UK Electricity Market Reform update: overview

by Reed Smith
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Background

The UK government’s Electricity Market Reform (EMR) programme represents the single biggest change to this country’s electricity market in a generation.

It has very significant implications for generators, suppliers, developers and consumers of electricity from both traditional (fossil) and renewable fuel sources, as well as for those considering financing some of the estimated £110 billion worth of new generation, transmission and other assets envisaged by EMR.

The development of EMR has been underway for nearly three years. Even so, considerable uncertainty remains as to the precise scope and impact of the reforms, most of which will not be implemented before at least 2014.

Indeed, this has tended to exacerbate some of the very problems EMR is designed to address (such as falling generation capacity margins and the inadequate pace of decarbonisation). Continuing uncertainty is tending to deter new investment until greater clarity exists, in turn rendering the reforms all the more urgent.

The past month has, however, seen numerous significant and long awaited EMR developments, with more to be published over the next couple of weeks. This is the first of a series of three client alerts which will highlight some of the key points emerging from the latest guidance and consultation documents issued by the Department of Energy and Climate Change (DECC). This alert will give an overview of EMR; in forthcoming alerts we will also comment on the transition from the Renewables Obligation regime to Contracts for Difference, and on the Capacity Market.

Recap of the scope of EMR

We have previously discussed EMR when it was first announced back in 2011, both in relation to how EMR will influence future generation projects and in relation to the Capacity Market. The scope of EMR is such, and the issues so complex and intertwined, that to some degree almost all actors in the UK electricity market supply chain will be affected by it differently, depending on the mix of technology in their portfolio and other factors. One of the main complications of EMR is that it will (and is intended to) impact the broadest mix of generation types, from large-scale nuclear power plants and offshore wind farms to modest solar, biomass and waste-to-energy schemes.

EMR is a multi-faceted reform programme, but at its heart lie three broad objectives sometimes referred to as the “three Cs”:

  • Carbon (i.e., decarbonisation – facilitating low carbon electricity generation such as nuclear power, and more renewables)
  • Continuity (comprising security of supply, bridging the "electricity gap”, and the problems created by the inflexibility of nuclear power and the intermittency of renewable power sources such as wind and solar)
  • Cost (keeping the cost of electricity supply to consumers as affordable as possible)

These objectives are obviously closely interconnected (and to some extent inconsistent with each other).

Decarbonisation within the EMR

The decarbonisation aspects of EMR comprise three main mechanisms, being:

  • the implementation of an Emissions Performance Standard;
  • the introduction of the Carbon Price Floor; and, crucially
  • the phase out of the existing Renewables Obligation (“RO”) regime and transition to a replacement system of subsidies, which will apply to renewables and nuclear power alike, based on Contracts for Difference (“CfD”).

The Emissions Performance Standard will apply to all new fossil fuel-fired power plant over 50 MW in the UK. It will not cover plant already consented, but may apply where existing plant are subject to significant upgrade/life extension. It will impose an annual carbon emissions limit initially set at 450g CO2/kWh (at baseload). It will apply to individual plants, not on a portfolio basis and will in practice have the effect of preventing construction of any new coal-fired plant unless fitted with Carbon Capture and Storage; crucially, it is not expected to constrain building of new gas plant.

The Carbon Price Floor is already in force and seeks to ensure that a minimum carbon price is maintained by imposing a tax on fossil fuel (coal, gas, LPG and oil) supplied to UK generators. It is managed through amendments to the Climate Change Levy regime and applies to taxable supplies from 1 April 2013. The rate of tax is designed to achieve a trajectory rising to £30 p/tCO2 by 2020 and applies, in simple terms, by way of a top up to the expected carbon price under the EU’s Emissions Trading Scheme.

The key change, and the one which is the subject of most discussion, is the introduction of the CfD. We shall consider the key aspects of the CfD in a separate alert following publication of the draft CfD provisions, expected later this week.

Continuity within the EMR

Continuity in the energy market is of particular concern if there is to be a concerted switch away from fossil fuel generation and towards a combination of nuclear and renewables (in particular wind and solar) power. With old coal-fired power stations being decommissioned over the next few years, and new large-scale renewable developments and nuclear plants yet to be built, it is likely that capacity margins will decrease in the short term. The Government’s aim is to ensure that, before new large-scale capacity comes online, there is sufficient capacity to respond to consumer demand.

Nuclear generation provides a consistent baseload that does not have the flexibility to respond to short-term peaks and troughs in demand; solar and wind generation both depend upon external, uncontrollable factors (i.e., whether the sun shines or the wind blows) and again cannot respond to demand.

Gas generation is considered less polluting than coal, and does provide flexibility to respond to peaks and troughs of demand. That said, it may be several years before Britain can provide shale gas at sufficient levels to make a dent in demand, and in the meantime reliance upon imported gas creates an energy security risk.

The continuity objectives are to be achieved principally through:

  • facilitating development of new renewable and nuclear projects, with the addition of gas-fired generation to supplement supply when the level of renewable electricity generation drops (e.g., periods of low wind). This policy is detailed in the Renewable Energy Roadmap, which we have discussed in a previous alert; and
  • the creation of a new Capacity Market for the guaranteed delivery of excess capacity in times of system stress (to increase generation levels to meet demand), plus certain “demand side response” measures, for example high energy users temporarily switching to standby generation or otherwise reducing their usage (reduce demand to meet generation levels).

We will consider the proposed Capacity Market in further detail in a future alert.

Cost within the EMR

The cost-reduction objectives are primarily met by the replacement of top-up support (which in theory applies whatever the underlying energy sells at) with a CfD which guarantees a certain energy price, supporting the generator in times of low energy prices, but requiring the generator to pay money back where the wholesale energy price is higher than the agreed energy price – and thereby preventing a windfall for generators when electricity prices are high.

Government estimates are that CfDs will save the average household consumer £62 per year on their electricity bills for the period 2016-2030, compared to a continuation of the RO regime. The new CfD regime will be discussed further in our next alert.

Key recent developments

Key developments in June and July 2013 have related primarily to the replacement of the RO regime with the proposed new CfD regime and the design of the proposed Capacity Market. Chief among these developments have been:

Comment

Nearly everyone has a different perspective on EMR depending on their place in the market, the technology in which they are (or intend to be) most invested, or their political persuasion.

There is undoubtedly a considerable degree of confusion, within (as well as beyond) Westminster, as to how the various strands of EMR sit together, and in particular as to the apparent conflict between measures to promote renewables on the one hand (principally the RO and CfD) and the Government’s Gas Generation Strategy (the so-called “new dash for gas”) on the other.

The reality is that both renewables and gas power are needed and, in particular, that promotion of new gas fired capacity in the short to medium term is essential to maintain adequate capacity margins to “keep the lights on” as old plant retire more quickly than renewables and new nuclear come on stream.

However, just relying on new gas fired capacity, such as shale gas, will not be sufficient for the Government to achieve its decarbonisation targets. On this basis, the Government will be relying on development of new large-scale renewable developments, principally offshore wind, to power it towards its goal of reducing greenhouse gas emissions by at least 80% by 2050. For this to happen, as we have covered in a previous alert, the Government need to attract investment. Publication of the draft CfD strike prices (which will be covered in our next alert) will go some way to convincing investors that they will get sufficiently certain returns, but it is yet to be seen if this will be enough for the offshore wind sector to flourish.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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