Electricity Market Reform - Energy and Climate Change Contents


Memorandum submitted by DONG Energy

EXECUTIVE SUMMARY

—  DONG Energy welcomes the package of measures contained within the Government's Energy Market Reform consultation on 16 December 2010. The Electricity Market Reform (EMR) project should create a framework for investment that is long-lasting, stable, predictable and transparent.

—  DONG Energy welcomes the Government's commitment to grandfathering the current Renewable Obligation technology bands but would like further assurances that the value of RO certificates will not be eroded as a consequence of a move to a new system;

—  The mechanism used to set any feed-in tariff must be simple and straightforward, whether differentiated by technology or otherwise. Such clarity is required to provide certainty and predictability for any developer or investor to ensure effective planning and funding. A regime that signals the tariff level several years in advance is necessary;

—  Government must avoid a hiatus between the establishment of a new feed-in tariff system and discarding the old Renewable Obligation regime to minimise political risk and uncertainty. Government must also quickly establish the fundamental principles and design of the future framework and demonstrate how the different policy measures will interact to ensure a well functioning market for electricity;

—  Any reform of the UK electricity market should be underpinned by the retention of a market-based approach which encompasses all forms of energy generation rather than establishing a separate low-carbon market;

—  DONG Energy is concerned that the delay in improving wholesale energy market liquidity will prevent the Government from attaining the objectives that it has set itself in bringing these measures forward. The objectives of EMR cannot be attained without first tackling the issue of electricity market liquidity.

1.  DONG Energy Company Profile

1.1.  DONG Energy is a leading energy company operating in Northern Europe and headquartered in Denmark. It is heavily expanding its UK business in renewable energy and Exploration and Production. It has a strong presence across the energy value chains. These include Exploration and Production, Generation (thermal and renewable), Energy Markets and Sales and Distribution. DONG Energy does not however supply energy to retail customers in the UK.

1.2.  By 2020, DONG Energy aims to have reduced its CO2 emissions per kWh of generation by 50 per cent, and by 85% by 2040. In order to achieve these targets, growth has been focussed on the two main areas of Exploration and Production and Renewable Power Generation. The United Kingdom has a major part to play in both areas.

Exploration and Production (E&P)

1.3.  DONG Energy is one of the largest acreage holders in the West of Shetland Region and a partner in the recently sanctioned Laggan-Tormore gas development. The company's first operated well in the UK (the Glenlivet gas discovery) was drilled in the West of Shetland in 2009. It has interests in a further six discoveries. Aside from the UK, DONG Energy is the operator of nine licences in Denmark, six in Norway and two in Greenland.

Renewable Power Generation

1.4.  DONG Energy is one of the most active offshore wind operators and investors in the United Kingdom. The company currently operates four offshore wind farms (Gunfleet Sands 1&2, Barrow and Burbo Bank). It has a stake in a further four sites currently under construction (London Array, Walney1&2 and Lincs). DONG Energy is the major shareholder in London Array and Walney1&2. It also possesses a strong pipeline of potential future renewable projects.

Thermal Generation

1.5.  In thermal generation, DONG Power UK has recently completed a new CCGT gas fired power station of 824MW output at Severn in South Wales.

2.    What should the main objective of the Electricity market reform work be?

2.1.  DONG Energy believes that the Electricity Market Reform (EMR) project should create a framework for investment that is long-lasting, stable, predictable and transparent. Any reform of the UK electricity market should be underpinned by the retention of a market-based approach which encompasses all forms of energy generation rather than establishing a separate low-carbon market. Clear price signals in a transparent market that correctly reflect electricity demand will ensure that necessary investment is forthcoming in all technologies. That said, the requirement for continued support of low carbon generation should be recognised and retained. This is particularly true of renewable generation as it reaches maturity.

2.2.  There have been a series of investigations and consultations over the last 18 months by Ofgem which have exposed the limitations of the existing wholesale electricity market in terms of liquidity. DONG Energy is disappointed that the Government has not chosen to address this issue directly; it has instead referred the issue to Ofgem, who have previously indicated that that it will take no action until the Government has resolved the nature of EMR. The objectives of EMR cannot be attained without first tackling the issue of electricity market liquidity. When electricity is priced effectively and transparently, and the market is well organized, trade will be liquid and a credible price reference will be established. From that forward trade can develop in a liquid market and provide longer term signals. But the first is a pre-requisite for the latter. Whilst DONG Energy acknowledges the need for cooperation and consistency between the EMR and market liquidity proposals, it is essential that the Government and Ofgem should resolve this issue at the earliest possible opportunity.

3.  Do capacity mechanisms offer a realistic way of achieving energy security, low-carbon investment and fair prices?

3.1.  As it currently stands, Britain is an "energy-only" market. That is, the market only pays for the energy and/or ancillary services that providers deliver and does not pay for capacity. Like other "energy only" markets, Britain has found it increasingly difficult to attract investment in new conventional generation capacity. This has been largely due to the impact on electricity prices of low carbon policies which support growing renewable generation. Before they commit their money, investors in conventional generation need to be confident that prices will be allowed to spike and that ancillary service markets are designed to provide the necessary revenue streams to guarantee a sufficient return.

3.2.  In some markets, such as the PJM in North America and the SEM in Ireland, capacity mechanisms have been introduced to overcome some of the perceived issues associated with energy-only markets and low carbon requirements. Such mechanisms can be designed to provide an independent revenue stream for conventional generation and to encourage a desired level of capacity investment, while imposing mitigation measures to avoid severe price spikes. However, the experience of such markets is mixed and other issue may arise as there will be an interaction with other market interventions such as feed-in tariffs.

3.3.  A key question remains over the best way to provide appropriate incentives to new conventional generation in order to relieve the risk of potential scarcity of capacity. Whilst capacity mechanisms are an effective means of stabilising the income of generators, there is no clear evidence that they encourage investment in new generation. Generators do not have any obligation to use the income from capacity mechanisms for new investment or to upgrade their existing assets. Arguably, a capacity mechanism is only required where market prices are capped, thus preventing price spikes from occurring and effectively guaranteeing a lack of clear signals to encourage investment.

4.  What is the most appropriate kind of capacity mechanism for the UK?

4.1.  The Government's EMR consultation proposes the introduction of a capacity mechanism to provide energy supply security by incentivising long-term investment and improving response to intermittency. The consultation appears to favour a centrally administered mechanism that will rely on the System Operator to agree contracts with providers. This is not dissimilar to the existing STOR contracts offered by National Grid. Whilst there may be merits in this approach, DONG Energy believes that a more transparent, market-based approach is more desirable.

4.2.  There are risks associated with a centrally administered approach, not least as it requires a single entity to determine the level and type of generation rather than allowing the market to determine and deliver the necessary capacity. Also, it is not immediately evident that contracts will be transparent to the market or available to an investor before an investment decision is made and so cannot be wholly relied upon.

4.3.  As mentioned earlier, DONG Energy believes that the primary driver of forward price improvement is increased market liquidity. Such an improvement would enable investment decisions to be taken with greater confidence. However, in considering a future where there is a higher proportion of intermittent generation and relatively inflexible baseload generation from new nuclear plant, it may be appropriate to introduce more explicit and additional rewards for flexible capacity. In these circumstances, the mechanism should be complementary to an existing energy market and allow the participation of both the generation and the demand sides. The mechanism should not simply offer a payment for capacity installed on the system but recognise flexible and available plant.

5.  Should the system of feed-in tariffs be focused on particular technologies or maintain a wider technology-based view?

5.1.  On a general note, it is important that any system of feed-in tariffs (FITs) is transparent and predictable to allow for long-term planning and appropriate capital allocation in due time and to attract third party financing.

5.2.  It is important that any change to the existing incentive framework should facilitate innovation and the advancement of new technology. DONG Energy believes that it is the role of Government to support the market in providing solutions to broader energy challenges rather than to select "winning" technologies. However, that is not to say that the level of support provided to each technology should necessarily be equal. Different levels of support for different technologies, as under the existing Renewable Obligation, are feasible and should be retained. Indeed, there may be some argument for considering different tariffs according to the nature of a project.

5.3.  The mechanism used to set any tariff must be simple and straightforward, whether differentiated by technology or otherwise. When developing offshore wind farm projects, which are capital intensive and have significant engineering challenges, long-term planning is essential to ensure efficiencies and synergies between projects. The ability to develop a pipeline of projects is one of the most attractive features of the UK market; allowing a rolling development and construction process to be implemented, and skills and resources to be moved between projects. Such an approach also allows supply chain certainty to develop, with long-term relationships being established between the offshore wind industry and suppliers. Any changes introduced through EMR should not erode these benefits.

5.4.  One of the most significant challenges for renewable energy projects is attracting finance at all stages of the value chain. From inception to commissioning, an offshore wind farm project can take approximately 5 years. Within this period, certainty on the tariff the wind farm will receive is needed well in advance of a final investment decision being made. Clarity on the tariff and market conditions is necessary to ensure new investment partners, such as pension funds and financial institutions, can be attracted. DONG Energy have been successful in attracting such investment under the RO mechanism and are confident we can continue to develop attractive projects under a FIT system if it allows certainty and predictability in appropriate timescales.

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

6.1.  Transition from one framework or set of policy interventions to another must be carefully managed and should not be rushed. The package of reforms should be developed holistically to minimise the risk of unintended outcomes and perverse incentives due to the interaction between the constituent parts of the package. However, this does not mean that all the reforms need to be implemented at the same time. A staged approach is feasible provided that there are clear objectives and a realistic timetable.

6.2.  The timescale over which implementation takes place must be sufficiently broad to allow for necessary changes to the industry framework and documents. Changes to these documents should only be effected when the objectives of the new regime are clear and fully understood.

7.  Will market reform increase political risk for investors or create uncertainty?

7.1.  The UK Government has clearly set out its intention to move to a low carbon economy, with a significant and welcome ambition for the role of renewable generation in the UK's energy mix. Interventions in the electricity market to date (by both the current and previous administrations) have further promoted this aim. However, it is also increasingly accepted that there are limitations to the existing framework for electricity trading and transmission which may delay the transition to a low carbon economy. For example, there is some uncertainty as to how investment in new conventional plant can be made attractive in a market dominated by low carbon generation.

7.2.  Whilst all change creates some political risk and uncertainty, the proposed reforms have been signposted to such an extent that any such effect will be mitigated. Indeed, they are well anticipated by both industry and investors. However, it remains important that existing generating stations and those under construction do not see unexpected reductions in future income, for example through erosion of support through the RO mechanism.

7.3.  Critically however, Government must avoid a hiatus between the establishment of a new system and discarding the old regime. Government must also quickly establish the fundamental principles and design of the future framework and demonstrate how the different policy measures will interact to ensure a well functioning market for electricity.

8.  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?

8.1.  The Government's proposed package of measures is welcome and will support continued investment in renewable generation.  However, as stated earlier, DONG Energy strongly believes that the full scope of the Government's ambition for the reforms can only be fully realised if it improves market liquidity in the UK wholesale power market.

8.2.  DONG Energy has considerable experience of working with the feed-in tariff mechanism in a wide range of other markets, including Denmark, and believes that it can be implemented successfully in the UK. It is essential however that any such mechanism should be simple and straightforward and designed to ensure effective capital funding for projects. A Premium or a Fixed feed-in tariff would achieve these aims.

8.3.  DONG Energy supports the introduction of a carbon floor price and believes it will improve the position of renewable and other low carbon generation in the electricity market. However, such a floor price will also have an impact on conventional plant which will remain by necessity an intrinsic part of the energy mix, both now and in the future. A capacity mechanism may offset some of this impact, depending on the way in which it is designed. However, as noted above, DONG Energy has reservations with respect to the effectiveness of this mechanism to promote new investment in flexible capacity that will respond quickly to peak demand.

9.  What synergies and conflicts will there be between the proposed mechanisms and policies already set in place?

9.1.  The Renewable Obligation (RO) has been in place for eight years and has provided good support for a significant amount of new investment in renewable electricity. A crucial issue for the UK will be how the transition between the RO and any new mechanism is managed and specifically how existing investment currently operating under the RO will stand in future. DONG Energy welcomes the Government's commitment to grandfathering the current technology bands but would like further assurances that the value of RO certificates will not be eroded as a consequence of a move to a new system.

9.2.  There is a potential conflict between a carbon price floor and the EU Emissions Trading Scheme (EU ETS). The UK will become the only participant in the EU ETS with a carbon price floor, which will potentially reduce the effectiveness of the EU ETS.

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

10.1.  DONG Energy supports the introduction of a carbon floor price as this will support investment in renewable technology through better representation of the cost of carbon in the energy mix. The implementation of this mechanism warrants further examination as it is likely to have interactions with the other proposals within the EMR document.

11.  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?

11.1.  Depending on the market design, the capacity mechanism may encourage demand side participation in the market. The carbon price floor may also make the UK market a more attractive market for electricity generation from other countries where a floor price does not apply. This could encourage the development of interconnectors between the UK and other electricity markets.

January 2011


 
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