Clive Moffatt, an advisor to independent generators, equipment providers and financial institutions on the implications of Electricity Market Reform, argues that we should address the shortcomings of EMR and recognise the central role of gas in delivering affordable and secure energy

 

We now have a government that says it is committed to “delivering a low-carbon economy at least cost to the consumer linked to the objective of increasing market competition”. This is easier said than done.
Whether we like or not, we now live in an “administered” energy market – in practice, one where regulatory risk is ever present. Any change in the rules affecting investment in one form of power generation has implications for the rest of the mix. Since the focus across the EU is on decarbonisation and supporting renewables, it is gas generation that has been marginalised.
For operators, investors (particularly gas to power) and consumers there is probably as much financial uncertainty surrounding energy policy now as there was when Electricity Market Reform (EMR) began in September 2010.

We now live in an “administered” energy market – in practice, one where regulatory risk is ever present.

What began as a policy focused on incentivising the decarbonisation of the electricity market has turned into a mixture of incentives and penalties that tries to combine carbon reduction with reducing costs to consumers and ensuring security of supply. Even after being elevated from climate change minister to secretary of state, Amber Rudd cannot make this “trilemma” suddenly disappear.
Adopting legally binding C02 targets across the EU means gas has been marginalised. Across the EU, 25GW of existing plant is likely to be retired in the next two years and another 100GW is at risk because of continuing demand destruction (partly due to energy efficiency measures), renewable production and cheaper coal.

Capacity operating outside the Capacity Market has a direct impact on auction clearing prices

In the UK, there is little clarity on future renewables and new nuclear generation, but this capacity operating outside the Capacity Market has a direct impact on auction clearing prices. Combined with uncertainty over the contribution of interconnection and demand-side response (DSR), it makes forecasting capacity prices beyond 2020 very difficult. The new secretary of state is on record as supporting new nuclear, but concerns are growing about the technical and economic viability of Hinkley Point C. The cost of new nuclear will be significantly greater than incentivising construction of new combined-cycle gas turbines (CCGTs) to provide cost-effective security of supply.
Significant barriers still obstruct new gas generation. The scope and terms of long-term contracts under the UK Capacity Market are under debate, in the UK (over price duration curves) and in Brussels (allowing DSR to benefit from long-term contracts). This uncertainty reduces the forecast capacity price and investor confidence.
The overhang of existing fossil fuel and the inclusion of existing nuclear capacity drove down the clearing price in the first Capacity Market auction (£19.40/MW) to significantly below the Department of Energy and Climate Change’s (Decc’s) estimate (£49/MW) of the net cost of a new-entry CCGT. The next auction in December 2015 is unlikely to clear above £25/MW, given current market dynamics.

Further regulation and rule changes could seriously undermine the ability of the Capacity Market to offer a credible and consistent market signal for new gas investment

Further regulation and rule changes could seriously undermine the ability of the Capacity Market to offer a credible and consistent market signal for new gas investment. That would jeopardise the £20 billion of new capacity that Decc says is needed before 2030.
In Brussels, the EU has still to make up its mind whether the proposed subsidy to EDF is justified and whether DSR should receive 15-year capacity contracts. And the outcome of a recently launched EU review to examine what it fears are highly divergent capacity mechanisms under consideration adds further uncertainty. Only a few weeks ago, in a bold statement of intent, the G7 group declared that there should be no fossil fuel generation after 2050. I strongly suspect that the desire to fuel economic growth, and concerns about affordability and security of supply, will water down this objective. That would require gas to be considered a low-carbon fuel.
A major overhaul of energy policy would seriously undermine investor confidence, but some new thinking and a lot more clarity are needed. It is not too late to begin to unpick regulatory incentives and penalties and place more reliance on much simpler market mechanisms to deliver affordable and secure energy.

More clarity and commitment
There are five areas where clarity and long-term commitment are required:
Price v quantity Every minister would love to be able to control both quantity and price of both carbon and generation capacity. But it is impossible to do all this at the same time without serious unintended consequences. This is the reason for the debate over the allocation, term and level of renewable subsidies, capacity payments and Carbon Price Support (CPS).
Short v long The government agrees that long-term subsidies are needed to incentivise investment in renewables and nuclear power, but tries to avoid them in the Capacity Market. As a result it has proposed to discount capacity payments, to equate them with one-year contracts for existing plant. But without long-term contracts, developers cannot raise the funding required to build new plant without raising the cost to the consumer.
Demand v supply Politicians and Decc accept that demand at peak times can be reduced (eg Ofgem estimates that potentially 4GW of demand could be withdrawn). But energy demand reacts to price and real incomes, and neither residential nor industrial customers are able and willing to cut demand significantly at times of system stress. So policymakers have underestimated how much new gas capacity is needed. Add overestimates of the contribution of renewable energy, interconnection, and new nuclear, and the impact of higher economic growth, and that “missing” gas generation is considerable.
Carbon v affordability The government has agreed long-term subsidies for low-carbon technologies. However, the budget for renewables and new nuclear post-2020 has yet to be decided. Combining the current £7.5 billion renewables allocation with new nuclear will require a much larger budget in the Levy Control Framework (LCF). Meanwhile, the overhang of existing old fossil fuel plant combined with a freeze on the CPS is inhibiting new investment in gas generation.
Volatility v security In September 2014, Michael Fallon (then energy minister) ruled out support for new gas storage, even though a consultant’s report for Decc concluded more storage would be of overall benefit. Fallon argued that the UK had ample suppliers via pipelines and liquefied natural gas (LNG), but it is in the short term (four to six weeks) where the UK is most vulnerable. More short-term flexible gas storage is required.

Policy response
What is the right response?
We should focus energy policy on security of supply and affordability, with less emphasis on decarbonisation. Decarbonisation should be addressed through a meaningful carbon price mechanism that is agreed across the EU. Revenues from a higher carbon price should be used to fund tax breaks for energy-intensive users, new technologies and those in fuel poverty.
If there is no EU-wide agreement the UK should opt for “soft” targets for UK decarbonisation, linked to a policy to reduce all subsidies to renewable and nuclear energy over the next 15 years and replace them with a steeper trajectory for the price of carbon. It should fix a range of feed-in tariffs (FITs) for specified technologies and an overall LCF budget, and let the market decide what to build. In the short term, this would help underpin the Capacity Market by accelerating the retirement of old fossil fuel plant; in the medium term it would allow all forms of generation to compete. We should reconsider the case for new nuclear and instead focus on new conventional gas generation to meet base and peak load demand. Long-term contracts for new plant should be encouraged by removing barriers – such as the Capacity Market’s price duration curves, and CO2 emissions targets that would require carbon capture and storage (CCS).

 

We should reopen the case to subsidise new fast-response gas storage to minimise gas and electricity price volatility.

We should reopen the case to subsidise new fast-response gas storage to minimise gas and electricity price volatility. The current gas security standard should be extended to embrace industrial users and power generators and Decc should evaluate the costs and benefits of introducing a public service obligation (PSO) on importers. Research by industrial users suggests that a PSO that would provide 5bcm of new storage would cost consumers just 1p per therm.
The government needs to recognise that gas is the cheapest and cleanest way of securing these collective policy goals and its role should not be marginalised in favour of less reliable and more costly options. Nor should steps be taken to increase the cost of investing in conventional gas generation (eg stricter CO2 targets). If government relied more on market mechanisms it would deliver a more equitable outcome for investors, developers and consumers.