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 challengemuch 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 electricityover double the rate
of the last decadein 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 programmesthe
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 investorsthe
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 companiestaking data provided to me by
Rothschild Investment Bankthe 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 smalleryou'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 hurdlesinstitutional
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 profitsvery
much the greater part, thereforefrom 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 availablede-rated
capacityas 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 1Carbon Price Support, Emissions
Performance Standard, targeted capacity mechanism;
b) option 2Premium payment Feed-in Tariff,
targeted capacity mechanism, Carbon Price Support, Emissions Performance
Standard;
c) option 3Feed-in Tariff (FIT) with Contracts
for Difference (CfD), targeted capacity mechanism, Carbon Price
Support, Emissions Performance Standard; or
d) option 4Fixed 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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