UK Electricity Market Reform is imminent

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21 November 2012, Electricity

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The draft Energy Bill follows a white paper released by the Department of Energy and Climate Change (DECC) in July 2011 and a technical update on the draft bill in December 2011. The final bill is expected to become law in 2013, but 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.

Back to basics: why is this happening at all?

The rationale for the bill is that there needs to be intervention to ensure the 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. The DECC does not believe that current market conditions provide sufficient encouragement for such investment. The department is asserting that intervention to address specific low-carbon investment and capacity issues in the market is required for three reasons:

* Firstly, low-carbon generation faces greater exposure to wholesale price risk than conventional fossil fuel generation. The former has high capital costs and low marginal operating costs, while the latter's fuel cost is naturally hedged as gas and coal are (still) the main price-setting plants.

* Secondly, because the current price of carbon is too low to incentivize investment in low-carbon generation.

* Thirdly, to correct market failures such as off-take risk and high barriers to entry due to poor market liquidity; failures that are of particular concern to small potential low-carbon generators.

Core parts of the Electricity Market Reform

A key part of the draft energy bill includes several provisions for change in the electricity market. The parts 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.

1. Feed-in tariffs (FiTs) with CfDs will be long-term contracts between low-carbon generators and a counterparty. Under these contracts, a long-term fixed price (called the "strike price") will be offered for generation, where the level of the strike price compared to the wholesale market price (the reference price) will determine the level of subsidy. The government intends CfDs to stabilize returns to potential low-carbon investors and reduce the cost of capital.

2. A capacity market is to be introduced to ensure security of supply. The DECC's estimates - based on Ofgem's modeling of future capacity margins - show that relatively lower margins could be faced from 2015 onwards.

3. A carbon price floor is a tax on fossil fuel used for power generation in order to support the carbon price, which, under the EU Emissions Trading System, is too low to stimulate low-carbon investment. Fossil fuel will be taxed in order to create a carbon price floor. The floor will start in 2013 at GBP15.70 per ton of CO2 and will increase linearly to GBP30 per ton of CO2 in 2020 (in real 2009 pounds sterling).

4. The EPS is a direct measure to limit carbon dioxide emissions from new fossil fuel plants at the station level, limiting annual emissions to 450g of CO2 per kWh. This annual cap effectively rules out any new coal plants that do not have carbon capture and storage (CCS), and could help to encourage investment in new gas-fired capacity. Concerns over the EPS stem from the possibility of excessive carbon emissions if gas-fired stations end up as baseload instead of as balancing capacity to complement intermittent generation.

Due to the delay in CfDs coming into operation (2014), the draft bill also provides for a Final Investment Decision (FID) enabling contracts in the interim. This provision allows the government to provide assurance and even negotiate a CfD. In practice, this FID process means negotiations regarding new nuclear projects, an example of which is currently in progress in the form of negotiations between EDF and the DECC regarding EDF's investment in new nuclear capacity at Hinkley Point (Somerset) and at Sizewell (East Anglia).

In addition, the bill will explain the Renewables Transitional arrangements for investments currently eligible under the Renewables Obligation (RO) scheme until April 2017. The DECC has studied other possibilities in high-level impact analysis, including extending the date of eligibility beyond 2017, and modifying the RO scheme for projects after 2017 to move to a fixed RO price, with the scheme being valid until 2037.

What can we expect from the bill?

In order to provide reassurance to the market, the bill should specify, or go some way to specifying, the following:

* What the strike price will be, or, if the DECC is not yet able to give a number, at least a range for the strike price until final prices are negotiated. Comments made by the Energy and Climate Change Committee in October 2012 indicated that a ceiling strike price of GBP100 per MWh for nuclear was being considered. This price is in line with the desired long-term cost for offshore wind (the next best alternative for large-scale low-carbon generation). Whether or not an indicative price is explicitly evoked will depend on the progress of the current FID negotiations between EDF, its co-investor Centrica, and the DECC. However, it is vital for transparency purposes that the bill provides for some level of parliamentary scrutiny following any agreement on a CfD for new nuclear.

* To what extent strike prices will vary across different low-generation technologies: nuclear compared with offshore wind, for example, and early-stage CCS projects. The government's intention is for universality of strike prices as much as possible in the longer term; however, in the short term, the bill will likely allow for differentiation of strike prices across technologies. The bill should ideally give detail on the strike price decision process as a reflection of the different risk profiles, notably for CCS projects.

* What the counterparty model will be. There has been back and forth commentary from the original single counterparty model, with liabilities for the CfDs underwritten by the government (in the white paper); to a multiparty counterparty model with liabilities underwritten by all electricity suppliers (in the draft bill); and then back to a single counterparty model that might be underwritten by government, or if not, should at least be legally enforceable (suggested by the Energy and Climate Change Committee). The implications of the counterparty model for investor confidence and the ensuing effect on the cost of capital are important; therefore, the bill will need to say where liability for CfD revenue will lie and how CfDs will be enforced.

* How the Treasury's levy cap will impact the number of CfDs that will be underwritten. To the extent that subsidy funding for CfDs comes from the DECC, there has been doubt expressed about the inherent cap that exists on the total amount of projects that will be eligible for CfDs. The DECC must clarify how the ceiling will be managed; for example, whether subsidies for particularly large projects will be allocated over several years.

* The bill needs to say how and when a capacity market will be introduced; whether it will be a strategic reserve or a market-wide capacity mechanism in which all generators would be able to offer capacity for a specific amount of volume (based on estimated future peak demand); and when the first auctions will occur. The option most likely is a market-wide capacity mechanism with auctions held in advance of the delivery year. Ideally, the bill should also follow the Energy and Climate Change Committee's recommendations and demonstrate how demand-side response could be used in conjunction with a capacity market.

* The carbon price floor is already law through the Finance Act 2011 and, as such, the bill will not be expected to modify any aspect of the level of the price floor. What has, however, been discussed by ministers is a decarbonization target for the power sector for 2030 (although such a target is, politically, very contentious among those who favor low-carbon investment over more investment in new gas plants).

* The bill will need to confirm when the EPS will be reviewed in 2015; in which cases plants could be exempt from the EPS (for example, in times of energy security emergency); and, most importantly of all, the grandfathering period (during which a project with building consent will not be retrospectively affected by a change in an emissions level restriction) for new power stations. At present, the proposed period is 30 years; however, this has been criticized as being too long with respects to endangering carbon-reduction targets should gas-fired generation be exempt.

Further details on the responsibilities and roles of Ofgem, the government, and the system operator may also come out in the bill, but will more likely be the object of secondary legislation in 2013 and 2014. The objective was for an operational framework to be available in autumn, with consultation on strike prices to take place in 2013; however, delays in the consultation and decision-making process mean that we can reasonably expect detail to be lacking. Datamonitor will provide analysis and comment on each part of the EMR once it is published before Christmas.

Source: MarketLine

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