Electricity Market Reform - Energy and Climate Change Contents

7  Capacity mechanism

179. The UK currently has an "energy only" market—that 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 electricity supplies".[217] 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 met—a capacity mechanism.[218]

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.[219] 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 is:

  • a centralised system (that is, an obligation on a single central body such as the system operator);
  • an approach in which volume is set rather than the price of capacity;
  • a targeted approach, rather than offering payments to all generators.[220]

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.[221]

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.[222] 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 with intermittency.[223] 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.[224]

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 pathway.

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 unexpectedly—for example if there was a technical problem.[225] However, there was also some support for the idea of using a capacity mechanism to ensure sufficient peak capacity margin. [226] 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.[227]
  • To ensure that existing fossil fuel plants do not close prematurely but remain operational in order to provide back-up capacity.[228]
  • To help mitigate wholesale electricity price spikes against a background of intermittent or relatively inflexible low carbon plant.[229]
  • To support the development and deployment of demand side measures by providing capacity payments to these functions too.[230]
  • To provide flexibility to deal with excess generation at times when demand is low and wind resources are strong.[231]

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.[232] 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.[233] 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 the investment.[234]

188. Others believed that given the uncertainty about many aspects of the future electricity system—including 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 capacity—it 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.[235]

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 technologies—in particular smart technologies—might 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.[236] 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.[237] 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.[238]


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 capacity.

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.[239] 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.[240] 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.[241]

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 countries.[242] Ian 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.[243]

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. These included:

  • 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 be dampened;
  • 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.[244]

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 mechanisms.

217   DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 86 Back

218   Ibid Back

219   Ibid Back

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

221   Ev 124 (DECC) Back

222   Ev 147 (Drax), Q 126 [Dr Edge], Ev 126 (Carbon Capture and Storage Association), Ev 211 (Centrica) Back

223   Mid-merit generation is that which falls between baseload and peak. Back

224   Q 269 [Mr Chapman] Back

225   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

226   Ev 214 (SSE), Ev w19 (ESB International)  Back

227   Ev 158 (DONG Energy), Ev 177 (Ofgem), Ev w32 (InterGen UK) Back

228   Ev w35 (RES) Back

229   Ev 197 (ScottishPower) Back

230   Ev 203 (Friends of the Earth), Q 93[Ms Cary] Back

231   Ev w10 (CHPA) Back

232   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

233   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

234   Ev 187 (National Grid) Back

235   Q 238 [Ms Sorenson] Back

236   Ev 187 (National Grid) Back

237   Ev 147 (Drax Power) Back

238   Q 83  Back

239   DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010 Back

240   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

241   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

242   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

243   Q 171 [Mr Marchant] Back

244   Ev 187 (National Grid) Back

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© Parliamentary copyright 2011
Prepared 16 May 2011