Energy and Climate Change Committee - Draft Energy Bill: Pre-legislitive ScrutinyWritten evidence submitted by Stag Energy

Who are we?

Stag Energy is a British company and was established in 2002. With a team led by George Grant, Chairman, the company draws on a depth of experience and has created and delivered over 10,000 MW of power generation and related infrastructure projects raising over £4 billion in commercial debt financing.

Stag Energy has made a significant investment in planning the development of new UK gas generation and gas storage to help provide the flexible support necessary to ensure the security of both gas and electricity supply at an affordable cost:

Established Watt Power, in association with the Noble Group, to develop flexible gas generation plants throughout the UK with an estimated total capacity of 1,500–2,000MW.

Established and developed the Gateway gas storage project—an £800 million 1.5 billion cubic metre facility in the East Irish Sea, in conjunction with Petrofac. It is the first storage project in the UK to secure a gas storage licence from DECC.

In order for these and other similar projects to proceed, there is an urgent need for the Energy Bill to clarify the measures required to support security of energy supply and the transition to a low carbon economy.

What is the scope and purpose of this submission?

This submission summarises our view of the scale of the transitional risks involved and the policy actions required to reduce or eliminate these risks.

It also highlights our views on (a) the guiding principles for a viable capacity market, and (b) the most cost-effective way of encouraging new investment in UK gas storage.

We have included a Statistical Appendix which contains some evidential support in the form of charts and tables.

What are our policy recommendations?

Below is a summary of our key policy recommendations:

Widen the scope of the Energy Bill beyond the components of the electricity market reform (EMR) package to embrace certain guiding principles relating to the wider issue of energy security with particular emphasis on underpinning new investment in the gas to power chain.

Amend the section on Capacity Payments within the Energy Bill to include certain operational principles to improve investor confidence—namely that the capacity mechanism will be designed in such a way as to:

(a)encourage new entrants in to the generation market;

(b)exclude projects which benefit from FITs and other mechanisms;

(c)evaluate bids using a range of criteria including price, reliability, flexibility and overall affordability (including carbon impact); and

(d)accept bids based on prices bid and not on the basis of some average or arbitrary clearing price.

Include in the Energy Bill:

(a)an explicit recognition of the inextricable link between gas and electricity security of supply;

(b)a target for the desired level of gas storage security; and

(c)a commitment to the introduction of a PSO mechanism to support new storage investment in the UK. Details can follow in secondary legislation.

A stable and predictable regulatory regime needs to be put in place as soon as possible to facilitate urgent new investment in both gas generation and storage. To this end, the commercial parameters of the capacity market and gas security support measures need to follow quickly behind the presentation of the Energy Bill to Parliament in Autumn 2012. Detailed commercial parameters can then be agreed and presented to Parliament before the end of 2012.

Separate but obviously related investigations into key policy issues led by DECC but involving OFGEM, Treasury and National Grid need to be integrated and accelerated to speed up the policy-making process. These currently include:

(a)OFGEM’s report on measures to improve long term gas security of supply (expected end May 2012).

(b)DECC’s consultation on gas generation strategy (expected report Autumn 2012).

(c)OFGEM’s consultation on Power Purchase Agreements (PPAs)—Call for Evidence June 2012—report expected Autumn 2012.

(d)OFGEM’s initial capacity margin forecast—expected September 2012.

(e)DECC’s on-going work on capacity market design with recommendations for consultation—expected mid 2013.

Stag Energy and its expert advisers would be delighted to give oral evidence to the ECC Select Committee in order to elaborate on the issues raised in this submission and take any questions from Members.

What is our perspective?

We support the Government’s decarbonisation strategy and the need, as stated by the Minister, to put in place “stable and predictable incentives for companies to invest in low carbon technologies”.

But the transition to low carbon will take many years. The Government has said that “gas has a critical role in the short and medium term as a reliable and flexible source to meet core demands now and balance demands in the future”. But in the Energy Bill, security of supply is subservient to the low carbon goal.

The Energy Bill fails to set out policy principles which recognize the inextricable link between electricity and gas security of supply and accept that stable and predictable incentives are also required to attract long term private capital to enable new investment in gas fired generation and storage.

What are our main conclusions?

The Energy Bill should embrace the wider issue of energy security and not just electricity market reform.

There needs to be an explicit recognition of the inextricable link between electricity and gas security of supply and the need to reduce the serious risks involved in the transition to a low carbon economy.

In summary our main conclusions are as follows:

A significant amount of new investment in gas-fired generation will be required by the end of this decade and beyond to ensure there is an adequate security of supply.

A large proportion of this new investment will need to be flexible capacity with the ability to respond quickly and efficiently to short term variations in demand.

Extending the life of existing nuclear plant will help maintain the level of installed capacity but it will also enhance the need for flexible plant to support the planned increase in intermittent renewable generation. New gas plant compares favorably with existing gas and coal plant in terms of its lower carbon emissions, reliability, flexibility and overall cost to consumers.

Because of vertical integration and the absence of log term supply contracts, the market does not provide the level of price certainty required to fund new investment. Faced with the prospect of operating at below full capacity and with no long term supply agreements, opportunities for new investors to recover fixed costs from electricity sales will be minimal.

Long term capacity contracts covering fixed costs are therefore essential to provide the revenue certainty required to access the low cost capital that the Government is seeking, and secure long term equity and debt funding to support new investment. With the right form of “Capacity Mechanism” (CM), the Government will secure significant new sources of private capital and increase competition in the generation sector.

Given the planned curtailment of coal-fired generation, it will be the cost of gas that determines the marginal cost of electricity when the wind does not blow and/or nuclear is not available.

If the expected increase in peak gas demand for generation is to be satisfied in a way that does not cause regular spikes in the price of gas, then more UK based flexible gas storage is required; this was a key recommendation of the Energy & Climate Change Select Committee’s report into energy security (October 2011).

Security of electricity and gas supplies are inextricably linked and action is required on both to minimize the cost of the transition to a low carbon economy for industrial and residential consumers. Construction of new generation and storage takes several years and investors need to be confident, sooner rather than later, that stable and predictable incentives will be forthcoming. Otherwise no investment will take place.

The Energy Bill therefore needs to include a recognition of (a) the need to attract new entrants/investment into the generation market and avoid over-reliance on the Big 6, (b) the security of supply dependency between power and gas, and (c) the need to take steps to increase the levels of flexible UK gas storage.

Separate but obviously related investigations/consultations led by DECC, Ofgem and Treasury in connection with the capacity market, Power Purchase Agreements (PPAs), gas generation and security of supply need to be integrated to speed up the policy-making process.

What are the key transitional risks?

A reduction in the security of supply due to closure of both uneconomic coal plant, older less flexible and efficient gas plant, and delay in the construction of new nuclear and/or renewable generation capacity.

A sharp reduction in the availability of flexible and efficient thermal generation able to meet peak demand for electricity when nuclear and/or wind is not generating.

A significant increase in the volatility of both gas and electricity prices due to regular and unpredictable variations in wind power generation.

Increasing international gas demand reducing availability, and increasing the price, of winter gas.

The inability of generators and industrial gas users to access gas when they need it at an affordable price due to the shortage of flexible UK based gas supplies.

A delay in the much-needed construction of both new UK flexible gas generation and gas storage due to political and bureaucratic delays in establishing a stable and predictable regulatory framework to underpin new investment.

How much and what sort of new generation capacity is needed?

We have to wait until September of this year for OFGEM, in consultation with National Grid, to produce the first capacity margin estimates which will provide a four year forecast to be updated on an annual basis.

However, DECC’s own analysis to date (and agreed by most commentators) indicates that the average available capacity margin will begin to tighten following LCPD plant closures by 2015 and can only be maintained if revenue certainty is provided through a clear regulatory framework in the near future.

Our own forecasts support this prediction (See Appendix—Section A). It will be challenging to maintain a 15%–20% capacity margin without the construction of new gas fired capacity of between 12 GW and 15 GW over the coming decade. This forecast takes into account the recent announcement to consider extending the life of existing nuclear plant.

Extending the life of existing nuclear plant would temporarily support the overall margin, but nuclear is not a flexible energy resource and having a high margin of installed capacity in the system does not guarantee security of supply at times of peak demand when either nuclear or particularly wind is not available to generate.

Flexibility is critical to ensuring security of energy supplies. There will be a need for more flexibility due to intermittent wind generation, changing demand patterns with electrification of heat and transport, larger unit sizes of new nuclear plant, greater level of inflexible plant (new nuclear and CCS) and ageing coal and gas plant.

The swing in the variability of electricity demand in excess supply was 7GW in 2010 for two hours duration and 11GW for four hours. It is expected that these swings will increase to at least 9GW and 14GW respectively by 2020. (See Appendix—Section B) Furthermore, the early retirement of older less economic coal and gas plant will reduce the available despatch of thermal plant (assuming no new investment) by 15GW over a three hour period.

In conclusion, there is an urgent need to encourage investment in new flexible gas infrastructure to underpin secure and affordable gas and electricity supplies.

Why do we need incentives for new investment?

Recognizing that the current illiquid and uncompetitive wholesale electricity market does not provide reliable forward price signals to encourage long term investment, the Government has concluded correctly that some form of capacity payment is needed to provide revenue certainty for investors. But in his introduction to the Energy Bill the Minister seems ambivalent: “a capacity market will be established—if required”

This adds to the uncertainty that has prevailed in the market ever since the EMR process began. We have had discussions with a number of equity and debt providers and the consensus is that the time has come for urgent clarity in connection with providing a stable and predictable regulatory regime.

In the words of Simon Wilde, Head of Power and Utilities at Maquarie Capital:

“There is no appetite amongst equity or debt providers to fund long term infrastructure projects where returns are volatile and unpredictable. To attract new entrants into the market the proposed capacity payment contracts need to be long enough—15 to 20 years—to reduce both the cost of capital and keep capacity payments low. For lenders and equity investors payments need to be large enough to cover fixed costs. In the absence of long term supply contracts, variable load factors and gas prices setting the marginal cost of electricity, there will be few if any opportunities for operators to use electricity revenues to cover fixed costs. However if the conditions on term and cover I refer to are met then there would be a significant number of institutional investors and banks prepared to invest in the UK generation market”

We have analysed what capacity payments under the proposed capacity auction might be under certain financial assumptions and for different types of existing and new generation capacity. (See Appendix—Section C)

The figures confirm that (a) for new highly efficient gas plant, the longer the amortization the lower the capacity payment and (b) existing thermal plant have lower fixed costs but this does not imply they offer the best value for consumers.

What is a reliable and affordable capacity market model?

DECC in conjunction with OFGEM, National Grid and Treasury is currently looking in detail at various capacity market design options.

However, from a commercial perspective, it takes three years to secure planning permission and another three years to build a new gas generation facility. Therefore, given the relatively short timescale up to the first scheduled auction (Q4 2014), we as a new investor are very concerned that the Government is not proposing to issue a final recommended solution until mid 2013.

We believe that it would boost investor confidence and facilitate progress if some operating principles for the capacity market were agreed this year and included in the Energy Bill to be presented in the Autumn.

There are FOUR guiding principles which we would propose be included in the Energy Bill which would (a) give new entrants the confidence to proceed with their developments and (b) allow DECC time to work through the complex detail required before implementation:

1.Encourage new entrants to provide reliable, flexible and affordable new gas generation. This would enhance competition and increase market liquidity.

2.Exclude projects supported by FiTs and other mechanisms including ROCs.

3.Evaluate bids on the basis of price, reliability , flexibility and overall affordability (including carbon emissions).

4.Bids to be accepted against prices bid as opposed to some form of average clearing price.

Affordability to the consumer is a critical factor. Within the context of the capacity mechanism, there are two aspects to affordability—the initial bid price at auction and the operational efficiency of the plant. We have analysed the relative running costs of different types of existing and new plant. (See Appendix—Section D)

The chart shows that existing coal and CCGT plant have much higher running costs than new flexible aero derivative CCGT and OCGT. Our analysis shows that (a) more expensive but more flexible gas plant has a lower overall running cost at reduced levels of demand which more than offsets the difference in the capacity bid price, and (b) with a single clearing price model there is a serious risk that less efficient plant will be rewarded and new, more efficient plant will be penalized.

As the focus of the Energy Bill is to deliver our low carbon objectives, it is essential that the Capacity Mechanism assesses the carbon impact of capacity being considered under this proposed structure.

How are electricity and gas security of supply linked?

The draft Energy Bill highlighted the expectation of electricity demand doubling by 2050. The recent National Grid energy forecast (TBE 2011) stated that 25% of electricity generation in 2050 is likely to come from gas with CCS. These objectives dramatically increase the pressure on gas supplies to be resilient and flexible.

Gas has a critical role to play in meeting the core demand for electricity in the short and medium term and in balancing demand and supply in the future. But while the Government has accepted that the issue of a potential capacity shortage has to be addressed, it has so far failed to acknowledge that complimentary action is needed to support UK gas security of supply.

Since the EMR was launched some 18 months ago, there has been an underlying assumption that (a) gas supplies are plentiful, and that (b) despite the rapid decline in UK indigenous production, imports of gas (via LNG terminals and pipelines) will be responsive to short term variations in demand.

However, the reality of the global gas market is that there are various sources of gas supply and optional destinations under any given price scenario. There is clearly a serious risk that at times of peak demand gas consumers may not be able to access the gas they need at an affordable price. (See Appendix–Section E)

Our view is that in terms of “affordability”, the risk of short term non-availability and resulting cost of gas poses the biggest threat to escalating energy costs for generators, industrial and residential consumers.

With the downturn in economic activity, the rapid exploitation of unconventional gas in North America has resulted in adequate global gas supplies in recent years. By 2015, it is widely expected that the market will tighten. The situation is aggravated by the existence of a number of key deficiencies in the UK wholesale gas market including:

the lack of an efficient forward gas market, where buyers can hedge contracts;

dependency on three–four major gas importers who may choose to store or sell gas outside the UK;

reliance on LNG imports with few long term contracts to underpin security of supply; and

very low level of UK based flexible gas storage relative to the size of UK demand.

The planned expansion in wind generation will prompt a significant increase in the peak demand for gas. Without greater security of gas supplies, gas generators and consumers will be exposed to (a) a greater frequency of supply disruption, and (b) increased price volatility. National Grid forecast that the daily variations in gas demand due to loss of wind could exceed 100mcm/pd compared with a daily average of 153mcm/pd.

Why the need to support more UK gas storage?

It is generally accepted that OFGEM’s proposal to increase the cost to suppliers for being short in the balancing market will itself not solve the problem of ensuring longer term supply security. OFGEM is due to report back to DECC by the end of May on what other measures are needed.

In October 2011 the ECC Select Committee concluded: “The UK needs to significantly increase its gas storage capacity. The Government must develop a strategy for achieving this”

We believe that an appropriate security policy target, consistent with EU standards, would be 5bcm of storage with a further 5bcm based around firm flexible contracts. (See Appendix—Section G)

Storage projects are high value projects requiring consistent and strong positive price signals to attract the necessary private sector financing. Current seasonal price differentials are not wide enough to attract long term investment and are unlikely to move in the right direction over a long enough period to enable long term funding to be secured. (See Appendix—Section F). Planning, so often a hurdle for major infrastructure projects, is not an issue in the gas storage sector. Projects equivalent to over 200% of existing gas storage capacity (10bcm) already have received the necessary planning consents.

We believe that a Public Service Obligation (PSO) on shippers and suppliers would be the most cost-effective market-based method of incentivizing investment in new UK based storage.

We advocate the introduction of a PSO framework to apply to all licensed gas suppliers and shippers whereby they would have defined access to storage based on their current market share.

What would be the impact on industrial gas users and consumers?

UK energy intensive users support the case for greater UK gas storage and the PSO. According to Dr Laura Cohen, Chief Executive of the British Ceramic Confederation, and member of the EIUG:

“More UK gas storage together with the requirement to use it via a PSO is likely to provide the highest supply security and hence the lowest price volatility since gas is held where it can be called upon, and holding a larger volume provides a larger contingency. Furthermore supplier PSOs are already the market norm in many European countries. We accept that this will result in an increased cost for all consumers and we need to understand the implications here more fully on annual bills including costs for paying for the storage assets and contents—but it is likely to be better than some other alternatives”

We estimate that the total cost of 5bcm of new storage will be £4 billion. This, it should be noted, is a fraction of the total required infrastructure cost estimated by the national Grid for the next decade. (See Appendix—Section H) Assuming that domestic consumers account for 50% of total gas consumers, the capital cost to domestic consumers will be £2 billion. Simple straight line depreciation of capital costs over a 30 year asset life equates to £67 million pa over a 30 year life span of the asset. For comparison purposes, this would equate to a simple amortised capital cost (over a 30 year period) of only £3.33pa for each household before factoring in the significant benefits of reduced energy price volatility and greater security of energy supply. (See Appendix—Section H)

Why the sense of urgency?

No new investment in either gas generation or UK gas storage will take place until clear regulatory principles are established and investors can proceed with confidence. These new assets may not be required immediately but they will be required before the end of this decade. Action is required now to put in place necessary measures to manage the risks and ensure a smooth transition to a low carbon economy.

In the interests of the wider UK economy, it is also important to note that the Government’s desire for private sector investment to underpin economic recovery will be significantly enhanced by new infrastructure investment. With a suitable regulatory framework, job creation and investment will flow into the economy and this would take place five—10 years before costs of security of supply feed through into higher energy prices.

May 2012

Statistical AppendixList of Contents

Section A

Required Additional Gas Generation Capacity

Required Additional Gas Generation Capacity—15% Margin

Required Additional Gas Generation Capacity—20% Margin

Section B

Greater Need for Flexible Capacity in the Future

Section C

Selected Generation Technologies to Estimate Capacity Payments

Selected Generation Technologies—Financial Assumptions

Selected Generation Technologies—Estimated Capacity Payments

Section D

Operational Efficiencies and Affordability

Section E

Uncertainties Over Future Gas Demand/Supply and Price Volatility

Section F

Absence of Investment Signals for New UK Gas Storage

Section G

Required Level of Additional UK Gas Storage

Section H

UK Infrastructure Investment Forecasts

Relative Costs of Energy Security for UK Consumers

Prepared 21st July 2012