Electricity Market Reform: the final bill has arrived

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20 December 2012, Electricity, Nuclear, Solar, Wind

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The UK government's draft Energy Bill was introduced into the House of Commons on November 29 to a predictably mixed reception. The bill will now be debated in the House of Commons and the House of Lords, and is expected to become law in 2013. However, the implementation of certain parts of the bill will be progressive; for example, the first Contracts for Differences (CfDs) are expected to commence in 2014.

Core parts of the Electricity Market Reform in the bill

The parts of the bill relevant to Electricity Market Reform (EMR) provide for a four-part package comprising CfDs, carbon price support, an emissions performance standard (EPS), and a capacity mechanism. Datamonitor will provide further analysis and commentary on these parts in the coming weeks.

* As expected, CfDs have been included in the bill, meaning that revenues are stabilized for generators over the duration of the CfD contract, reducing commercial risk and thereby somewhat reducing the cost of capital for new investment. The bill has confirmed that there will be a single, government-owned counterparty.

* Further, before CfDs come into action in 2014, a final investment decision (FID)-enabling process is in the bill to ensure that low-carbon projects that are ready for an investment decision can go ahead. The advent of any FIDs will depend on the mediation of a strike price. Negotiations are currently underway between EDF and the Department of Energy and Climate Change (DECC) regarding the utility's investment in new nuclear capacity at Hinkley Point (Somerset) and at Sizewell (East Anglia). Negotiations are reported to be progressing, but not sufficiently to prevent EDF from reportedly postponing its final investment decision for Hinkley C to April 2013.

* Also of note regarding the CfDs is the government's intent that CfDs will be awarded in a two-stage process. This is in response to consultation comments raising concerns over whether projects with long development times will be able to have relative certainty of obtaining a CfD following applications for planning permits and agreement to connect to the grid.

* The government confirmed that it will action a capacity market, administered by the National Grid, the system operator. The first auctions for capacity could be held from 2014 to cover peak demand in the winter of 2018/19.

* The carbon price floor, already part of law, will start as planned in April 2013 at GBP15.70 per ton of CO2 and will increase linearly to GBP30 per ton of CO2 in 2020 (real 2009 pounds sterling).

* The bill has confirmed an EPS annual limit of carbon dioxide emitted by all new fossil fual plants equivalent to a rate of 450g per kWh, which will apply until and including 2044. The EPS allows for grandfathering of this level until 2045. The bill does not mention an explicit review date for the EPS, but it does confirm that fossil fuel plants could be used (and the limit therefore suspended) in "exceptional circumstances"; that is, if there is an electricity shortfall or the significant risk of one.

* In addition, the bill has a chapter on the transitional measures that mean renewable investors can choose between being eligible under the existing Renewables Obligation (RO) scheme until April 2017, or the CfDs. The policy intent is to calculate the ROCs as they are presently done until March 31, 2027, and then move to a fixed ROC system from 2027 for the 10 years until the end of the ROC scheme in 2037. However, the precise date of implementation will be in secondary legislation for transitional arrangements.

* Lastly, the government has provided for taking powers to modify suppliers' license conditions to improve the liquidity of, and competition in, the wholesale electricity market. Liquidity is currently lacking, which poses a risk to smaller independent generators that might undertake CfDs and seek to sell to the market directly, instead of having a power purchase agreement.

Datamonitor notes that the bill provides for a new statement - the "Strategy and Policy Statement" (SPS) - which will define the responsibilities and roles of Ofgem, the government, and the system operator, in the aim of achieving greater transparency and alignment between these entities in energy policy. The first SPS is intended to be prepared for draft consultation in 2014.

What was missing from the bill?

The element that was notably absent was the serious consideration of demand-side reduction, strongly recommended by the Energy and Climate Change Select Committee. The government has only just initiated a consultation on the options to encourage electricity demand reduction, including premium payments, efficiency obligations, or use of the capacity market. The consultation, due to end on January 31, 2013, is long overdue and will allow the government to decide on whether a demand reduction measure is explicitly included in the capacity mechanism part of the bill.

There is no 2030 decarbonization target, although the government aims to set a decarbonization target range for the power sector in secondary legislation in 2016 subject to the "...consideration of wider economic factors," in DECC's words. The future target will necessarily follow advice from the Committee on Climate Change (CCC) on the fifth carbon budget that covers 2028 to 2033, and will undoubtedly also be subject to political negotiation.

The postponement of a decarbonization target is the most noticeable part of the bill, and has raised the most reaction. Datamonitor believes that, on one hand, the absence of a target is likely to have a negative impact on low-carbon investor confidence, and that, on the other hand, investor confidence will be buoyed by the explicit increase of the Levy Control Framework (LCF) cap to GBP7.6bn (in real 2012 prices). The LCF cap - which limits the amount that can be passed onto consumers through bills over and above tax - covers the current RO, feed-in tariffs, and a subsidy called the Warm Home Discount. CfDs will fall under the LCF cap once they are implemented.

A large portion of this levy cap could go to renewable generation as opposed to new nuclear, which is already facing final investment decision delays in Somerset as noted above. Given this, and the government's aim of reaching 30% of electricity generation from renewable sources by 2030 as set out in its 2009 Renewable Energy Strategy, the renewables industry has received a considerable boost from the bill.

As for the consequences for consumers, who ultimately bear the costs of the EMR, Datamonitor notes the more than trebling of the current LCF of GBP2.35bn and that the government's estimate of an increase in annual bills by GBP95 by 2020 is just that, an estimate. Datamonitor still believes that the increase in bills is highly uncertain and will depend on the amount of gas in the energy mix and how much energy efficiency can be realized.

Gas is and will continue to be a large element in the generation mix if the increase in wind capacity is realized. More wind means that more gas capacity will be required (although operating less frequently) to ensure peak demand is met. Indeed, in its recent Gas Strategy, the government confirmed its belief that some 26GW of new gas-fired power generation capacity may be needed by 2030, in part to replace retired conventional thermal and nuclear generation.

All things equal, investors are drawn to technology like gas with low capital costs in the construction phase. The landscape, it must be underlined, is dynamic. Technology costs for renewables, gas prices, and even renewables targets are changeable. However, there is the obvious danger that if doubt persists as to the level of strike prices for other types of technology then the government's target for gas generation will be all-too-easily met, and at grandfathering levels that imperil carbon reduction targets.

Added to the uncertainty over the EMR's impact on residential consumer pricing is the government's intention in its Retail Market Review to make suppliers offer a simplified range of tariffs. A single "cheapest tariff," which would have been quite the contrary, is not a part of the bill. The government's intention, based on Ofgem's proposals, is to have suppliers offer no more than four core tariffs for each fuel type and payment type. For example, a customer who pays bills quarterly would have a maximum choice of four electricity and four gas tariffs from his or her supplier.

This would mean that average prices would likely stabilize over time, leaving those customers who have never switched and are potentially parked on higher tariffs better off on one hand, but on the other, leaving consumers that actively switch and take advantage of cheaper deals worse off.

The bill has taken two steps forward, but should be careful not to take one step back

Datamonitor believes that the bill has gone some way toward reassuring investors that the government is committed to increasing low carbon generation in the UK's generation mix. However, the amount of year-on-year growth in wind capacity that is needed to realize the 30% target is very steep, and although not impossible, the renewables industry would have drawn confidence from an explicit decarbonization target.

In the absence of a decarbonization target, the debate and secondary legislation must reassure low-carbon investors that funding and support will continue past 2020 through to 2030, avoiding any fears of asset stranding should renewables targets be met before 2020. That is, there must be sufficient confidence to invest in the supply chain for the renewable generation industry in the UK, as opposed to importing equipment.

Given that funding for the years after 2020 will be decided following the next election, 2016 will indeed be a crucial time for low carbon power. The main question that secondary legislation and debate should clear up is how much of the funding will be allocated to wind projects that will operate well beyond 2030, and how much will go to nuclear projects that will not be online before 2020. The balance between the two is far from trivial, as according to Datamonitor's research there would need to be further increases in the LCF beyond 2020 to fund both.

The thirst for precise details will remain during the course of 2013. Elements of essential detail that we will see in secondary legislation and in government negotiation will be:

* The practical elements of the CfDs (strike price levels and decision rationale for nuclear and other low-carbon generation projects).

* The practical workings of the counterparty (how levies will be calculated and funded from suppliers, what backing the counterparty will receive).

* The likelihood and range of a decarbonization target for the power sector.

This further essential detail will be critical to complete the picture so that it has a plausible chance of meeting the three-sided problem of being low carbon, cost effective, and secure electricity. At present, only the last goal will be met effectively.

Source: MarketLine

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