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

1. Energy UK has been formed by merging the Association of Electricity Producers, the Energy Retail Association and the UK Business Council for Sustainable Energy. With over 70 members we cover the broad spectrum of the energy industry and include companies of all sizes working in electricity generation, energy networks and gas and electricity supply, as well as a number of businesses that provide equipment and services to the industry. Our members generate more than 90% of UK electricity, supply up to 26 million homes and last year invested £11 billion into the economy.

2. Energy is the lifeblood of modern society. In the UK a massive increase in investment is required in the next decade and beyond:

to replace ageing plant;

to provide the UK with security of energy supply;

to move towards a low carbon economy; and

to bring long term affordable energy to consumers.

3. For these imperatives to be achieved, Energy UK seeks to work closely with government, regulators and our members at all times. In this context we believe that the draft Energy Bill is a critical step on the road towards a low carbon, secure and affordable energy future for the UK, which in turn will be a driver for economic growth, a creator of jobs and of opportunities.

4. We welcome the opportunity to respond to the ECC’s Select Committee Inquiry and call for evidence on the draft Energy Bill. Alongside the bill, DECC has also published a series of policy updates in the form of annexes aimed at providing clarity on the electricity market reform proposals being considered and implemented through legislation. The draft Energy Bill is complex and we are still assessing it and the accompanying policy documents before coming to a final view on all of the specific issues. For the purposes of this evidence we have therefore set out general points and issues for which further clarity is needed.

5. We have engaged with the Electricity Market Reform (EMR) policy development from its outset and early in the process identified eight guiding principles by which EMR proposals should be judged:

Consistent with EU ETS and compatible with EU law.

Durable and long-term framework.

Practical and implementable within timescales required for investment.

Reduces political and regulatory risk.

Avoids undue complexity.

Compatible with open, dynamic and competitive wholesale and retail markets, supportive of new-entry.

Safeguards against impacts on committed future investment.

Reasonable cost to customers.

Summary

Energy UK welcomes the publication the draft Energy Bill legislating for the reform of the electricity market. It is crucial for investor confidence that momentum for reform is maintained and timely progress is made to develop the details of the policy that the framework legislation aims to implement.

Central to attracting much needed investment in low carbon generation to the UK is the introduction of a stable, robust and durable support mechanism.

Members generally are supportive of the CfD mechanism and welcome the progress that has been made. Important details remain to be resolved in order to provide the essential and appropriate level certainty through primary legislation. Therefore, there are some companies that believe the legislation should be flexible to enable an alternative premium feed in tariff mechanisms to be considered in the future should this be appropriate.

A clear, fair and transparent process for agreeing support levels and allocation of CfDs must be developed taking into account the Levy Control Framework (LCF).

It is essential that a robust and enduring payment model for securing the CfD revenue stream be in place which enables market participants to manage any risks economically and efficiently. The issue of ensuring that there is a robust counterparty to the contracts remains critical.

It is also crucial to ensure a smooth transition from the existing RO regime to the new CfD mechanism so as to avoid an investment hiatus.

Members recognise that the Government is proposing to develop concepts for a “capacity market”. In so doing it will be necessary to consider the range of issues that stem from the different structures and business models of those who will be affected by this development. We will be providing further thought on the capacity market proposition through a paper that highlights the key matters and options that need to be taken into account.

Companies support the approach taken by the Government towards the EPS. In particular, the commitment to grandfathering the EPS level of 450g/kWh (set as an annual limit) and to enshrining this principle in primary legislation. This is an essential aspect of securing investor confidence.

It is vital to understand and manage the impact that reform of the electricity market will have on consumers. The impact assessment should be updated to reflect policy proposals as they stand. Government and industry should undertake a consumer engagement campaign to explain the energy story, provide transparency on the costs and benefits of moving to a low carbon economy, and help individuals, businesses and communities understand the role that they could play, particularly in terms of energy efficiency and distributed generation. Energy UK would be keen to inform such work.

Energy UK’s Response

Timescales

6. We welcome the publication of the draft Energy Bill legislating for the reform of the electricity market and see this to be a pivotal step. The Government has also set out a detailed delivery timetable and, given the need to avoid any investment hiatus, it is crucial that they meet this. It follows that reforms should be implemented within the expected legislative timetable with the Bill being introduced early this autumn and completing its passage through Parliament during within the session, with a view to achieving Royal Assent as early as possible in 2013.

7. Considerable work is still needed to develop the various elements of the package especially the design of the Contracts for Difference (CfDs) and the Capacity Market and the Institutional Arrangements Framework. It is therefore crucial that timely progress is made to develop the details of the policy that the framework legislation is designed to enable.

8. The overall aim must be to improve long-term confidence for investors. Investors need early clarity on the proposals underpinned by the primary legislation. The terms of the primary legislation must be clear so as to give proper effect to the proposals without unintended consequences. There is much work still to be done and we must see a step up in the progress being made. Any slippage on the current delivery timetable would undermine confidence, and impact on the delivery of low carbon energy, not to mention supply chains and potential jobs.

9. The draft Bill gives extensive enduring powers to the Secretary of State to change, amend or modify the elements of the EMR package, which contrary to the intent, could introduce significant political and regulatory risk and uncertainty for investors. In similar past circumstances, for example the introduction of the New Electricity Trading Arrangements, Government directed that a scheme be introduced, raised the required licence and code changes and then left the market to deliver. This is not the case in the draft Energy Bill, which will allow future energy market interventions by the Secretary of State, on an enduring basis. Any such interventions should be governed by clear criteria and objectives. Discretionary powers might be subject to appropriate time limitation provisions or indeed limited to use on a single occasion. If interventions take place then the process should be transparent with full consultation of affected parties, and any changes implemented on sensible timescales with transition periods to avoid cliff edge.

10. Companies have also highlighted the need for consistency of timing on the EMR proposals and Ofgem’s work on market liquidity and cash-out reform. There needs to be greater recognition of the interdependencies between these areas of work by the Government and the Regulator. Energy UK is working to develop a paper outlining key interactions and interdependencies within the EMR package and with broader energy policy goals including the work of the regulator.

Contracts for Difference (CfD)

11. Energy UK members welcome the Government’s commitment to supporting low carbon technologies. Central to attracting much needed investment in low carbon generation to the UK is the introduction of a stable, robust and durable support mechanism. Members generally are supportive of the CfD mechanism and welcome the progress that has been made. Important details remain to be resolved in order to provide the essential and appropriate mix of certainty through primary legislation, therefore there are some companies that believe the legislation be flexible to enable an alternative premium feed in tariff mechanisms to be considered in the future should this be appropriate.

12. Companies agree that Government must develop a clear, fair and transparent process for support levels and allocation of CfDs. Companies recognise the need to limit the total cost to customers of the proposed measures, provided that the level of investment is consistent with delivering the UK Government’s legal obligations to meet the 2020 renewable target and to comply with its carbon budgets.

13. Whilst we recognise the importance of an overall levy control framework, this must be carefully designed and implemented to maintain investor confidence. The HMT Levy Control Framework (LCF) has the effect of limiting expenditure under the CfD and potentially the capacity market regimes over the spending review period. This creates significant risk that projects which have been developed at considerable cost will either not be awarded a CfD or will be subject to a lower than expected strike price, once they have reached the point of a final investment decision. An important requirement here is to devise a system in which companies developing projects in response to the CfD framework and the available strike price can be confident that their project will be rewarded as expected when they get to the point of making a final investment decision.

14. In designing a system that might address this, companies (at this stage in their thinking) would highlight three main areas:

A levy control framework over a longer period than the Spending Review could provide more certainty.

In calculating the cost of a CfD for levy control purposes, it may be helpful to use a notional rather than an actual wholesale price.

Having specific volume caps for each technology looks particularly difficult as an option.

15. Through the levy control framework, the Government will need to find an appropriate balance between supporting energy investment in the UK and limiting costs to consumers. It is essential that the EMR Delivery Plan and design of mechanisms are consistent with meeting allowed budgets under the control framework, without negatively impacting investor confidence. Energy UK is committed to working with Government on how this can be achieved.

Payment model

16. To make the CfD viable there is strong agreement amongst companies that a robust and enduring mechanism for securing the CfD revenue stream must be in place. It should not adversely impact on the balance sheet or credit rating of any participants or transfer undue risk to suppliers and their customers. It must provide confidence to banks and other sources of finance resulting in a lower cost of capital for low carbon projects thereby offering best value for money for consumers.

17. It is essential that the arrangements enable market participants to manage any risks economically and efficiently. When CfDs were first proposed there was a shared expectation that they would be backed by the Government1 however this proposal has now been withdrawn. The issue of ensuring that there is a robust counterparty to the contracts remains crucial. The Government needs to urgently update the analysis in its impact assessment to ensure that there is robust evidence based policy making.

18. We have been working with the Government to understand how the current payment model proposal would work in practice and give investors the assurance they need. Companies are concerned that the proposal outlined in the draft Operational Framework and draft Energy Bill lacks clear legal precedent and there are significant concerns that it might not be enforceable.

19. In particular, as DECC itself notes in the draft Operational Framework, the multi-party nature of the current payment model means that dispute resolution procedures may not be as straightforward as in the case of ordinary bilateral contracts where the number of parties are limited. We therefore welcome the Government’s recognition of industry’s strong concerns and support the opportunity to engage further on the detailed design work through pre-legislative scrutiny.

20. In addition, we also welcome that the Government is in parallel considering an alternative payment model which would include a single counterparty under a bilateral contract. It is important to fully consider the range of possible options. Under a bilateral contract model the question of the identity and robustness of the counterparty and its ability to recover its costs is clearly a critical issue.

21. In short, further details on both of the models being considered are needed to facilitate a full and effective assessment. However, we would like to emphasise that there are important issues that need resolving for any payment model to be workable including:

(a)Cost recovery:—Investors will need assurance that both contract terms and cost recovery mechanisms will be maintained in the long-term. The Government must legislate for the entrenchment of the cost recovery process. Legislation should explicitly allow for suppliers to collect revenue from consumers to pay generators under the CfDs (and vice versa).

(b)Dispute resolution:—As stated above it is important to note that it is critical for investors to have a clear understanding of the dispute resolution process under the CfD.

(c)Change of law:—Investors will need to understand what provisions there are to protect against future changes in law and/or material tax changes. Change in law provisions will be critical in enabling parties to manage risks. The terms of the contract that enable and help parties to manage a change in circumstances (eg effective market indexation for the reference price) will also need to be developed.

(d)Strike Price:—A robust and transparent process for setting the strike prices under the CfD will be essential. Strike prices will vary for different technologies and companies. Companies support the proposals in the draft Energy Bill to include provision to set strike prices for the CfDs through an administrative process initially. Potentially, at a later stage, moving to a competitive process. Under the administrative process, early visibility on strike prices will be critical for investment, so the Government must stick to its timetable of early notice of draft rates by mid-2013 and final rates by late 2013.

(e)Allocations/penalties:—There needs to be a clear and transparent framework under which the CfD allocation process runs. Whilst we fully recognise the need for fiscal constraints on the overall level of support for low carbon generation, we wish to note that the concepts of allocation rounds (with implicit volume caps) and development penalties cause significant concern. Developers incur significant costs in taking a project to financial close, so the risk of not then being allocated a CfD due to over-subscription will increase risks and associated costs for developers. Likewise, the introduction of penalties for late commissioning will add further risk to the process for developers without any apparent benefit for overall fiscal management.

(f)Accountancy treatment:—We are concerned about the impact of the accounting treatment of the CfD on both generators and suppliers. Should the contracts be classified as a financial instrument then the accounting treatment will create a significant burden on balance sheets. Industry, accountants and DECC need to have a common view on the accounting treatment of the CfD and capacity mechanism on suppliers and generators. Energy UK can assist Government in convening appropriate experts to understand accountancy treatment. DECC might also consider establishing an expert group which considers the implications of proposals on suppliers.

22. The issues outlined above will need to be fully addressed to make the CfD mechanism viable and help deliver investment. Investors need to understand, and be satisfied with, provisions dealing with these. Energy UK will continue to engage with Government on this, we are developing a paper exploring the payment model options and how to address the above issues.

Investment instruments

23. Companies generally welcome the intention to provide support to investors making early investment decisions, in order to prevent a hiatus. However, with the opportunity to introduce investment instruments before the full detail of the CfD is in legislation, we would like to emphasise the importance of this being a fully transparent process. The Final Investment Decision (FID) enabling process will set the precedent for future CfDs, so there must be sufficient visibility of the process and outcomes, including for developers of future projects.

Capacity Mechanism

24. Companies recognise that the Government is proposing to develop the concepts for a “capacity market”. Although companies do not have a single view on the need for or timing of such a mechanism, because of the diverse business models which they operate, they are committed to helping to develop an effective model through Energy UK.

25. Companies understand that the draft Energy Bill scopes out the capacity market design in general terms, leaving much of the technical detail to secondary legislation provisions. We understand this provides sufficient flexibility to develop the design as work progresses through engagement with industry experts and stakeholders. That said, early clarity on scheme design and timely decision-making on its introduction are needed to facilitate cost-effective, optimal investment decisions in terms of both existing and new plant. It is important to avoid undue complexity in scheme design so as to ensure consistency with the existing market (including features such as forward trading).

26. It is also important to fully explore the opportunities for the involvement of Demand Side Response (DSR) and electricity storage in the Capacity Mechanism, recognising the potential environmental benefits and also any limitations, especially on duration of its availability and the challenges in establishing a counterfactual.

27. We will be providing further thought on the capacity market proposition through a paper that highlights the key matters and options that need to be taken into account.

Conflicts of interest

28. We welcome the Government’s recognition of the need to consider potential or perceived conflicts of interest between the delivery of the EMR functions by the System Operator and National Grid’s other businesses. We are engaging with DECC via the EMR Expert Groups to improve our understanding on emerging developments in this respect and consider possible mitigating actions as appropriate.

Renewable Obligation: Transitional Arrangements

29. Concerns have been raised that any surprise outcomes on DECC’s Banding Review proposals for wind, or indeed further delay in the confirmation of the new rates, would be very damaging for investor confidence in wider Government energy policy.

30. It is crucial to ensure a smooth transition from the existing RO regime to the new CfD mechanism so as to avoid an investment hiatus. We therefore support the Government’s commitment to the use of grace periods for the planned closure of the RO. It is essential that this is designed properly to allow for flexibility on delivery issues such as grid connections and radar installations which are outside a developer’s control. It has been suggested by some that at least 18 months would be appropriate to deliver the necessary flexibility.

31. Companies agree that an appropriate mechanism for reducing uncertainty is to provide an early notice of a clear transition process. Some companies are concerned about the potential for delay to the current anticipated timetable for the introduction of CfDs. Should this occur, then RO would need to be extended to reduce the risk of a hiatus in renewable investment, which if it happened would in turn have an adverse consequence in respect of meeting the EU 2020 renewable target.

32. Companies would like to convey their support for the Government’s intent in the Bill to provide confidence regarding future RO incomes in the final years of the scheme. In particular, the proposals enabling the fixing of the price of RO certificates (ROCs) issued between 2027 and 2037. However, it is felt that to provide the certainty required for continued investment under the RO, Government should confirm the formula that will be used to calculate the fixed ROC value. The EMR Technical Update provided this, confirming details of how headroom and the buyout price would be set. However the draft legislation does not convey this, with there being wide reaching powers that do not describe the process set out in the Technical Update and give the Secretary of State power to modify ROC values at any future date.

Emissions Performance Standard (EPS)

33. Companies support the approach taken by the Government towards the EPS as set out in the EPS policy update Annex. In particular, the commitment to grandfathering the EPS level of 450g/kWh (set as an annual limit) is very important in terms of providing the necessary investor certainty for new build CCGTs. The commitment to enshrining this principle of the EPS proposals in primary legislation is also welcome as an essential aspect of securing investor confidence. The running hours of gas plant will be constrained by the level of the carbon price in the 2030’s and beyond, so the new gas plant required to ensure security of supply in the next decade is unlikely to be generating unabated at high load factors post 2030. It will be important to review the draft Bill provisions to ensure that they give full effect to the Government’s intent.

Costs to consumers

34. It is vital to understand and manage the impact that reform of the electricity market and the implementation of other Energy Policy such as smart meter roll out will have on consumers. As part of this, steps to update the impact assessment of the policies must be taken as the process of finalising policy details continues.

35. As we make progress in decarbonising the electricity sector, government should be transparent about the costs and benefits of energy policy in order to gain the trust and buy-in of consumers. It will also be important to ensure that there is support available to the vulnerable in society. Energy UK has will continue to work with government to identify and implement ways to tell the energy story to consumers and will continue to work with the relevant departments and consumer groups to devise effective ways to engage with consumers.

Enhancing Ofgem’s regulatory accountability—the requirement for merits-based appeals

36. A stable and predictable regulatory regime is vital to investor confidence and the competitiveness in the UK energy sector, bringing benefits to consumers. Part of this is ensuring that the regulator’s enforcement decisions are subject to an appropriate level of independent scrutiny.

37. The Energy Bill will add to the large number of obligations given to energy companies. In many cases, Ofgem acts as enforcer of these obligations; it is able to impose sanctions for what it judges to be non-compliance, including the power to levy financial penalties of up to 10% of global turnover.

38. Energy UK believes that existing checks on Ofgem’s enforcement decisions2 should be strengthened by giving regulated firms the right to appeal on the merits of the case. This would align Ofgem’s level of accountability with that of Ofcom.3

39. The Select Committee on the Constitution recommended this change in its 6th Report of Session 2003–04.4 The arguments are even stronger now: (a) since 2004 more relevant obligations have been imposed on energy companies, (b) in 2011 Ofgem acquired the ability to make licence modifications without the approval of a qualified majority of licensees and (c) DECC is currently consulting5 on giving Ofgem new powers to secure redress that would not be subject to a financial cap.

Notes

This response represents a broad consensus of Energy UK members’ views. Some member companies may hold different views on particular issues and we would point out that National Grid was not a contributor to this response.

June 2012