UK: Electricity Market Reform: The Capacity Market And Contracts For Differences

In June 2014 the UK Government released its 'finalised policy positions for implementation of the electricity market reform' (EMR) programme, which it frames as the 'biggest reform to the electricity sector since its privatisation'. The reforms are designed to achieve three goals – decarbonise electricity generation; keep the lights on; and minimise the cost to consumers – and are centred on two key incentivisation mechanisms; Contracts for Differences (CFDs) and the Capacity Market mechanism. Both are underpinned by auctions in which (a) low-carbon generators compete for a CFD or; (b) generators and demand-side users compete for a retainer payment in return for meeting capacity commitments during periods of peak demand where the system comes under stress. December 2014 was the critical milestone date for the auctions, but both proved controversial. The CFD auction was postponed until February 2015 due to appeals over auction eligibility criteria, with the final results announced on 26 February 2015 to criticism from the solar PV industry in particular. The results of the Capacity Market auction were subject to heavy media criticism for a range of reasons mentioned below.

In brief, the CFDs represent the UK Government's new subsidy regime for major renewable projects and are designed to support low carbon generation by providing generators with the pricing certainty needed to invest in otherwise uncompetitive low carbon technology. Following allocation/auction rounds, CFDs will be entered into by successful generators and the government-owned Low Carbon Contracts Company Limited (LCC Co) on a longterm contractual basis (15 years). The CFDs themselves will consist of two components – a short-form contract amended to suit the dynamics of the particular generation project and a substantial set of standard terms and conditions that are incorporated into the CFD Agreement. In summary, generators will receive (or pay) the difference (Difference Payment) between a measure of the cost of investing in a particular low-carbon technology (Strike Price) and a measure of the average market price for electricity (Reference Price). Generators will receive a Difference Payment where the Reference Price is below the Strike Price, and will pay the Difference Payment where the Reference Price is above the Strike Price. Initially, the Strike Price will be set administratively by the Government with a view to moving to a competitive price discovery model over time.

In contrast to CFDs, the Capacity Market offers all generators (new and existing) and large demand-side users the opportunity to receive capacity payments in return for binding commitments to increase output or reduce consumption during system stress events commencing October 2018 (auction rounds will occur on a year-ahead basis). The regime is designed to encourage investment in reliable capacity and to offset exposure to unreliable supply sources such as wind in order to keep the lights on. Capacity payments are determined through a competitive auction process run in descending clock format starting with the Price Cap (which for the December 2014 was set at GBP 75 per kw), with offers reducing until the minimum price is reached at which supply offered by bidders is equal to the capacity required (ie, the clearing price). Successful generators and demand-side users are then offered one year capacity agreements (up to three years for refurbished plants), with new builds offered 15 year capacity agreements, all at the clearing price. The bite comes in the form of a penalty participants must pay if they fail to provide the contracted capacity or make it available during system stress events. The penalty is 1/24th of the participant's annual income from the Capacity Market. Although penalties can be significant, a participant will only be penalised if there is a system stress event when a capacity market warning is in force and the plant is not available. In summary, capacity market warnings provide at least four hours' notice to deliver, and delivery is only required where the system stress event occurs or is ongoing after this period.

Although the Government has put a positive spin on the results of the December 2014 Capacity Market auction, the results raise questions as to whether the capacity payments merely provide a windfall to prop up ageing fossil fuel plants or, in some cases, subsidise capacity that would have been delivered in any event. The Government ended up procuring 49,259 MW of capacity from 46 companies at an unexpectedly low clearing price of GBP 19.40 per KW, with the majority of contracts for capacity going to combined cycle gas turbine plants. While arguably good for consumers (who ultimately bear the cost of the program via household bills), the low clearing price meant that new builds found it difficult to compete, securing only 5% of the allocated capacity. In fact, new builds made up the largest group by capacity that failed to bid low enough to reach the clearing price. Some analysts have therefore been critical of the results, suggesting that in many cases subsidies are flowing to existing gas-fired, coal and nuclear capacity that would have continued to generate with or without the capacity payments.

The results of the CFD auction attracted less criticism, although the outcome for the solar PV industry was particularly disappointing with only five projects winning CFD contracts at particularly low strike prices, raising industry concern over the viability of the CFD scheme for small to medium project developers. The big winner of the CFD auction was wind, with 17 onshore and two large offshore wind projects winning CFD contracts. The next round of auctions is due to take place in autumn 2015, and industry is concerned to clarify the level of support around future auction rounds. In response to the auction results, Renewable UK's Chief Executive stated in a press release that "the industry has really extended itself... on the cost reduction agenda, and the Government needs to respond positively with a clear signal about future rounds and long term support, to enable the continued development of low carbon power at a good price". Implementation of the EMR programme has got off to a shaky start. Although it is too early to assess how effective the EMR mechanisms are going to be in delivering the Government's goals in the long term, it is far from clear that the EMR will deliver the investment needed in renewables.

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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Brett Hartley
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