UK: Full "Steam" Ahead? Government Powers On With Proposed Energy Market Reforms

The UK Government recently published a draft Energy Bill which will implement its Energy Market Reform proposals. When passed into legislation, the Energy Bill will introduce a new legislative framework for the delivery of low carbon energy. The Energy Market Reform is perhaps the most important development in the energy market since privatisation in 1989.

Introduction

The Department of Energy & Climate Change (DECC) has announced that approximately one fifth of existing electricity generating plant will close over the next decade and the current market will not deliver electricity at the pace or scale required to meet demand in the future. DECC believes that £110 billion will be required to be invested in electricity generation and transmission by 2020 to ensure security of supply.

The Government is also committed to achieving the emissions reductions, decarbonisation and renewables targets that it has set itself. The Government wants future supply to come from cleaner but less proven technology. The market reform proposals are, therefore, seeking to achieve massive investment in low-carbon technology which is more expensive than conventional technology. Without some form of incentive, there may well be a lack of interest from private companies to commit to the development of clean technology. With the focus on low-carbon technologies, the Government is also addressing the issues raised by these technologies which are less flexible and more intermittent in their generation of electricity.

The proposals set out in the Energy Bill not only have to balance the competing needs of securing long term electricity supply and ensuring climate change commitments are met, but the Government has stated that it also wants to ensure that heat and power remain affordable for consumers. In order to achieve these objectives, the Energy Bill will:

  1. Implement the Electricity Market Reforms (EMR);
  2. Clarify the role of Ofgem through a new statutory Strategy and Policy Statement;
  3. Establish an Office for Nuclear Regulation to regulate the nuclear power industry;
  4. Provide for the potential sale of the Government Pipeline and Storage System; and
  5. Make changes to the offshore transmission regulatory framework.

This Article focuses on the implementation of the EMR. Under the EMR, two new market mechanisms will be introduced into the existing wholesale market. The first is the Feed-in-Tariff Contracts for Difference (FiT CfD) and the second is the capacity payment mechanism to be used within a capacity market. These mechanisms will be supported by the Carbon Price Floor and the Emissions Performance Standard (EPS).

The FiT CfD and the capacity payment mechanism will be administered by the System Operator, part of the National Grid and regulated by Ofgem, ensuring (it is hoped) value for money and incentivising effective performance, although the Government will set the strike price for the FiT CfD.

Feed-in-tariff Contracts for Differences

FiT CfDs are intended to facilitate investment in low carbon generation by providing stable and predictable incentives for companies investing, while removing the long term exposure to price volatility. Importantly it will also apply to nuclear generation.

The generators' returns are stabilised by the setting of a fixed level known as the strike price. Generators will enter into long term (10 – 15 year term) contracts. Under these contracts, generators will receive revenue by selling their electricity into the market as usual. Where the market price is below the strike price, the generators receive a top-up payment for the additional amount. On the other hand, if the market price is above the strike price, the generators must pay back the difference. 

The FiT CfDs are, therefore, different from the existing Renewables Obligation (RO), as there is no requirement to pay back any money under the RO if the generators are enjoying high electricity prices. When introduced in 2014 the FiT CfDs will be available alongside the RO until the RO is totally phased out leaving FiT CfDs as the only available incentive for renewable generation. It is currently proposed that eligible generators will be able to choose whether to continue under the RO or switch to FiT CfDs until 31 March 2017. Whether there is enough incentive for a generator to switch is a different question.

Similar to the RO "banding", DECC has proposed that the strike prices are set at different levels for different low-carbon technologies. It is expected that during 2013 the Government will announce the strike prices for the initial / transitional phase during the period 2014 to 2018. It is likely that the strike price for the period after 2018 will be set as early as 2015, once the System Operator has gathered evidence on pricing which it will do from 2014. It is currently expected that the strike price will be indexed annually by reference to the Consumer Price Index.

While the draft Energy Bill sets out an overarching framework for FiT CfDs, it lacks detailed legislative provisions and changes to licences and codes (which have not yet been published) are still under development. Generators will want to be certain that in entering into FiT CfDs they are able to properly finance projects and be protected from future changes in the law. As there is a lot of detail still to be clarified, investors and generators may be deterred from engaging with the Government in bringing forward proposals for new projects.

The Government is aware of the risk that the EMR could lead to a delay in investment for large energy projects and the Government has already considered measures to facilitate project approval before and during the implementation of EMR. The Energy Bill contains powers for the Secretary of State to issue what is currently known as an "investment instrument" to a generator ahead of the introduction of FiT CfDs. The investment instrument is intended to be analogous to a FiT CfD and give some comfort to an investor on its potential return.

Capacity Mechanism

The second mechanism proposed under the EMR is the capacity mechanism. This is intended to provide a form of insurance against the possibility of future supply blackouts. The capacity mechanism should ensure that consumers benefit from reliable electricity supplies at affordable costs.

The EMR will introduce a capacity market. A forecast will be made to determine the future peak demand for electricity, and this will be used to determine the level of reliable capacity needed to ensure security of supply.

Providers of capacity will have the opportunity to bid in a central auction. If they are successful the provider will enter into a capacity agreement. Under the capacity agreement, the provider guarantees to have capacity available in a given year in the future (currently proposed to be around four years after the year of the auction) should it be needed. The provider will receive a guaranteed revenue stream for providing the capacity, in addition to the revenues from the electricity market. If a provider is unable to provide the capacity when it is required, they will have to pay a penalty.

The timing of the first capacity auction will be decided by the Secretary of State based on advice for the need for such an auction according to technical analysis and expert advice. However, if the legal framework is in place, the first auction could, if it was needed, be run by the System Operator as early as 2014 for the capacity to be in place by 2016. The government will continue to have responsibility for when to activate the capacity market and set the volume sought.

Other Measures

The Emissions Performance Standard (EPS), which will impose an "emissions limit duty" on the operators of fossil-fuel (i.e. natural gas, oil or coal) power stations is another key measure. It will only apply to new capacity. The EPS duty will oblige such plant not to emit more than a specified amount of carbon dioxide in each year of operation. Biomass and energy from waste plant will not be affected by the proposed EPS.

The Energy Bill contains further provisions for the making of regulations on monitoring and enforcing compliance with the emissions limit. Both the monitoring and enforcing arrangements are currently modelled on those set out in the EU Emissions Trading System.

Another important measure is the Carbon Price Floor. Under this proposal generators who produce electricity from fossil fuels will now be subject to the Climate Change Levy and this will be set at a rate which takes account of the carbon content of the fuel used.  The intention is to create a stable carbon price that encourages investment in low carbon generation.

 Next Steps

There is a lot of detail still missing from the draft Energy Bill. The Government has stated that it will make a final decision on the operational framework and payment mechanism for FiT CfDs by autumn this year. Also expected later this year are further details on the respective roles and responsibilities of the Government, the System Operator and Ofgem in relation to the EMR, with the necessary secondary legislation being adopted during 2013 – 2014. The Government proposes a detailed consultation on the design of the capacity market during 2013.

There is therefore much more that needs to be done by the Government in order to clarify and finalise its EMR proposals before generators, investors and bankers will have the confidence and understanding to help deliver the Government's desire for a low carbon energy future.

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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