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

The draft Energy Bill, published on 22 May 2012, proposes “radical reform of the electricity market” to deliver the investment required to ensure continued security of energy supply and fulfilment of the government’s international commitments to deliver lower carbon emissions, while minimising the cost to consumers.

Ofgem welcomes the publication of the draft Energy Bill, and supports these objectives. Ofgem’s Project Discovery identified the unprecedented challenge Britain faces in attracting the huge investment needed, and estimated the amount of investment could be as much as £200 billion under certain scenarios when it published its report.

To assist the Energy and Climate Change Select Committee with their pre-legislative scrutiny of the Bill, this written submission focuses on two elements: Electricity Market Reform and the Strategy and Policy Statement set out in Chapter Eight in the Bill.

Section One: Electricity Market Reform.

Ofgem supports the high level objectives of Electricity Market Reform (EMR), which recognise the challenges we outlined in our final report on Project Discovery in February 2010.

In that report1, Ofgem pointed out that the current market arrangements would not be sufficient to deliver secure, low carbon electricity at a reasonable cost to consumers. We set out a range of possible measures to address these concerns, ranging from reforms to improve price signals, such as cash out reform and a carbon price floor, to more direct measures to support investment, such as long term low carbon contracts and a capacity mechanism.

The broad measures proposed in EMR, of a carbon floor price combined with long term contract support for low carbon plant and a capacity mechanism broadly align with Project Discovery, and we commend the Government for giving these reforms high priority in its energy policy.

We believe a well designed set of measures along the lines proposed could strike the most appropriate way to reconcile both low carbon objectives, supply security and the needs of investors and consumers.

However to achieve this goal, it is important the Government gets the details right, both in terms of the design of the EMR instruments and the regulatory and governance arrangements surrounding them. There are a number of aspects of the EMR proposals that as they stand may result in higher than necessary costs to consumers and increased risk and uncertainty to investors.

We believe it is important to introduce a well designed capacity mechanism at the earliest possible opportunity and to confirm this decision without delay.

Ofgem believes a capacity mechanism is an essential part of the EMR package, given the measures to support low carbon generation will inevitably reduce prices and load factors of other capacity (including the existing fleet), whilst at the same time increasing risk to investors in such plants.

We are pleased to see that this dynamic has been recognised by DECC in the Policy Overview accompanying the draft Bill2. Despite this, it remains government policy that the capacity market will only run if forward looking capacity assessments suggest it is needed.

Ofgem believes such a mechanism provides an important signal to investors and uncertainty over its implementation is likely to increase risk to supply security and/or lead to higher prices for consumers. A well designed mechanism should not lead to consumers bearing unnecessary costs during periods of surplus capacity, and ensures investors can take earlier and lower cost actions to avoid shortages in the future. Ofgem believes that the Government needs to state clearly whether there will definitely be a capacity mechanism; when it will start; and clarify the treatment of new and existing plants.

We would recommend a design for the FiT CfD contract that does not distort short term dispatch economics.

The Government’s “minded to” position is to pay out CFD payments based on the actual output of generators rather than a measure of availability. As DECC have pointed out in the annex to their Policy Overview, CFD payments based on output “affects dispatch decisions of CfD supported plant”, which has the potential to “distort the merit order”.3

Ofgem believes that such distortions risks causing harm to consumers and competition, and could result in higher prices, increased uncertainty to investors and increased costs to the system operator. Moreover, this distortion has the potential to impact cross border flows in a manner that further increases costs to GB consumers and the economy and we suggest that the Government ensures consistency with the objectives of the single European market.

DECC has commissioned analysis which shows the dispatch distortion to 2030 to be “minimal”, although it acknowledges that this is highly dependent on assumptions, and in some circumstances the distortion could be much greater. DECC also acknowledges that this distortion could result in up to 600 hours of negative prices by 2030, and has suggested that measures should be taken to counter this effect.

In general, Ofgem believes it is better to avoid serious distortion of markets unless there is strong justification to do so, largely because the consequences are difficult to predict and are more likely to reduce efficiency and increase costs. In this case we believe that there are simple alternatives that avoid this distortion and that the reasons provided for paying on metered output are far from convincing4. In general, concern that low carbon plant will not be given sufficient priority in dispatch is already being addressed through the carbon floor price.

We believe, as far as possible, that prices for the long term CfDs should be set through competition.

Ofgem welcomes DECC’s progress in developing a clear timetable for the transition from administrative setting of strike prices in the early stages of EMR, through to competitive auctions. However, we remain concerned that achieving value for money for consumers will depend initially on a mixture of bilateral negotiations on a case-by-case basis and administrative price setting.

We also remain concerned that the plans for transition are contingent to a significant degree on the emergence of market conditions which support the introduction of competition. The timetable provided appears ambitious when set against the criteria that need to be met, so there remains a considerable risk that most of the low carbon investment needed before 2030 will take place under broadly administrative arrangements. We would prefer DECC to establish a clear timetable for the introduction of a competitive process.

We would like DECC to explore whether the support arrangements themselves could be changed or could evolve in a way that better facilitates competition (through, for example, separating technology specific support from long term price hedging). We believe there should also be more explicit consideration of whether there should be limits to the length of time specific technologies should benefit from tailored levels of support before being required to compete directly against other (low carbon) capacity.

The Government’s favoured CfD contractual framework envisages a multi-party statutory contract between low carbon generators and suppliers in general. We are keen to learn about DECC’s plans for enforcement and about the implications for small suppliers and the prospects for new entry.

It is not clear how the obligations placed on suppliers to comply with the requirements of CfD contracts will be given effect. More specifically, it is not clear whether (and if so how) Ofgem will be responsible, ultimately, for ensuring suppliers comply with their requirements through, for example, enforcement of licence conditions. Any uncertainty over the ability to enforce the terms of the CfD contract may reduce its effectiveness and undermine the confidence of investors.

Even though DECC gave reassurances in the “Policy Overview” we do remain concerned about the potential impact of increased credit and collateral requirements on small suppliers and the risks to new entry. We welcome the fact that Government recognises this issue and has committed to working with Ofgem to understand the consequences.

Clarity on responsibility for the regulation and governance of industry arrangements, including those introduced under EMR, is imperative.

It is important that the EMR arrangements do not constrain Ofgem’s ability to carry out its duties as an independent regulator and that there is absolute clarity about the governance of the industry arrangements going forward. We would prefer the Government’s new broader powers to be subject to a sunset clause to avoid undermining confidence in the stability of market arrangements going forward. There is a risk that EMR arrangements introduced by Government, may impact existing market arrangements, reducing their effectiveness and undermining the confidence of market participants.

These considerations are particularly important in relation to our objective under European directives (which have now been incorporated into our principal objective) of promoting a “secure and environmentally sustainable” single European market when carrying out regulatory functions. It is likely that Ofgem will be required to implement changes to market arrangements in pursuit of this objective and it is important that EMR does not restrain our ability to do this.

We broadly welcome the proposals put forward in the EMR policy overview, which envisage Ofgem continuing its current role as the regulator of National Grid’s system operator activities after the scope has been broadened to cover EMR delivery. It is important to ensure that the relationship between the system operator and the Government in carrying out the EMR delivery functions, and in particular the arrangements for reporting and accountability, does not compromise Ofgem’s ability to carry out its role as an independent regulator.

There are both opportunities and risks inherent in using the system operator as the EMR delivery body. Ofgem will continue to work with Government to consider these implications.

Ofgem and Government are working jointly to identify the potential synergies and conflicts of interest that arise from the system operator acting as the EMR delivery body. This work, which is expected to complete before the end of 2012, will depend strongly on the detailed design of the EMR instruments, and, in particular, the degree of discretion the system operator has in performing this role.

Section Two: The Strategy and Policy Statement.

The Strategy and Policy Statement (SPS) is the Government’s policy proposal for strengthening the current framework for gas and electricity market regulation. The SPS is intended to bring greater clarity and coherence to the roles of government and the Gas and Electricity Markets Authority (the Authority). It aims to do this through a statement that sets out:

(a)the strategic priorities, and other main considerations, of Her Majesty’s government in formulating its energy policy for Great Britain (“strategic priorities”) to which the Authority must have regard,

(b)the particular outcomes to be achieved as a result of the implementation of that energy policy (“policy outcomes”). The Secretary of State and the Authority must carry out their respective regulatory functions in a manner which they consider is best calculated to further the delivery of the policy outcomes subject first to fulfilling the principal objectives,

(c)the roles and responsibilities of persons (whether the Secretary of State, the Authority or other persons) who are involved in implementing that policy or who have other functions in connection with it. This section will have no legal effect.

Potential Benefits

Ofgem welcomes the potential benefits which the SPS can deliver in particular through greater clarity of:

(a)Government’s strategic priorities for the energy sector; and

(b)the respective role of Government, the regulator and other industry players as appropriate.

In addition we welcome the Government’s reaffirmation of its commitment to independent economic regulation in energy. The Authority’s independence is a critical component of, among other things, investor confidence in the sector. We note that the Authority’s independence (which is enshrined in European law and which has been reflected in domestic legislation through the implementation of the EU Third Energy Package) is unchanged by the SPS and the Authority will be required in carrying out its regulatory functions to fulfil its principal objective to protect the interests of gas and electricity consumers.

Nonetheless the SPS does have the potential to make a difference to the way the Authority operates. Ofgem recognises that the Authority’s role has become broader in recent years and that it now has an important contribution to make to a wider set of policy goals. We consider that, as set out in the Ofgem Review, it is right that decisions are taken by the body that has the legitimacy, expertise and capability to arbitrate between the required trade-offs. It is for Government to put in place strategic policy objectives for the gas and electricity sector. The Authority’s independent regulatory decisions should form a logical and coherent part of this broader strategic policy framework subject to fulfilling its principal objectives.

In future the Authority will be required to have regard to a strategic framework and it will need to set out how it intends to further delivery of SPS policy outcomes and will have to report against them. This enhanced reporting will increase regulatory accountability significantly, particularly if Government fulfils its intention as set out in the command paper5 to “include a limited number of short policy outcomes that result from high-level strategic trade-offs that Government has made.”

The SPS framework as drafted has the potential to deliver greater clarity about the respective roles of government and the regulator, greater clarity about the government’s strategic policy objectives and to increase regulatory accountability which could all contribute to a more certain environment for investors.

Risks

It is not however certain that the SPS will deliver these improvements. The Energy Bill only contains powers which enable the designation of the SPS (and future statements) and as such there is no SPS at present. We will want to consider the detail of the draft SPS as it develops carefully.

We note that there are a number of circumstances in which the SPS could be changed. Although we think that the circumstances which enable the SPS to be changed are reasonable, there is no explicit limit on the frequency of change. Frequent changes to the SPS on the grounds that there were significant changes to energy policy would do much to undermine the investor confidence which the SPS was designed to increase and could potentially undermine the perception of the Authority’s independence.

There are also no explicit limits to the number of policy outcomes which can be specified and the detail of those outcomes. We welcome the Government’s statement (in the command paper) that the SPS should contain a limited number of short, strategic policy outcomes as referred to above. This has gone some way to alleviating our concerns. Nonetheless the way in which the SPS is drafted and revised will be critical in ensuring that its potential benefits as fully supported by Ofgem are not undermined.

June 2012