Environmental Audit CommitteeWritten evidence submitted by EDF Energy

Executive Summary

The UK’s energy system is in a state of flux. The existing electricity market framework has served consumers well by delivering high levels of reliability but is now being stretched in an attempt to deliver outcomes that reflect a different set of policy objectives and a different economic climate.

The UK needs infrastructure fit for the 21st century and the urgent challenge now is to secure the vital investment required to ensure there is adequate capacity to meet future electricity needs while reducing emissions at least cost to consumers. The Government has taken a clear leadership position in setting the framework for reducing greenhouse gas emissions, and we need to ensure that we maintain the momentum needed to make the transition to a low carbon economy.

EDF Energy believes that the Electricity Market Reform (EMR) proposals as laid out in the Energy Bill are capable of providing the right framework for the low carbon investment that the country needs, while keeping costs down for consumers.

Reform of the existing electricity market arrangements is necessary to ensure that investment comes forward to deliver the reliable diverse energy mix required to achieve the UK’s energy policy objectives. The transition to a low carbon economy will mean moving away from a market based on the short run marginal cost of fossil fuel plant to one that is likely to be based on the long run average costs of electricity production.

The EMR proposals are consistent with the history of the development of UK energy markets, where changes to the objectives of energy policy have necessitated Government action to develop the market.

We have reviewed the report by Oxford Energy Associates but do not consider that the various definitions of the types of subsidy available could be applied to market redesign and EMR. The EMR package does not confer an economic advantage to market operators and does not represent a subsidy.

The report demonstrates the difficulty of establishing a universally agreed definition of the term “subsidies”. A wide definition of the term “subsidy” makes it difficult to both identify and measure its impact on the economy. Narrow definitions are able to identify precisely transfers between the Government and other parties, and are able to quantify the impact of a particular measure. EDF Energy notes that the Government’s implied definition of “subsidy” (in the context of nuclear new build) has followed this approach by defining it as a “levy, direct payment or market support for electricity supplied or capacity provided” only available to specific technologies. We welcome the clarity that the Government’s definition provides to investors.

We would also highlight that the report contains some inaccuracies with respect to the role of the Nuclear Decommissioning Authority and also the restructuring of British Energy in 2005.

EDF Energy notes that the scope of the inquiry has primarily focussed on the upstream section of the energy system but consider that as much attention needs to paid to the funding of downstream initiatives and their impact on customers’ bills.

About EDF Energy

1. EDF Energy is one of the UK’s largest energy companies with activities throughout the energy chain. We provide 50% of the UK’s low carbon generation. Our interests include nuclear, coal and gas-fired electricity generation, renewables, and energy supply to end users. We have over five million electricity and gas customer accounts in the UK, including both residential and business users.

Assessing Subsidies

2. EDF Energy welcomes the literature review of subsidies contained within the report by Oxford Energy Associates. However, we believe that the work highlights the fact that much of the debate over the concept of subsidies remains inconclusive, and that an accepted definition of the term is unlikely to achieve universal agreement outside of a technical economics description. We do not agree with the implied assertion that any form of Government guarantee or spending relating to the private sector is a “subsidy” given that there are a number of public policy objectives and imperatives behind such support. In fact, it is normal for Governments to try and attract private sector investment through a number of policy measures, including tax allowances and relief, and yet these are rarely considered “subsidies”.

3. Narrow definitions have the advantage of precisely identifying transfers between the Government and other parties, and we favour such an approach to ensure that like is always being compared with like. Wider definitions are likely to be more subjective in scope and face inherent difficulties in being adequately measured for policy purposes. In addition, a vague definition will face problems in trying to assess overall consumer benefit or detriment.

4. The assessment of the benefits of subsidies has to consider some fundamental properties of the energy market. Electricity supply, for example, has a systemic importance to the economy. Its overall contribution to economic welfare is not related to the profits obtained by generators. In the event of sustained power cuts there would be vast disruptions for downstream industries and consumers, and this would be socially and politically unacceptable.

Role of Taxes and Subsidies in the Context of Market Reform

5. EDF Energy notes that environmental taxes are generally considered to be an acceptable means by which to penalise harmful environmental impacts. Such taxes work on the basis of restricting market activities that generate negative externalities. As HM Treasury notes, the objective is to help “shift the burden of tax” from “goods” to “bads”.1 Subsidies should be considered as part of this same framework where the objective instead is to support “goods” in contrast to “bads”, and should not have pejorative connotations.

6. It is widely agreed that carbon pricing is a key element of climate change mitigation policy, as it ensures that the environmental and social cost of carbon emissions are internalised and reflected in the price of goods and services. Industry consensus is that greater certainty in the future long-term price of carbon will form an important and significant part of the electricity market framework required to increase investment in low carbon generation.

7. However, the current EU ETS price is not providing the long-term signal to make the relevant investments in low carbon generation. EDF Energy therefore welcomed the Government’s introduction of a carbon price floor from 1 April 2013 as part of its reforms to drive low carbon investment. This will ensure that all generators pay a minimum price for their carbon emissions and is consistent with the Government’s commitment to operate a “polluter pays principle”. A more transparent and level playing field will prevent distortions to the wholesale electricity price from developing.

8. We agree with the Government that a strong carbon price signal should sit alongside supporting policy frameworks, such as the Electricity Market Reform (EMR) package, that can together help to reduce the costs of decarbonising the electricity sector. If the issue of negative externalities is not adequately addressed (eg through a robust carbon price) then this can cause further difficulties for the assessment of any support in the energy sector.

9. Having reviewed the report by Oxford Energy Associates, we do not consider that the various definitions of the types of subsidy available could be applied to market redesign and EMR. This is because the current proposals for energy reform are just that—market reform. They are consistent with the history of the development of the Electricity Pool, New Electricity Trading Arrangements (NETA) and British Electricity Trading Transmission Arrangements (BETTA). In each case, changes to the objectives of energy policy necessitated Government action to develop the market.

10. The existing electricity market framework has served consumers well by delivering high levels of reliability but is now being stretched in an attempt to deliver outcomes that reflect a different set of policy objectives and a different economic climate. As our existing power stations start to close, we are also seeing more fundamental changes in the composition of the industry. The past decade alone has seen the UK become a net importer of gas as its North Sea reserves begin to decline.

11. The Government has stated the direction of travel it wishes to take in terms of its energy policy objectives, and the reality is that this will require a different market solution than the system we currently have. The current “energy only” market is based on a system where generators are only paid when they actually produce and sell electricity, and do not obtain any payments for the economic service of being available to produce energy. Our analysis shows that continuing with an “energy only” market will progressively reduce plant margins and will fail to ensure security of supply.

12. There is general industry agreement that a well designed capacity market will have a key role in ensuring security of supply. As the Government has stated, a capacity market “will provide an insurance policy against the possibility of future blackouts by providing financial incentives to ensure we have enough reliable electricity capacity to meet demand”.2 The early introduction of the capacity market will reduce uncertainty for existing plant and will avoid the need for new replacement capacity before it is really needed. This will be a more a cost-effective option for consumers.

13. The analysis informing the EMR process has indicated that the existing “energy only” market framework will not provide a satisfactory solution for the Government’s stated objectives of decarbonisation, security of supply and affordability. Due to the change in the generation mix, the electricity system will be required to move away from competing on marginal costs set by fossil fuel input costs, to a system that is likely to be based on long run average costs. In addition, there will a greater focus on the need for capital investment and repayment. It will not be possible to make this transition without interim arrangements to accommodate a system using a single price reference. This is especially important if conventional plant is not penalised for the true costs of its emissions due to shortcomings in the carbon price.

14. Investors should be allowed to make a reasonable return with an acceptable sharing of risk so that the final outcome represents a fair deal for both consumers and investors. Achieving an efficient allocation of risk is particularly relevant for low carbon generation projects as they tend to require very large upfront investments. In addition, under the existing market arrangements, such plant are largely price takers with volatile revenue streams that are influenced by fluctuating fossil fuel prices and which do not have any direct link to their actual generation costs. By contrast, fossil fuel plants such as CCGTs involve lower sunk costs and their revenue is highly correlated with variable costs. This means that the gas price amounts to a natural hedge for the electricity price, and costs can be passed through to consumers. Since the issue of efficient risk allocation affects both overall investment incentives (which affects security of supply) and also relative incentives of low carbon versus other generation capacity (which affects decarbonisation) not addressing it explicitly could undermine the effectiveness of the measures that are primarily aimed at delivering secure, affordable and low carbon energy supplies.

Contracts for Difference

15. With specific reference to EMR, EDF Energy agrees with the Government that Feed-in tariffs with Contracts for Difference (CfDs), in conjunction with the carbon price floor, are capable of working for all low carbon technologies (including renewables, nuclear and fossil fuels with carbon capture and storage) and, indeed, are designed to do so. They will give all such projects access to the long-term, stable and reliable revenue they need to justify the large upfront investment required. The mechanism will therefore provide a vital underpin to enable financing of low carbon projects.

16. The CfDs will be a key component of ensuring value for money for customers by shielding them from the damaging impacts of high and volatile fossil fuel prices. Offering a fixed price (via the “strike price”) will ensure that consumers pay no more than is necessary when the underlying power price is high. This is because the CfD is designed to be two-way. When the market price is above the agreed strike price, the generator will be required to pay back the difference to electricity suppliers (via the counterparty body). If the reverse is true then generators will receive the price they achieve in the electricity market (the market reference price) plus a “top up” to the agreed strike price from the reference price. This will ensure value for money and price stability for consumers. In this respect the mechanism is a major improvement for customers over the Renewables Obligation.

17. It is important to highlight that, while the strike price will be a fixed price, it is not a guaranteed return or risk-free, as the operators of CfD plant will still be required to (a) construct the plant to budget (b) generate to receive the strike price (and hence will continue to face operational risk) and (c) participate in the wholesale market to achieve the market reference price (and not just the “top up”). Therefore under the CfD mechanism, the generator will still be exposed to wholesale market price signals and will be required to efficiently schedule and maintain its plant accordingly.

18. The strike prices for all low carbon technologies will initially be set administratively (or through negotiation) while the new market framework develops, and will be based on the “most up-to-date cost and deployment data available”.3 However, the Government has made it clear that it will move to a competitive price discovery process for all low carbon technologies “as soon as practicable”4 (potentially as soon as 2017 for technology-specific auctions and the 2020s for technology-neutral competitions). Either way, the strike prices will be established in an objective and transparent manner. This will provide benefits to consumers by ensuring the effective delivery of a secure diverse mix of low carbon generation plan at the least cost.

19. The CfD mechanism will expose the relative cost positions of generation technologies so it creates an incentive for least cost low carbon generation.

Nuclear New Build

20. EDF Energy is committed to delivering affordable, secure, and low carbon supplies based on a diverse energy mix, including nuclear and renewables. We would clarify that we have never sought a subsidy for nuclear new build and believe that the Government has made clear its position on the matter.

21. Clarification of what was meant by “no public subsidy” for nuclear new build was confirmed in a Written Ministerial Statement on energy policy by Chris Huhne MP, the then Secretary of State for Energy and Climate Change on 18 October 2010. He wrote:

“To be clear, this means that there will be no levy, direct payment or market support for electricity supplied or capacity provided by a private sector new nuclear operator, unless similar support is also made available more widely to other types of generation.”

22. The CfD mechanism, for which nuclear new build is eligible, is therefore consistent with the Secretary of State’s definition of “no public subsidy” for new nuclear operators. We firmly believe that the strike price should be based on delivering a fair deal for both investors and customers, be affordable and provide value for money.

23. In addition, we would highlight that it is the Government’s policy that the operators of new nuclear power stations must set aside funds over the operating life of the power station to cover the full costs of decommissioning and their full share of waste costs. This is a requirement that EDF Energy would fully comply with in the development of its nuclear new build plans.

Existing UK Nuclear Assets

24. EDF Energy would highlight that liabilities remaining from the early research and nuclear power development programmes are, and always have been, public liabilities. The costs of dealing with them are therefore the Government’s responsibility and not a subsidy. It is therefore not clear why Oxford Energy Associates report describes these activities in the section headed “Nuclear Subsidies”. The Nuclear Decommissioning Authority (NDA) is the public body responsible for the decommissioning and cleaning up of the civil nuclear facilities previously under the control of British Nuclear Fuels Limited (BNFL) and the United Kingdom Atomic Energy Authority (UKAEA). These include the first generation Magnox power stations and associated fuel reprocessing facilities.

25. There is one particular area of Oxford Energy Associates’ evidence that we feel needs to be corrected. Reference is made to the financial intervention by the Government in British Energy and the resulting waste liabilities. It is suggested that the Government had provided a £5 billion “bail out” but this is not accurate. The Government provided a credit facility of up to £650 million but not all of this was used and, in fact, was paid back with interest by British Energy during its restructuring.

26. Finally, we would point the Committee to two separate analyses by the National Audit Office (NAO) of the British Energy restructuring and sale to EDF Energy. In its report of March 2006 titled “The Restructuring of British Energy”, the NAO has a table that shows that, as of 28 February 2006, the “total net benefit to the taxpayer of rescuing British Energy” was positive and worth £2.7 billion.

27. A follow-up NAO report, titled “The sale of the Government’s interest in British Energy”, published in January 2010 noted that “the Government sold its stake in British Energy when energy prices were at a peak, and got a good price”. As a result of the sale, the proceeds were transferred to the Nuclear Liabilities Fund, which was set up to meet the cost of future decommissioning of British Energy’s nuclear power stations. As of March 2009, the Fund was valued at £8.3 billion—significantly higher than the estimated decommissioning costs of £3.6 billion.

28. The restructuring of British Energy was ultimately a profitable deal for the taxpayer. Equally, it was strategically important in that it secured a significant proportion of the UK’s electricity generation, which may have been jeopardised had the company been allowed to go into administration.

29. We would highlight that the existing eight nuclear power stations, now part of EDF Energy, continue to make a key contribution to the UK’s low carbon generation mix and the wider economy. For example, in 2012 the plant generated 60TWh of electricity. This was almost 50% higher than the last year before the stations were acquired by EDF Group in 2009. This performance is a result of the £300 million annual investment in the power stations and this is in addition to £350 million spent on plant operations every year (with 90% of the total being spent in the UK).

30. In February 2012, EDF Energy announced that it would continue to seek life extensions for all its nuclear power stations where it is safe and commercially viable to do so. We are expecting an average life extension of seven years across our Advanced Gas-cooled Reactor (AGR) fleet, and have a strategic target of 20 years for Sizewell B. This will avoid the emission of almost 340 million tonnes of CO2 if the same amount of electricity is generated by fossil fuels—equivalent to removing all the cars from UK roads for nearly five years. In addition extending the plants’ lives will also bring significant training and employment opportunities for a new generation of nuclear engineers and operators as we seek to develop the UK’s position as a primary source for skills and expertise in the industry.

31. Our decision in December 2012 to extend the lives of Hinkley Point B and Hunterston B power stations, which in total employ more than 1500 employees and contractors, by seven years to 2023 will help maintain vital skills in the UK nuclear industry. Above all, the recent performance of the plant, and the planned plant life extensions, demonstrate the key role that the UK’s existing nuclear fleet has in providing the reliable, low carbon electricity that the country needs.

Downstream Impacts

32. EDF Energy notes that the scope of the inquiry has primarily focussed on the upstream section of the energy system but consider that as much attention needs to paid to the funding of downstream initiatives. We support the principle behind Government schemes, such as the Green Deal and Energy Company Obligation (ECO), to increase the installation of energy efficiency and other measures. However, it is vital that the cost implication of these initiatives, in terms of affordability and impact on customers’ bills, is fully evaluated. It is also important that a distinction between energy and social policy objectives is made as there is a risk that conflating the two will lead to more costly outcomes for customers as more expensive solutions are inadvertently prioritised over those that more cost-effective. Customers need to be fully aware of, and understand, the objectives and implications of energy policy (in terms of cost) if we are to build support for market reform and the benefits of the transition to a low carbon economy.

14 June 2013