Electricity Market Reform - Energy and Climate Change Contents


Memorandum submitted by E.ON UK

SUMMARY

The main objective of electricity market reform has to be to provide investors in new low carbon generation with a market framework which will reward these investments and support delivery of the UK's climate change goals.

Our initial reaction to the Government's proposals is that it is positive for investors looking to commit to new nuclear or CCS projects but that we need to consider more fully the impact of what is a complex package on the electricity market as a whole and on existing generation assets.

The impact on renewables investment is also less clear as the Renewables Obligation is an existing effective incentive mechanism. The transition to any new regime will need to be managed carefully to avoid delays in investment.

We do not favour the introduction of mechanisms to incentivise capacity unless a compelling case has been made. The potential of more flexible demand, additional electricity interconnection and storage should be investigated first as a means of addressing the impact on supply security of growth in wind generation.

However if a capacity mechanism is implemented a mechanism of the limited type proposed may be the best option.

The transition to a low carbon power system has to be managed in a way which energy companies and potential new investors can credibly finance. The Government needs to consider carefully the impact of its proposals on the viability of existing plants which can help maintain security of supply so that new investment requirements on the industry remain manageable.

The cost of making the transition to a low carbon generation sector makes successful delivery of energy efficiency policies such as the "Green Deal" even more important. This will both directly reduce consumers' fuel bills and reduce the amount of generating capacity which needs to be built.

The Government's proposals may be effective in reducing political risk for new low carbon investments through the use of contracts for differences (CfDs) but the package as a whole envisages a wider role for Government in directing investment. This creates a potential for more political risk which will need to be considered as part of the consultation.

How much political risk exists in the proposed new framework will depend on how Government implements its proposals in practice, the extent to which it acts consistently with its energy policy objectives including the national policy statements, and the degree of consensus between the political parties over time.

The rest of this evidence addresses the Committee's specific questions.

What should the main objective of the Electricity Market Reform project be?

1.  The main objective of electricity market reform has to be to provide investors in new low carbon generation with a market framework which will reward these investments and support delivery of the UK's climate change goals, which depend on largely decarbonising the UK power market by the 2030s. This is mainly relevant to nuclear or new coal and gas power stations with carbon capture and storage (CCS) as renewable sources are already supported by the Renewables Obligation. For nuclear this framework needs to be effective from around 2020 onwards which is when new stations are likely to begin operation. A robust and reasonably predictable carbon price trajectory which can be relied on over a long enough period to reward the investment will reduce risks and help bring these investments forward.

2.  The EU emissions trading scheme (EU ETS) has so far been the principal policy to incentivise low carbon investment. This allows the market to determine the most efficient investments within the cap and incentives are set at an EU level which ensures the most cost-effective investments are made across the EU. However the EU ETS has to be underpinned by an effective international agreement to function effectively. The outlook for carbon prices is uncertain in the light of the limited progress made in the UNFCCC negotiations. In addition, any international agreement may not extend beyond 2020, so, even when agreement is reached, it may not be fully effective in underpinning the operation of the EU ETS after that date. This is a potential problem for new low carbon investments which will largely rely on incentives available after 2020 to secure adequate returns.

3.  In these circumstances and given the UK's own statutory climate change goals, the UK Government needs to explore alternative policies to decarbonise the UK power market, although it should aim to do so in a way which is consistent with the international regime and the EU ETS in particular.

4.  The impact of the large volumes of wind generation needed to meet the UK's renewable targets also needs to be considered. This leads to an increasing requirement for flexible plant to respond to varying levels of wind output and electricity demand. However large volumes of wind reduce the load factors of other plant which then need much higher prices to be viable. These higher price periods will be relatively infrequent and unpredictable, as they will only occur, for example, where there is little wind coupled with very cold temperatures, and such higher prices may also raise political or regulatory difficulties.

5.  This issue needs to be looked at as part of market reform but there are a number of potential solutions. The potential of flexible demand, additional electricity interconnection and storage should be investigated as a means of addressing wind intermittency impacts, before considering new mechanisms to incentivise capacity.

6.  All new policies must be considered in relation to their impact on security of supply and the affordability of energy prices. The transition to a low carbon power system has to be managed in a way which energy companies and potential new investors can credibly finance. The Government needs to consider carefully the impacts of its proposals on the viability of existing plants which continue to be needed to maintain security of supply, so that new investment requirements on the industry remain manageable.

7.  The cost of the transition to a low carbon generation sector makes successful delivery of energy efficiency policies such as the "Green Deal" even more important. This will both directly reduce consumers' fuel bills and reduce the total volume of generating capacity which needs to be built.

8.  The Government has now published its proposals for electricity market reform and for a carbon floor price. Our initial reaction is that the package is positive for investors looking to commit to new nuclear or CCS projects but that we need to consider the impact of what is a complex package on the electricity market as a whole and on existing generation assets. We are still in the process of assessing the implications of these proposals so cannot give definitive views yet.

Do capacity mechanisms offer a realistic way of achieving energy security, low-carbon investment and fair prices? What is the most appropriate kind of capacity mechanisms for the UK?

9.  In general we do not favour the introduction of capacity markets. International experience has been mixed and almost all capacity mechanisms have had to be changed significantly after their initial implementation. This leads to a period of instability and additional regulatory risk. In the UK, the issue is whether sufficient flexible capacity can be incentivised to be made available when there is a large volume of variable wind generation on the system. Our preference is for the UK to wait to see whether more demand side response and the increased use of interconnectors can resolve this issue by providing additional flexibility to the UK system.

10.  The EMR consultation does not provide a convincing explanation of why capacity mechanisms are needed and why any potential problems cannot be resolved in other ways. We will, however, be providing views on DECC's design options but have yet to reach a definitive view. It may be that the limited option proposed, similar to the Swedish reserve market, is less undesirable than more radical alternatives which would have major effects on the existing market. It will be important as a minimum to ensure that existing capacity can participate in any new mechanism as there is no point building new power stations to meet requirements which can be met by existing assets.

Should the system of Feed-in Tariffs be focused on particular technologies or maintain a wider technology-based view?

11.  The Government has proposed a system of feed-in tariffs (FITs) based on contacts for differences (CfDs). The Government has not provided much detail but we would expect these to offer different levels of income through the strike price for different technologies as their costs vary substantially, as illustrated in the DECC consultation, and the UK needs to develop a diverse range of technologies to meet its CO2 emissions reduction goals in the long-term. As these CfDs will replace the Renewables Obligation (RO), these contracts will also need to incentivise sufficient renewable generation to meet the UK's 2020 obligations under the EU renewables directive.

12.  Different contract designs may be needed which are appropriate to the cost or operational characteristics of different technologies, a point made by Redpoint in their supporting analysis. For example coal and CCS or biomass projects would need contracts with prices aligned with their short run marginal costs of which fuel accounts for a large proportion, and CfDs for wind might need to take account of their intermittent and less predictable output.

Will it be feasible to deliver EMR in one go, or will regulations and implementation be spread over time?

13.  The process of market reform needs to be completed promptly to ensure investors can make well-informed decisions and to avoid investments being deferred until there is clarity, but it should not be rushed as misjudgements may prove difficult and costly to correct. As the policies interact with one another, investors will need to see the complete picture which suggests that the overall framework should be in place at the same time. The process of defining appropriate levels of support under CfDs will, however, need to be flexible and may evolve over time as the costs of these technologies change.

Will market reform increase political risk for investors or create certainty?

14.  The objective is clearly the latter. We will want to ensure that market reform provides us with a reliable framework for investment which reduces political risk. The proposed FIT/CfDs appears effective from that point of view in that it introduces a contractual basis for new investments which are a more robust basis for investment as contracts are less open to change than say a FIT determined though secondary legislation, or a tax measure. It is possible for Government to address any perceived shortcomings in CfDs through, for example, fiscal measures at a later date, but this is a risk under any support mechanism.

15.  However, the proposed package of measures does raise a number of issues in respect of political risk:-

(a)  The proposed FIT/CfD approach is a more directional approach by Government in the market. Whether new low carbon investments go ahead or not may depend rather more on the Government's willingness as a counterparty to sign contracts compared to current policies where investors come forward with investments in response to incentives such as the RO. However, the Government already influences outcomes through a number of technology specific policies and the planning system. How much political risk will exist under the new proposals will depend on how Government implements the new framework in practice, the extent to which it acts consistently with its energy policy objectives including the national policy statements, and the degree of consensus between the political parties over time.

(b)  The introduction of a carbon floor price through Climate Change Levy (CCL) reform is not a reliable basis on which to make long-term investments as tax levels are open to change or abolition by successive Governments and the rates are set yearly. Although the combined effect of the carbon price provided by the EU ETS and the application of the CCL carbon price support rates would overall provide a higher average value for carbon, we will now need to factor in uncertainties about both the future level of the EU ETS price and the future level of the CCL. This will primarily affect generation investments not covered by CfDs which will largely remove these risks for new low carbon plant. However, for other power stations, a sudden change in the CCL rate could radically affect its economic viability. Given that the level of carbon price support will have a significant effect on the amount of revenue that needs to be paid to investors by Government under the proposed CfDs, Governments may be tempted to raise the CCL rate simply to narrow the gap. The Government will need to find a way of assuring market participants that the CCL rates will be set through a mechanism which can be predicted over the long term, preferably by relating its level to the EU ETS price, to ensure a predictable overall carbon price.

(c)  As discussed above capacity mechanisms are difficult to design correctly. This is an additional lever available to the Government or the regulator to make changes in the market. This is in itself an additional source of political uncertainty which the Government will need to assess.

(d)  The proposed emissions performance standard could be changed by future Governments, notwithstanding the commitment by the current Government that, once an EPS is set, the level will not be changed for the lifetime of the investment.

(e)  Overall, the Government is proposing to introduce four different policy mechanisms. This complexity in itself creates risks that the interaction between them has not been fully understood by Government or market participants. This may increase the risk that there will be unintended consequences that will need to be corrected.

16.  We hope that these uncertainties can be resolved during the consultation process. However a broad degree of political consensus on the way forward will be helpful from an investor's perspective.

Will the Government's proposed package of carbon price floor, EPS, FITs and capacity mechanism provide sufficient transformation to achieve goals on climate change, security of supply and affordability?

17.  Yes, provided they are designed correctly, and subject to the points and reservations we have raised above.

What synergies and conflicts will there be between proposed mechanisms and policies already in place?

18.  This question needs further assessment but the following points seem relevant:

(a)  Consistency with EU energy market legislation and policy. The proposals need to be consistent with legislation to harmonise and liberalise the EU electricity market as set out in the Third Package and with rights under the European Treaty. Some of the proposals will also require state aid approval from the European Commission.

(b)  The interaction of the Renewables Obligation and the proposed FIT/CfD structure and the transition from one to the other will need to be clarified to avoid any investment hiatus. This is addressed in the consultation.

(c)  The effect on the existing energy market of a system of capacity payments needs to be understood.

Will a carbon floor price be feasible in the context of EMR and at what level should it be set?

19.  The key issue for new investment is the relationship between the carbon floor price and the FIT/CfD structure designed to incentivise new low carbon investment. At present it appears that the floor price, which is being implemented through removing the exemptions on payment of the levy for supply of fossil fuels for power generation and the level of rebate from fuel duty provided for the purchase of oil for power generation, will have a limited role in incentivising new low carbon investment which will primarily be driven by the FIT/CfD which largely fixes project income. However, it will enable the Government to influence the level of payments made to or from generators under CfDs by setting the price at a level which delivers (together with the EU ETS) a reference price more in line with the CfD strike price. This may help ensure that the CfD is more robust from a political perspective particularly if any net payments to generators are being recovered from consumers. This suggests that the carbon floor price needs to have a trajectory which becomes material when payments under CfDs become due around 2020 for new nuclear capacity. As discussed above, this should be achieved by relating the CCL rate to the EU ETS price to set an overall value for carbon which investors can predict.

20.  The major direct effect of the proposed approach will be on existing power stations. As the intention is to impose a supplementary tax on top of the EU ETS price, as opposed to using the rebateable mechanism proposed in the Conservative Party policy paper "Rebuilding Security" (where a generator offsets his liability to the tax by his expenditure on purchasing carbon allowances under the EU ETS), the effect is likely to raise the cost of emitting CO2 above the EU ETS carbon price. This will be negative for plant with a higher carbon content, reducing the economic viability of this plant. To avoid penalising plant needed to maintain security of supply in the medium term the rate should start low and only begin to rise at the end of the decade when it is needed to incentivise new low carbon capacity.

21.  In the longer term as the UK power market decarbonises and fossil plant sets the marginal wholesale price for less of the time, the effect of the carbon price on wholesale prices will diminish. The carbon price will need to rise significantly during the 2020s to maintain investment incentives.

What effects will EMR have on the development of capacity for electricity storage and the development of interconnectors between the UK and other electricity markets?

22.  It is too early to say what the effects will be of the various policy proposals. The introduction of a carbon support mechanism may lead on balance to an increase in imports and a reduction in exports across the interconnectors as imports will not be taxed but electricity produced in the UK will be. However this seems unlikely to have a major effect on incentives to develop more interconnection. We would expect demand for new interconnection to arise principally from differences in wholesale prices between different markets and the opportunities for increased trading this provides. This could arise as a result of the increased role of wind generation on the UK system and its effect on UK wholesale prices (which are likely to become more variable) if this growth in wind is not matched in adjoining markets.

23.  The introduction of a capacity mechanism may also affect cross-border trade and may raise the question of whether overseas capacity should be eligible to bid into such a mechanism. If the package overall leads to more investment in UK generating capacity and higher capacity margins in excess of UK demand, then this could lead to more exports from the UK, so the overall impact on trading is difficult to assess. As referred to above the Government will want to ensure that its proposals are consistent with the EU third legislative package aimed at harmonising EU internal energy market rules.

24.  We would expect growth in storage and more demand side response to be incentivised anyway by the impact on wholesale market prices of the expected increase in wind generation on the UK system but the proposed capacity mechanism should also be designed to incentivise these options if they are reliable methods of meeting peak demand.

January 2011


 
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