House of Commons - Electricity Market Reform

Electricity Market Reform - Energy and Climate Change Contents

4 The electricity wholesale market

60. The big omission from the Government's set of objectives is reform of the electricity wholesale market itself. As it stands, "Electricity Market Reform" is a misnomer. The core of the electricity market—the wholesale market—would not be changed by the measures proposed in the Consultation Document. Rather, the Consultation proposes a number of "bolt on" measures that reform the subsidies and structures around the market, not the market itself. In this Chapter, we consider structure of the electricity market and the importance of liquidity and how these factors will influence the outcomes of Electricity Market Reform.

The need for reform of the wholesale market

61. We heard that improving the way that the market operates is vital. It will be necessary to attract new investment in the sector and to underpin the operation of the measures proposed in the Consultation. The Government is attempting to create a system that will be sustainable for the long-term. In order to achieve a long-lasting electricity market structure that delivers all three of the Government's objectives, it will be necessary to address the core of the market itself. However, the Government continues to delegate that responsibility to the regulator, Ofgem, which has so far been unable to break through the dominance of the "Big Six" vertically integrated players (Centrica, E.ON, RWE npower, SSE, Scottish Power and EDF) to create a fully effective electricity market.

62. Professor Dieter Helm expressed how the objectives of EMR were jeopardised by the status quo in the electricity wholesale market:

The problem for Ofgem is that, having finally admitted in Project Discovery that security of supply would not be achieved by the market—it claimed for a long time that it would be—it now has to go one stage further and admit that liquidity and transparency, and NETA, do not mix.[65]

63. He argued that "what happens to NETA in the FITs long-term contract world and the capacity market is not discussed in the document" and suggested returning to a system that resembled previous electricity trading arrangements known as "the Pool", which required virtually all electricity in England and Wales to be bought and sold directly through the pool and therefore enjoyed high liquidity and price transparency.[66] Dr Barrie Murray agreed that "it is a delusion to think that DECC or Ofgem are going to establish an optimal way forward by tinkering with market" and that much more substantial change was required.[67]

64. Several independent generators told us that reform of the wholesale market is necessary to underpin the Government's objectives. For example, InterGen UK said in their written evidence that "large-scale reform of the electricity market is required to support the Government in meeting its long-term three-fold objective", saying that "action to improve liquidity is an essential precursor to EMR".[68] Similarly, ESB International said that "market reform proposals need to be underpinned by significant improvements in wholesale market liquidity" and that they "would seek for Government or Ofgem to publish further thoughts and proposals at the earliest opportunity".[69]

LIQUIDITY AND THE PROBLEM OF VERTICALLY INTEGRATED PLAYERS (VIPS)

65. Liquidity is an important feature of a well functioning market. It is the ability to quickly buy or sell a desired commodity or financial instrument without causing a significant change in its price and without incurring significant transaction costs.[70] A key feature of a liquid market is that it has a large number of buyers and sellers willing to transact at all times, leading to a significant volume of individual trades.

66. The current market arrangements have encouraged the formation of "vertically integrated" companies. The UK electricity market is dominated by the Big Six vertically integrated players, which own both generation and supply businesses and enjoy opportunities to "self-supply" electricity, bypassing the electricity wholesale market. This has resulted in low levels of liquidity in the wholesale market because generators can sign confidential bilateral contracts with retailers outside the wholesale market. This leads to a lack of reliable price signals, which deters investments from outside the incumbent Big Six.[71]

67. Many of our witnesses agreed that illiquidity and the lack of a long-term and transparent reference price was a barrier to new investment in the electricity sector.[72] A liquid wholesale market is necessary to allow investors to manage risk effectively and to reduce the scope for market manipulation. Transparent prices are needed as a basis for investment decisions, so that potential entrants can assess opportunities to enter the market. For International Power, liquidity was a problem "particularly for less standard products such as peak and off-peak, as these markets are particularly 'thin'".[73] Improved price formation and market access were important to independent generators "looking to 'hedge' output forward at a fair price, and on timescales that are more consistent with availability of fuels".[74]

68. We heard that liquidity would have an impact on the effectiveness of the EMR package and that EMR would affect liquidity. ESB International suggested that without a liquid and transparent market, the measures introduced in EMR may not be effective: "The "FiT with contract for difference" mechanism that is favoured by Government relies on a transparent and robust wholesale price, driven by generation cost".[75] International Power agreed that the Government would need to "ensure a robust reference price for the CfD FITs mechanism".[76] Other witnesses emphasised that the EMR proposals would themselves have a knock-on effect on liquidity. For example, Drax Power told us that a capacity mechanism could reduce wholesale market liquidity "as the volume of capacity that is subsidised increases in a market that already suffers from low liquidity".[77]

69. The lack of liquidity also means that in the GB market there is only a limited reference price over the longer-term. In such scenarios, the case for new investment is weakened, because of a lack of reliable price signals; this can deter new entry and competition in the sector.[78]

70. The current market arrangements do not facilitate a fully functioning wholesale electricity market which transmits the price information necessary to attract investment. We recommend that the Government incorporate a review of the present trading arrangements and liquidity in the forthcoming White Paper.

OFGEM'S ROLE IN IMPROVING LIQUIDITY

71. Parliament has delegated responsibility for liquidity and competitiveness in the electricity market to the regulator, Ofgem. In this section we consider whether responsibility for ensuring competitiveness and liquidity is best left to Ofgem.

72. Ofgem has been responsible for promoting competition in electricity and gas markets since 2000. Since 2009 Ofgem has been monitoring and investigating the liquidity of wholesale electricity in Great Britain. It is concerned that the wholesale market is not delivering the products and signals that all market participants need to operate their businesses effectively. In particular, independent suppliers and generators find it difficult to manage risk with the wholesale products currently available. This could be damaging the interests of consumers in the supply market, especially if it means that there is no viable competition for existing suppliers.

73. In its evidence, Ofgem noted some positive signs, such as through a new trading platform (N2EX) and the efforts of one of the Big 6 to sell energy "clips" in sizes more suitable for smaller suppliers. Ofgem believes that that it is in the best interests of the market to have greater liquidity and notes that some markets in Europe have achieved greater liquidity than the UK.[79]

74. Since Ofgem gave evidence to us, it has carried out substantial work on competition in the wholesale market. On 21 March 2011, Ofgem published the preliminary findings of its latest Retail Market Review, which found that "further action is needed to make energy retail markets in Great Britain work more effectively in the interests of consumers. Consumers are at risk from a number of features in the market which reduce the effectiveness of competition".[80]

75. Ofgem was right to tie this work into the EMR process. Its proposals would require the Big Six to make available between 10% and 20% of their power generation into the market through a regular Mandatory Auction.[81]

76. Professor Helm doubted the ability of Ofgem to change the wholesale market with its current mandate, arguing that the current arrangements were "part of its institutional history".[82] He suggested that the Ofgem Review is an opportunity to change its culture to reflect the Government's new priorities. We agree that Ofgem's priorities have been to secure affordability for consumers. The Ofgem Retail Market Review set out that "Ofgem's principal objective is to protect the interests of consumers, present and future, wherever appropriate by promoting effective competition".[83] It is vital that competition and liquidity are improved to meet the Government's other objectives of decarbonisation and security of supply. We believe that measures to improve the market must be pursued with these other objectives in mind.

77. The Ofgem Review was announced by the Secretary of State on 27 July 2010 and is exploring whether changes are needed to the regulatory framework of the electricity market and to the structure and role of Ofgem. The consultation closed on 24 September 2010 and the Government Response was published on 16 December 2010. The Government's conclusions on the review are expected to be published in "Spring 2011". The Association of Electricity Producers told us that the Government's conclusions should include "clarification of where current Ofgem initiatives such as Project TransmiT and review of market liquidity would be relevant to the outcome of these [EMR] reforms".[84]

78. We heard suggestions for ways in which the Government could act directly to improve liquidity in the electricity market. Professor Helm reminded the Committee about the relative advantages of the Pool trading arrangements which, he said, were much better at delivering a liquid and transparent market than the current design, explaining that "NETA replaced a compulsory energy market—you had to sell into it, and you had to buy out of it, therefore, by definition, it was liquid and transparent—with the opposite."[85] He concluded that "the problem is NETA".[86]

79. We also heard other ways of adapting the market in order to improve its suitability for increasing amounts of intermittent generation. For example, Dr Barrie Murray suggested a development in the role of the System Operator (SO), National Grid, to manage intermittent supply. He said that National Grid was "best placed to determine need and should be incentivised to contract for capacity considering all options including demand side management and import/export. The SO should also be incentivised to coordinate wind and marine output forecasting as part of a centralised management function".[87] The Welsh Power Group also proposed an extension of the role of the SO as a central buying agency for more reserve capacity to balance increasing intermittency.[88] National Grid agreed that "the mechanisms currently employed by National Grid as System Operator to procure 'balancing services' could also be extended or amended to provide additional 'back-up' capacity".[89]

80. DECC must consider the future evolution of the electricity wholesale market as part of the Electricity Market Reform process. The review of Ofgem is an opportunity to ensure that it delivers decarbonisation and security of supply alongside affordability for consumers.

81. DECC should investigate the full range of options for improving liquidity in the wholesale market. DECC must also consider its options for making the wholesale market fit for a low-carbon future. We would recommend an evolution of the System Operator's role and a reform of the "balancing mechanism".

82. The UK has a significant role in influencing EU policy and the Government should be ambitious in its decarbonisation programme to show leadership at the regional level. However, it is important that UK initiatives should not adversely affect EU policies. We are concerned that not enough work has been done to explore these interactions. For example, the European Commission warned that the UK's proposed carbon price floor risked distorting price signals given by the EU's cap-and-trade scheme, the EU Emissions Trading System (EU ETS).[90] We return to the issue of interactions with EU ETS in chapter 6.

83. National Grid told us that "the EMR project should fully take into consideration EU objectives and initiatives such as the development of the internal energy markets (including the Third [Liberalisation] Package and relevant legislation on state aid)".[91] The Third Liberalisation Package is an attempt to promote interaction between the electricity markets of different EU Member States. From the UK, this is increasingly possible through electricity interconnectors, which now link transmission systems across the seas between the UK, France, Ireland and the Netherlands. National Grid said that "it will be vital to ensure that interconnection with Europe is taken into consideration when determining appropriate generation requirements".[92] SSE told us that "increased interconnection within the EU seems inevitable" and suggested that "a range of interconnector scenarios are tested against the proposed reforms before these are finalised".[93]

84. The Committee notes that EMR represents a move to more intervention in electricity markets, away from the trend of liberalisation in Europe—a trend that began in the UK. GE emphasised that the UK has often been a leader in energy market reform in the EU. GE said that "the current reform process will be keenly observed in other member states; however, these benefits will only arise if the UK system has sufficient regulatory arrangements in place with Europe".[94] They also told us that "the costs of meeting UK Government objectives are likely to be significantly reduced over the longer term if policy objectives are more integrated with the single European market".[95]

85. The Government must acknowledge the direction of travel of the electricity market in future, which may well include increasing interconnection with other European markets. The Government should explore how this will affect the Electricity Market Reform package in its White Paper. Electricity Market Reform needs to be accompanied by a strategic vision of the shape of the market in coming decades, including the European dimension.

⁶⁵Q 90 Back

⁶⁶Q 90 Back

67 Ev w1 (Dr Barrie Murray) Back

68 Ev w32 (InterGen UK), section 3.1 Back

69 Ev w19 (ESB International), section 5 Back

70 Ofgem, Liquidity in the GB wholesale energy markets, Discussion Paper 62/09, June 2009 Back

71 DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 32 Back

72 For example, EV W10; Ev w19 (ESB International); Ev 147 (Drax Power) Back

73 Ev 153 (International Power), section 24 Back

74 Ev 153 (International Power), section 24 Back

75 Ev w19 (ESB International), section 23 Back

76 Ev 153 (International Power), section 23 Back