Update on Electricity Market Reform: The Capacity Market

by Reed Smith

This is the last of a series of three short client alerts summarising recent developments in the UK government’s Electricity Market Reform (EMR) programme.

In the first alert, we gave an overview of the EMR programme as a whole, and in the second we looked at the mechanism for Contracts for Difference (CfDs) implementation (replacing the existing ROCs regime). The other crucial aspect of EMR is how the UK government will ensure that, in the transition to a low carbon electricity regime, there is enough electricity supply to meet demand. In this alert, we will focus on the Government’s proposals for a so-called “Capacity Market” in the UK, as well as summarising the next steps to be taken for implementation of EMR more generally.

The Capacity Mechanism

The Capacity Mechanism has, until now, been the area of the EMR package of reforms about which the least detail was known. Few details had been provided since the 2011 technical update.

The Department of Energy and Climate Change’s paper, entitled Capacity Market – Detailed Design Proposals, was released on 27 June, and provided at least some of the bare bones surrounding this proposal, although much of the flesh remains missing.

Earlier this year the head of Ofgem, the UK electricity regulator, articulated a stark vision of a Britain plunged into darkness, shorter working weeks and manufacturing shut downs as early as winter 2014 if urgent steps are not taken to address the country’s looming energy gap. This is not a theoretical warning, but a real possibility. As environmental regulations drive the shut-down of old fossil-fired plants, and new nuclear capacity remains mired in delay and arguments about the necessary level of subsidy, electricity generation capacity margins sit at their lowest levels since privatisation of the industry a generation ago.

To ensure that there is sufficient supply of electricity to meet both consumer and business demand, the Government wants to “incentivise sufficient reliable capacity”, using both the supply and demand sides of the equation to ensure that there is “a secure electricity supply even at times of peak demand”.

There are therefore two aspects to the proposed Capacity Market:

  • Increasing potential supply, by ensuring that there is sufficient “spare” capacity that is able to generate during periods of high demand when additional electricity is required. In terms of the Capacity Market, we are talking not of traditional plant margin but instead about generating capacity which is only called upon in times of potential generating shortfall.
  • Reducing demand, whether this means electricity users agreeing to limit their electricity use in periods of high demand (Demand Side Response (DSR)), or through incentivising permanent electricity demand reduction.

To increase potential supply, as well as incentivise DSR, the Government is planning to hold auctions in which companies bid either to provide an increased supply of electricity, or agree to limit their electricity use to a certain level, on short notice.

The mechanism will be technology neutral; that is, it will be open to both new and existing generation assets, as well as companies offering DSR, to bid for a “capacity agreement”, subject to a minimum capacity of 2MW. However, importantly, entities will not be able to participate if their plant already benefits from ROCs, a CfD or the small-scale FiT regime. It also appears that, at least initially, the auctions may not be open to non-UK-based generators.

The system will operate predominantly on the basis of a forecast of future capacity needs, four and a half years ahead of the relevant delivery year. The requisite amount of net capacity for such future delivery year will then be contracted through a competitive central auction four years ahead. That said, many DSR suppliers are likely to find it difficult to commit to lowering usage four years in advance; therefore, the four-year-ahead auction will be supplemented by a further “year-ahead” auction much closer to the relevant delivery year, allowing for more DSR participation, as well as enabling the Government to “fine tune” the capacity requirements to reflect any changes to anticipated demand since the four-year-ahead auction was held.

The first four-year-ahead auction is planned for the end of 2014, with the corresponding year-ahead auctions starting from 2017. Based on the currently planned auction dates, the first new capacity contracted under this mechanism would be available to cover capacity requirements over winter 2018/19.

Successful bidders will be awarded a “capacity agreement” under which they will receive a monthly capacity payment (paid by and shared between electricity suppliers) in return for committing to provide capacity when requested (whether or not they are actually ever called upon to provide such capacity). Obligated generators will pay a financial penalty if they fail to provide such capacity when demanded. Participants’ capacity delivery obligations will be triggered by defined “stress events”. The Government envisages that generators will receive a minimum four-hour warning of a capacity call. The most recent paper does not contain details as to when a draft “capacity agreement” will be published.

The Government envisages that agreements will be limited to an annual term in the case of existing plant, but that new plant will be able to secure longer term agreements up to maximum term limit (still to be confirmed, but likely to be of around 10-years’ duration). Projects whose construction commenced after May 2012 will have the option to be treated as new plant for these purposes.

Given that agreements are tendered four years in advance, it may be that by the delivery year a successful bidder is not actually able to provide the required capacity (due to delays in construction of plant, etc.). To avoid this resulting in a lack of capacity, the Government envisages that secondary trading of contracted capacity will be possible (both physical and financial) a year ahead of, and during, each delivery year. This would enable non-participant plant to take over some or all of another party’s capacity agreement, subject to certain qualificatory provisions.

The Capacity Market is a vitally important component of the UK’s future energy policy. The most likely beneficiaries of the policy are developers of new gas-fired generation plant, these having the most established technology and being quickest to build and easiest to finance. It is these proposals, when coupled with December 2012’s Gas Generation Strategy and clear Governmental support for shale gas exploration and production in the UK, that have led critics and other commentators to dub the Government’s policy a new “dash for gas”.

However, many details are yet to be resolved, and questions remain. For example, what proportion of the anticipated capacity requirement will be contracted through the four-year-ahead auction, and what proportion will be left pending the subsequent year-ahead auction? Or will the Government leave the proportion flexible, making the determination based upon how preferential it determines the actual tenders to be? The level of penalty for failure to provide committed capacity is likely to be an essential determinant of the success of the scheme, with high penalties likely to either deter potential bidders or drive up prices, whereas low penalties would be unlikely to encourage the compliance that is fundamental to the UK’s energy strategy. We await these further details.

Next steps

Much progress is expected to be made regarding EMR policy over the next few months and early next year.

  • A detailed policy proposal regarding the supplier obligation to make payments to a private, Government-owned counterparty, for payment under CfDs, will be published in Autumn 2013
  • Secondary legislation covering the eligibility criteria and other detailed implementation of the CfD is to be subject to consultation in October 2013
  • The Energy Bill is likely to be passed towards the end of 2013 or early 2014
  • Final allocation process for CfDs and final CfD terms are likely to be published by December 2013
  • Changes to the ROC regime will come into force on 1 April 2014 under the proposed Renewables Obligation Order 2014
  • Secondary legislation relating to the implementation of the Renewables Obligation Fixed Price Certificate scheme is expected to be consulted upon in Spring 2014
  • Secondary legislation relating to the implementation of CfDs is expected to come into force in July 2014; at the same time, the CfD counterparty will become operational (subject to State Aid approval)

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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