UK Electricity Market Reform: a political compromise

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23 November 2012, Electricity

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The draft Energy Bill is expected to become law in 2013, but implementation will be progressive; for example, the first contracts for differences (CfDs) are expected to commence in 2014.

The rationale for the bill is to ensure sufficient scale and pace of investment in low-carbon generation, adequate security of electricity supply, and affordable energy costs for customers: what could be termed the sacred energy trinity.

A key part of the draft bill includes several provisions for change in the electricity market. The parts relevant to Electricity Market Reform (EMR) comprise a four-part package of CfDs, carbon price support, emissions performance standards, and a capacity mechanism.

Ahead of next week's formal publication of the bill, Ed Davey confirmed on November 22 the provision of a cap under the Levy Control Framework (LCF) and the absence of a decarbonization target for the electricity sector. Both have direct implications for low-carbon investment in the UK over the next 20 years.

* The LCF provides support for low-carbon renewable generation. The Treasury has agreed on a cap of GBP7.6bn (in real 2012 prices) and GBP9.8bn (nominal 2020 prices) up to the 2020/21 financial year that can be passed on to consumers through the existing renewable energy levy part of their bills. As a point of reference, this is a threefold increase on the current GBP2.35bn subsidy cap for low-carbon electricity for the 2012-13 financial year. The government estimate of the actual increase in the average household energy bill is GBP95 by 2020 (GBP20 in 2012), but Datamonitor notes that this estimate would be higher if it included the 20% overrun allowance permitted under the LCF and if the government's suggestions for single tariff reform are realized.

* The widely discussed 2030 decarbonization target for the power sector will be absent from the bill. However, the bill will provide for a target range to be set in 2016.

In addition, and slightly overshadowed by the previous two points, is the fact that the bill will follow the recommendation of the Energy and Climate Committee and will establish a government-owned private company to act as the single counterparty body under the CfDs. Further, the government confirmed that it will action a capacity market, which may see auctions for capacity held from 2014 to cover peak demand in the winter of 2018/19.

From the low-carbon generators' viewpoint, on the one hand the LCF is a positive announcement as it provides certainty as to the level of support that will be available. Similarly, the announcement of counterparty under CfDs that will mean enforceability of contracts will also provide reassurance to investors considering entering into CfDs, and it would mean that the government will not be directly liable for compensating generators.

However, on the other hand, the decision to postpone setting a decarbonization target sends a clear signal to low-carbon generators - nuclear and wind alike - that the government considers new gas-fired generation to be part of the UK's future energy landscape.

The Committee on Climate Change (CCC) summed the issue up when it said that the lack of a carbon target will leave "a high degree of uncertainty for investors and does not address widespread investor concerns raised in recent months."

Gas-fired generation investors, however, will feel reassured, but will wait for the government's Gas Generation Strategy to be published in December to understand in more detail how the government plans to integrate gas with low-carbon generation by approving new gas-fired plants. Also of note for anyone interested in energy security is the extent to which the strategy will address the controversial issue of fracking.

The government has stated that the bill will "provide certainty to investors in all generation technologies and provide protection to consumers." The government also aims to achieve a target of 15% of electricity generated from renewables by 2020.

Datamonitor does not believe this last goal will be realized. The carbon price is still too low (a clearing price of E6.62 was realized in the UK's latest EU Emissions Trading System allowances) to stimulate investment in low-carbon generation. Although it is true that the bill has the potential to help the UK to increase renewables' share of the generation mix, it will not allow it to achieve its renewable targets, where a decarbonization target arguably would have.

Further, legally binding carbon reduction goals remain. The CCC has set the levels for carbon budgets from 2008-22, advising reducing emissions of all greenhouse gases by at least 34% by 2020 (relative to 1990). These targets are potentially incompatible with a substantial increase in gas-fired generation should renewable investment be lacking.

Clearly Prime Minister David Cameron is leaving the possibility open in 2016 to treat carbon reduction goals with pragmatism, elevating the UK's energy competitiveness ahead of environmental concerns.

The elephant in the room is the lack of consideration for demand-side reduction. Improving energy efficiency, increasing the use of renewable heat, insulation, and electric vehicles are just a few of the ideas that have been recommended to the government.

In summary, in the next few months there will be a thirst for more detail to give investors certainty. Low-carbon generators will be somewhat reassured by this glimpse at the bill, but will be desperate to know what price will be decided on and how much latitude the government will give to new gas generation in 2016.

Consumers will see their bills rise whatever does, or does not happen. The bill is the result of heated political negotiation within the coalition government, and the compromise that has emerged can be summed up as "more clean energy yes, but not too much, and not at any cost."

The sacred energy trinity will not be achieved by the bill; however, it is a useful compromise in view of the inherent problems of coalition government. The future energy generation mix must be one that is balanced across the range of fuels to achieve energy security at a reasonable cost. This will certainly be at the expense of carbon reduction targets, but the political reality is that carbon reduction targets are the most adjustable part of the equation in voters' minds.

Source: MarketLine

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