“Dozens of dirty diesel generators”. Hardly the headlines the government was hoping for when it set up the capacity market. Yet, when the second auction came to a close this winter, it once again became clear that small scale diesel generators had ended up among those subsidised. The cost this time? £176 million on small scale diesel generation over 15 years - even more than the £109 million in the first auction. Experts have told Utility Week that without changes to the market it could be even worse in the next round.

While the primary purpose of the capacity market may be to ensure security of supply, it doesn’t exist in isolation. It wouldn’t be necessary if the government wasn’t also trying to cut carbon emissions. The government’s dilemma is that, in trying to achieve one of those objectives, it is apparently compromising the other. On the one hand it’s committed to closing all of the UK’s coal fired power stations by 2025. On the other, it’s subsidising one of the few forms of generation that is as carbon intensive in order to replace lost capacity.

Jimmy Aldridge, senior research fellow at the Institute for Public Policy Research (IPPR), told Utility Week there are “…more bill payers’ subsidies going to the dirtiest form of generation available at the same time that the government were over in Paris trying to negotiate a climate deal, and doing good work towards that end. From our perspective that’s a step in the wrong direction, in trying to come up with a sustainable energy policy.”

Small scale diesel generation produces 1010gCO2/kWh according to figures from IPPR. By comparison the combined cycle gas turbines which the government was hoping to contract in the auction produce a mere 378gCO2/kWh.

So how did this happen? It isn’t because diesel generation is itself especially cheap. As Tom Porter, partner at consultancy firm LCP, explained: “In a competitive market we would not expect diesel generators to be as cost efficient as new gas generators.”

Instead, it’s the multiple sources of revenue they’re able to take advantage of which have made diesel generators competitive.

There is, of course, the capacity payments themselves; £18/kW in the most recent auction. There’s also contracts for National Grid’s Short Term Operating Reserve (STOR).  In his report for IPPR ‘Mad Maths: How new diesel generators are securing excessive returns at bill payers’ expense’, Aldridge calculated that for a typical set of diesel generators this could be expected to bring in £20/kW each year.

However, the most important source of revenue is triad avoidance payments. As the small scale diesel generators are ‘embedded’ in the distribution network, they are exempt from Transmission Network Use of Service (TNUoS) charges.

It means they can help energy users reduce their peak load and therefore their TNUoS charges, without incurring the charges themselves. Aldridge calculates that this could bring in yearly revenues of £35/kW.

On top of all this, diesel generators have been able to avoid several restrictions faced by others. They are small enough to be exempt from the EU’s Industrial Emissions Directive, which places limits on nitrous oxides, sulphur oxides and dust. The same is true for the Emissions Trading Scheme, which would otherwise require them to obtain allowances for the carbon dioxide they emit.

At first glance it seems like stopping diesel generators from winning capacity contracts should be simple; just ban them from entering bids. However EU competition rules mean that the capacity market must be technology neutral, and therefore particular forms of generation cannot be barred.  

Aldridge’s report suggests emissions limits are a way round this, calling on the government to, “introduce an amendment to the Energy Bill … that prevents any generator with an instantaneous carbon intensity over 450gCO2/kWh from accessing 15-year contracts.” Diesel generators would be prevented from entering bids, without explicitly banning them.

Another alternative is looking at the exemption from TNUoS charges. A joint report published by LCP and Frontier Economics calculated that triad avoidance payments make up 60 per cent of the revenue stream for a typical diesel generator.

It suggests getting rid of the exemption for the “sunk cost” element of the TNUoS charges, describing it as “wasteful and distortionary”. Without this source of income, the report says diesel generators “would require a capacity price of £55/kW” in order to be profitable, more than three times the final price in December’s auction.

 “It would level the playing field and therefore bring a result more in line with what would have been expected,” report co-author, Tom Porter, told Utility Week.

As things stand the government has yet to truly acknowledge the problem. When the energy secretary, Amber Rudd, was challenged in the Commons by shadow energy minister, Lisa Nandy, she responded: “Diesel will form a part of the future, but only in very small amounts. Let us remember that it is there as back-up and will be switched on occasionally when it is needed. The addition of the capacity market to people’s bills will be a matter of a few pounds.”

Dave Jones, policy analyst at environmental campaign group Sandbag, says the government may be hesitant to make any drastic changes: “If they’re too big the UK may need to bring the whole capacity mechanism through the European state aid case again.”

However, he believes something needs to be done: “There’s very much a kind of momentum from people suddenly realising the investment opportunity for diesel.”

Jones added: “There’s no reason this couldn’t snowball and we end up with even more being contracted in next year’s capacity mechanism.”

That’s a scenario the government will want to avoid. As ministers review the outcome of last December’s auction – watch this space.