When the European Court of Justice set aside GB’s Capacity Market (CM) in November saying it was illegal state aid, it took the industry entirely by surprise. Even those who were aware that the hearing had taken place, back in summer 2017, had expected that if the challenge were upheld, the outcome would simply be changes to the market structure. The court case did not get a mention in forward-looking industry updates – unlike other challenges such as the removal of embedded benefits, which was the subject of repeated warnings from Ofgem and National Grid.
The ECJ’s decision to set aside the Capacity Market has halted upcoming T-1 and T-4 auctions. It came just a few days before suppliers had to make a Capacity Market payment, and immediately before National Grid was due to publish its prequalification list for the upcoming auction. and put a stop on payments for the coming winter. Revenues earned in October 2018 will not be paid in December as anticipated and no further revenues will be recognised. The status of payments made in respect of previous years is not clear. Those auctions took place under so-called transitional arrangements, which have a different status under state aid rules. What does it means for the industry? That depends.
The short term
Retailers with 200,000 customers or more will not have to make Capacity Market payments – a charge per MWh supplied – this winter. Payments already made for October and November 2018 will be reimbursed. That may come as a relief to some that have seen retail margins disappear over the year. Others will be more cautious in case the payments are reinstated or Ofgem lowers tariff caps accordingly.
Vertically integrated companies have both retail customers and generation. Rating agency Moody’s assumes that for them, “the loss of capacity revenue will be offset in the short term by higher retail profit”. But it said: “By mid-2019, however, we assume that retail prices will fall to reflect these lower costs.”
Existing generators will be the hardest hit. They will lose about three months of revenue in 2018 – around £100 million – over the coming winter, according to Moody’s. If the scheme is not successfully reinstated or replaced, they will lose £1.1 billion in 2019. And with the T-4 auction planned for January now cancelled, potentially £4.3 billion of contracts over the next four years will be at risk.
The figures, published in a briefing note, illustrate why demand-side response (DSR) organisations and Tempus Energy were celebrating the ECJ’s ruling. The companies regard the payments as largely a source of revenue for old, largely fossil-fuelled, plant because DSR cannot compete in the CM auction on the same basis as generation.
The industry has a huge short-term shock to weather over the next two winters – one exacerbated by the uncertainties that surround Brexit and the sheer lack of government bandwidth. The immediate – and entirely unexpected – halt to payments, and potential repayments, means more than a change in total revenues. There are cash flow issues, especially for plants commissioned for the first time this winter that will be expected to start paying back investors. And there is huge uncertainty about the technicalities of the judgement. If plant closes, unable to make an economic case to stay on the bars without CM revenues, it may risk default payments if the CM is reinstated. CM participants are even expected to complete test runs required under CM rules on the assumption they will be needed in future. Who pays these costs?
Before the ruling, GB had entered the winter with a loss-of-load expectation well below the maximum set by government – with plentiful capacity – hence government comments that security of supply is not compromised for the winter. In practice, the situation is more complex and depends on individual plant circumstances. Some have been optimistic that coal plants, which are back in the money this year as gas prices rise, may no longer be economic, giving a boost to low-carbon generation and more flexible gas plant. Others regard that as too simplistic – and companies that have kept plant open until now on the basis of CM revenues that have disappeared are unlikely to swallow the cost without seeking recompense.
A broader issue is investor confidence. Moody’s said: “Before the court’s decision, we had regarded capacity revenue as highly predictable for generators, a credit positive”, but it is no longer clear that investors will consider it as low risk. But the risk profile of the UK Capacity Market has skyrocketed and there will be calls for government action from those who have invested on the basis of CM revenues and have to face investment committees. They will seek urgent clarification – if not compensation.
The long term
What about plants in the pipeline, including the growing fleet of gas engines? The calculation is different. CM payments are one revenue line among several and auctions have resulted in very low prices, so it is unlikely to be a main driver of the project. Developers may consider that the short-term shock will drive some older plants out of the market, reducing the margin and increasing price volatility. This may be positive for new flexible plant and drive up CM payments if the market returns.
How long will it be until the situation is resolved? The government has said it will resubmit the Capacity Market to state aid authorities. There are political implications in the re-examination. The European Commission has passed four other capacity markets in other countries since considering that of GB. Some say that makes it hard to hold up, or fail, a new version of the GB market. That may be true, but equally the Commission’s own position has been that it prefers energy-only markets and that capacity markets are a temporary measure, so it has at least equal political interest in dismissing GB’s if the re-examination has that outcome. Finally, it is not clear whether an amended scheme will be considered under assumptions at the time the first submission was made, or viewed as a new submission. That could change some terms of the EC’s investigations.
In some cases, state aid investigations have taken as little as 6-12 months. But the current permission was set aside on the grounds that the authorities had not spent enough time and effort in investigating its implications for DSR. It seems unlikely that anything less than a full investigation will be contemplated, which could take up to 20 months (as in the case of Poland).
And it will be held to account. In a blog post Tempus Energy chief executive Sara Bell said: “The ‘serious doubts’ that the Commission should have had go to the core of the discriminatory and anticompetitive design of the scheme and the lack of an appropriate assessment of the potential of demand-side response to meet our capacity needs. These factors will now have to be considered in full, with evidence formally invited from all stakeholders. This is not simply a case of rubber stamping a ‘re-approval’, as much as the government may wish otherwise.”
First published in the November 2018 issue of New Power Report