House of Commons - Electricity Market Reform

Electricity Market Reform - Energy and Climate Change Contents

5 Long term contracts

86. In the current market, generation that is capital-intensive with low running costs (such as low-carbon technologies like wind) is exposed to the volatility of a wholesale market in which prices are set by the marginal cost of gas and coal generation. The EMR Consultation Document set out several options for low-carbon generation revenue support: feed-in tariffs (FITs), supplier obligations and regulated asset bases.[96] The proposals favoured a FIT with contract for difference (CfD). Under the Government's proposals, CfD would be chosen for all low-carbon technologies. This section examines the choice of CfDs and whether it is the most appropriate option for all kinds of low-carbon generation.

87. Feed-in tariffs are long-term contracts between Government and (in this case) a low-carbon generator, giving a guaranteed tariff or price for a defined period. In some cases this contract also gives a guaranteed buyer for the electricity. There is already a FIT for small renewables generation, which began in April 2010 under powers introduced in the Energy Act 2008. This applies to generation under 5MW. The EMR Consultation proposes a FIT for large scale low-carbon generation. Long-term contracts are an effective way to offer attractive returns and reduce the risk of investment in low-carbon generation, which should deliver the massive amounts of capital required.

88. There are three main forms of FIT as proposed in the EMR consultation:

a) Premium FIT: would pay a fixed premium on top of the variable wholesale electricity price. Generators therefore receive a "bonus" in addition to their revenues from selling electricity in the wholesale market. This type of FIT is used in Spain;

b) Fixed FIT: would pay a fixed payment which generators receive instead of revenues from selling electricity in the market. This is the model of FIT used in Germany for onshore wind, offshore wind, PV, biomass, hydro, landfill gas, sewage gas and geothermal; and

c) FIT with a Contract for Difference (CfD): is a long term contract with the agreed "strike" price set at a fixed level, where payments are made to "top up" the difference between the average market price and the agreed price. The FIT payment would be made in addition to the generator's revenues from selling electricity in the market. According to DECC, the CfD could work both ways, so that generators would be obliged to return money if electricity prices are higher than the agreed tariff.[97] This model of FIT is used in the Netherlands for renewables (the "sliding premium") and in Denmark for offshore wind.

89. A FIT with CfD is intended to maintain the efficiencies of the price signal as generators will have an incentive to sell their output whenever the market price is above the variable cost of their plant, as they will keep any upside—in other words, clever and efficient generation strategies will still allow companies to make profits, maintaining the incentive for efficient generation. A one-sided CfD would allow the holder to receive the shortfall between the market and strike price, but would not be liable to pay back any upside profit from selling at a higher market price.

90. FIT with CfD is the Government's preferred option, but the Government felt that it was necessary to consult on an alternative model. It considered a premium feed-in tariff as a credible alternative that could enable the electricity sector to meet the Government's decarbonisation and security of supply objectives.

91. Since 2008, the Netherlands has used a FIT very similar to a FIT with CfD to incentivise renewable technologies (the "sliding premium"). Generators have to sell their electricity (either into the wholesale market or in bilateral contracts) and then an energy agency pays them a top-up payment (differentiated by technology) up to the tariff level. The tariff is decided by the Government. Contracts are signed by the energy agency for 15 years. The reference price is the average annual spot market price. The top-up is paid out monthly to facilitate cash flow for smaller generators. It is in effect a one-way CfD in that if the electricity price goes above the tariff then the generator keeps all the upside.

92. In Denmark a FIT for offshore wind has been in operation since 2005, which is also very similar to a CfD model. For major offshore wind farms the required support is set by means of a tender procedure. The Danish Energy Authority has run four auctions for three offshore wind sites (one was re-tendered). The principal criterion determining allocation was the amount of the feed-in price per kWh of electricity produced that applicants requested in order to carry out the project.[98]

93. In general, most witnesses to this inquiry were supportive of CfDs, including the Big Six. The exception among the Big Six was SSE. Ian Marchant (SSE) thought "that is the wrong way to go, because we need a vibrant, liquid energy market and CfDs go to the heart of that". Instead, he argued for a premium FIT which, he believed, "is easier to do—it is less intrusive on the market and easier to remove when the technology of CCS, nuclear and offshore wind can compete against a carbon energy and capacity price".[99]

94. Statoil favoured a premium FIT "as this has most in common with the existing model, retains the exposure for generators to the electricity market and is the easiest to implement".[100] It went on to point out that different kinds of investors prefer different kinds of risk profile and recommended that "investors were given the choice between models (Premium Feed-inTariff or Contract for Difference)".[101]

Designing a UK FIT

95. One major difficulty with long-term contracts is that there is no clear reference price against which the Government should set the level of the subsidy. The size of the subsidy, however, is vital to the success of the scheme: too low and not enough low-carbon investment would be forthcoming; too high and there would be substantial costs for consumers, because the extra rents enjoyed by low-carbon generation would be passed on to electricity customers.

96. According to DECC's Impact Assessment costs to consumers would be dependent on the efficiency of the Government's incentive setting. It found that a £5/MWh error in the level of the subsidy could result in £4bn additional costs for consumers by 2030.[102]

97. The Government would benefit from a clear reference price in the electricity wholesale market in setting the subsidy level, but the lack of a clear reference price is a consequence of the illiquid wholesale market.[103] International Power believed that a liquid market "will in any case be needed to ensure a robust reference price for the CfD FITs mechanism being proposed".[104] Andrew Wright (Ofgem) argued that a CfD arrangement relied crucially on having a reliable reference price.[105]

DIFFERENT LEVELS OF FEED-IN TARIFFS FOR DIFFERENT LOW-CARBON TECHNOLOGIES

98. It is possible to set the level of a Feed-in Tariff differently for different kinds of low-carbon technology in order to take into account different stages of development, costs and financing challenges.[106]

99. EDF energy suggested that "a single flat payment is unlikely to provide sufficient returns to deliver all of these technologies and that some renewable technologies in particular will require higher payments until they become mature".[107] Dr David Kennedy (Committee on Climate Change) argued that "there has to be some kind of banding mechanism, effectively".[108] The Renewable Energy Association pointed out the different requirements of technologies at different stages of development, observing that "the needs of established technologies are very different from emerging technologies. The mechanism would need to span innovative marine renewables, where devices are still being developed […] to mature renewables such as onshore wind".[109]

100. We heard two main alternatives for setting the subsidy level for FITs. The first option was for the level to be set by Government. The second option was to use an auction methodology. An auction would have the benefit of minimising costs for consumers through competition and "market discipline", allowing the market to discover the most efficient mixture of low-carbon and renewable technologies.[110]

101. Currently, support for low-carbon generation is through the Renewables Obligation (RO), which obliges electricity suppliers to source an increasing proportion of electricity from renewable sources. The RO is structured in "bands", with different levels of support for different technologies. These levels have been set by government in consultation with companies. Since April 2009, different technologies have been placed in bands which are rewarded with different numbers of RO Certificates (ROCs) per MWh according to their estimated electricity generating costs. DECC employed consultants to advise on banding levels initially, and the Department is now considering resetting the level of ROC support every four years.[111]

102. The Renewable Energy Association warned that a government-set approach would expose developers to uncertainty about how long support would last at a certain level.[112] Professor Helm pointed to the degree to which political lobbying could influence this process and Good Energy argued that such approaches suffer from a lack of transparency and "a lack of understanding about the level of support given by the taxpayer", which in turn "leads to debate about whether this support is justified".[113]

103. Alternatively, a reverse-price auction or tendering process could be used to set the levels of FIT support. In this process, individual developers would bid against one another to provide a certain volume of electricity at a certain level of support, with contracts awarded to those that bid for the lowest tariff. In theory, the use an auction mechanism delivers the lowest cost electricity to the grid.

104. Some witnesses believed that auctioning removed the risk of leaving too much to the judgement of the Government. Professor Helm spoke of the dangers of an "interventionist" way of setting subsidies, saying that it would mean "a glorified banded ROC system" in which "the Government will pick the technology".[114] Such a system could be "wide open and vulnerable to picking winners, picking technologies, political lobbying, rent capture, and […] the climate change pork barrel".[115] We share this view and believe that it should not be Government which has to predict the best mix of low-carbon generation technologies.

105. Eventually, it may be possible to create a long-term signal through contracts that is technology neutral. Ideally, EMR would create a level playing field for all kinds of low-carbon generation, with the market taking the lead in the exact mix of projects. Sara Vaughan (E.ON) explained that in a market-led situation, as an investor, "we may be bringing forward an offshore wind project; we may be bringing forward a biomass project; or we may be bringing forward a nuclear project; and they will all be looking at the same market regime. So the state is not making that decision".[116]

106. However, we believe that auctions could be problematic for some of the key technologies in the short term. There may be few bidders willing to risk participating without a clear reference price. Several witnesses expressed concern that auctions would not provide the long-term price signals required for investments.[117] Simon Skillings told us that "the cost characteristics, the timetable and the investment risks are all so different. I cannot imagine what a technology-neutral auction would look like. It is bound to favour one or the other".[118] The Renewable Energy Association warned that the Government must not repeat mistakes made in the auction process for the Non-Fossil Fuel Obligation (NFFO),[119] where "winners curse" meant that many of the contracts awarded were not delivered.[120] The Association of Electricity Producers warned that "the vagaries of a tender process do not necessarily ensure the required outcomes are achieved. The government will need to be mindful of the potential burdens that participating in an auction/tender could present to generators, in particular smaller renewables plants".[121] In particular, the high capital costs associated with some low-carbon generation such as nuclear and CCS could pose a problem because to "get a project to the point where you might enter it into an auction, you are talking about investing several hundreds of millions of pounds", which would pose a considerable risk if developers were then unsuccessful in the auction and could lead to an "empty room" with no willing bidders.[122]

107. For these reasons, the Secretary of State appeared to rule out the option of auctioning contracts in the short term.[123]

108. The Committee recognises that different levels of Feed-in Tariff ("banding") are required to support technologies at different levels of maturity and with different financing needs. In the short term, levels should based on technological and economic considerations. This process must be transparent and levels must be set for a defined period, with clear triggers that would activate a review if levels need to be reassessed.

109. In its White Paper, the Government should acknowledge the problems of relying on auctions to set Feed-in Tariffs for most technologies in the short term, but it should set out conditions under which it would shift to an auction-based process in the future.

Different kinds of Feed-in Tariff for different low-carbon technologies

110. As well as requiring different levels of support through banding of Feed-in Tariffs, we heard that different kinds of long-term contract may be appropriate for different kinds of low-carbon technology. This section presents the evidence that we heard suggesting that the CfD approach may not be the most appropriate kind of FIT for all low-carbon generation alike.

111. In general, witnesses were supportive of FITs. However, not everyone agreed with the Government that a FIT with CfD was the most appropriate type of FIT for every kind of low-carbon technology. Supporters of a CfD model included EDF, Intergen, Scottish Power, Alstom, E.ON, Drax and the Welsh Power Group.[124] The reasons for support included:

A CfD will retain exposure to price fluctuations through participation in the wholesale market (this would not be the case with a fixed FIT).[125]
It would avoid windfall profits and ensure that excess revenue due to high market prices is returned to end customers.[126]
It was perceived to offer best value for money.[127]

112. Those who preferred a Premium FIT (PFIT) included: RES, Centrica, SSE, Statoil and International Power.[128] The main reason given for this preference was that a PFIT was felt to be the option that was closest in nature to the existing Renewables Obligation (RO). This means that only modest market reforms would be required to transfer from an RO to PFIT, making it the easiest to implement.[129] Ian Marchant (SSE) saw a pPFIT as easier to do: "it is less intrusive on the market and easier to remove when the technology of CCS, nuclear and offshore wind can compete against a carbon energy and capacity price".[130]

113. Chris Hunt (Riverstone) highlighted difficulties with a PFIT. If fossil fuel prices were to rise significantly, a PFIT would result in a windfall profit to low-carbon generators. In his view, this made a PFIT a less attractive option.[131]

114. There was also some support for the fixed FIT proposal. Friends of the Earth argued that the consultation document "may offer too negative opinion of the merits of a fixed FIT".[132] DONG Energy supported either a PFIT or a fixed FIT:

133

115. Different kinds of generation have different financing and operational requirements and low-carbon generation must not be viewed as a homogenous category. Simon Skillings (E3G) told the Committee that "the CFD instrument [the Government] describe is clearly not appropriate for all the technologies [...] the technologies are all very different".[134]

116. In particular, the CFD may not be the right instrument to support wind generation. The best prices for electricity will often be when the wind is not blowing because at these times supply will be less and other resources will need to be found to meet demand. Electricity from an unreliable source will be worth less than electricity from sources whose output is more dependable. Wind generators are therefore likely to receive less than the average price in the electricity wholesale market. Wind generators would have only limited ability to vary their output to benefit from the sort of "market discipline" that the Government wishes to encourage. Renewable Energy Systems told us, for example, that CfD "does not benefit wind generators as they would remain exposed to short term price risk. Wind generators are likely to realise substantially less than the contract 'strike price', yet this lower level of realisable revenues would be largely hidden".[135] RES argued that a premium FIT would be better for wind generators.[136]

117. Juliet Davenport, CEO of Good Energy, also told us that the CfD approach is unlikely to be suitable for small-scale generation. She said that a CfD "will be very hard for small generators to manage, and potentially the administration costs will be significant".[137] Good Energy recommended that an expansion of the current FIT system would be a better solution for some generators.[138]

118. Statoil believed that "the single auction approach overlooks the fundamentally different financing, operational and investment characteristics of different technologies".[139] According to Green Alliance, many investors may want mechanisms that reduce their exposure to electricity price risk and are simpler to understand, for example a standard FIT rather than a premium FIT.[140] This would mean paying a standard price for electricity from certain technologies, rather than add the tariff as a premium onto a variable wholesale price.

119. The CfD approach may also present difficulties for generation with carbon capture and storage (CCS). CCS presents the opportunity to keep the price and flexibility benefits of fossil fuel generation with lower carbon emissions, but the technology is currently untested and expensive and is likely to require substantial support. CCS presents different contractual challenges from other low-carbon generation because it is flexible and also has very high variable costs. A contract would need to provide for flexible short-term operation.

120. Electricity storage should also benefit from a different kind of FIT. Swanburton, a specialist storage consultancy, told us that "The use of feed-in-tariffs is often seen as an inhibitor to storage, as the renewable producer claims an income from selling into the network, and leaves the problem of management of any surplus electricity to the system operator or central buying agency"[141] A long-term contract may need to recognise the amount of energy fed into the store, rather than the output because electricity can be lost in the process. Alternatively, a FIT could remunerate output at a different rate, providing an incentive for the storage operator to increase efficiency.[142]

121. The main argument for the Contract for Difference is the Government's desire to achieve the investment certainty offered by fixed prices while maintaining the efficiency of a competitive market. However, this approach is not appropriate for all kinds of low-carbon generation. Different kinds of low-carbon generation are at very different stages of technological maturity, with very different operational and financing requirements. Feed-In Tariffs should recognise the unique characteristics of different low-carbon technologies. Proper discussion of these possibilities is a serious omission from the consultation.

122. The Government must recognise more clearly the different financing requirements of low-carbon technologies and investigate the possibility of different kinds of long-term contract for different kinds of low-carbon technology. The Government should consider Contract for Difference for nuclear, but it should recognise that some technologies such as wind generation cannot easily respond to market signals under a Contract for Difference and may be exposed to lower than average prices. We also believe that Carbon Capture and Storage and electricity storage should benefit from Feed-in Tariff support, but that a Contract for Difference may not be the best model. These technologies are likely to require bespoke contracts. The White Paper should offer a flexible solution to meet these different objectives.

FEED-IN TARIFFS AND NEW NUCLEAR

123. One of the main beneficiaries of the CFD approach is likely to be the nuclear industry. In our inquiry on National Policy Statements, we heard that the Government had identified sites suitable for up to 16GW of new nuclear generation by 2025, with the first new capacity coming online in 2018.[143] We recognised that building significant new nuclear in that timescale would be extremely challenging and would require substantial support from the Government.

124. The Coalition Agreement expressed support for new nuclear power generation "provided that they are subject to the normal planning process for major projects (under a new National Planning Statement), and also provided that they receive no public subsidy".[144] The Minister of State told us that the industry was keen to invest in new plant.[145]

125. The Secretary of State argued that a subsidy for nuclear generation would be "something which is specific to the industry".[146] He observed that:

147

126. Redpoint's analysis suggested that new nuclear stations could be competitive without subsidy under Baseline assumptions if future carbon prices rise to the levels assumed by Government.[148] However, they recognised that "the key issue is investors' lack of confidence" that those prices will be reached. EMR therefore rightly proposes to include nuclear in the system of Feed-in Tariffs with Contracts for Difference.

127. WWF were "strongly of the view that a new Feed-in Tariff scheme should not apply to new nuclear power stations (which would appear to breach the pledge in the Coalition Agreement not to provide any public subsidy to new nuclear power stations)".[149] Greenpeace pointed out that nuclear is a mature technology not a developing one. They argued that "there is no case for support in making it market ready".[150] Friends of the Earth agreed that "These incentives are only appropriate to help newer technologies compete with existing players in a system which currently heavily favours older technologies".[151]

128. E3G thought "A UK floor price for carbon is simply a new subsidy for existing nuclear power. It would be an expensive addition to taxpayer or bill-payer costs and deliver no new energy output".[152] In addition, nuclear generators already in operation could receive windfall profits from the increased prices.

129. We recognise that the views of the Big Six on the use of FIT with CFD for all low-carbon generation vary according to their generation fleet and plans for development; in general, those companies with substantial amounts of nuclear in their portfolios favoured the combination of a FIT with CFD and carbon price support. Those with a greater component of renewables or fossil fuel generation and without a lot of nuclear did not favour the package. Ian Marchant, CEO of SSE, believed that the package had been designed around the requirements for new nuclear and warned that:

153

130. Renewable Energy Systems argued that the package was very beneficial for new nuclear build, but that it was unsuitable for encouraging renewable generation.[154]

131. In September 2010, the Secretary of State told the Committee that "the economics of nuclear are actually very similar to the economics of renewables. The cost is effectively all upfront and the marginal cost is virtually zero".[155] While we see the economic resemblance, we are not convinced that the finance and support requirements are the same for all forms of low-carbon generation. There are also important differences in that nuclear power is predictable and its fuel use is controllable and therefore might be considered more reliable and preferable for consumers, while neither is the case for wind, for example.

132. If it is the Government's policy objective to develop large amounts of new nuclear generation, then it is almost certain that it will require policy or financial support that will amount to forms of subsidy. While a Contract for Difference Feed-in Tariff may be the best option for nuclear generation, it may not be the best for all low-carbon generation. The Government must not go down the route of Contracts for Difference for all low-carbon generation just because it does not feel able to differentiate between nuclear energy and other low-carbon technologies. The White Paper should address the advantages, risks and challenges of promoting new nuclear generation head-on and honestly; it should not distort the market merely to save political face about the precise meaning of the Coalition Agreement for Government.

How will contracts be designed?

133. It is not clear from the EMR consultation whether the Government intends to be the counterparty to contracts, or whether it would delegate this function to Ofgem or to a completely new institution. Ian Marchant of SSE said that he was concerned "about putting the state in as the buyer […] Let us be clear—the CfD is a contract with the state, or the state will create an energy agency".[156] Professor Helm argued the case for an expert institution:

In this architecture, you can call it what you like, but it is a job for something like an agency, which is given a very clear remit by DECC as to what the targets are that it has to achieve, and a legal framework to the reforms—I suspect that that will be one of the many annual Energy Acts that we will have going forward. It needs that framework and it needs a skilled set of people who will not be rotated around. This needs expertise and we have none of that within our existing framework.[157]

134. The Secretary of State recognised that various options are available. He told us that "One option is clearly to go for a completely new institution, another would be to look at existing institutions to try and fulfil that role". He stressed that when new investors look at the contracts on offer it would be important that "they know that they have a counterparty that is utterly creditworthy and will respect the legal contract that they have signed."[158]

135. The White Paper should identify which institution will be given power to create appropriate contracts and set this up as quickly as possible. If this role is not taken on by Ofgem, a shadow body should be set up in advance of legislation. Government should concentrate on the powers of this institution rather than the detail of the contracts and clarify its role, objectives, composition and funding as soon as possible. The agency must be totally independent and not susceptible to political influence.

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

97 DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 48 Back

98 DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 118 Back

99 Q 171 Back

100 Ev 137 (Statoil) Back

101 Ev 137 (Statoil) Back

102 DECC, Electricity Market Reform-options for ensuring electricity security of supply and promoting investment in low-carbon generation, Impact Assessment, p 5 Back

103 Ev w10 (CHPA), section 4; Ev 191 (EDF Energy); Q 171 [Mr de Rivaz] Back

104 Ev 153 (International Power), section 23 Back

105 Q 33 Back

106 Ev w10 (CHPA), section 16 Back

107 Ev 191 (EDF Energy), section 12 Back