential costs of decarbonisation are properly explained to consumers. If these reforms are to be sustainable, they must have public support.
To give confidence in the EMR package a number of factors need further exploration. Future levels of interconnection, carbon price trajectories, the contribution of decentralised generation, technological improvements and the pace of electrification in the domestic heating and transport sectors will all affect the low-carbon transition. One key factor is the Government's assumption that gas prices will continue to rise. If gas prices fall then the lack of volume-based targets for low-carbon electricity will mean continued reliance on gas generation in the short term. This risks the possibility that large amounts of stranded gas assets may be created if carbon capture and storage technologies are not viable in the 2020s. These details need to be considered in the forthcoming White Paper.
The Government must set out a target timetable for implementation as quickly as possible because the uncertainty created by the EMR consultation is already deterring investment, although this aim must be balanced against the need to get the proposals right. EMR must be coordinated with complementary reforms, such as EU market coupling and the transmission pricing review. The longer these reforms remain on the drawing board, the more likely we are to experience a serious hiatus in energy sector investment. The UK's targets are too tight to risk back-loading the effort any further.
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