Electricity Market Reform

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1 npower Roundtable on the Electricity Market Reform Capacity Mechanism and Contracts for Difference UK Business speaks: A call for certainty 22 April 2013

2 This report summarises and outlines key concerns and expectations of some of the UK s largest businesses, as discussed at npower s recent roundtable on the Capacity Mechanism and Contracts for Difference (CfD), which took place on 22 April As such, it has been discussed with DECC and BIS for consideration as part of their ongoing EMR design discussions.

3 Contents 1.0 Introduction Executive summary Roundtable discussion 1. Capacity Mechanism 2. Contracts for Difference 3. Electricity Market Reform Conclusion and recommendations Next steps Appendices i. About the Electricity Market Reform ii. Roundtable presentations Electricity Market Reform 1

4 2 npower Roundtable

5 1.0 Introduction Electricity Market Reform 3

6 1.0 Introduction npower is committed to giving businesses a voice on UK energy market legislation and has been at the forefront of engaging business on the Electricity Market Reform (EMR) since it was first proposed in Giving businesses a voice in the Electricity Market Reform The purpose of EMR is to reform the UK electricity market to attract the investment needed to replace the ageing energy infrastructure and meet future increases in electricity demand. To ensure that businesses have a voice in this process, npower has worked on its customers behalf to ensure their views are heard within Government and have contributed at each design stage of legislation. To date npower has: Held customer roundtables in February 2011 and October 2011 Conducted its own consultation to ensure time-poor businesses had their say during the process Presented its findings to DECC. RWE, npower s parent company, is in the unique position of sitting on all of DECC s Expert Groups for EMR, including the groups responsible for the design of Capacity Mechanism and Contracts for Difference. This provides the opportunity for npower to offer expert knowledge on EMR to customers, as well as the inside track on latest government thinking. This latest roundtable event debated the current EMR proposals under design discussion the Capacity Mechanism and Contracts for Difference (CfD). More background on these policy areas can be found in Appendix i. The roundtable followed recent npower-hosted customer events where other key pieces of legislation affecting business consumers were discussed and debated. Topics included Feed in Tariffs, the Carbon Reduction Commitment, and the Energy Intensive Industries compensation package. Following each event, a report was produced, submitted to and discussed with Government to ensure businesses had their voices heard in each consultation. Capacity Mechanism & Contracts for Difference roundtable The Capacity Mechanism and Contracts for Difference (CfD) roundtable took place on 22 April 2013 and was hosted by Wayne Mitchell, Industrial and Commercial Sales and Marketing Director at npower. Presenters were: Fergal McNamara, Head of Capacity Market Design at the Department for Energy and Climate Change (DECC), who provided an overview of the Capacity Mechanism Paul Dawson, Head of Market Design and Regulatory Affairs at RWE Supply & Trading (RWEST), who provided an overview of how the Capacity Mechanism will affect UK businesses Arjan Geveke, Assistant Director of Energy Policy at the Department for Business, Innovation & Skills (BIS), who provided an overview of electricity intensive user exemptions for CfD Mary Teuton, EMR Project Manager at RWE npower, who provided an overview of the Contracts for Difference Supplier Obligation Further details on all presentations can be found in Appendix ii. 4 npower Roundtable

7 Introduction 1.0 The roundtable was attended by 20 delegates, of which 14 were major energy users, energy consultants and key industry stakeholders: Government representatives Arjan Geveke Assistant Director of Energy Policy, Department for Business Innovation & Skills (BIS) Fergal McNamara Head of Capacity Market Design, Department for Energy and Climate Change (DECC) npower Wayne Mitchell Industrial and Commercial Sales and Marketing Director, npower Paul Dawson Head of Market Design and Regulatory Affairs, RWE Supply & Trading (RWEST) Mary Teuton EMR Project Manager, RWE npower Ian Preston Head of Direct and Technical Sales, npower Major Energy Users Senior Energy Manager Major Energy User in the Building Materials Industry Rob Williams Head of Energy Supply, BT Senior Energy Manager Retail Sector Senior Energy Manager Retail Sector Angus Berry Energy Manager, Thames Water Senior Energy Manager Major Industrial Company Simon Russell Manager UK Electricity Supplies, Tata Steel Senior Energy Manager Major Fashion Retailer Senior Energy Manager Major Car Manufacturer Peter Beveridge Energy Efficiency Manager, Scottish Water Energy consultants Bruce Toper Head of Energy Procurement, EnergyExcel Andrew Horstead Head of Commodities Research, Utilyx Industry Stakeholders Policy Advisor Leading Business Representative Karthik Suresh Operations Director, the Energy Services Partnership Electricity Market Reform 5

8 6 npower Roundtable

9 2.0 Executive Summary Electricity Market Reform 7

10 8 npower Roundtable

11 2.0 Executive summary It was clear from the roundtable that businesses are worried about the Capacity Mechanism and view the scheme as complex and unwieldy. Views on the Capacity Mechanism Businesses are calling for more clarity on how the scheme will work and how this will impact on business particularly those making long-term investment decisions. The key concerns raised in the roundtable were: Cost uncertainty and impact on budget forecasting Businesses are unclear about how the Capacity Mechanism will affect energy prices, how they can respond to the costs associated with it and how this uncertainty will affect crucial planning cycles. Lack of confidence in the aims of Capacity Mechanism and scheme longevity the effectiveness the Capacity Mechanism was hotly debated and key questions were asked about whether the scheme will be successful in generating new capacity, whether the incentives will be effective enough, how it will work alongside other energy market mechanisms and how success will be measured. Lack of understanding of how the scheme will work in general, businesses find the scheme complex to understand and need fundamental questions about how the scheme will work answered by Government. Views on Contracts for Difference (CfD) The clear message from businesses on the CfD is that they need certainty over its costs, preferring a fixed CfD cost to a variable one. Businesses also want assurances that the CfD market will be transparent. The key concerns raised in the roundtable were: Cost uncertainty Businesses at the roundtable had many questions and concerns related to the cost implications of CfD, which largely focused on the need for fixed costs, the administrative burden it would create, and a call for exemptions for energy intensive industries. Investment uncertainty Some businesses with potential to invest in new generation are uncertain as to whether to progress, without clarification of the value of CfD. There is also concern about the impact of CfD on UK competiveness in the global market and the impact this will have on parent company investment in the UK. Market transparency Businesses are calling for assurances that the CfD market will be transparent. Views on the Electricity Market Reform Ongoing uncertainty around the EMR is undermining current business investment and putting off future investment. The key concerns raised in the roundtable focussed on: UK competitiveness There is real concern about the impact of EMR on the competitiveness of UK businesses with EU counterparts and within the global marketplace. Political uncertainty Businesses are asking what is being done to secure the longevity of EMR. What is to stop future governments from changing the legislation again? Electricity Market Reform 9

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13 3.0 Roundtable Discussions Electricity Market Reform 11

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15 Roundtable discussion 3.0 One of the main areas of interest to attendees was the basis for payment and it was indicated that DECC was closely considering triad peaks as a charging methodology 3.1 Views on the Capacity Mechanism DECC Overview What is the Capacity Mechanism? Fergal McNamara from DECC discussed how the Capacity Mechanism a market-wide mechanism designed to give electricity generators financial incentives to provide adequate, reliable capacity has been created to address the security of the supply challenges facing the UK. He set out how closure of existing generation plant, coupled with tightened capacity margins, have led to a need for government intervention to incentivise the generation capacity that the UK needs over the coming decade. Fergal presented the high-level design of the Capacity Mechanism, from the Reliability Standard that will be established by Government to set the net amount of capacity which is needed to ensure security of supply, through to the auction, trading, delivery and payment stages of the market. One of the main areas of interest to attendees was the basis for payment and Fergal indicated that DECC was closely considering triad peaks as a charging methodology, which would then be recouped by suppliers. More detail on the Capacity Mechanism design can be found in Appendix ii. What are the key milestones for the legislation? Fergal explained that the design of the Capacity Mechanism is going through the House of Commons as part of the Energy Bill, before going on to the House of Lords, and is expected to achieve Royal Assent in December He also detailed how DECC has been working with industry stakeholders to try to finalise a design for a capacity market with the aim of running the first auction in 2014 for capacity delivery in Fergal also noted that the draft Delivery Plan of how the Capacity Mechanism will work will be published in July 2013, with a final version published in December of this year. Electricity Market Reform 13

16 3.0 Roundtable discussion There are concerns that the timescales are too tight to implement the Capacity Mechanism, especially with many details still yet to be decided and the consultation response not due until Spring 2014 The Supplier View Implications of the Capacity Mechanism for business Paul Dawson, Head of Market Design & Regulatory Affairs for RWE Supply & Trading (RWEST), which is part of the RWE group, went on to discuss how the Capacity Mechanism will impact the UK energy market and major energy users. He discussed how RWE has several key concerns about the impact of the mechanism, including: i. Cost to consumer - The Capacity Mechanism will come at a price, and these costs will be passed on to energy users. Its design is yet to be finalised but RWE is concerned that this additional cost will further add to the burden on UK businesses, with the cost to end-users being disproportionately high, relative to the energy security risk. The proposed Capacity Mechanism design also risks encouraging the building of new plant instead of using existing plant, given that DECC is minded to award longer term contracts to new plant, which is, again, a more expensive way to secure capacity ii. Investor confidence - There is an argument that says that having a Capacity Market actually reduces the perceived need for one. This is because a Capacity Mechanism would increase the cost and lower demand for energy at times of energy scarcity, reducing the need for the Capacity Mechanism to come into play. This could create uncertainty among investors. Additionally, while the Capacity Mechanism is aimed at supporting investor confidence, any new scheme that is introduced undermines previous ones on which investment decisions had already been made. This can create a general lack of confidence going forward. It also defers potential investment while policy decision-making is ongoing. iii. Design evolution during implementation phase - There are concerns that the timescales are too tight to successfully implement the Capacity Mechanism, especially with many details still yet to be decided and the consultation response not due until Spring As a result, if there are issues in the design, there may not be time to address them within the current timeframes. iv. European approval and integration - The Capacity Market requires State Aid approval from the EU, but the EU is concerned about individual state interventions in energy markets in case they lead to the dilution of the single internal energy market they have been working on for 10 years. The EU is therefore considering what role individual state interventions can play and how they will fit into their overarching vision. 14 npower Roundtable

17 Roundtable discussion 3.0 Paul did, however, stress that the Capacity Mechanism also offers opportunities for businesses: i. Demand side response within the Capacity Mechanism - Businesses can generate additional revenue by participating in the demand side response part of Capacity Mechanism (where consumers can bid to reduce their demand at periods of system stress). ii. Indirect demand side response - Based on the current thinking regarding the Capacity Mechanism Supplier Obligation, there may also be opportunities to reduce costs via load management (through the avoidance of costs such as triads or equivalent Capacity Mechanism costs). However, it was noted that while some of these benefits are attractive for business, RWE considers that businesses would have had access to similar benefits in the existing UK energy market. The Business View Summary It was clear from the roundtable that businesses are worried about the Capacity Mechanism and view the scheme as complex and unwieldy. The topic was hotly debated at the roundtable, with key industry stakeholders, major energy users and consultants all expressing real concerns about the scheme, questioning how it works, the lack of cost certainty associated with it, and confusion about how it sits alongside other legislation with similar aims. The key concerns raised in the roundtable were: Cost uncertainty and impact on budget forecasting Lack of confidence in the aims of Capacity Mechanism and scheme longevity Lack of understanding of how the scheme works Detailed views Cost uncertainty and impact on budget forecasting It was understood from Fergal s presentation that the impact on costs would be two-fold - initially the Capacity Mechanism is expected to reduce wholesale costs. However, it would also incur an additional charge on customer bills to pay for the scheme itself as a non-commodity charge. Businesses are unclear about how the Capacity Mechanism will affect energy prices and how they can respond to costs associated with it. The clear and passionate message from businesses at the roundtable is that any costs associated with the Capacity Mechanism need to be communicated as early as possible by Government so they can be factored into energy and business planning cycles. This point was reiterated by most at the roundtable, as the necessity for known costs is paramount in helping to build robust business cases for investment in energy efficiency - a crucial element of meeting the UK s climate change targets. It was also highlighted how this is particularly important in regulated industries such as the water sector. Electricity Market Reform 15

18 3.0 Roundtable discussion Angus Berry Energy Manager for Thames Water Senior Energy Manager Major Industrial Company Rob Williams Head of Energy Supply for BT Bruce Toper Head of Energy Procurement for EnergyExcel We work on a five year business plan cycle so having a five year window to plan for any changes is really essential to us. Will we know what the charges for the Capacity Mechanism will be in advance so we can forecast these costs or invest in ways to reduce our capacity at peak times? Quite often all these costs come too late and we re left making guesses in our business plans. There may be a reconciliation mechanism proposed for the Capacity Mechanism but some sort of cost certainty would help us with our business planning. The pace at which we re moving forward on cost certainty is what frustrates us the most. I think it s important that we have visibility of what the costs will be as early as possible so we ve got it in our planning cycle. Businesses also expressed real concern about how the additional pass-through charges associated with the Capacity Mechanism will impact on the different elements of their bill. As the wholesale price element is proportionally reduced, so is the businesses ability to manage price risk through flexible purchasing arrangements. How will these costs affect the split between the wholesale price and all the other charges? Wholesale prices are getting proportionally smaller and smaller as time goes on because of all these additional charges. 16 npower Roundtable

19 Roundtable discussion 3.0 Is there any evidence or analysis showing that the proposed Capacity Mechanism will achieve its aims of ensuring a reliable UK energy supply? Peter Beveridge Energy Efficiency Manager for Scottish Water Senior Energy Manager Major Fashion Retailer Lack of confidence in the aims of Capacity Mechanism and scheme longevity A major topic for discussion was how robust the Capacity Mechanism will be and whether it will actually be effective in achieving its aim of providing adequate, reliable capacity at times of peak demand. Businesses are keen to know if there is any evidence or analysis showing that the proposed Capacity Mechanism will achieve its aims of ensuring a reliable UK energy supply. The broad concerns surrounding the aims of the scheme fall into four main areas: i. Will it successfully generate new capacity? Businesses at the roundtable were unconvinced that the proposed Capacity Mechanism design will be successful in creating new generation sources. Many sought reassurances from Government on how the mechanism will actually create new generation, and real and lasting energy security for the UK. Is there any analysis to prove that the Capacity Mechanism will be successful in attracting generators to provide capacity to the UK? What are we going to get out of the Capacity Mechanism in terms of energy security? Will it be a service that is largely similar to what we have now? In terms of political pressure then, if you re telling me that we are going to pay more for electricity, have more likelihood of brown-outs and we re not going to get any protection from the penalty scheme, that puts a case for us to start trying to apply political pressure to scrap the whole scheme. I think if you apply that to industry-wide service sectors, generation, manufacturing, I don t see this scheme lasting. I think this will be another CRC where we will get two years into it and it will be binned by a new minister. Electricity Market Reform 17

20 3.0 Roundtable discussion ii. Are the incentives effective enough? There was also debate around whether there will be sufficient incentives and penalties within the capacity market to ensure it is effective and generators stick to their obligations to help balance the grid. Senior Energy Manager Major Fashion Retailer Senior Energy Manager Major Industrial Company Senior Energy Manager Retail Sector Simon Russell UK Electricity Supplies Manager for Tata Steel My concern is that the capacity market won t be of any worth to us as end users. For example, if I lose 50% of my revenue stream at peak selling because the power capacity has failed and the relevant generator is fined, and you give me my remuneration based on expected demand, that s not going to be equivalent to my loss of selling. So I don t see that there s an incentive there to guarantee that capacity on the power grid. So are we going to face higher payments for electricity, have a higher likelihood of brown-outs and also not have any protection from the penalty scheme? iii. Will it work alongside other energy market mechanisms? Businesses at the roundtable were confused about how the Capacity Mechanism and triads would work together. Businesses that have the ability to turn down consumption during peak triad periods can make significant financial savings in transmission charges. Presumably we can assume that the Capacity Mechanism will have a higher cost than triad charges - otherwise there s not much point in doing it because triads provide a cost effective mechanism already. So, why go through all the trouble of creating another mechanism to stop your peak demand? I can see the benefit in switching things off in peak triad periods and making savings through energy efficiency. However, I don t think we re going to see the same sort of benefit from a capacity-style market just focussing on the same periods as triads. Our sites already have massive incentives to avoid the peak periods now with balancing cost, distribution and transmission tariffs. But we would be receptive of any optional schemes to gain additional benefits. Businesses were also concerned that raising investment to support participation in the Capacity Mechanism as a small-scale generator will be difficult, as company boards no longer have confidence in the longevity of energy initiatives. STOR was cited as an example of where energy managers succeeded in raising investment. However, as the Capacity Mechanism is being introduced before the benefits of STOR have been fully realised, it will be a very difficult for businesses to sell to their boards to secure the necessary funds to support. 18 npower Roundtable

21 Roundtable discussion 3.0 iv. How will success be measured? In addition, due to the long timeframes between auctions and delivery dates it will be some time before it is clear if the schemes are successful or not. Businesses are also concerned that by the time the results are known, many auctions will already have taken place, making it difficult to build in effective scheme improvements. Senior Energy Manager Major Industrial Company Simon Russell UK Electricity Supplies Manager for Tata Steel Because capacity is provided with a delivery date that s four years in advance, it s going to be the fifth or the sixth Capacity Mechanism auction before you can tell if the process is right. So, how do you know in the second year of auctions, before any capacity has been delivered, if the system works? You won t know what the problems with the system are because delivery of the first power still won t have happened. Is there a risk that we end up in some kind of feedback loop with the Capacity Mechanism? As time goes on, could we keep reassessing our future energy capacity and keep finding an insufficient supply, so we would need to keep going for more and more capacity. Eventually this becomes the way we build all power stations in the UK and we end up chasing our tail. Electricity Market Reform 19

22 3.0 Roundtable discussion Lack of understanding of how the scheme will work It was clear that businesses have fundamental questions about how the scheme will work, with much of the debate focusing on key questions about the design of the mechanism and its impact on major energy users. Senior Energy Manager Retail Sector Bruce Toper Head of Energy Procurement Response by for EnergyExcel Fergal McNamara Head of Capacity Market Design for DECC Simon Russell UK Electricity Supplies Manager for Tata Steel For example, businesses are unsure whether participants in the capacity market are judged on a site-by-site or whole organisation basis. I m not clear on the criteria planned to be used to determine the charges on end users. Is it going to be based on peak demand and will it be like triads or will there be some other way of determining this peak demand? Will suppliers bid on volume on a plant-by-plant basis or as whole organisations? Would smaller generators be able to bid on volume or would the market be restricted to large suppliers? It would be helpful if there was more to be done for small users on a portfolio basis rather than by a plant-by-plant basis. That might be possible in subsequent years, but in the early years we are very focused on investment so it will be done on an organisation basis. Businesses are also asking for exemptions from the cost of Capacity Mechanism for intensive users. Exemptions have not currently been planned into the Capacity Mechanism design. This seems illogical as big energy intensive users are baseload users, yet the reason for the Capacity Mechanism is for intermittency cover and major energy users are not contributing to intermittent peaks in demand. So, there is a strong argument for energy intensive exemptions in the Capacity Mechanism. 20 npower Roundtable

23 Roundtable discussion 3.0 At present, npower estimates the impact of the CfD to be between 5 and 10 per MWh - so it is a very significant cost. 3.2 Views on Contracts for Difference (CfD) BIS Overview Arjan Geveke, Assistant Director of Energy Policy at the Department for Business, Innovation & Skills (BIS), provided an overview of energy intensive exemptions for CfD. He detailed how Government intends to exempt electricity intensive industries from additional costs arising from new long-term contracts for difference designed to bring on investment in low carbon power plant, such as nuclear power stations and wind farms. He went on to discuss how the scope of the exemption is currently being considered by DECC and BIS, who will run a consultation in 2013 once the proposed exemption has been further developed. The exemption will require State Aid clearance from the European Commission. More detail on CfD can be found in Appendix i & ii. The Supplier View Implications of Contracts for Difference (CfD) for business Mary Teuton, EMR Project Manager at RWE npower, discussed how the CfD will impact the UK energy market and major energy users. As the final CfD Supplier Obligation is not yet finalised, it is unclear as to how electricity suppliers intend to manage CfD. However, Mary explained how npower is committed to approaching the CfD in a very open and transparent manner. It intends to pass the costs of the CfD through to all customers equally (save for any exempted industries) and industrial and commercial customers will be able to see CfD costs as a separate line item on their bills. At present, npower estimates the impact of the CfD to be between 5 and 10/ MWh so it is a very significant cost. Once strike prices are known in July it will be possible to calculate a more accurate figure. npower also discussed how it is pushing strongly for a fixed rate CfD set by DECC, with any under / over recovery factored into the next period s rate. The key reasons for this approach are that it: Reduces costs to the consumer as it negates the need for suppliers to build in any risk premium Reduces monthly volatility of bills Provides transparency and visibility of price and volume information with early / timely publication of information, supporting budget forecasting for end users Will be the easiest to implement (and hence lowest cost) Provides a level playing field across competitors (removing any confusion when comparing suppliers). Electricity Market Reform 21

24 3.0 Roundtable discussion To ensure cost certainty - which is fundamentally important for businesses - there should be a fixed cost for CfD, not a variable one. The Business View Summary While businesses are largely supportive of the Government s broader aims to move to a low carbon future, it was again apparent during the discussions on CfD just how concerned and confused they are about ongoing policy developments. Fundamentally, businesses are unsure of the aims of the scheme and how they translate into what they are doing in their own business. The key concerns raised in the roundtable were: Cost uncertainty Investment uncertainty Market transparency Detailed Views Cost uncertainty: Businesses at the roundtable had many questions and concerns related to the cost implications of CfD, which largely focused on the following four areas: - Fixed costs are needed - Administrative costs - Exemptions needed - Impact on Power Purchase Agreements (PPAs) i. Fixed costs are needed The sentiment from the businesses attending the roundtable was clear and unanimous. To ensure cost certainty which is fundamentally important for businesses there should be a fixed cost for CfD, not a variable one. There was a feeling that Feed in Tariffs a variable rate had caused issues in 2012 in terms of interpreting the number, forecasting the budget required and the practicality of asking for additional funds from their boards to cover FiT payments, which had run into millions for some customers. Customers are therefore keen to avoid repeating this situation with CfD. Senior Energy Manager Major Car Manufacturer Senior Energy Manager Retail Sector Senior Energy Manager Major Industrial Company The complexity of the variable rate just gives us more work to do. We have lots of variable costs already, so adding to them would just make my job more difficult and most of us are looked at to provide price certainty as the main function of our roles. Businesses don t like taking risks so price certainty is key. 22 npower Roundtable

25 Roundtable discussion 3.0 ii. Administrative costs There are also real concerns that there will be heavy administration costs on business, particularly through the process of reconciling costs for CfD. Simon Russell UK Electricity Supplies Manager for Tata Steel Senior Energy Manager Major Car Manufacturer I m not sure I like this word reconciliation being used. I d much rather it was like distribution network charges so that if they under recover it goes into next year s charges and there is no reconciliation. I think reconciling costs would be difficult for cash flow forecasting and whatever mechanism you use would be very difficult to administer. iii. Exemptions needed There was also strong feeling that Government should endeavour to keep the costs down for electricity intensive industries as much as possible. The CfD exemptions were discussed and businesses attending the roundtable were concerned about which businesses will qualify for exemptions and the uncertainty over when there would be EU State Aid approval for these exemptions. In particular, there were calls for exemptions for vulnerable industries to protect UK competititveness. Senior Energy Manager Major Energy User in the Building Materials Industry While there may be potential CfD exemptions for energy intensive industries, they are subject to State Aid approval. Until this is finalised, we are still in the land of total uncertainty and unable to make any predictive planning in terms of our energy strategy. And it s how long uncertainty carries on for that is the real issue for us. Electricity Market Reform 23

npower EMR Explained Session The Energy Event 10 th & 11 th September 2013

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