UK: Energy Bill - Capacity Market

Last Updated: 20 December 2012
Article by Paul Brennan

The Capacity Market is intended to provide investors with the certainty they need to put adequate reliable capacity in place to meet expected demand, and protect consumers against the risk of supply shortages. The Market will only be introduced if and when necessary, although DECC indicates that it is minded to run the first auction round in 2014, for delivery of capacity in the year beginning in the winter of 2018/19.

The Bill goes little further than providing the Secretary of State with a very wide set of powers to introduce arrangements relating to the provision of electricity or reducing electricity demand through secondary legislation, including through "capacity agreements", which can be issued pursuant to a competitive "capacity auction" process or otherwise. Regulations may also be made imposing obligations on capacity providers in addition to, and possibly as an alterative to, such agreements.

All that is clear on the face of the Bill is that any capacity agreements that are introduced as a result of the new powers may impose obligations (including as to payment) on the capacity provider and payment obligations on "electricity suppliers"; even the meaning of that term will not be certain until the secondary legislation is introduced. The provisions of the Bill relating to capacity have not changed greatly from the provisions of the consultation draft of the Bill released earlier this year.

The Electricity Market Reform Policy Overview and its Annexes released by DECC in conjunction with the Bill indicates that it is the Government's intention that the provisions of the Bill will be implemented to the following effect:

  • a forecast of future peak demand will be made, four years ahead of the delivery year in which it is needed;
  • the net amount of capacity needed to ensure security of supply (which is likely to be informed by an enduring reliability standard) will be contracted through a competitive annual central auction run by National Grid;
  • generators, demand side reduction (DSR) and storage providers will be able to participate in the capacity auction. Both new and existing generating plant will be eligible to participate in the auction, though there will be exceptions (e.g. low carbon plants holding CFDs with administratively set prices, and, it is rumoured, Reserve Providers with long term STOR contracts);
  • providers of capacity successful in the auction will enter into capacity agreements, committing to provide electricity or reduce demand for electricity when needed in the delivery year/s (in return for capacity payments) or face financial penalties; and
  • the costs of capacity payments will be allocated amongst electricity suppliers in the delivery year.

References in the tables below to "Sec of State" are to the Secretary of State for Energy and Climate Change. References to the "Policy Overview" are to the Electricity Market Reform Policy Overview and its Annexes released by DECC in conjunction with the Bill. Numbered items in the commentary on the Energy Bill and its predecessor draft relate to the equivalently numbered matter in the Issues column.

Capacity Market

Issue

Draft Bill

Energy Bill

Legal effect of Capacity Agreements

(i) the basis on which capacity agreements will bind the affected parties and how their terms are to be enforced by the affected parties is unclear;

(ii) lack of clarity as to who is party to a capacity agreement, and whether such agreements may be made obligatory;

(iii) uncertainty as to whether funders will be able to take adequate security over capacity agreements or benefit from step-in rights.

(i) Regulations may make provision for the purpose of providing capacity to meet consumer demand, including by "capacity agreements". Capacity agreements are "instruments" by virtue of which a "capacity provider" may be obliged to provide capacity, and capacity providers and electricity suppliers may be obliged to make payments. This general description is subject to any further provision made by Regulations issued in respect of capacity agreements. Regulations may make provision for enforcement of a capacity agreement including by a person or body who is to administer the settlement of capacity payments or capacity incentive (although there is no specific provision for the terms to be enforced as if it were a private contract between the parties).

(ii) The identity of capacity providers is not defined, but Regulations may make provision as to the conditions that must be satisfied by a person in order to enter a capacity auction or become a capacity provider. The term "electricity suppliers" is to be defined by Regulations. The draft Bill does not refer to the "parties" to a capacity agreement.

Specific provision is made for Regulations to require payments to be made by electricity suppliers or capacity providers to a settlement body. Other than that there are no significant changes. Capacity agreements appear to be instruments created pursuant to Statute rather than private contracts.

(ii) & (iii) It remains unclear if there will be a counterparty to a capacity agreement which can be required or empowered to enter into a direct agreement with funders.

The Policy Overview envisages the settlement body making within day back-to-back payments between suppliers and capacity providers.

Issue of Capacity Agreements

(i) excessive State intervention in electricity market;

(ii) conflict of interest between National Grid's role as transmission system owner/operator and operator of the capacity auction.

Regulations may provide for capacity agreements to be issued by the SO (National Grid or a replacement body determined by the Sec of State) and provide for rules regarding competitive tendering for capacity agreements ("capacity auctions") although other ways of issuing capacity agreements (including by the SO or Sec of State) are not precluded. Regulations may provide for the manner in which the Sec of State may exercise his functions in relation to capacity agreements. There is no specific provision requiring the SO to issue capacity agreements in accordance with its (to be amended) licence conditions.

The possibility of compulsory imposition of capacity agreements on capacity providers with administratively set prices is not excluded.

No significant change, save that that specific provision is made for regulations to provide for:

(i) appeals to be made in relation to the outcome of capacity auctions and for the SO;

(ii) imposition of functions on the SO (including with respect to enforcement).

(ii) Separate Briefing Note on institutional reform to follow.

Timing of Capacity Agreement Awards and Awards

(i) Uncertainty as to whether capacity auctions will be introduced, and whether a capacity provider will have a choice as to whether or not to enter a capacity agreement;

(ii) Difficulty of coordinating financial close with capacity agreement award for new plant.

The process for awarding capacity agreements process is to be defined by Regulations and any auction Rules prepared pursuant thereto by the SO.

No significant change.

The Policy Overview indicates that Government is retaining discretion on whether and when to run the auction, and when the first delivery year will be, but that it is minded to run the main auctions 4 years in advance of the delivery date, with the first auction to be held in 2014, for delivery of capacity in the year beginning in the winter of 2018/19. It also indicates that secondary auctions are likely a year ahead of the delivery date in order to fine tune the capacity requirements and to accommodate DSR.

Eligibility

Lack of clarity as to: (i) qualification criteria for capacity auctions;

(ii) interaction with Feed-in Tariff Contracts for Differences (CFDs) and investment instruments.

(i) Eligibility criteria may be defined by Regulations.

(i) No significant change, save that specific provision is made for regulations to provide for appeals in relation to decisions as to eligibility for capacity auctions. The Policy Overview indicates that both new and existing capacity will be eligible to participate in capacity auctions.

(ii) The Policy Overview indicates that Government is minded that any plant awarded a CFD with an administratively set strike price will not be eligible to participate in the Capacity Market. The position will be reviewed for CFDs with competitively set strike prices. The Policy Overview is silent on the interaction with investment instruments and uncertain with respect to plant funded under the Renewables Obligation.

Capacity Agreement Terms

(i) nature of service to be provided under a capacity agreement, treatment of maintenance outages etc.;

(ii) duration;

(iii) dispute resolution;

(iv) impact of change of law;

(v) allocation of payment obligations amongst suppliers;

(vi) nature and effect of Force Majeure;

(vii) risk of the retrospective imposition of terms

"Providing capacity" is defined as providing, or reducing demand for, electricity, phrases which themselves may be defined by Regulations.

Regulations may make such provision as the Sec of State considers necessary or desirable as to such terms which may or must be included in capacity agreements including:

(i) the circumstances in which capacity must be available;

(ii) duration);

(iii) dispute resolution;

(v) calculation of payments due and obligations of new licensed suppliers and persons who cease to hold supply licences.

No significant change, save that:

(v) Specific provision is made for Regulations to require for payments to be made by electricity suppliers to a settlement body.

The Policy Overview indicates that:

(i) capacity providers will be obliged to deliver energy or reduce demand whenever needed to ensure security of supply; specific terms will be developed for DSR and storage providers;

(ii) most existing plants will only have access to annual agreements, whereas new plants (and existing plants in need of a certain level of capacity payment, e.g. for refurbishment) will be able to choose the most appropriate length of agreement for them (between 1 and 10 years), before the start of the auction. Plant whose construction commenced before the first auction but after May 2012 will have the option of being treated as new plant, if a distinction between new and existing plants is to be made.

(v) the basis of apportioning costs to suppliers will be based on their market share, possibly taking account of:

  • peak demand - estimated, future or historical;
  • half hourly demand or annual demand; or
  • number of customers and customer profiles.

(vii) changes to Capacity Market rules contained in codes or licences will be controlled by a formal governance process; it argues that some of the key terms of longer term capacity agreements (e.g. price) can be given protection by limiting retrospective changes to rules.

Pricing

Uncertainty as to:

(i) how the price to be paid to capacity providers will be set and by whom;

(ii) treatment of utilisation prices or BM Bid Offer Pairs for actual production/demand reduction;

(iii) whether price indexation prices will be permitted and whether generators with different fuels will be allowed different indexation methodologies.

(i) Prices may be set competitively but administrative price-setting is not precluded.

(iii) Indexation of prices not specifically mentioned.

No change.

The Policy Overview indicates that:

(i) Government is undecided whether prices for capacity agreements awarded through the auction process will be set as bid or at the clearing price, but prices are likely to be set on the same basis for both new and existing capacity;

(ii) capacity providers will be obliged to deliver energy at times of system stress, with no option to make themselves available at a given price in the Balancing Mechanism as an alterative to actual production/demand reduction;

(iii) price indexation may apply (but not which index will be used).

Breach

Uncertainty as to:

(i) the level of penalties that will be imposed on capacity providers in the event of default, and concern as to the risk of exposure to balancing charges as well as financial penalties; risk of changes in the level of penalties after the award of a capacity agreement;

(ii) whether generators will be required to provide security in respect of possible penalties;

(iii) whether generators will be able to manage their exposure in the event of project delays in building new capacity;

(iv) whether secondary trading of capacity providers' obligations is a viable option given that the capacity market will only be introduced if there is a capacity shortfall.

(i) Regulations may include provisions for the imposition of penalties for default;

(iii) & (iv) Regulations may permit secondary trading of capacity agreements.

No change, but see comments on enforcement below.

(ii) Regulations may require capacity providers to provide collateral.

The Policy Overview:

(iv) recognises that parties will wish to engage in trading and hedging to manage their exposure to risk, indicating that further work will be undertaken to see if this can be facilitated.

(i) & (iii) indicates that further work is being undertaken on penalties, including proposals for the capping of liabilities, and the possibility of capacity profiling (especially for DSR and storage) and inclusion of maintenance windows.

Enforcement

Regulations may make provision for enforcement and dispute resolution by any person (including Ofgem), including:

  • powers to impose financial penalties;
  • by arbitration;
  • appeals.

Regulations may provide for capacity provision obligations to be enforceable by Ofgem under the Electricity Act through enforcement orders, which, in the event of noncompliance, could result in substantial fines, as well as civil proceedings from persons affected by the contravention.

No change save that, in addition to the enforcement measures included in the draft Bill, Regulations regarding the enforcement of capacity provision obligations may also result in Ofgem being empowered to make consumer redress orders (without going through the enforcement order process), including to compel capacity providers who are in breach of their agreements to pay fines and/or pay compensation to customers in total of up to 10% of turnover.

Ofgem

Scope of powers.

Regulations may, in addition to making specific provisions with respect to enforcement etc. make provision conferring functions on Ofgem for any purpose related to capacity provision.

No significant change.

Other Requirements

Uncertainty as to the nature of scope of "other requirements" which may be imposed in addition to capacity agreements.

Regulations may impose requirements otherwise than by means of a capacity agreement upon any other person carrying out functions in relation to a capacity agreement, as well as (more generally) Electricity Act licence holders and capacity providers. Such other requirements may in particular relate to:

  • the manner in which functions are to be exercised;
  • restrictions on the use of generating plant; participation in a capacity auction;
  • the inspection of plant or property.

A slight change in wording, but the explanatory note to the Bill indicates that the list of "other requirements" that may be imposed by Regulations is non-exhaustive, so it appears that the Bill gives the Sec of State very wide power to make Regulations for purpose of providing capacity to meet consumer demand.

Control of Cost and Contracted Volumes

Uncertainties as to:

(i) the level of capacity that will be contracted;

(ii) the level of costs that suppliers and hence consumers will be exposed to;

(iii) interaction with Climate Change Act emissions targets;

(iv) interaction with the Treasury's levy control framework.

(i) to (iii) The Secretary of State is placed under a duty to have regard to the 5 yearly emissions budgets and the 2050 emissions target under the Climate Change Act, the 2020 target under the Renewable Energy Directive, as well as costs and the security of supply considerations.

The circumstances in which a capacity auction may or must be held and the amount of capacity to be contracted will be established by Regulations, which may provide for the Sec of State or Ofgem (but not the SO or any other person) to decide on the level of capacity to be contracted.

(i) & (ii) The Policy Overview indicates that the decision on how much capacity to contract for will be taken by Ministers, probably by reference to a reliability standard for the system, taking into account the anticipated cost of meeting the standard.

(iv) The National Infrastructure Update released with the Chancellor's Autumn Statement indicates that the announced Levy Control Framework cap (of up to £7.6 billion p.a. – at 2012 values – in 2020/21) applies purely to support for low carbon electricity investment. It remains to be seen if and how the Levy Control Framework, which was originally expressed as applying to "all DECC's existing or new policies which entail levy-funded spending", will impact on the Capacity Market.

Credit Risk

(i) Uncertainty as to credit-worthiness of suppliers and/or a single body counterparty (if that option is chosen);

(ii) Uncertainty as to management of credit risk presented by capacity providers if required to pay penalties.

Credit risk could possibly be addressed by Regulations.

Regulations may make provision for payments to be made by electricity suppliers or capacity providers to the settlement body for the purpose of enabling it:

  • to meet its costs;
  • to hold sums in reserve;
  • to cover losses in the case of insolvency or default of an electricity supplier or capacity provider.

Regulations may also make provision to require electricity suppliers or capacity providers to provide collateral. However, the protection afforded to the settlement body is not as comprehensive as that afforded to the CFD counterparty – see previous Briefing Note, Energy Bill – Low Carbon Generation.

State aid

Need for State aid approval from EC?

State aid is not mentioned in the draft Bill.

The DECC Policy Overview indicates that DECC is considering how the Capacity Market interacts with State Aid rules, and will engage closely with the Commission to ensure compliance.

EU Energy Market Law

There are a number of questions as to the compatibility of the Capacity Market with existing EU legislation such as the Internal Electricity Market Directive and the Security of Electricity Supply Directive, as well as legislation and EU network codes being developed under the Third Legislative Package for electricity.

The functions of Ofgem and the Secretary of State with respect to the Capacity Market will be governed by the principal duty and general objectives under sections 3A to 3D of the Electricity Act 1989 but, curiously, not section 3E, which requires Ofgem to carry out its Electricity Act functions in the manner it considers is best calculated to implement, or to ensure compliance with, any binding decision of ACER or the European Commission under the Third Legislative Package.

The DECC Policy Overview indicates that the treatment of interconnected capacity is as yet undecided, but at the very least the contribution of interconnected capacity will be deducted from the amount of capacity to be procured in order to meet the chosen reliability standard. DECC will "look to ensure that arrangements are consistent with the development of the EU single market for energy and the implementation of the Target Model" (i.e. market coupling and a European framework for grid capacity allocation and congestion management).

Comment

Work on the Capacity Market appears to be considerably less advanced than work on CFDs, with the result that the provisions of the Energy Bill are much more widely drawn than the comparable provisions for CFDs. In contrast to CFDs, it appears that capacity agreements will be instruments created pursuant to powers under Statute and secondary legislation rather than standard contract arrangements, which could prove an obstacle to raising funds for development of new capacity – the entire raison d'etre for the new regime.

The involvement of the Secretary of State in determining the level of capacity to be contracted (even if he does not take direct responsibility for awarding the agreements himself, but delegates that function as well as payments functions to the SO and a settlement body respectively) could have a significant bearing on whether the proposed arrangements will require State aid approval. No less significant are the requirements of the Security of Electricity Supply Directive, and the framework currently being developed under the Internal Electricity Market Directive. Consequently, the European's consultation Generation Adequacy, Capacity Mechanisms and the Internal Market in Electricity warrants close attention. The Commission proposes that common criteria should be used for ensuring that capacity mechanisms comply with the requirements of both energy policy and competition policy. The Commission's initial proposals for such criteria are as follows:

  • The capacity mechanism should be clearly necessary having taken into account:
  • the potential for security of supply to be secured through the normal operation of the internal energy market, in particular:
    • increased interconnection and, in particular, the completion of identified projects of common interest (e.g. interconnectors and offshore grids);
    • steps to encourage effective competition by addressing the position of dominant undertakings
  • less distortionary measures which could be taken, such as steps to improve energy efficiency and increase participation of DSR;
  • the counterfactual of what would occur under normal market rules;
  • The capacity mechanism's duration should be clearly limited and clearly specified, and:
  • its impact on the market should not make it difficult to disapply the mechanism in the future;
  • its retention should be subject to review;
  • The capacity mechanism should be open to undertakings operating in other Member States, to the extent they are able to provide electricity to the relevant market;
  • It should not act as a barrier to cross border trade or competition in the internal market by:
  • artificially altering trade flows or the location of production, in particular by:
    • restricting the ability of generators in the relevant Member State to export electricity;
    • distorting their behaviour in the day ahead and intraday markets;
    • distorting investment signals in the internal market leading to the inefficient locational choices for generation;
  • distorting market signals or foreclosing the market, for example so as to:

    • diminish incentives for consumers or generators to respond to high prices at periods of scarce capacity;
    • undermine incentives for the deployment of new techniques for demand reduction or electricity storage and generation;
  • creating market power or exclusionary practices, for example by:
    • strengthening or maintaining the market power of incumbent generators;
    • maintaining inefficient market structures or undertakings, so as to deter new market entrants;
  • It should be non-discriminatory and should:
  • be conducted through a competitive bidding process;
  • allow demand response and energy efficiency solutions to compete on an equal basis to generation;
  • be technology neutral insofar as it is directed towards security of supply concerns;
  • It should be the least cost solution:
  • costs imposed on suppliers or others must be kept to the minimum necessary;
  • capacity providers must not be overcompensated;
  • the award process should be conducted in a transparent, open and non-discriminatory, market based manner;
  • the duration of payments should be clearly justified;
  • Associated costs should be allocated to security of supply beneficiaries with different classes of consumers being treated in a non-discriminatory way.

Simples!

7 February 2013 is the deadline for responses to the Commission's consultation.

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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