Press Releases
Electricity market reform - major effects on UK power industry. View the AEP press release here.
View MoreELECTRICITY MARKET REFORM ONE YEAR ON
In December 2010, the Government published a long-awaited consultation on Electricity Market Reform (EMR). Seven months later it made a firmer declaration of its intentions when it published a White Paper. A year on from that ground-breaking consultation, is the reform programme really going to happen?
Earlier this year, I found it hard to believe that it would be delivered in full. It was much easier to imagine that some of it would be quietly deferred or forgotten. After all, it was an ambitious agenda and on some issues, progress between the consultation and the White Paper was far from obvious. That something needed to change was widely accepted, but, as is so often the case, ‘how’ was more challenging. Some of the electricity companies held different views on key proposals and at times, the Government department responsible for the reform seemed burdened by the whole thing. The ‘Technical Update’ of December 2011, however, suggests that the ambition is undiluted and it begins to answer one or two of the big questions.
A brief reminder of why ‘Electricity Market Reform’ is under way
Judged against what it was set up to do, the UK electricity market has been a success. When the electricity supply industry was privatised in 1990, the Government wanted the gold-plated state industry to be taken off its books and subjected to customer-driven, private sector disciplines - regulated where it had to be, but, competitive wherever possible. Electricity production was made competitive immediately, albeit, initially, with few competitors. In two stages, industrial and commercial customers were able to choose between competing suppliers of electricity and by the late 1990s, this right was extended to domestic customers. Millions of customers have taken advantage of this and most do so to get a better price.
But, by the late 1990s, even with a large number of participants, the generation market was not thought to be competitive enough and it was reformed. In 2001, a compulsory (for most electricity producers), half-hourly, day-ahead market - the Pool - was replaced by the ‘New Electricity Trading Arrangements’ (NETA) – a system of bi-lateral contracts with a balancing mechanism, where electricity was to be traded much the same as other commodities, except, of course, that unlike coffee, wheat or cocoa, it could not be stored. Introduced by Tony Blair’s Labour Government, this was arguably a more brutal mechanism that the market that it replaced. Carefully designed to reward reliable supply and penalise failure to deliver, the new market also abandoned the Pool’s controversial capacity payments. Above all, it signalled that competitive electricity prices continued to be important politically.
But, the industry had hardly finished paying the near £1 billion bill for this change before the political priorities for the sector took a different turn. The argument that global warming and climate change caused by human activity – including fossil-fuelled electricity production – came to dominate energy politics. Concern about security of supply also climbed the agenda, prompted by the prospect of growing dependence on imported gas. Those themes lie behind the reform proposals which began to take shape in 2010.
In December 2010, I wrote on the AEP website:
‘Many ageing power stations have to be replaced, because they no longer meet EU air quality requirements (old coal- and oil-fired plant) or because they are at the end of their working life (old nuclear stations). At the same time, there are binding targets to be met – a) for the UK’s self-imposed reduction in carbon emissions and b) to conform with the EU Renewable Energy Directive 2009, which means that, in the next nine years, about 30 per cent of the UK’s electricity will have to come from renewable sources, predominantly wind power.
Could we just ‘do nothing’? Yes, but, that would probably result in a greater dependence on the current ‘cheapest solution’ – new gas-fired power stations - slowing down the transition to low-carbon electricity and increasing dependence on gas imports, rather more than the Government and many power companies think would be wise. Several companies want to build new nuclear power stations, which involve very high up-front costs and long build times, before they can deliver competitively-priced, low-carbon electricity. But, our present market does not look attractive to new nuclear investment, which, importantly, the Government is also very keen on. It is similarly unattractive to ‘carbon capture and storage’ technology which, if it can be proved to work on a large-scale, could enable the UK to go on using fossil fuels in the next decade and in the longer-term, low-carbon future.
… … This represents an unprecedented level of investment in the industry. Furthermore, it has to come from private investors at a time when money is hard to come by and those that have it are understandably cautious about where they put it. There are many reasons for their caution. Experience of the recent financial crisis is an obvious one. Less obvious is that some of the technologies that they are being asked to put their money into are relatively new and seen as riskier than traditional stakes in utilities. Not only that, but, many of the technologies are under-pinned not simply by supply and demand, but, by public policy on environmental issues. Power industry investments are for the long term. Political horizons are closer, which means that public policy does not always offer them the stability that they require’.
To attract the investment necessary to achieve the transition to a low-carbon electricity industry and avoid power shortages, four measures are being pursued by the Government
· Replacing the Renewables Obligation with long-term contracts for low-carbon electricity generation, through Feed-in Tariffs with Contracts for Difference (FiT CfD)
· A Carbon Price Floor, below which, in the UK, the carbon price would not be allowed to fall – an affirmation of the Government’s commitment to reducing carbon emissions and an incentive for new investment
· An Emissions Performance Standard (EPS) to set limits on the CO2 that a fossil-fuelled power station could emit and making it impossible to contemplate new coal-fired electricity production without carbon capture and storage technology
· A Capacity Mechanism to deliver security of supply
What progress has been made?
Enough to make clear that the enormity of this task is not going to stop the Government’s efforts to deliver. For some time, my guess was that the project was over-ambitious and therefore likely to be watered down. But, the steps announced in the 2011 budget, the White Paper in July and the Technical Update in December suggest that the ambition is undiluted.
The 2011 budget put a Carbon Price Floor in place from 2013. The July White Paper declared in favour of the Feed-In Tariff with Contracts for Differences, rather than a ‘Premium Feed-In Tariff’ and it is now decided that the Capacity Mechanism will be one which operates market-wide, rather than via a ‘Strategic Reserve’, albeit it will not be introduced until the Government considers that the existing capacity is insufficient. That may sound reasonable, but, in itself, it promises uncertainty. At least we now know that the System Operator will manage those latter two processes – the Feed-In Tariff and the Capacity Mechanism. The fourth part of this package - the Emissions Performance Standard – always looked an unnecessary appendage (with the EU emissions limits and the UK carbon price floor in place) but, even this idea has not been discarded.
Investment
Without much tighter EU carbon limits and a higher, more predictable carbon price, the UK’s electricity market could not deliver the huge amount of low carbon investment that the Government requires to achieve its world-leading and self-imposed ambitions for reduction of carbon emissions.
The Technical Update of December 2011 was up-front about the investment challenge. Fair enough, because that’s why market reform is under way. But, to secure the investment, the package has to be credible overall. That means resolving uncertainty and offering an attractive return, but, there needs to be a great deal more detail in place before the credibility box gets ticked. The credit-worthiness of the mechanisms is fundamental – ‘critical’ says the Technical Update. We have known that since the long-term contracts were proposed and we now know a little more about the framework for delivering this. The System Operator, National Grid, will be at the heart of it, albeit the ‘… exact nature of the relationship between Government and the System Operator…’ is yet to be agreed. So, where does the risk come to rest if it is not borne by National Grid? Answer: ‘… we will work closely with National Grid to develop suitable arrangements that meet Government’s objectives whilst protecting the interests of National Grid’s investors through appropriate protection from balance sheet risk’ and ‘… it is anticipated that the costs of meeting the FIT CfD will be borne by suppliers which, in turn, are free to pass these costs to consumers’. More details are expected early in 2012.
A changing industry
A new electricity supply industry, shaped by tight constraints on carbon emissions and a desire to minimise fuel imports presents a huge challenge and for many of the participants, a huge opportunity. In fact, the destination may be close to where we have to be when finite fossil fuels are in short supply. But, this is about a forced march to that place, rather than an evolutionary stroll. It is about pursuing vision, or anticipating events, rather than responding to them. That requires a level of intervention which is at odds with the thinking behind the Electricity Act 1989. But, energy policy changes and visions change.
Eventually, we shall be able to manage the power system better with smarter grids. The management of the grid today is not exactly dumb, of course. It helps to deliver an astonishing level of reliability for a ‘just-in-time’ product. We shall have to do even better though, because a system that has successfully provided power in response to changing customer demand, will also have to accommodate large amounts of power that demands to have a customer.
By then, smart meters will enable the customer to make smarter use of that power. A monitor in the kitchen already tells me that electricity is costing £1.30 an hour more than usual when my wife is in the shower. It does not know who is in the cubicle of course and I assume that it signals the same rate when I am in there. But, smart meters will do much more than a monitor and they will complement the smart grid.
Electric heating displacing gas boilers? A take-up of heat pumps that use the heat in the air or the ground and make better use of it? Electric cars? I have already had a test drive in one. OK, it was in Brussels and it may have needed re-booting before I could persuade it to take me back to its parking space, but, it was still pretty impressive. Our cities will be cleaner places when there are lots of these about. They will be quieter, too. So, we shall have more reason to remember our kerb drill.
Cash matters
Whatever the vision, delivery is down to how much investors are prepared to put into the industry. In turn, that depends on how bankable the Feed-in Tariff is; how different the CfD is (and different from what, exactly) and how and when the Capacity Mechanism will operate. Common sense says that we should not have a capacity mechanism until there is an issue over capacity and the Technical Update recognises that. So, high-level decisions about such a mechanism will be taken, but, the auction process to deliver the capacity will not come until the System Operator (and perhaps, Ofgem) has made estimates about future security of supply. Note too (investors will), that the Technical Update expects the capacity market to ‘… have a dampening effect on electricity market prices’. Reconciling a capacity market with an energy market has always been a challenge.
The £200 billion that was the ball park figure used for investment needed by 2020 - in generation, transmission, gas infrastructure, smart grids, smart meters etc - remains a huge sum. The AEP has argued for years that it is vital that the UK should be an attractive destination for investment in energy infrastructure. Despite the controversial cut in support for photovoltaic installations, there is probably still a high level of trust in promises made by the UK governments – at least, the kind of promises that underpin energy policy. That probably gives this country an advantage. Whether it will be sufficient to secure £200 billion remains to be seen. What would be the effect of raising and spending only part of that sum - some of it, rather than all of it? We face a huge level of intervention, but, it is not quite central planning. Of course, even when we did have central planning, it was far from efficient, so plus ça change … perhaps.
It remains to be seen exactly how high the incentives to invest need to be. It is an important question, because it has a bearing on costs and prices. In the longer run, the customers pay for everything and we forget that at our peril. The Government thinks that they will be better served by the interventionist approach of EMR that provides plenty of capacity and is intended to avoid the volatility that comes with importing of fossil fuels. At the moment, customers are pre-occupied with the effect of more recent price rises, so the domestic ones, at least, are not likely to show much gratitude for the prospect of savings on bills that are years away. Frustratingly, neither are they showing as much interest as expected in insulating their homes – even when the service is provided free of charge.
Everything is connected to everything else
The EMR story has some way to run and investors have a lot to watch on the radar. The Technical Update promises more detail on FiT CfD and the EPS early in 2012 and more policy announcements in spring and summer 2012, with a view to legislation being enacted by spring 2013. So, 2012 will be an interesting year for those waiting to invest. Note that a chapter of the Technical Update is dedicated to ‘Enabling investment decisions for early projects’. If you hope to be a developer of a low-carbon power project, DECC wants to talk to you about the ‘form of comfort’ that you might want before deciding to go ahead, particularly if you might otherwise defer or cancel the project (email the Financial Investment Decision Enabling Project Commercial Team)
There are, of course, other important reviews under way that cannot be seen in isolation from EMR. Projects like TransmiT, the Retail Market Review, cash-out reform and various European proposals, including the Energy Efficiency Directive and the 2050 Road Map come to mind. Ah, Europe. The EU expects to deliver the long-awaited single market for energy by 2014 and it will want to find time to check out EMR – particularly the proposal for a capacity mechanism, in relation to inter-connection - to ensure that it is compatible. Currently, of course, the EU is pre-occupied with the financial crisis.
David Porter, Chief Executive, Association of Electricity Producers
January 2012