Memorandum submitted by E.ON UK|
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
The rest of this evidence addresses the Committee's
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
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
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
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
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
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
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.