Electricity Market Reform: An orderly transition ?

The recent UK Electricity Market Reform package is attempting a difficult balancing act. The government appears to be trying to retain the existing competitive market structure while overlaying a toolkit of policy interventions which allow it to influence market outcomes. The uncertainty associated with this approach increases investment risks and threatens security of supply…

August 8, 2011

A policy toolkit for market intervention

The UK government is attempting a difficult balancing act with its Electricity Market Reform (EMR) package. The vision behind EMR is to provide a framework to incentivise private investors to deliver an orderly transition to decarbonisation of the power sector, at a price tag which is palatable for consumers. This is an ambitious objective and the government deserves some credit for pursuing such a policy. The policy line of least resistance would surely involve token gestures on decarbonisation while focusing on the potentially fatal issues of security of supply and consumer bills. But good intentions do not guarantee success.

For private investors to deliver the objectives set out in the EMR White Paper government policy must set out a consistent long term vision of market structure, regulation and the role of the government. The White Paper falls along way short of this. The government appears to be attempting to retain the existing competitive market structure while overlaying a toolkit of policy interventions which allow it to influence market outcomes, particularly around capacity mix. Central to the design of this intervention toolkit are a number of, to some extent conflicting, political agendas. These include:

  • Support for development of renewable generation
  • Support for new nuclear (without transparent public support)
  • Opposition to new unabated coal, but support for Carbon Capture and Storage (CCS) technology
  • Opposition to (transparent) policy driven increases in consumer bills
  • Concern over security of supply

Rather than go into the detail of the specific design, motivations and shortcomings of each of the EMR policy measures (Feed in Tariffs (FiT)/Contracts fof Differences (CfDs), Emissions Performance Standard, Capacity Mechanism and the Carbon Price Floor), we reference an excellent summary by Malcolm Keay of the Oxford Institute for Energy Studies. This allows us to focus on the impact of EMR on generation investment.

Searching for a third way

There are broadly two models for electricity market design that could be used to support private investment in generation infrastructure:

  1. A competitive wholesale market with transparent rules, strong independent regulation and a ‘sharp’ (cost reflective) market price signal to induce investment
  2. A centrally administered solution where an independent body with a clear mandate uses a transparent approach to determine and deliver against capacity targets (e.g. via capacity auctions)

DECC and Ofgem have openly deliberated over the merits of one model versus the other in the lead up to the White Paper. However EMR appears to be trying to steer a dangerous course towards a middle ground.

The design of the current market structure, specifically the implementation of NETA in 2001, was based on delivering a competitive wholesale market with a clear price signal to investors. Without fundamentally reforming this approach, the policy toolkit announced in the White Paper appears to hand DECC a control panel with which to influence capacity outcomes. The waters are further muddied by a lack of clarity as to how DECC will interact with Ofgem as regulator, the Treasury as administrator of the Carbon Price Floor (CPF) and any new function set up to administer the FIT/CfDs.  This does not sound like an environment that is consistent with a sharp market price signal to induce investment. In fact it is difficult to see how this approach will not make investors very nervous.

EMR uncertainty increases investment risks

Delivery of investment by reducing the cost associated with investor uncertainty is presented as a core objective of EMR. The policy measures certainly go some way towards reducing the market risk associated with renewable and nuclear capacity. But investment risk as a whole would appear to have increased as a result of the White Paper, particularly for thermal plant investors. A summary of key policy related investor risks by capacity type is shown in Table 1.

Table 1: Key policy related investor risks

There is clearly a large degree of uncertainty still remaining as to how the EMR policy will be implemented, particularly around the Capacity Mechanism. This will likely result in a one to two year investment hiatus until there is more clarity around the new rule book.

More concerning is the inherent uncertainty in the EMR design itself, given that it equips the government with the tools to fundamentally alter the market landscape over an investment horizon. DECC has explicitly described the EMR policy measures as ‘a toolkit that can be used to achieve any desired level of decarbonisation’, suggesting that intervention flexibility is an objective of EMR design. Indeed there is a worrying track record of piecemeal policy intervention to support renewable capacity over the last decade. It is a brave investor who believes the use of the EMR toolkit will not be influenced by the evolution of market outcomes and the political objectives of the government of the day.

EMR is being implemented in a capital constrained environment with balance sheets stretched and financing tight. The level of political and regulatory risk associated with the reformed market will have a direct impact on investor’s capital costs and their commitment to delivering new capacity.

EMR threatens security of supply

The scale of the UK’s capacity replacement challenge is best represented with numbers. There are scheduled closures of more than 18GW of capacity this decade: 11.5 GW of LCPD thermal plant by 2016 and an additional 7 GW of nuclear capacity by 2020. In addition weak market spreads and the Carbon Price Floor threaten the closure of a number of older thermal plant. In aggregate the UK will need to replace somewhere between a quarter and a third of its generation capacity by the end of the decade.

Conventional coal (due to the EPS) and new nuclear (due to development timelines) can not play a meaningful role in replacing capacity over a 2020 time horizon. The contribution of carbon abated coal will almost certainly be limited to demonstration projects given the cost of CCS and the lack of clarity around its support. Renewable output will rise from its current contribution of around 6% of UK output, but realistic build rates suggest it will fall well short of the government’s 15% target. So maintaining security of supply will primarily come down to investment in new gas plant and life time extensions of existing thermal capacity.

The EMR policy announced to date appears to compromise the incentives for thermal capacity. The carbon price floor directly increases generation costs. Other policy interventions weaken the market price signal. Presumably the government will attempt to address this with the announcement of the details of a Capacity Mechanism in December. But using yet another policy intervention to address the knock-on effects of previous measures is unlikely to improve investor’s confidence or the long term viability of the market. The evidence is mounting against an orderly transition to decarbonisation of the UK power market.