Energy and Climate Change Committee - Draft Energy Bill: Pre-legislitive ScrutinyWritten evidence submitted by the Energy Technologies Institute

About the Energy Technologies Institute

The ETI is a public-private partnership between global industries—BP, Caterpillar, EDF, E.ON, Rolls-Royce and Shell—and the UK Government.

Public sector representation is through the Department for Business Innovation and Skills (BIS), the Technology Strategy Board (TSB), the Engineering and Physical Sciences Research Council (EPSRC) and the Department of Energy and Climate Change (DECC).

The ETI brings together projects that accelerate the development of affordable, clean, secure technologies needed to help the UK meet its’ legally binding 2050 targets.

We make targeted investments in projects in offshore wind, marine, distributed energy, buildings, energy storage and distribution, carbon capture and storage, transport and bio energy. These projects bridge the gap between laboratory scale research and development and commercial deployment of large-scale engineering projects.

Summary of Evidence

1. The government is right to focus now on decarbonisation of the electricity sector. Our work on energy system modelling robustly supports decarbonisation of electricity by 2030 as the right approach to meeting our 2050 carbon targets.

2. Our evidence to the committee contains four key points. The first two relate to the drafting of the bill; the latter two relate to how the EMR regime is implemented and placed within a broader strategy for decarbonisation in future.

(a)Create a stable investment environment: The design of EMR could be improved to give a more stable, credible and attractive environment for investors. This will help to ensure that investment comes forward at an affordable cost of capital.

(b)Allow contracting for demand side contribution: EMR has not, so far, addressed the potential demand side contribution to electricity decarbonisation. The Bill could leave open the potential to develop a mechanism for contracting for demand side interventions.

(c)Take full account of energy system-wide value: There are multiple inter-dependencies within electricity systems and across the entire UK energy system (including heat and transport). These are central to creating an integrated, cost-efficient, low carbon UK energy system. Good policy will look beyond an “electricity silo” to be informed by a system-wide perspective. Simple levelised cost metrics (cost per MWh) do not reflect system-wide value and are not a good guide for selecting the right mix of technologies. EMR delivery plans and contracting decisions need to take explicit account of energy system-wide inter-dependencies.

(d)Ensure complementary policies support low carbon technologies: In addition to EMR, all low carbon generation technologies will need complementary technology-specific policies and strategies to promote investment in innovation, development and deployment. The regime will be more powerful if it is clearly integrated with coherent supporting policies.

Creating a Stable Investment Environment

3. In order to bring forward the required investment in low carbon electricity generation the Energy Bill needs to create confidence and certainty around revenues for investors in low carbon electricity. Pre-legislative scrutiny provides a key opportunity to examine how the Bill could be improved to increase confidence and clarity among the investment community who will be relied on to finance the decarbonisation of the electricity sector.

4. Our engagement with investors and the finance community point clearly to the importance of investor confidence in securing the development and deployment of competitive low carbon technologies. For example, the recent report of the offshore wind cost reduction task force, which ETI was part of, clearly highlights the importance of driving down the cost of capital.

5. In our view the process of pre-legislative scrutiny and consultation offers an opportunity to examine ways of improving the proposed legislation in terms of the strength and reliability of signals to investors. Our emerging work on CCS financing (carried out jointly with the Ecofin Research Foundation) suggests that there is considerable scepticism about the UK’s long term commitment to carbon targets.

6. Developing and applying a stable and transparent approach to EMR will help to drive down the cost of capital and benefit consumers. The contracts for difference approach will introduce an important tool to de-risk projects by offering stable revenue streams. However, to finance the development of technology and supply chain capacity investors and industry will need visibility around the size and scope of the market, and confidence that there will not be sudden, sharp changes of policy and the outlook for support measures.

7. From this perspective, the structure envisaged for the regime is both complex and exposed to significant policy risk. As well as government, it encompasses a system operator and a panel of experts, neither of whom will have clearly defined statutory duties. The recently published operational framework also suggests a possible “independent expert” function for resolving disputes and determining contract variations. This may be perceived by investors as unduly complex and vulnerable to unpredictable influence.

8. The Bill and the accompanying documentation also does not clarify how the government will ensure coherence between its carbon budget, its published Carbon Plan, and its approach to delivering EMR. This, along with the closeness of the department to the delivery plan, may cause investors to perceive a significant risk that the EMR delivery plan and associated funding commitments will be subject to short-term spending review pressures. This could lead to doubts about the size and attractiveness of future UK markets for low carbon electricity generation, and drive reluctance to commit serious investment to developing the necessary technologies and supply chain capabilities, as well as inhibiting future reductions in the cost of capital for low carbon generation projects.

Key issues for the committee

9. It is important to consider how the investor credibility of the EMR statutory framework could be strengthened. Consideration could be given to arrangements that would reduce hands-on government involvement in relatively short-term delivery issues, or would progressively reduce this over time. This tends to be the pattern in other regulated sectors, even where public financing is very significant. For example, responsibility for more of the contracting and short-term delivery could be delegated to an independent body within a clear statutory framework.

10. A statutory requirement to demonstrate the coherence of EMR delivery plans (in particular the funding envelope available for EMR) with the government’s broader strategy for meeting carbon budgets could improve the investability of low carbon electricity projects in the UK. One possible mechanism would be to put the EMR delivery plan onto a statutory basis, requiring that it clarify broad resource parameters (without compromising competition for contracts for difference).

11. These ideas are examples of approaches or mechanisms that the government could consider in improving the Energy Bill. No doubt there are other potential options. The pre-legislative stage offers the opportunity to examine these fully before finalising the Bill.

Demand Side Measures

12. There is significant potential for demand side interventions to contribute to the decarbonisation of the electricity sector. In many cases such demand side interventions require significant investment and the rewards will be similarly affected by market uncertainties and risks. There is considerable work ongoing in this area including the ETI’s £100 million Smart Systems and Heat programme recently announced by the Prime Minister. This will build understanding of mass-market consumer behaviours and needs, to support genuinely effective service products and business models.

13. Clearly the design of contracts for difference to remunerate investments in demand side measures presents particular challenges. However, in principle there does not appear to be any reason why appropriate contracts could not be devised for appropriate kinds of demand side interventions. This could create opportunities for new business models to emerge in demand side interventions.

Key issue for the committee

14. While it may be difficult to resolve the many design questions now, the bill could be framed in a way which does not close down the potential for future development of demand side contracts for difference or related reward mechanisms. This is also potentially relevant to the capacity mechanism.

Taking Account of System-Wide Value in Policy Design

15. Over the past three years the ETI has, in collaboration with its members and a number of sector experts, created a world class bespoke modelling capability for the UK energy system—the Energy System Modelling Environment (ESME). This allows us to systematically model the UK’s pathway to decarbonisation under a range of scenarios, taking account of the underlying costs, engineering properties and inter-dependencies of key energy technologies.

16. Our work on energy system modelling robustly demonstrates that taking a system-wide approach substantially reduces the economic cost of decarbonisation (“system-wide value”). Energy system modelling supports the government’s emphasis on decarbonising the electricity sector. But it also highlights strong inter-dependencies between the design choices for low carbon electricity (generation and grids) and systems for meeting heat and transport needs.

17. Some technologies can be applied both within and outside the electricity sector (for example, biomass energy projects can generate electricity or produce synthetic natural gas or hydrogen; carbon capture and storage can be applied to electricity generation and in industry), while others have inter-dependencies across the boundary of the electricity sector (for example, intermittent renewable electricity generation can be combined with energy storage technologies). From an energy system perspective, electricity is simply one of a portfolio of alternative ways to convert, store and distribute energy to meet our needs. If electricity policy is designed in isolation, we risk taking an unbalanced and higher cost approach to decarbonisation.

18. To take one example, ETI’s energy system modelling points to a critical role for carbon capture and storage both within and outside the electricity sector. It suggests that if we do not successfully develop CCS in the UK, the annual cost of meeting carbon targets is likely to increase by over 1% of GDP by 2050. Notably it also highlights the potential economic benefit of applying CCS in combination with biomass, as a means of generating negative carbon emissions. This delivers high system value by making it possible to meet carbon budgets and continue using fossil fuels in some applications where low carbon alternatives are particularly costly. A coherent strategy for developing CCS requires taking account of the costs and benefits across the entire energy sector, and not just within the electricity sector. Developing CCS in the electricity sector could unlock broader decarbonisation benefits by de-risking subsequent deployment of CCS in industrial and biomass applications. The government will maximise the impact of resources by taking account of these broader decarbonisation benefits in decisions on contract pricing, allocation and contract design.

19. Even within the electricity sector, individual generation technologies are not interchangeable, in that:

(a)They have different operating profiles (for example, ability to ramp up in response to demand; intermittency/variability) marginal costs and places in the merit order.

(b)They have different strategic exposures to, for example, extreme weather events, global commodity prices, or design faults.

(c)They are at different stages of technology, market and regulatory development.

Key issues for the committee

20. Decisions on EMR should take account of the “system-wide value” of technologies, in terms of:

(a)Inter-dependencies within the electricity sector—for example, the need for investments in grid connection/reinforcement, the despatchability of capacity or the cost and availability of electricity storage. These effects are sometimes not captured in levelised cost analysis.

(b)Strategic inter-dependencies with non-electricity systems—for example, electricity generation choices will have an impact on, and should be informed by, emerging options for addressing variability in our daily and seasonal demand for heat in buildings.

(c)Portfolio value—this is the option value created by having a balanced portfolio of proven technologies which can be deployed as circumstances emerge and change in future.

21. The EMR documentation sets out a route to technology-neutral (but electricity-specific) market mechanisms in the 2020s, but is silent on questions around system-wide value in the sense described above. There remain important questions about how to incentivise and select competing technologies for best overall decarbonisation value.

22. The importance of interdependencies (and therefore “system-wide value”), and the likelihood of multiple market failures, implies the need for a strategic approach to designing and combining market and administrative contracting mechanisms. It will be very challenging to design technology-neutral electricity market mechanisms that adequately reflect wider energy system-wide value effects. There could remain a valid case for some degree of technology specificity in future EMR implementation.

23. EMR delivery plans (and updates) could usefully be based on an explicit and regularly updated energy system-wide perspective. The delivery plans could then set out how system-wide considerations will be taken into account in CfD allocation, pricing and contract design across technologies. For these purposes, it is important to note that simplified metrics such as levelised costs of electricity do not capture broader system-wide effects and value.

Complementary Technology Policies Will be Needed to Support Deployment of a Balanced Portfolio of Low Carbon Generation

24. EMR addresses a generic barrier to the deployment of all forms of low carbon electricity generation by providing a mechanism to deliver stable premium revenue streams. Investors can therefore see a route to clear returns on investment in low carbon generation. However, a range of complementary policies and interventions are needed if EMR is to achieve its full impact in developing and deploying a balanced portfolio of low carbon generation. These policies need to focus on the specific barriers to development and deployment of individual technologies.

25. These issues are highlighted, for example, in the work of the task force on offshore wind cost reduction or in DECC’s CCS commercialisation programme. DECC is already working on many of these issues through a variety of routes, and its strategies for the various technologies need to be reflected in EMR delivery plans.

26. Complementary policies are needed to address a range of risks around issues such as consenting, support for innovation, insurance and liabilities, access to electricity grids, charging for transmission and regulatory regimes.

27. While the ambition is towards technology-neutral contracting in the 2020s, it is important to note that complementary policies will still need to address the technology-specific barriers.

June 2012