Last Thursday the UK government abruptly halted the Capacity Market to comply with a European Court of Justice (ECJ) ruling. The implications of this are an immediate stop to capacity payments under existing agreements and the cancelling of auctions in 2019.
The government’s announcement was the equivalent of an immediate and indefinite zero capacity price outcome for all CM participants. It is an understatement to say it was a surprise of the first order.
You can read elsewhere about the details of the ECJ ruling, but in today’s article we set out some initial thoughts on the potential market implications of CM suspension.
Impact of suspending payments on existing capacity providers
Halting capacity payments has an immediate margin & cashflow impact on all holders of 2018-19 capacity agreements. This includes owners of coal plants, CCGTs, engines, nuclear plants & DSR capacity.
Most of the capacity across the current delivery period is under T-4 agreements (from the first auction in 2014). A 20.8 £/kW price applies for these agreements (the 19.4 £/kW clearing price adjusted for inflation).
While a single T-4 clearing price applies, the impact of suspension of payments varies significantly by asset. There are four main factors that drive this:
- Derating factor
- Portion of asset margin driven by CM
- Extent of leverage (i.e. project/owner debt structure)
- Length of contract (i.e. 1 year vs 15 year)
The asset owners that are most exposed are those that rely on CM payments to:
- Cover fixed costs in order to remain cashflow positive
- Meet debt repayments.
Older & less efficient CCGTs and coal plants are most vulnerable in the first category. Leveraged engine & DSR projects are vulnerable in the second category.
This is where uncertainty around the extent of CM payment suspension is very important. A temporary halt of a couple of months before payments are reinstated may be painful but is unlikely to precipitate major closures or defaults. The costs of operating capacity are largely sunk over this time horizon.
However, a prolonged or indefinite suspension of payments will have real implications for more vulnerable capacity owners relatively quickly. This may mean mothballing, accelerated closures and defaults.
For that reason, expect a sharp and strong lobbying response from affected owners. The interests of utilities, IPPs, flex developers and aggregators in pressuring the government to reinstate payments appear to be strongly aligned. The main hurdle to achieving this seems to be one of legal process rather than overcoming structural conflicts within the industry.
Impact on security of supply & policy
The government has tried to allay fears that CM suspension threatens security of supply this winter. That may be right in the sense that existing capacity is likely to remain operational between now and next March.
But beyond this narrow interpretation there can be little doubt that CM suspension represents a major threat to security of supply. The Capacity Market has been the cornerstone of the government’s policy platform to ensure enough flexible capacity is operational to keep the lights on.
Again, the interests of the government, consumers and a significant majority of market participants appear to be aligned in ensuring the CM does not suddenly disappear. The alternative stop gap solution is for the government to get Grid (as system operator) to ‘do all it takes to ensure security of supply’. The flawed SBR mechanism is reminder of why that is likely to be a bad outcome.
What the ECJ ruling may precipitate is an acceleration of the government’s review of the CM. For example, a significant broadening of the CM to include other types of generation (e.g. renewables) was already under discussion. But complex reforms of this nature are not well suited to ‘gun to the head’ haste. An interim solution is required to stem the bleeding and buy some time for well-considered reform.
Impact on investors
The key immediate impact of CM suspension on investors, is the cancellation of the 2019 T-4 and T-1 auctions. The government has indicated it may hold a T-3 auction for the 2022-23 capacity year instead.
This imposes a direct cost on investors relating to the carrying cost of capacity projects intended for the 2019 auctions. But perhaps more importantly, the uncertainty associated with CM suspension is likely to have a greater intangible impact on investor confidence. The cost of that uncertainty is passed on to UK consumers via higher cost of capital to deliver required capacity.
Investor patience has already been tested by Brexit, the price cap, embedded benefit reforms and the charging review. The CM has been a source of relative stability over the last 4 years… until last week.
Uncertainty may result in more marginal investment projects being delayed, shelved or canned. It may also speed up the process of consolidation & aggregation of development projects that is already underway. And that may extend to the fire sale or closure of vulnerable existing assets, particularly those that become cashflow negative or cannot meet debt payments.
Uncertainty is likely to remain, at least for the next few weeks given the parallel issues with Brexit negotiations. But the path through that uncertainty is likely to favour a level-headed approach to the structured assessment of risks, including stress testing asset cashflows to quantify the impact of potential outcomes.