Electricity Market Reform - Energy and Climate Change Contents

2  Background

The British Electricity Trading and Transmission Arrangements (BETTA)

8. The electricity markets were last reformed to create the New Electricity Trading Arrangements (NETA), which came into force on 27th March 2001, and then extended in April 2005 to cover Scotland under the British Electricity Trading and Transmission Arrangements (BETTA). At this time, the priority was to deliver sufficient capacity at low cost and to create as large a single-price energy market as possible. A wholesale market was designed that favoured cheap and flexible gas and coal capacity as well as encouraging "vertical integration" where a company owns generation and supply businesses.

9. Under the BETTA system, there is an electricity wholesale market between electricity generators and suppliers, which contract directly with one another. This is intended to promote competition and efficiency in order to minimise costs for consumers. This is an "energy only" market, where producers are paid for the energy they produce for their customers. Electricity is then sold in the retail market between electricity suppliers and consumers. Domestic consumers can choose to switch between electricity supply companies.[7] Under the EMR proposals, the four "pillars" would affect the way that capital is invested in the UK electricity sector, but it would not affect the way the market functions.

10. The market operates on the basis of rolling half hourly slots. Generators are required to contract with customers one hour ahead of actual supply ("gate-closure") and to declare their final settlement to the System Operator, National Grid. Companies are subject to "settlement charges" if they do not meet their contractual positions. For example, if a generator generates more or less electricity than they have contracted to provide, or a supplier requires more or less electricity than they have contracted to buy, then they will face a charge. [8] After gate closure, the system operator can call on bids and offers from generators and suppliers to balance supply and demand. The system operator also has a other balancing options ("Short Term Operating Reserve") which it can call upon, such as pumped storage, voltage reduction or interruptible contracts.

11. BETTA was designed to support large, centralised, predictable fossil-fuelled and nuclear generation. This creates difficulties for intermittent electricity sources. For example, the current approach depends on predictable generation capacity which can commit to deliver precise volumes of electricity a year or even more in advance on long-term contracts. Suppliers can fine-tune their portfolio of contracts closer to delivery as actual demand becomes clearer. This may not be suitable for the low-carbon future needed. Wind power may be predictable in the short term and can be forecast accurately a few hours ahead of delivery, but it cannot be guaranteed for a particular half-hour slot in the weeks, months or further ahead.

12. Unlike gas-fired power stations, low-carbon generators face high upfront construction (capital) requirements and low operational costs. They are therefore more exposed to uncertainty in future electricity prices. Wholesale electricity prices tend to be set by the short-run marginal costs of gas (and sometimes coal) plant (including the costs of CO2 emissions under the EU Emissions Trading System). This means that electricity prices move in line with the price of gas. In this way, gas plants are naturally hedged against changes in the electricity price, but low-carbon generation is not. This makes investment in low-carbon generation riskier than investing in gas-fired plant. This in turn makes the cost of capital higher for low-carbon plants.

13. Low-carbon generation is also at a disadvantage because the benefit of "clean" generation is not properly priced in the market. The EU Emissions Trading System (EU ETS) creates a carbon price, which partially adds the cost of greenhouse gas emissions to the price of generation.[9] However, while the ETS has been successful in encouraging generators to switch from coal-fired to gas-fired generation, the carbon price has not been high enough to encourage investment in low-carbon generating plant. In addition, the price has been subject to high levels of volatility, and the lack of a reliable and credible long-term carbon price signal impedes investment in low carbon technologies because it cannot be used to build an investment case.[10]

14. Good Energy told us that "existing renewable generation is there in spite of the market structure not because of it".[11]

The new priorities

15. In 2011, the Government's policy priorities have evolved: they must now balance a number of competing objectives, including the extremely difficult and urgent need for decarbonisation. While the BETTA arrangements have been successful in delivering on narrow, affordability objectives, they are not sufficient to deal with the new aims of decarbonising the electricity supply and delivering security of supply in a low-carbon world.

16. There are three reasons for this. First, the scale of the investment challenge—much of the UK's existing plant is set to close over the next decade and a great deal of investment will be needed to replace this capacity. Second, the new capacity needs to be "low-carbon" generation (renewables, nuclear or fossil fuel with carbon capture and storage) which tends to be more expensive than conventional plant. Third, BETTA is an "energy only" market, where producers are paid for the energy they produce for their customers. There may need to be a stronger signal for investment in "spare" capacity to provide security against a greater level of intermittent and inflexible renewables.

17. These problems suggest that Government must reduce the risks of investment in order to reduce the cost of capital, especially for low-carbon generation. Shaun Mays of Climate Change Capital told us that "the cost of a 1% or 2% change in the cost of capital [...] makes a huge difference to the amount of money that goes in".[12]

The investment challenge

18. The energy sector faces an enormous investment challenge. Ofgem has estimated that the UK will need around £200bn investment in generation, electricity networks and gas infrastructure. Of this, at least £110bn would be needed in new generation and transmission assets in electricity—over double the rate of the last decade—in order to meet UK climate change, renewables and energy security targets, replace ageing plant and increase interconnection.[13] During our inquiry, we have given particular attention to the potential sources of new investment and how these sources of capital can be accessed.

19. The Pew Environment Group concluded that UK investment in "clean energy investments" in 2010 had dropped precipitously because investors are not confident of the present Government's policy conviction:

    After achieving a fifth-place ranking for clean energy investments in 2009, the United Kingdom dropped out of the top 10 in 2010. Investment levels in 2009 were driven by large volume financings for offshore wind energy and the government's commitment to strong action on climate change. But 2010 brought a new government to Great Britain, and investors appear to believe that there is a high level of uncertainty about the direction of clean energy policy-making in the country.[14]

20. The Government must reverse the downward trend in "clean" investment. It must create more attractive returns and reduce the risks of investment in order to reduce the cost of capital in the electricity sector.

New sources of finance are needed

21. The investment challenge comes at a time when the traditional investors in the sector, the Big Six energy companies, face balance sheet constraints.[15] Together, the companies operating in the UK energy sector are currently investing around £8bn annually in the energy sector, a significant increase from levels in the 1990s. This has already resulted in heavy borrowing to implement current investment programmes—the sector is highly "leveraged".[16]

22. This means that investment from other sources will be needed. Dr Gordon Edge of RenewableUK believed that of the £200 billion investment needed in the energy sector only about £45 billion would be possible from the current balance sheets of the Big Six.[17] He said that other forms of finance, such as conventional project finance, could bring the figure up to around £105 billion, leaving about £95 billion to come from somewhere else. Dr Edge suggested that this money could come from institutional investors—the pensions fund and insurance companies.[18]

23. The ability of the Big Six to meet the level of investment needed has also been questioned by Ofgem. Alistair Buchanan, Chief Executive of Ofgem, told the Committee that "if you look at those companies—taking data provided to me by Rothschild Investment Bank—the capex [capital expenditure] profile of E.ON and EDF as companies is falling, as group companies is falling quite substantially".[19]

24. Peter Atherton (an analyst at Citibank) pointed out problems with skills, organisational capacity and supply chain hold-ups for investment in new UK capacity. The supply chain difficulties were confirmed by the Big Six during the Committee's one-off session in December. They pointed to a skills shortage in the nuclear industry in particular.[20]

Investment is a global game

25. The level of investment from the Big Six is also affected by competition for investments from other countries. Alistair Buchanan said that E.ON was looking eastwards now, not towards Europe, for the development of its business, that it was looking for much higher returns than previously and that it would be selling existing UK assets, 50% of which would be sold in order to enhance its balance sheet.[21] He also told us that:

[...]we're looking at an investment proposition where the Big Six have their own capital issues [...] We have some very big players as well, like EDF, who are running at around, what, £160 billion enterprise value, and E.ON at £100 billion; but the two British champions, SSE and Centrica are much smaller—you're looking at £20 billion and below. So you have a big diversity of scale.[22]

26. The UK is facing considerable competition from other countries, where not only does investment offer potentially greater returns but there are fewer planning and regulatory hurdles—institutional investors can choose to invest their money in any sector anywhere in the world and where growth prospects are greater. However, Sara Vaughan (Director of Regulation and Energy Policy, E.ON) responded to this claim, telling us:

    When we [E.ON] announced our strategy in November last year, we made it clear that we were seeking to get 25% of our profits from other markets outside Europe by 2015. This reflects the opportunities for growth in those other markets, but it also means that we are looking to get 75% of our profits—very much the greater part, therefore—from Europe. The UK is a key market for E.ON. We are already investing in the UK. Over the last three years, we have invested more every year than we have taken out in profit.[23]

What the Government is proposing

27. The BETTA market aims to deliver energy at least cost by promoting competition in wholesale and retail markets. The EMR proposals would reward the amount of electricity available—de-rated capacity—as well as the type of generation on offer. The consultation proposed four "pillars" of market reform: carbon price support (CPS); long-term contracts such as feed-in tariffs (FITs); an emissions performance standard (EPS) and a capacity mechanism.

28. The DECC EMR consultation sets out four possible packages of reform:

a)  option 1—Carbon Price Support, Emissions Performance Standard, targeted capacity mechanism;

b)  option 2—Premium payment Feed-in Tariff, targeted capacity mechanism, Carbon Price Support, Emissions Performance Standard;

c)  option 3—Feed-in Tariff (FIT) with Contracts for Difference (CfD), targeted capacity mechanism, Carbon Price Support, Emissions Performance Standard; or

d)  option 4—Fixed payment Feed-in Tariff, targeted capacity mechanism, Carbon Price Support, Emissions Performance Standard.

29. As part of option 3 (the Government's preferred package), FITs would offer financial support for low-carbon generation; a CPS would underpin the cost of carbon pollution to increase certainty in the carbon price and encourage low-carbon alternatives; an EPS would prevent new coal-fired generation from being built without the potential for pollution abatement from carbon capture and storage (CCS); and a targeted capacity mechanism would offer payments for availability of flexible capacity.

30. Collectively, these packages of instruments are designed to change the risk/reward profile of investments in the UK energy sector and certain technologies. The current arrangements place electricity price risk on private energy companies. The intention is to provide higher and more secure returns for capacity and for low-carbon technologies, shifting market price risk away from investors to the Government and ultimately to the consumer.

7   National Audit Office, The electricity generating landscape in Great Britain, July 2010, p 7 Back

8   National Audit Office, The electricity generating landscape in Great Britain, July 2010, p 8 Back

9   In the EU ETS, a cap on overall CO2 emissions from industry and a requirement to hold allowances to cover emissions creates a market for EU Allowances [EUAs]. Demand in the market gives EUAs a price, which is intended to reflect the cost of pollution associated with the activity. Back

10   Environmental Audit Committee, Fourth report of Session 2009-10, The role of carbon markets in preventing dangerous climate change, HC 290, para 51 Back

11   Ev 130 (Good Energy) Back

12   Q 182 Back

13   DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 5;

HM Treasury, Budget 2010, 22 June 2010, p 28 Back

14   Pew Environment Group, Who's winning the clean energy race: 2010 edition, March 2011 Back

15   Q 23 [Mr Buchanan] Back

16  Written evidence submitted by Scottish and Southern Energy [GIB 22] to the Environmental Audit Committee as part of its Green Investment Bank inquiry www.publications.parliament.uk Back

17   Q 132 Back

18   Q 132 Back

19   Q 23 Back

20   Oral evidence taken before the Energy and Climate Change Committee on 7 December 2010, HC 670 Back

21   Q 23 Back

22   Q 23 Back

23   Q 171 [Ms Vaughan] Back

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© Parliamentary copyright 2011
Prepared 16 May 2011