UK: UK Electricity Market Reform: Shaping the Future

Last Updated: 20 January 2011
Article by Deloitte Energy & Resources Group

Most Read Contributor in UK, August 2017

The Need for Reform

Reform of the UK electricity market is intended to solve a number of problems that the UK Government believe prevent the current electricity market arrangements from supporting the achievement of key policy objectives. There are three objectives in particular that are felt to be at risk:

  1. A Low Carbon Generation Mix

    At the moment, the main incentives for the development and operation of less carbon intensive generation in the UK come from the imposition of carbon costs on fossil-fuelled generators under the EU ETS, and from additional revenue to renewable electricity generators from the renewables obligation scheme. However, the combination of these are not sufficient to achieve the scale of investment into low carbon generation that is required to meet the UK's targets. The current arrangements do not adequately incentivise investment in low carbon generation because of electricity price uncertainty, low prevailing levels of EU allowance prices, and policy uncertainty.
  2. Security of Electricity Supplies

    Around a quarter of existing UK generating capacity will close by 2020 due to its age (combined with tightening environmental regulations). A significant share of new capacity is expected to be wind power. As more wind power is added to the system, there will be an increased need for flexible generating plants that can ramp up and down to offset fluctuations in wind output. Given that future baseload electricity supply is envisaged to come from nuclear, renewables and coal-fired generation fitted with carbon capture and sequestration (CCS) (none of which are particularly adaptable), flexible plants will need to recover a return over a limited number of operating hours. But, the current UK electricity market arrangements do not adequately reward peaking and flexible plants which therefore risks compromising security of supply.
  3. Affordability

    Low carbon generation is more expensive than the marginal fossil-fired generation – a combined cycle gas turbine (CCGT). This means that electricity prices will rise as the sector decarbonises, which makes ensuring affordable electricity a significant challenge for government. Consequently, the UK Government has to ensure that its measures to incentivise low carbon generation are cost effective and mitigated by initiatives to promote and support energy efficiency.

The Proposed Interventions

The DECC consultation, in parallel with the consultation on a floor price for carbon, is intended to set out potential changes to the market arrangements that will resolve these issues, without requiring public subsidies for nuclear projects. The proposed interventions include:

  1. A Form of Feed-in-Tariff for Low Carbon Generation, Including Nuclear

    Top up payments to be made to low carbon generators under long-term contracts to achieve an aggregate revenue appropriate for their type of technology. The top up payment would be assessed by the difference between a benchmark index for wholesale electricity prices and a pre-determined revenue requirement for each technology. If wholesale prices rise above the agreed price, generators would pay-back the difference. Low carbon generators would still sell their electricity through the existing bilateral electricity market. The consultation paper opens up the option for this tariff to be set by periodic auctions, with potential new low carbon generation bidding in their required tariff.
  2. An Emissions Performance Standard for New Power Plants

    A maximum CO2 per MWh limit for new UK power stations would be set. This would effectively rule out new unabated coal-fired power stations, but would allow new gas-fired plants and coal-fired plants with at least partial carbon capture and sequestration (CCS).
  3. Targeted Capacity Payments to Flexible Plants

    Targeted capacity payments are made to flexible plants to act as cover for intermittent wind output. Capacity payment systems are used in a number of electricity markets around the world, with a different framework for setting the level of payments and ensuring capacity availability. In this case, the suggested option is for a central body to contract for capacity to cover any expected market shortfall via periodic tenders. Other than this contracted capacity, there would be no capacity payment to generation on the system. This would in effect extend the capacity available under existing short-term operating reserve.

Will They Work?

Although the measures will interact and the overall effect on the market will come from the combination of them, it is possible to consider the extent to which the main individual elements of the package will achieve their desired effect:

  1. The Feed-in-Tariff

    The proposed feed-in-tariff will reduce the market risk faced by low carbon generators, hence improving the investment flow. But, the consultation paper is silent on how this will operate in the bilateral UK power market, appearing to hand over much of the responsibility to Ofgem

    The proposed system will largely remove the wholesale electricity price as a risk faced by low carbon generators - importantly ensuring that the low carbon generation incentive delivers an acceptable revenue stream regardless of fossil fuel and carbon prices. It is to achieve this through contracts-for-differences (CfDs), which at the margin still leave the generators exposed to incentives based on wholesale market prices that are used as a reference price for the CfDs. The question mark hanging over this mechanism, is whether a sufficiently liquid UK wholesale electricity price index can be identified to act as a reference price that is a reasonable estimate of the revenue that low carbon generators would otherwise earn, and which is not open to uncompetitive distortion. This was one of the problems with CfDs struck against the Pool price during the 1990s.

    Illiquid exchanges can have prices affected by large trades and this is an issue if the UK Government is bound to make compensation payments on the basis of these prices. Requiring low carbon generators to sell their output through the bilateral market under a specified process would increase liquidity, but would then transfer significant risks onto supply markets.
  2. An Emissions Performance Standard (EPS) for New Power Plants

    The proposed emissions performance standard will prevent unabated new coal-fired generation. It is proposed that any perceived risk for CCGT investors, who may be concerned that that the EPS will be tightened through time, is catered for by grandfathering of the EPS for existing and new plant according to their online date. This proposed reform should achieve its stated objective - in terms of preventing the most carbon-intensive forms of new generation. The setting of an emissions limit at a level where coal-fired generation with partial CCS can still be built, balances the need to limit emissions against the desire to prove carbon capture and sequestration on coal-fired plants. However, it is not clear what risks a new coal-fired plant faces in the event its CCS is offline. It may put the whole plant's output at risk which would deter such investment.
  3. Targeted Capacity Payments to Flexible Plant

    The splitting of the market between contracted and un-contracted plants, and the asymmetric value placed on capacity provided by these groups, will further reduce the operation of market forces.

    The introduction of contracts for some peaking capacity will reduce the need for this plant to rely on peak prices. This indifference may lead to wholesale energy prices being depressed. Given the potential effect on peak prices, not paying capacity prices to existing plants that are not contracted for system support, raises a risk that too much will shut, either threatening security of supply or forcing the contracted part of the market to expand to fill the gap. Together, these points serve to emphasise the need under the government proposals for a new centralised body to not just offer capacity payments, but also to co-odinate CfD auctions and generally take responsibility for the power sector. This is a significant risk for market players, not least because the government has not yet faced up to the logical consequences of its own proposals.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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