The UK Electricity Market Reform and the Capacity Market

The UK Electricity Market Reform and the Capacity Market Neil Bush, Head Energy Economist University Paris-Dauphine Tuesday 16 th April, 2013

Overview 1 Rationale for Electricity Market Reform 2 Why have we favoured a Capacity Market? 3 Key design considerations and current positions 4 Next steps 5 Q&A 2

1 Rationale for EMR The UK electricity market faces significant challenges Fifth of plant closing by 2020 Long run electricity demand could double by 2050 Weak signals in the pure wholesale market for low carbon generation Creating right incentives for low carbon and back-up generation 3

1 Rationale for EMR EMR introduces a package of measures to provide investor certainty Carbon Price Floor (CPF) The Carbon Price Floor will provide long-term certainty about the cost of carbon in the UK electricity generation sector Contract for Difference (CfD) Feed-in Tariff with Contracts for Difference (CfD) will provide long-term revenue certainty and reduced revenue volatility Emissions Performance Standard (EPS) An Emissions Performance Standard will provide further certainty on the regulatory environment for fossil fuel plant by providing clarity on the emissions cap from new non-abated thermal plants Capacity Market (CM) Capacity market legislated for. Designed to provide investors with the certainty they need to put adequate reliable capacity in place, and protect consumers against the risk of supply shortages 4

2 Capacity Market rationale Where is increasing pressure for action on security of supply coming from? What is security of supply? Where is the pressure? Means a variety of things now Minimise expected level of unserved energy/loss of load expectation Diverse fuel mix and sourcing of supply Diverse technology mix Sufficient supply to balance supply and demand in medium/long term build Sufficient supply to balance supply and demand in real time availability and dispatch Social pressure if lights to go out Concern of massive spikes and volatility in wholesale prices and consumer bills; increasing risk of missing money problem Increasing intermittency on system (wind and solar); traditional generation playing different role Increasing retirements on system environmental regulation and coal plants; nuclear in certain countries Consumer bill concern heightened by current household/business balance sheet pressures Increasing reliance on intermittent and less flexible generation accentuates pressure 6

2 Capacity Market rationale Incentivising new build flexible generation case of CCGTs/OCGTs 1. Spark spreads 2. Licensing and permitting 3. Envisioned role in supply mix Electricity demand Capacity margins Gas price Current and future estimates Difficulty of obtaining license? Current and future requirements Where will siting be? Baseload, mid merit, peakeror back up generation? What are decarbonisation objectives? What are prospects for storage and interconnection? Key drivers 4. Cost of capital and portfolio considerations Any reasons why different from other technologies? Players in the sector State of financial sector 5. Policy and regulatory What is expected carbon price? Any emission performance standards for new build? Separate mechanism for ensuring security of supply? Revenue from balancing/ancillary service markets 6. Construction costs of playing envisioned role in supply mix What are costs of becoming more flexible/faster ramp up times? What are costs of becoming CCR? Is the necessary gas supply infrastructure (pipelines, LNG import terminals, etc.) in place? 7

2 Capacity Market rationale What are the options and why are capacity markets being favoured? A Energy only market Missing money and implicit price cap concern Arguable whether will rise to VoLL; what is the socially acceptable level? Conditions for movement to capacity markets Options B C D E Strategic reserve/generator of last resort/direct tender Procure but stay out of wholesale market; dispatch when needed at trigger point Would have to be at high level still acceptable? Slippery slope concerns Greater role for balancing markets Role will arguably increase over time with intermittents Different product real time balancing vs. incentivising new build Same pressures as energy only market on prices Demand response Ensure responsive demand side; need to aggregate customers + smart metering/price responsive consumer Useful, but takes time and still issue of missing money Increasing interconnection Social pressure on prices Growing acceptance of missing money problem from energy only market Belief not mitigated by balancing services, interconnection or demand response alone Increasing intermittency on system creating further pressure Conditions of movement to capacity market increasingly being met Allow for sharing of capacity margins across jurisdictions Economically effective idea, but does not solve missing money problem F Capacity market (either through price or volume setting) Capacity market sits alongside wholesale market Used in Ireland, Spain, PJM, ISO-NE, etc. 8

2 Capacity Market rationale If properly designed, Capacity Markets should lead to equivalent revenues to energy-only markets Equivalence of revenues: for eligible resources, overall revenue should be equivalent to revenues for selling electricity in an efficient electricity market. Capacity markets will provide the residual missing money that would exist in a perfect energy-only market. OECD quote: In the future, dispatchabletechnologies.will require that a portion of their revenues be derived from other sources than energy-only electricity markets if they are to stay in the market and provide the necessary back-up services. Capacity payments or markets with capacity obligations will play an important part in addressing this issue (OECD Nuclear Energy Agency, Nuclear Energy and Renewables ). Paymentsbetween electricity suppliers and capacityproviders: we anticipate a settlement agency will administer payments, but payments themselves will be between suppliers and capacity providers What are exitoptions? combination of allowing more responsivedemand side to develop through DSR, smart metering, etc. and cash out reform 9

3 Key design considerations in a capacity market What are the key design considerations in a capacity market? 1. Eligibility 1. Product 2. Eligibility 3. Incentives to be available What are we wanting to buy with a capacity market? Availability (able to deliver energy) at times of system stress Different from capacity providers declaring themselves available at particular times Demand side response? Imports? Low carbon? Electricity demand reduction? New vs. existing plant? Retrofitting of existing units? How do you define a system stress warning? Should it be ex ante or ex post? What should penalties be based upon? What is the appropriate relationship with VoLL? Which VoLL? Should there be a penalty cap? Should you have spot tests? Should obligation occur on plant level or portfolio level? Key design considerations 4. Procuring optimal amount and in right location What does the demand curve look like? How do you define the various points? How do you avoid overpayment? How do you incentivise capacity where needed? Is it important to take into account system constraints? 5. Length of contract and frequency of auctions How long should capacity contracts be? Should they be different for new and existing? For existing should they be different for those wanting retrofit? How long in advance should auctions be run? Should there be residual auctions? 6. Consistency with other market arrangements, secondary trading and payment Do you want to encourage secondary trading? Who holds the physical obligation? How does CM interact with wholesale market and balancing/ancillary service markets? What is the appropriate payment model? 11

3 Key design considerations in a capacity market Capacity market high level design Capacity to procure Auction Secondary trading Delivery Payment Forecast of peak demand translated into a capacity requirement Timing of first capacity auction Total MW capacity contracted from willing providers through central auction Includes DSR, storage etc. as well as generation Lead time between auction and delivery year; Arrangement to enhance role of DSR Capacity providers may hedge their risk by trading financial products in private markets Providers of capacity commit to be available when needed or face penalties in delivery year Capacity Market coexists with wholesale market Choice of penalty model balance certainty vs. effective incentives Costs of capacity shared between suppliers (probably in proportion to their market share) Choice of payment model 12

3 Key design considerations in a capacity market Capacity market development what are we legislating for in the Energy Bill? Legislating for introduction of a Capacity Market -Government minded to run first auction in 2014, for delivery of capacity in the year beginning in the winter of 2018/19. A final decision will be taken subject to evidence of need. This will be informed by updated advice from Ofgemand National Grid which will consider economic growth, recent investment decisions, the role of interconnection and energy efficiency, as well as consideration of the outcome of the review of the 4th Carbon Budget. Delivery at times of system stress: In return for a predictable revenue stream, capacity providers will be obliged to deliver energy at times of system stress (rather than simply declaring themselves available at particular times). They will be penalised if they fail to deliver energy at times of system stress. Capacityto contract to ensure new capacity is able to participate in the first capacity auction, the lead time between the auction and the delivery year will be four years 13

3 Key design considerations in a capacity market Capacity market development what are we legislating for in the Energy Bill? Eligibility low carbon plants receivingsupport through CfDs will notbe able to participate in the Capacity Market, at least whilst CfD strike prices are set administratively. If rules make any differentiation between new and existing plants, those plants built between May 2012 and the first capacity auction will have the option to be treated as new. This will ensure no disincentive to invest now. Pilot auctions if Capacity Market is implemented, the Government also intends to run pilot auctions for delivery of DSR and storage from 2015-18. Length of agreements - We expect existing capacity to have access to 1 year agreements, but longer (around 10 year availability) to new build plants and for existing plants in need of a certain level of capacity payment to enable access to longer term agreements (e.g. to undergo refurbishment). 14

5 Next steps We will be publishing more details shortly on the design of the Capacity Market Forthcoming work (May 2013) Finalising auction design More detailed eligibility rules Developing reliability standard, in conjunction with National Grid Developing capacity agreements Finalising detail of penalty model Further development of the payment model Institutional and governance arrangements 16

4 Next steps Next steps Date May 2013 July 2013 Milestone Capacity market final design proposals published Contract for Differences (CfD) final contract published July 2013 October 2013 onwards By the end of 2013 By the end of 2013 Draft Delivery Plan, including draft reliability standard and renewable CfDstrike prices, published for consultation Government consultations on secondary legislation for Energy Bill Energy Bill receives Royal Assent subject to Parliamentary time and the will of Parliament First Delivery Plan, including final reliability standard and renewable CfDstrike prices published (subject to Royal Assent) 2014 EMR delivery mechanisms up and running (subject to Royal Assent), including first CfD signed in mid-2014 and capacity auction for delivery in winter 2018/19 17