Memorandum submitted by SSE
SSE understands the reasons and motivations for Electricity
Market Reform and the need to accelerate investment in the electricity
sector. However, the current combination of preferred options
would have the opposite effect and would be likely to deter investment.
In particular, DECC's proposals for Contracts for
Differences (CfDs) and a targeted capacity intervention would
represent a very high level of central control over the electricity
market. Very little scope for market decision-making and competitive
differentiation would remain and policy risk would increase substantially.
As a result, the motivation for the private sector to invest,
particularly in the development stage of large projects, would
be considerably undermined and many of the key benefits of liberalised
markets (competitive pressure on costs; innovation; responsiveness
to shocks and uncertainty) would be lost. The following summarises
SSE's views on the four key reform areas.
CARBON PRICE
SUPPORT
SSE believes that strengthening the long-term carbon
price signal is an important element of EMR. In particular, visibility
on the carbon price beyond 2020 is needed, given the uncertainty
over the status of the EU ETS after that date and the timing of
investments. In designing Carbon Price Support (CPS), HMT and
DECC need to ensure that it:
(i) increases investment but does not unnecessarily
raise customers' bills or distort the market through undue windfall
gains and losses to existing generation. In practice this means
CPS needs to be at a notional level (eg £1/tonne) until 2020,
after when the majority of low carbon capacity will start operation;
(ii) is set to deliver a "bankable"
carbon price trajectory. This means the tax should be adjusted
so the overall carbon price (EU ETS plus CPS) is never outside
a narrow range, and the trajectory needs to be set for a long
period in advance. This is similar to the approach suggested by
the Prime Minister for the fuel price escalator and moves away
from a tax which can be changed every year at the complete discretion
of Treasury, which is not a viable basis for investment and is
not bankable; and
(iii) does not result in UK carbon prices being
substantially higher than prices in mainland Europe. This would
place UK generators at a significant cost disadvantage and result
in a significant increase in interconnector imports.[59]
Providing these conditions are met, SSE believes
CPS can help enhance investment and ensure the merit order favours
low carbon.
CAPACITY MECHANISM
SSE believes a general capacity payment - paid to
all capacity according to its availability at peak demand - is
needed to secure sufficient capacity going forward. The current
market framework is already deficient in rewarding investment
in system reliability, as large sections of the market can effectively
avoid long-term costs of providing this "insurance"
by contracting on a short-term basis (ie there is not a fully
developed market for reliability). As the level of inflexible
plant on the system increases (ie wind and nuclear), these problems
will be exacerbated, with thermal plant becoming increasingly
reliant on infrequent and uncertain price spikes to pay back investment.
Combined with uncertainty around market reform, there are now
serious concerns over whether sufficient investment in firm capacity
will come forward over the coming decade.
Crucially, the mechanism must cover all capacity,
including demand side resource. Any mechanism which attempts to
pay only a subset of capacity (eg only peaking or new) will simply
increase risks for all other types of investment. The "targeted
mechanism" proposal could be highly damaging. With the potential
for centrally-tendered plant (and uncertainty around the timing
and volume of this) market-based investment would be sterilised.
Developers would be concerned that if they did invest this would
be "crowded-out" by tendered plant and hence would hold
back investment or may even strategically defer investment in
the hope of securing a tender. Tenders of new plant would also
force premature closure of existing plant - raising the overall
costs of securing an adequate capacity margin. This would all
lead to a "slippery-slope" - where an increasing amount
of plant is tendered for and the role of the market eroded.
Conversely, a general capacity payment could substantially
de-risk investment in capacity, reduce costs of finance and bring
forward the most cost-effective forms of capacity. Therefore,
costs facing the consumer would be limited to what is needed to
pay the unavoidable "insurance premium" that is needed
to provide sufficient capacity to balance the system on a daily,
monthly and annual basis.
SUPPORT FOR
LOW CARBON
The Renewables Obligation (RO) is now a well-designed
and well established support mechanism and, as such, SSE does
not believe there is a case for reform.[60]
The difficulties in the rate of renewables deployment have been
related to grid access, transmission charging, planning constraints
and financing construction/operational risks (the same issues
that will delay nuclear) - not the support mechanism.
It is therefore welcome that, should the RO be replaced,
it will be "vintaged" for existing and upcoming investments
- however, the period that the RO is open for new investments
should be extended until 2020 (and "vintaged" until
2040), to ensure investments needed to meet 2020 targets are not
adversely impacted.
If the RO were to be replaced it would be important
to keep the new renewable capacity "in the market",
such as through a Premium FIT. Taking low carbon generation out
of the market through Contracts for Differences (CfDs) would substantially
undermine the basis of liberalised markets and could have a number
of damaging effects:
— Loss
of competitive pressure. With contracts
for electricity in effect being with, and set by government, the
scope for competition in supply and in contracting of energy would
be heavily restricted. Moreover, market signals on when, and how
much to build would be lost and competitive pressure on the supply
chain would be reduced. In particular the ability to generate
value through prudent risk management and by selecting the "right"
projects is a fundamental motivation to invest for all developers
which would be largely removed with a system of CfDs;
— Limited
scope for price discovery. CfDs inherently
require more government involvement in fixing prices, increasing
the information requirements for government and the risks of setting
the "wrong" price. In particular, the scope for the
market to "self-correct" for general movements in construction
costs over time would be removed. Therefore, under a CfD, developers
would require a significant premium to cover this risk, raising
costs to consumers;
— Reduced
development capital. With CfDs, developers
would not be in control of the build decision (with this being
subject to the successful award of contract) and hence the motivation
to invest at this crucial development stage would be substantially
reduced. This would be particularly acute if the CfD prices were
determined by auction. There is a risk very few parties would
be willing to commit the substantial development capital needed
to submit sensible bids without any guarantee of contract. Therefore,
there may be little competition for contracts. Moreover, successful
bids may not be robust and include underestimated costs (so-called
"winner's curse"), and consequently many projects would
fail to be delivered (as was the experience with NFFO auctions);
and
— High
transaction costs and implementation issues.
CfDs would require substantial contracting, payment and cost-recovery
systems which would involve high setup and running costs. Moreover,
finding an appropriate price index against which to set the contracts
would be challenging and, if costs are recovered through a variable
levy on bills, suppliers would face substantial cash-flow risks.
The increased complexity implied here would also be a deterrent
to new investors on both the generator and supply side. This runs
contrary to the desire to introduce a mechanism which avoids the
perceived complexities with the RO. CfDs would be much more complex
and, with experience, generators are now very comfortable with
the RO.
Before extending support beyond renewables, SSE believes
it is important to first assess the impacts of CPS and a capacity
mechanism (once their design has been established) to determine
what funding "gap" remains. Should this remain, explicit
and clearly targeted support for nuclear, such as a Premium FIT,
may be needed which will need careful design. The impacts of extending
subsidy coverage through a CfD scheme on wholesale markets and
dispatch patterns also need to be carefully assessed and managed.
The analysis so far has been at too high a level and does not
adequately take account of the behavioural and perception issues
which always affect markets.
EMISSIONS PERFORMANCE
STANDARD (EPS)
An EPS on new plant as proposed can provide a useful
backstop to prevent build of plant that is inconsistent with climate
change goals. SSE agrees that it should be set as an annual limit
(to allow build of peaking plant) and that the appropriate level
is the equivalent of 450gCO2/kWh for a plant operating
at baseload. The principle of grandfathering this level is extremely
important otherwise investment will be heavily deterred. Moreover,
any revision of this level should be conditional on successful
demonstration of CCS on both gas and coal.
As a final comment, SSE has some concerns that the
impacts on wholesale prices of the proposed EMR package have not
been given sufficient weight and analysis in the consultation
nor have the range of potential unintended consequences been fully
explored.
SSE'S PREFERRED
REFORM PACKAGE
The following summarises what SSE believes to be
a workable reform package, within the options presented in the
consultation, which enhances investment and minimises market distortion:
— Carbon
Price Support - at very low levels until 2020 when a target price
within the range £20-40/tonne should be implemented;
— a general
capacity mechanism - covering all "firm" capacity (and
demand-side management);
— retention
and extension of the RO for renewables (and, if any reform is
made, a Premium FIT is the best option); and
— an
Emissions Performance Standard on new build as proposed.
January 2011
59 For example, a carbon price differential of around
£5/tonne would theoretically make it more cost-effective
to build a CCGT abroad with a corresponding interconnector, rather
than build a CCGT domestically. Back
60
Since its introduction in 2002, the RO has seen the level of renewable
electricity from 1.8% to over 6.6%. Back
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