UK: Electricity Market Reform - An Introduction To The Energy Bill

The Energy Bill was published on 29 November 2012. This is one of the most-anticipated pieces of legislation in recent years. It has been promoted by the UK Government as the framework that will unlock the billions of pounds of investment needed to replace generation capacity that will disappear from the system this decade and secure a low-carbon future.

So, will the Energy Bill keep the lights on? Will it give birth to a new world of low-carbon generation in the UK? The Bill has a long way to go through Parliament, and the devil will be in the detail of the regulations spawned by the Act, but in anticipation that its central tenets will remain intact, we are publishing two short guides:

  • Feed-in Tariff with Contracts for Difference
  • Capacity Market

How will Contracts for Difference work?

The Feed-in Tariff with Contracts for Difference is a subsidy regime that is intended to de-risk generation from fluctuations in wholesale market prices. By reducing the financial risks faced by low-carbon projects, it is intended to encourage investment at least cost to the consumer.

In the context of EMR, Contracts for Difference ("CfD") will work as follows:

  • low-carbon generators with a CfD will sell their electricity into the market in the normal way, either through long-term supply contracts or through the wholesale electricity market
  • the CfD – a long-term private law contract with the CfD counterparty – will pay the generator the difference between an estimate of the market price for the electricity ("reference price") and an estimate of the long term price needed to bring forward investment ("strike price")

How will prices be set?

CfDs will only encourage long term investment decisions if the industry has confidence that prices will be set in such a way as to reduce exposure to market fluctuations to the level that it considers comfortable.

Initially, CfD strike prices –which will be CPI-indexed - will be set by the Government (as with RO subsidy levels), but in due course it is intended that it is replaced by competitive price setting.

National Grid (as the System Operator) published a call for evidence for renewables strike prices in October, and it is intended that strike prices will be issued and consulted on in DECC's draft delivery plan in July 2013 and finalised by the end of 2013.

Reference prices for variable and baseload generation will be set differently. Variable generation reference prices are likely to be based on the hourly day-ahead prices, and the Government is committing itself to ensuring that there remains sufficient liquidity in the market so that reference prices (and so, payments under CfDs) cannot be manipulated.

Further analysis requires to be conducted before the market has a clear picture on how prices are to be set for baseload generation.

Allocation of CfDs

CfDs will be allocated on a first come, first served basis.

Generators will be able to apply for a CfD at early stages in project development (e.g. wind projects will be eligible from the point at which they have secured planning permission and accepted a connection offer). This contrasts with funding under the Renewables Obligation, where the level of funding is not known until commissioning.

Each generator will specify a target date for the commencement of generation. If National Grid determines that the project is eligible and affordable within the available budget, it will require the CfD counterparty to offer a CfD to the generator.

Generators will then work to commission their project with the Target Commissioning Window (TCW) prescribed in their CfD (which will vary from one technology to another but will be set to provide developers with a degree of flexibility during the construction phase).

Once a project can generate electricity, a developer can then nominate when –within the TCW –payments under the CfD should start. Generators that commission after the end of the TCW can still claim CfDs, but the term of the CfD will be reduced to reflect the length of delay. Failure to commission by a Long-Stop Date leads to termination of the CfD.

Making payments

The generator sells electricity in the market in the normal way (through long-term contracts with suppliers or by selling through electricity markets). The generator then either receives or makes payment under the CfD, depending on whether the electricity price in the reference market is below or above the strike price. The mechanism is intended to ensure that generators receive (broadly speaking) the strike price for electricity and so can plan for reasonably certain revenue flows without benefitting from spikes in wholesale prices.

The "difference payments"under the CfD will be based on price and volume. So, for each settlement period the difference amount will be calculated as the amount that is the product of the metered output and the difference between the (index-linked) CfD strike price and the CfD reference price.

How will CfD payments be funded?

CfD payments by the CfD counterparty will be funded by a new levy on electricity suppliers, which will undoubtedly be passed on to consumers.

The counterparty's payment obligation under each contract for difference will be conditional on it having received payments from suppliers under the supplier obligation. It is therefore a "limited recourse" obligation –pay when paid - and so the covenant of the counterparty is unlikely to be a funding obstacle.

When the reference price is forecast to exceed the strike price (so potentially giving rise to a generator obligation to pay) the generator will be required to provide collateral to the CfD counterparty.

PPAs and CfDs

In publishing the Energy Bill, the UK Government acknowledges that conditions in the PPA market for smaller, independent generators will need to improve. At this stage, there are no proposals other than a commitment to "initiate work"with independent developers to ease the transition to CfDs, and a largely unsupported expectation that the introduction of CfDs will make it easier for suppliers to offer PPAs. Pronouncements thus far from DECC will offer little comfort to independent generators.

The Contract for Difference

The contract for difference will last for 10 years for carbon capture and storage and 15 years for renewables projects (the duration for nuclear is yet to be determined).

The Energy Bill is published with Heads of Terms for CfDs. The intention of Government is that contracts are standardised so far as possible, while acknowledging that there will be a need for project-by-project variations.

© MacRoberts 2013


The material contained in this article is of the nature of general comment only and does not give advice on any particular matter. Recipients should not act on the basis of the information in this e-update without taking appropriate professional advice upon their own particular circumstances.

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