With six months to go until the first capacity auction, the Department of Energy and Climate Change (Decc) recently unveiled the design of the bidding process, plus the total capacity it plans to procure: 53.3GW, or 80 per cent of UK peak demand. As the energy industry digests the details, mutterings that the design is flawed are growing louder. One thing is for sure: many questions remain about the capacity market, a key plank of Electricity Market Reform. Here are eight of them:
1. Why is the capacity market procuring 53.3GW of capacity?
The number is based on National Grid’s models of future demand, which, critics say, are notably risk averse. There may be an inherent conflict of interest in National Grid, the system operator, also running the capacity market. Its overriding interest is to keep the lights on, leading to the suspicion that it may overestimate the amount of electricity needed. While the independent experts’ report published by Decc exonerated National Grid from any overt conflict of interest, it did question some of the key assumptions that informed its estimates of energy demand.
2. Are the assumptions too conservative?
National Grid is not taking into account energy coming from interconnectors in times of system stress. This is a very conservative approach: the panel of independent experts argues that it would have been reasonable to count 50 per cent of the capacity of interconnectors as imports at times of system stress, which would have resulted in a 2.3GW reduction in the total needed. Meanwhile, the loss of load expectation set by Decc is just three hours. In other words, the government has decided to procure enough energy to mean that, in a worst case scenario, demand would outstrip supply for three hours a year.
3. Will new power stations set the price too high?
The higher the capacity being procured, the more new capacity will be included in the auction. New capacity costs more because it needs to be built: this will push up the final price at the auction, whereby the highest price included in the auction is the price then paid for all the capacity. According to Cornwall Energy’s analysis, A Fortress Built on Sand: “There is now a probability that – given the uncertain outlook for some existing gas and coal plant – new-build plant may be setting the clearing price for this first auction.” This will increase the overall cost.
4. How much will consumers pay?
The capacity market is a massive transfer of risk from generators to customers, but just how much customers will pay is subject to some controversy. Decc’s latest impact assessment initially suggested it would be just £2 per year, but following questioning by The Daily Telegraph, it conceded that this figure was in comparison with a projected future scenario whereby there was no capacity market. In fact, the department acknowledged, customers will be paying an average of £13 per household per year to subsidise power stations by 2020.
5. Will the capacity market deliver the right conditions for investment?
The jury is still out. On the one hand, the capacity market offers potentially generous public subsidies to investors in power stations for as much as 15 years. On the other, the market is complex, controversial and far from secure. Frontier Economics’ Dan Roberts says: “There’s an awful lot of regulatory intervention in power station building, and the rules are still in the process of stabilisation. Even if each company in the auction had just a couple of power stations that were new build, that could easily cost £500-700 million. That’s an awful lot of investment that’s going to be decided in a single process.”
6. How will the capacity auction affect the wholesale market?
UK power traders have hit out at the auction plans, arguing they could cause prices on the wholesale market to fall because of the partial subsidy, rendering the market incapable of producing an accurate price signal for future investment. “If you need £5 to run, and you are subsidised to the tune of £2, a generator would only need £3, so the market settles at £3,” one trader said.
By undermining the market, the government could risk breeding a dependence on subsidy because the wholesale price signal offered will be too low to bring forward investment in new plant.
7. Will it stop blackouts?
With a fifth of the UK’s power stations shutting over the coming decade, the capacity margin – the average supply excess over winter peak demand – is expected to tighten. That increases the risk of blackouts.
The crunch point will come in 2015/16. Under Ofgem’s reference scenario, there is a 1 in 12 risk of blackouts that winter, rising to 1 in 4 if expected demand reduction does not materialise.
The capacity market does not come into force in time to beat the mid-decade squeeze. The first auction will bring on capacity by winter 2018/19, allowing four years for gas plant to be built. There will also be a year-ahead auction, aimed at demand-side response. However, the capacity market is central to plans to restore a healthy margin towards the end of the decade.
8. Will it need European approval?
Any form of public assistance that has the potential to distort competition or affect trade is classed as state aid and must be cleared by the European Commission. The contracts for difference regime and the exemption of energy-intensive industries from green costs fall into that category, as does the capacity market. A decision is expected later this year.
According to Morgan Cole lawyer Paul Brennan: “Although some of the Commission’s proposed criteria for assessing capacity mechanisms appear to be met by Decc’s capacity market (for example, the non-discriminatory contract award process and relatively short-term contracts for existing plant), European endorsement cannot be taken for granted.”
The UK is one of several member states developing a capacity market, which may be a problem in the future if the EU decides they should be standardised. Frontier Economics’ Roberts says: “A patchwork being developed across Europe just increases the risk that they won’t last in their current form – and that’s a recipe for more interventions.”