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

Introduction and Summary

The European Climate Foundation (ECF) is an independent foundation supporting work on climate and energy policy in Europe. The ECF has specifically addressed the future of the European electricity sector both in terms of technical routes to decarbonisation and the policy implications. The ECF’s UK Programme has commissioned the present submission on the UK draft bill’s proposed capacity market because this issue is now under consideration across Europe and so the UK’s conclusions may have pan-European significance.

ECF has commissioned this independent analysis from Simon Skillings at Trilemma UK and the content of the submission reflects the views of the author and his reviewers and ECF is pleased to submit the analysis to the Committee for its consideration.

The submission reflects key concerns with the provisions of the Draft Energy Bill to authorize the Secretary of State to design a “capacity market” and put it into operation at his discretion. There are three major problems with the approach set out:

Lack of clarity about the future role of a capacity market.

Inflexible design based on flawed assumptions about the future reliability challenge.

Lack of an appropriate incentive framework for the System Operator and, in particular, the absence of strong drivers to stimulate the market in provision of demand side resources.

The following remedies are proposed to address these shortcomings:

The Energy Bill should be based on a clear Government position on the circumstances in which a capacity market will be introduced. The Bill should set out the basis upon which the Secretary of State will define the level of reliability that the System Operator must deliver and how this will be reviewed and updated over time. This is necessary to enable the System Operator to efficiently procure the necessary reliability products and investors to assess how the value proposition for investment in resources may evolve.

The Energy Bill should include a clear statement recognising that the future reliability challenges require an increasingly flexible portfolio of despatchable resources, including demand response, and not just a quantity-based approach (firm capacity) to deliver system reliability. It should direct the System Operator to regularly forecast net demand1 on the system and design and implement the mechanisms that value and deliver the products and services required to reliably operate the system over both operational and investment timescales. It is unnecessarily restrictive to attempt to specify market design on the face of primary legislation.

The Energy Bill should include a mandate for the Regulator to establish an incentive framework for the System Operator to minimise the costs of delivering reliability. In addition, the Secretary of State should establish minimum targets for the procurement of demand response to help kick-start the market in the provision of these services and ensure the System Operator develops the necessary systems and expertise to exploit the benefits of demand response.

Context

The need, or otherwise, for a capacity mechanism in electricity markets has been the subject of on-going controversy since liberalisation was first introduced. Although theoretical micro-economics suggests that energy only markets will efficiently deliver the optimum level of security for consumers, there are a series of problems that may prevent this from happening in reality. This is for two principle reasons:

There is concern that regulators or politicians will intervene to prevent the high prices that naturally occur during periods of tight supply and that are necessary for investors to make a return. This might either happen directly through price capping, or indirectly through side-deals that encourage reserve capacity to be available and, thereby, suppress prices for all other participants.

It is difficult to monetise the potential future value of periods of high prices. This is because the great majority of consumers lack understanding to hedge their exposure and do not expect to have to do so, whilst the intermediaries on whom they rely (suppliers) have no obligation to provide such a hedge and face asymmetrical risks in choosing to do so as a commercial strategy.

These problems give rise to the so-called “missing money” thesis which, in effect, says that the market left to its own devices may provide a lower level of security than customers have grown to expect. Whilst the “missing money” thesis is taken seriously by many policy makers, the introduction of capacity mechanisms to remedy the concerns remains controversial. This is because experience of capacity mechanisms has given rise to a number of perceived problems, in particular:

They create a significant policy risk for investors and the long term value of capacity payments can be largely discounted (in much the same way that investors discount the long-term value of carbon price).

Poorly designed capacity mechanisms can distort markets and can be easy to exploit through the exercise of market power.

They can suppress short-term price signals and, thereby, remove incentives for efficient demand response to price.

Many policy makers, including until recently those in GB, have therefore opted to retain the energy-only market. However, as part of the Electricity Market Reform process, the UK Government has decided that a capacity payment mechanism is likely to be required to preserve reliability through the upcoming period in which there will be a sizeable increase of variable renewable resources to meet renewables and decarbonisation targets and, at the same time, a significant number of existing conventional generators are expected to retire. Although significant elements of the design envisaged for the GB market remain to be defined, a series of important decisions appear to have been taken and are embodied in the Draft Energy Bill. This paper sets out some concerns with these decisions and provides recommendations for the drafting of more robust legislation.

This submission draws in large part upon the attached paper, “Beyond Capacity Markets—Delivering Capability Resources to Europe’s Decarbonised Power Market” that was recently published at the 9th International Conference on the European Energy Market in Florence, May 2012 and is provided as an attachment to this submission. As discussed in the attachment, there is now substantial world-wide experience associated with the design of capacity mechanisms, as well as a growing understanding of the important changes in the system and reliability challenges that these mechanisms were originally intended to address. In particular, whereas the focus of these mechanisms has been to deliver a quantity-based standard of resource adequacy (firm capacity in MWs), the challenges of the future will also require an increasingly flexible portfolio of resources capable of rapidly changing output or flexing demand frequently and continuously throughout the year around the energy available from variable renewables. In fact there is good reason to expect that success in addressing the system flexibility dimension can have significant benefits in reducing the need for investment in firm capacity. This submission sets out the key design considerations in delivering these capabilities to the system in the context of the new reliability paradigm, including the need to actively enable participation of the demand-side.

Delivering Reliability to the System

There are two steps involved in the design of capability mechanisms designed to deliver what the system needs to maintain reliability:

Step 1: Define the “reliability product or service”.

Step 2: Determine how it should be valued.

Much of the design effort is generally devoted to the second step and this has been the case in the UK process where there has been considerable debate as to whether the System Operator should run a market-wide auction or merely procure “strategic” reserve capacity. However, step 1 is also extremely important since forthcoming changes in the power system mean that we cannot assume that the same product that has delivered reliability in the past will continue to do so into the future. Definition of the “reliability product” requires a number of questions to be addressed including:

What is the critical period or circumstance in which system reliability is under most stress?

What is the service that will deliver reliability during this period?

How much of this service do individual providers offer?

How far in advance and for how long must providers deliver this service?

Traditional approaches to capacity mechanism design have assumed that all (or a sufficient proportion of) capacity is able to provide the range of operational flexibility that will enable the System Operator to balance supply and demand in real time. Therefore, it has been possible to separate the concepts of “resource adequacy”, which involves having enough total capacity available over planning time horizons, and “system quality” which involves maintaining certain system parameters (eg frequency, voltage) within statutory limits during operational timescales. Given this assumption, the critical period in which system reliability is under most stress is the time of peak demand and the service that is required to deliver reliability during this period is firm capacity. If there is enough firm capacity available to meet the winter peak demand then it is assumed that this capacity will have the inherent flexibility to maintain operational security throughout the year, provided the short term pricing signals ensure that this flexibility is made available when required.

The UK capacity market proposals are based on this assumption and it is therefore being designed to deliver adequate firm capacity to meet winter peak demand. On-going design work is currently considering the third and fourth questions listed above, deciding how much firm capacity individual providers actually deliver and the appropriate commitment period in which they will be required to deliver the service. However, there is increasing evidence that this paradigm may not be appropriate to the reliability challenges that will emerge over the next decade and it is, therefore, important that the market design to deliver reliability remains sufficiently flexible to meet these new challenges.

The New Reliability Paradigm

Some electricity markets, including both those with and without capacity mechanisms, have successfully stimulated investment in new power generation capacity. The principles underpinning these investments are illustrated in the following diagram:

New power plants are more efficient than existing power plant and will therefore be able to operate a lower cost. This efficiency advantage has enabled new power plant to operate at, or near, base load and throughout the day earn market prices set by older and higher cost plant. Moreover, the technology of fossil-fired power plant is relatively mature and investors can confidently expect that a construction project will be completed to time and budget and the power station will, thereafter, work reliably. The new power plant will, therefore, be continually earning an operating profit, or “energy credit”, that can be relied upon to recoup financing costs and deliver project returns.

However, the increase in the proportion of variable renewable generation will change this previous investment logic as illustrated in the following chart based upon a recent pan-European study2 that investigated the changes needed in the power sector associated with delivery the levels of decarbonisation envisaged in the EU Commission 2050 Roadmap.

This chart shows the annual variation in total and net demand for the “GB South” region in 2030, where net demand is the total demand less the output from variable renewable generators. It can be seen that the volume available for traditional base load generation is significantly reduced and the majority of non-renewable resources must operate in a flexible mid-merit mode. This creates two significant challenges to the current investment logic:

Firstly, there is more uncertainty over the energy credit that power plant will earn since it depends on the ability to operate during shorter periods of high prices.

Secondly, there is likely to be a requirement for the plant to operate in an extremely flexible mode with multiple stop/start cycles being required, potentially daily throughout the year.3 There is an investment cost burden associated with creating this capability and yet the payback is extremely difficult to estimate and is associated with significant uncertainty.

The first of these changes potentially affects the appetite for investors to pursue power plant projects and increases the argument that some form of capacity mechanism is required to stabilise earnings. The second issue, however, has the potential to affect the type of assets that are built and their operational capabilities. Unless the value of investing in the technical capability to provide flexibility is sufficiently predictable, there is a risk that the system operator will be forced to choose between despatching the resource portfolio so as to ensure supply security and despatching so as to minimize costs to consumers.

Indeed, when considering the design of the required “reliability product”, the critical period or circumstance in which system reliability is under most stress is no longer simply the time of peak gross demand. Instead, the most challenging threat to reliability arises when consumer demand and the availability of variable renewables is changing in opposite directions, something that can happen any day, every day, at any time during the day, and even several times a day. It will occur to the greatest extent in situations where demand is either increasing towards system peak whilst the availability of variable renewables is reducing to a minimum, or falling to system minimum levels whilst the availability of variable renewables is increasing to a maximum. These circumstances highlight that the ability of resources to respond to a rapidly changing level of net demand is as important as the overall quantity of firm capacity. Therefore, the answer to the second design question—what is the service that will deliver reliability during the most challenging periods—is no longer simply firm capacity.

As discussed, actual experience with capacity markets such as the one being proposed in the Draft Energy Bill, confirm that “what you value is what you get”. That is, a capacity payment mechanism that values only one capability—the quantity of firm MWs committed to be available during the few hours of highest total demand—will result in the vast majority of revenues going to existing, conventional fossil-fuelled and nuclear generators that are likely to be relatively inflexible, and to new generators with the lowest all-in cost, which are also likely to be relatively inflexible. While some of these generators (eg, traditional mid-merit CCGTs4) have load-following capabilities, they very likely would not be “flexible enough” to reliably meet the net demand associated with a rising share of variable renewables in the power mix.

Finally, an important change that is expected to occur over the coming decades is that the GB power system will become increasingly physically interconnected with neighbouring power systems. This interconnection has many advantages in terms of system reliability since larger balancing areas have less need for, and greater access to, operational reserves and are less prone to systemic failures such as the dependence of renewable availability on weather conditions.5 Therefore, the Draft Energy Bill should not prematurely lock into a specific capacity payment design given these developments or the related market design issues discussed under Section V.G. of the Attachment. In particular, it is unclear how the capacity market design reflected in the Draft Energy Bill will operate in line with market coupling principles and potentially larger balancing areas.

Demand Side Resources

Power system operators have traditionally balanced supply and demand through controlling the output of the power plant portfolio. It is now widely accepted that the ability to adjust demand has the potential to provide a cost effective alternative that avoids significant investment in supply side resources. Where these resources have been enabled to participate in US organized markets, experience confirms both their cost-effectiveness and high level of reliability as a system resource.6 However, these opportunities have yet to be exploited on a significant scale in GB, in part because some of the enabling technologies are only now beginning to be deployed, but also due to (increasingly anachronistic) concerns that a system operator cannot rely upon demand side resources in the same way as those on the supply side. These constraints on the development of demand response will be exacerbated where the design of capacity mechanisms (and other financial incentives) is based on typical investment and technical capabilities of generation plant. For example, the basis upon which it is decided how much of the reliability product is provided by an individual resource often includes site visits and availability testing that does not translate well into the situation where demand response is provided from multiple locations.

To overcome these barriers it is necessary that the design of the mechanism to pay for reliability resources and the associated regulatory framework is equally applicable to demand-side and supply-side resources. Two issues are of particular importance:

The mechanism must recognise the differences between the investment and operational characteristics of demand and supply side resources and the design must not favour one against the other.

Positive incentives will be required to drive the development of the market for the provision of demand response and the deployment of the necessary technology. This could initially involve volume targets for the procurement of demand response services. Ultimately, a strong financial incentive on the System Operator to minimise the costs of procuring reliability resources should be sufficient to sustain the growth in this market.

Draft Energy Bill and the Capacity Mechanism

The Draft Energy Bill contains powers for the Secretary of State to design a “capacity market” and put it into operation at his discretion. There are three major problems with the approach set out:

Lack of clarity about the future role of a capacity market.

Inflexible design based on flawed assumptions about the future reliability challenge.

Lack of an appropriate incentive framework for the System Operator and, in particular, the absence of strong drivers to stimulate the market in provision of demand side resources.

The deferral of a firm decision to implement a capacity market creates unnecessary and potentially harmful uncertainty affecting investment in the market. It fails to provide a clear Government position on the “missing money” thesis or articulate a long term strategy for how it may be addressed. It appears that the decision on the introduction of the capacity market will be based on future assessments of firm capacity margin over winter peak demand; however, there is no indication of how the Government will decide whether the margin is adequate or inadequate. Introducing an approach only when investment is required is consistent with a philosophy of making periodic targeted interventions rather than including a mechanism to ensure reliability as an enduring part of the market arrangements. This concern is exacerbated by the absence of any strategy for how the payment mechanism may, or may not need to evolve in light of an increasingly interconnected EU power system.

The Energy Bill should be based on a clear Government position on the circumstances in which a capacity market will be introduced. It should also set out the basis upon which the Secretary of State will define the level of reliability that the System Operator must deliver and how this will be reviewed and updated over time. This will enable the System Operator to efficiently procure the necessary reliability products and investors to assess how the value of capacity payments may evolve.

The Draft Energy Bill assumes that the critical period for reliability will be the winter peak demand and the System Operator should procure capacity that will be firm during this period. There is no guarantee that this will be the primary reliability challenge going forward and, indeed, there is increasing evidence to the contrary. Therefore, there is a risk that the costs of delivering reliability will be unnecessarily high as the System Operator is likely to implement separate mechanisms to procure the products and services that will deliver reliability in addition to those bought through the capacity market. In particular, it is likely that the operational capabilities of resources will become at least as important as the amount of firm capacity they provide.

The Energy Bill should, therefore, include a clear statement recognising that the future reliability challenges require highly flexible resources, including demand response, and not just a quantity-based approach (firm capacity) to deliver system reliability. It should direct the System Operator to regularly forecast net demand on the system and design and implement the mechanisms that value and deliver the products and services required to reliably operate the system at least cost over both operational and investment timescales. It is unnecessarily restrictive to attempt to specify market design on the face of primary legislation.

The role of the System Operator envisaged under the Draft Energy Bill is simply to mechanically manage the capacity market. It has no discretion over the nature of the products procured or the way they are procured and no incentive to seek out cheaper alternative providers such as those from the demand side of the market. The framework needs to be established such that there are strong sustainable incentives to minimise the costs of delivering the necessary level of reliability.

The Energy Bill should include a mandate for the Regulator to establish an incentive framework for the System Operator to minimise the costs of delivering reliability. In addition, the Secretary of State should establish minimum targets for the procurement of demand response to help kick-start the market in the provision of these services and ensure that the System Operator develops the necessary systems and expertise to exploit the benefits of demand response.

June 2012