7 Capacity mechanism|
179. The UK currently has an "energy only"
marketthat is generators get paid only for the electricity
they generate. Markets elsewhere in the world (and earlier incarnations
of the UK's own market) sometimes include some form of capacity
payment, which is intended to ensure that there is enough excess
capacity on the system to provide security of supply.
180. As the consultation document shows, two factors
in the predicted emerging electricity market will influence this
requirement. First, increased use of inflexible baseload generation
capacity will reduce the ability to turn power stations on and
off to meet fluctuation in demand reasonably. Second, an increased
reliance on intermittent resources such as wind requires more
capacity to be available to replace intermittent capacity when
it is unavailable. The consequence is a need for stand-by generating
capacity, requiring the existence of substantial flexible plant
which may only be required for a few hours a year, but which has
to be paid for.
181. According to DECC's consultation document, the
margin of excess capacity on the UK's electricity system will
drop over the next decade, causing concern about "keeping
the lights on" and the increased risk of supply shortfalls.
DECC concludes that it will not be possible to address this shortfall
by making improvements to the operation of the current market
and that "it is necessary to introduce a capacity mechanism
in order to provide greater assurance of the future security of
DECC provide the following description of a capacity mechanism
in the Consultation Document:
Currently market participants decide the optimal
capacity margin. An alternative is to determine the level centrally,
and introduce a policy to reward the provision of capacity to
ensure this margin is meta capacity mechanism.
182. It was widely agreed amongst our witnesses that
of the four measures set out in the Government's consultation
document, the capacity mechanism was the least well developed
in terms of providing detail about how such a mechanism would
be designed and how it would operate in practice. The consultation
suggested that a capacity mechanism would require an assessment
of the appropriate level of capacity margin for the system and
"some form" of explicit payment to incentivise investment
to deliver this capacity.
The consultation summarised how a capacity mechanism could be
implemented (including capacity payments, capacity obligations,
capacity auctions, reliability options and a tender for targeted
resource). It went on to investigate different design features,
concluding with a stated preference for a capacity mechanism that
- a centralised system (that
is, an obligation on a single central body such as the system
- an approach in which volume is set rather than
the price of capacity;
- a targeted approach, rather than offering payments
to all generators.
Rationale and objectives
183. There is some ambiguity about the Government's
rationale for introducing a capacity mechanism. In its submission
to this inquiry, DECC stated:
The Government believes some form of capacity
mechanism is necessary to ensure security of supply in future.
Analysis suggests that as levels of low carbon generation increase,
the price signal alone may not be sufficient to incentivise adequate
levels of the additional flexible backup capacity required to
run for only a few hours operation a year.
184. A key uncertainty about DECC's proposals is
whether the capacity mechanism is designed only to deal with peak
demand scenarios or if it applies to capacity more generally.
We heard evidence that flexibility requirements to deal with increased
penetration of intermittent renewables are not necessarily the
same as requirements for meeting peak levels of demand.
For example, peaking plants are only required to run for short
periods of time (say, a few hours at a time) but periods of low
wind could last for several days or weeks. This means that a
capacity mechanism will need to apply to mid-merit as well as
peaking plant if it is to fully deal with problems associated
Jeff Chapman (Carbon Capture and Storage Association) told us:
We ought to discriminate between short-term peaks
and the flexibility needed to keep the power on all the time.
If you lose a lot of supply through intermittency in the typical
few days of the anticyclone in January, you must have a lot of
capacity sitting by to be able to fill that gap.
185. This is an important distinction since it will
affect the type of fossil plant that could be used to provide
flexible back up services in the future. It is possible that unabated
fossil plant might be permitted on the system if it only operates
for a few hours each year to provide back-up capacity at times
of peak demand. However, if back up generation is required over
periods of days, fossil plant providing this service would need
to have CCS fitted in order to comply with the decarbonisation
186. The majority of submissions we received recommended
that a capacity mechanism should focus on delivering flexible
capacity that would be readily available should the wind not blow.
The Welsh Power Group also pointed out that new nuclear power
stations are likely to be the largest plants on the system, so
there will need to be sufficient reserves to cover one of these
stations going offline unexpectedlyfor
example if there was a technical problem.
However, there was also some support for the idea of using a capacity
mechanism to ensure sufficient peak capacity margin. 
In addition to these two broad aims, a number of other, more specific
objectives for a capacity mechanism were proposed:
- To support the development
of new capacity of all types, including conventional generation,
in particular in response to the planned closure of several coal-
and oil-fired power stations under European environmental legislation
and planned decommissioning of nuclear plants coming to the end
of their lifetimes.
- To ensure that existing fossil fuel plants do
not close prematurely but remain operational in order to provide
- To help mitigate wholesale electricity price
spikes against a background of intermittent or relatively inflexible
low carbon plant.
- To support the development and deployment of
demand side measures by providing capacity payments to these functions
- To provide flexibility to deal with excess generation
at times when demand is low and wind resources are strong.
187. While there is little debate over the potential
for increased levels of inflexible and intermittent sources of
power to pose problems to the system, many witnesses questioned
whether the case for a new capacity mechanism at this point in
time had been adequately made.
Several witnesses felt that modifications to the existing balancing
mechanism (which incentivises generators and suppliers to ensure
that there is sufficient generating capacity to meet demand on
the system) and the Short Term Operating Reserve (STOR) contracts
that are run by National Grid could be sufficient to meet requirements
imposed by increased penetration of renewable generation.
National Grid told us:
We do also agree that it is important to consider
whether an additional intervention to bring on sufficient "back-up"
generation is necessary. However, there is more work to be done
before we can conclude that further intervention in the form of
explicit capacity payments is required. It may be that adjustments
to existing market mechanisms will be sufficient to facilitate
188. Others believed that given the uncertainty about
many aspects of the future electricity systemincluding
the contribution of new technologies such as smart meters, smart
grids and storage, potential future levels of interconnection,
and the success or otherwise of long-term contracts in bringing
forward investment in new low-carbon generating capacityit
was simply too early to put a capacity mechanism in place. Christina
Grumstrup Sorensen (DONG Energy) told us:
Some of the means are not yet fully developed
on the demand-side management and we should really embrace this
opportunity to develop these things. We will not be able to know
exactly what will be available 10 years from now, so solving it
on a 10, 20 or 30-year horizon with all of these mechanisms not
at hand right now could be dangerous.
189. At present, there is very little wind on the
system and therefore dealing with its intermittent nature is not
a problem. It will only cause problems once there is a much greater
penetration on the system. At the moment, levels of intermittent
renewables are forecast to reach the scale at which balancing
starts to be a problem around 2020. However, there is no guarantee
that this will turn out to be the case.
190. Given that dealing with large levels of intermittent
power is not yet a pressing problem for the UK electricity system
and given that there is still so much uncertainty about the role
new technologiesin particular smart technologiesmight
play in meeting this challenge, it may be too early to make detailed
policy design decisions about capacity mechanisms.
191. It is too early for the Government to specify
what capacity mechanisms might look like. Legislating for capacity
mechanisms now may restrict the scope to take account of future
technological developments and the success or otherwise of interventions
such as long-term contracts.
192. The Government needs to analyse more fully
the nature of the problems of increased intermittency, and in
particular, the potential need for flexible capacity and demand
side measures at all times, not just at times of peak demand.
Capacity mechanisms would need to be able to deal with this wider
problem, rather than focusing solely on meeting demand at times
of peak usage.
193. While we believe it is too early to design an
effective capacity mechanism, it is not too early to start thinking
about the building blocks that will be needed should a capacity
mechanism be required in the future, including the institutional
arrangements needed to implement a mechanism.
194. The Government's preferred option is for a central
body to determine how much additional capacity is required. It
is not clear at the moment whether this body would be DECC, Ofgem,
the System Operator or an entirely new agency.
This will need careful consideration. The decision-making body
will need the skills and expertise to make a very complex calculation;
capacity demand and availability figures are "notoriously
difficult to forecast" according to Drax.
In addition, there is potential for a capacity mechanism to result
in a more prescriptive approach to the balance of the energy mix,
so consideration must be given to whether the decision-making
body could be subject to political pressure if it is deciding
which types of generation will be eligible for capacity payments.
195. If the Government decides that a new agency
is needed to deliver capacity mechanisms, then planning will be
required well in advance of a proposed introduction date for the
mechanism. Given the timescales involved in setting up new organisations,
decisions on the institutional arrangements for capacity mechanisms
will need to be concluded swiftly. It may be possible for the
new agency with responsibility for setting long-term contracts
that we recommended in chapter 5 to also administer capacity mechanisms.
196. In his oral evidence to the Committee, Professor
Helm summarised the key issues associated with institutional arrangements
for a capacity mechanism:
The institutional demands on Government include
the skill set required, the expertise to decide what contracts
to sell [...] and the contracting process itself. Those are demands
that I think [...] DECC or Ofgem do not possess. It is no good
going down this route of doing the capacity markets, the FITs
and the long-term contracts, unless one wills the means to the
end. The means to the end are very substantial changes in the
institutional apparatus, whether that is an energy agency, whether
it is the Department doing things, the people that we need or
the framework of that. That is mentioned in the documents, but
if we want this whole thing to be rolling by 2014, all the institutional
stuff to do these things has to be rolling by 2014 as well.
197. If capacity mechanisms are introduced then they
should be designed carefully to ensure that there is sufficient
flexible capacity (both generation and demand) on the system to
deal with increased levels of intermittent and inflexible generating
198. The Government has stated a preference for a
targeted capacity mechanisms, in which capacity payments are made
only to those generators that provide the additional capacity
needed to make up any anticipated shortfall in the capacity mechanism.
This is in contrast to a market-wide capacity mechanism, where
all generators are paid the same.
199. However, many existing generators were opposed
to the introduction of a targeted mechanism.
In particular, there was concern about the so-called "slippery
slope" effect, where it is more attractive to be within the
targeted subset of capacity receiving the capacity payment than
remaining in the market. A targeted capacity payment could exacerbate
the "missing money" problem, where the prevention of
high prices at times when the system is tight removes the incentive
for new investment. The result would be a lack of market-based
investment outside the capacity mechanism, meaning that the targeted
capacity has to be expanded. This could ultimately result in all
capacity being included in the mechanism.
200. Although this problem is acknowledged by DECC
in the consultation document, many witnesses who gave evidence
to our inquiry were sceptical that it would be possible to avoid
this problem, particularly because it has proved to be a difficulty
where targeted capacity mechanisms have been introduced in other
Marchant (SSE), told the Committee:
We need a capacity market in the UK, and it should
be for all capacity. Any targeted mechanism anywhere in the world
ends up being changed into all or nothing.
201. The System Operator, National Grid, currently
holds responsibility for balancing the grid and the balancing
mechanism is one of the primary incentives for investment in new
capacity in the current system. In its written submission to our
inquiry, National Grid expressed concerns about plans to introduce
capacity mechanisms and highlighted a large number of issues that
it believes will require further attention in designing such mechanisms.
- the potential for distorted
scheduling and consumption decisions;
- practical issues associated with specifying the
required functionality of capacity;
- issues associated with ensuring appropriate settlement
of technology specific revenue streams;
- a risk that incentives on the demand side may
- the potential for additional obligations or complexity
to dissuade new entrants;
- the need to ensure consistency with capacity
limitations on the network;
- the timing of introducing capacity mechanisms
with regard to tackling emerging energy security problems; and
- affordability to consumers.
202. It is clear that designing effective capacity
mechanisms is complex and cannot be rushed. The White Paper must
set out plans to avoid the "slippery slope" problem.
While it is too early to legislate for the detail of future capacity
mechanisms, it is not too early to prepare for the design of capacity
mechanisms which are accurately calibrated to meet the future
need at minimum cost. The White Paper should pave the way for
the creation of a new independent agency that would have responsibility
for designing and administering both long-term contracts and capacity
217 DECC, Electricity Market Reform Consultation
Document, Cm 7983, December 2010, p 86 Back
DECC, Electricity Market Reform Consultation Document,
Cm 7983, December 2010, p 98 Back
Ev 124 (DECC) Back
Ev 147 (Drax), Q 126 [Dr Edge], Ev 126 (Carbon Capture and Storage
Association), Ev 211 (Centrica) Back
Mid-merit generation is that which falls between baseload and
Q 269 [Mr Chapman] Back
Ev w26 (Welsh Power Group), Ev w32 (InterGen UK), Ev 208 (GE Energy),
Ev 153 (International Power), Ev 137 (Statoil), Ev 191 (EDF Energy),
Q 120 [Mr De Rivaz], Q 171 [Mr Sambhi], Q126 [Ms Thompson], Ev
126 (Carbon Capture and Storage Association), Ev w17 (REA), Ev
147 (Drax), Ev 158 (DONG Energy) Back
Ev 214 (SSE), Ev w19 (ESB International) Back
Ev 158 (DONG Energy), Ev 177 (Ofgem), Ev w32 (InterGen UK) Back
Ev w35 (RES) Back
Ev 197 (ScottishPower) Back
Ev 203 (Friends of the Earth), Q 93[Ms Cary] Back
Ev w10 (CHPA) Back
Ev 143 (E.ON UK), Ev 139 (RWE npower), Ev 187 (National Grid),
Q 101 [Mr Less], Q 239 [Mr Haworth], Q 270 [Mr Ripley] Back
Ev 139 (RWE npower), Ev 187 (National Grid), Q 101 [Mr Less],
Q 239 [Mr Haworth], Q 270 [Mr Ripley], Q 126 [Dr Edge] Back
Ev 187 (National Grid) Back
Q 238 [Ms Sorenson] Back
Ev 187 (National Grid) Back
Ev 147 (Drax Power) Back
Q 83 Back
DECC, Electricity Market Reform Consultation Document,
Cm 7983, December 2010 Back
Ev 147 (Drax Power), Ev 153 (International Power), Ev 191 (EDF
Energy), Ev 197 (ScottishPower), Ev 214 (SSE), Q 150 [Dr Riley],
Q 171 [Mr Marchant] Back
Ev 153 (International Power), Ev 214 (SSE), Q 171 [Mr Marchant],
Ev 187 (National Grid), Q 101 [Mr Tutton], Q 235 [Mr Cross], Q
236 [Ms MacNaughton] Back
Ev 153 (International Power), Ev 187 (National Grid), Ev w45 (IET),
Ev214 (SSE), Q 101 [Mr Tutton], Q 235 [Mr Cross], Q 236 [Ms MacNaugton] Back
Q 171 [Mr Marchant] Back
Ev 187 (National Grid) Back