Security of Supply and the Capacity Market

Amber Rudd Excerpts

Tuesday 1st March 2016 Written Statements

[The Secretary of State for Energy and Climate Change (Amber Rudd)]

I wish to set out the Government’s intention for reforms to the way we secure electricity capacity for future years, to ensure a secure, affordable supply in the short and longer terms. In laying this statement before Parliament, I am also setting out the Government’s policy intent to makes changes to our policy on the capacity market and the corresponding Electricity Capacity Regulations 2014 and the Capacity Market (Amendment) Rules 2014.

Security of supply—the context

Delivering energy security is the number one priority for DECC. Maintaining the secure electricity supplies that hard-working families and businesses across the country can rely on is our key objective. We face a legacy of years of underinvestment which has left us more open to the risk of any quickening in the pace of plant closures. To address this we need to start building new capacity now, especially gas, to guarantee our energy security in the 2020s.

At the same time, the huge movement in global commodities prices during 2015 has lowered consumers’ energy costs but has made generating power unprofitable for most non-renewable plant. Thermal generators are experiencing lower utilisation levels as a result of increasing renewable capacity and coal plant, in particular, are facing large losses. In consequence, we have seen several closures announced and other plant may be at risk. We therefore need decisive action now to ensure energy security.

Our principal existing security of supply tool is the capacity market (CM). Two CM auctions have now been held, for delivery in 2018-19 and 2019-20 respectively. While, given the target levels that were set, the auctions procured relatively little new capacity, both auctions went smoothly and secured capacity at very low prices for consumers.

Capacity market review

As a result we have been reviewing the CM mechanism to ensure it remains fit for the purpose of bringing forward the new capacity we need, particularly gas plant, as older plant such as coal come off the system.

The clear message from industry and investors that we have heard as part of the review is that the mechanism retains their confidence; is the best available approach to our long-term security of supply; and that regulatory stability is of crucial importance. At the same time, we have heard clear concerns that we must do more to protect against delivery risks; that we need to tighten the incentives on those with agreements to honour those agreements; and ensure that the full range of delivery risks are accounted for in our procurement decisions; and that we must avoid the risk of under-buying, or buying too late—which would mean that new plant had insufficient incentive to come forward. The overarching message has been that the volume of capacity procured needs to rise and the clearing price needs to increase as a result in order to provide the appropriate incentives for the market to bring forward new gas capacity.

We have reflected on these messages, and agree with them. We are therefore now proposing a plan of reform for the CM in three important respects:

Buying more capacity, and buying it earlier. We will expect the next CM “T-4” auction in December 2016 to buy materially more capacity than might otherwise have been the case;

Tightening delivery incentives on those who have agreements to deliver against them and to penalise those who renege more severely;

Tackling how wholesale prices impact in the short term on energy security, holding a new auction to bring forward the first CM delivery year to 2017-18. We propose to hold a new one-year ahead auction this coming winter for delivery in winter 2017-18.

Buying more capacity, and buying it earlier

We need to buy more capacity, and buy it earlier, in order to manage the increased risks we face in the next decade as we transition away from coal and as older plant close. The precise target for the next (December 2016) four-year ahead CM auction will not be set until summer, once Government have had the chance to review detailed recommendations from National Grid. But we have been discussing with them, and with our own panel of technical experts (PTE), the range of factors which it is appropriate to take into account. It is clear from these discussions that the incorporation of a new sensitivity to reflect these increased non-delivery risks will be recommended. We would expect this as a minimum to lead to an increase in the target volume of around 1GW, and we will be seeking expert advice on whether it should be higher. We will also consider whether it is appropriate to cover for a more extreme cold winter scenario.

We are also likely to bring forward much of the target procurement to the four-year ahead auction, that we might otherwise leave until one year ahead. In previous auctions we have set aside 2.5GW for purchase at the one-year ahead “T-1” stage, but purchasing more of our estimated requirement earlier should help new plant such as gas participate to meet those requirements.

Of course, the precise target will be set in the light of all the evidence available at the time, including crucially an updated value for money analysis. There could for example be trade-offs in purchasing capacity early, which may hedge against risk and allow new resources to compete, but which brings with it some risk of over-procurement if demand subsequently shifts. Nonetheless, taken together, we would expect the next auction to purchase significantly more capacity—perhaps over 3GW more—than would otherwise have been the case. And, of course, if it becomes clear that plant which already have capacity agreements for the 2020-21 delivery year will fail to make good on their agreements, then we would expect to re-buy that capacity too from other sources.

We are confident that a healthy pipeline of robust baseload and peaking gas projects stands ready to take advantage of the opportunities we are creating, and that the revised CM will deliver the new plant we need. Consultation suggests that, provided the CM is reformed in the way described, there are few if any other barriers to these projects coming through to fruition—but the Government will continue discussions with developers and investors to ensure that no unnecessary barriers exist to bringing forward an appropriate mix of plant.

Tightening delivery incentives

It is crucial for our security of supply that, when companies take on an obligation to deliver, they then make good on that commitment. If they do not, it creates shortfalls in capacity that need to filled, putting our security of supply unacceptably at risk. It is also potentially unfair to other bidders who would have been able to secure agreements. For this reason we need a robust system of checks both on new build projects, to ensure that they are on track to deliver by the delivery year, and on existing plant to ensure that they honour their agreements. At the same time, it is important that our requirements and sanctions regime are not so punitive that legitimate projects are dissuaded from participating in the first place.

We consulted in October on a range of potential new requirements to tighten the assurance regime around new build projects. In the light of responses, we are now implementing a number of these proposals—including a ban on failed projects from participating in future auctions, increased monitoring and reporting milestones, and potential increases in credit cover for projects who cannot demonstrate sufficient progress by the 11-month stage. Taken together, and on top of the existing requirements, these should materially increase the incentives on projects to have robust delivery plans in place from an early date and, if they are to fail, encourage them to fail early, allowing more time for National Grid to seek alternative sources of supply.

However, we also heard evidence that one of our original proposals, for a system of pre-auction finance tests linked to auction bids, could act as a barrier to entry for robust independent projects. We take these concerns seriously, and are therefore not proposing to implement these proposals now as they stand. Instead, we are now inviting views on an alternative suggestion, that credit cover for all new projects should be increased at the pre-auction stage.

At the same time, we are taking the opportunity to consult on higher termination fees for existing plant who renege on agreements, to ensure that they fulfil their commitments.

Holding a new auction to bring forward the first CM delivery year to 2017-18

The reforms outlined above will mean that the CM can guarantee our security of supply now and in the future. But we also need to take decisive action in the shorter term.

National Grid has a firm plan in place to take the actions needed to maintain our margins this coming winter and the Contingency Balancing Reserve (CBR) supports them in balancing the system in light of tightening margins. But the price of securing reserves of this sort has been increasing in recent years; and it has always been recognised that a reserve, if allowed to grow too large, can cause distortion in the market.

We therefore propose to bring forward the start of the CM delivery period by a year, by holding an auction this coming winter (likely to be in January 2017) for delivery one year ahead, in winter 2017-18. This auction would purchase 100% of CM requirement for that year—in other words, while its structure and timings will be similar to the T-1 auction, it will procure our full capacity requirement, not just a top-up. This will provide assurance for the 2017-18 year and enable the CBR to be closed for that year as it is replaced by the CM. Ofgem have said that they expect the need for the CBR to disappear once the CM is in place.

This Government have promised to remove distortion and interventions from the market. We recognise that although the CBR has safeguarded our energy security, it increasingly risks doing so at the cost of distorting investment and plant closure decisions. By introducing the CM early, we allow the market to operate better earlier with less price volatility and uncertainty—a more efficient way of delivering energy security.

Diesel

Finally, we have heard a number of complaints that diesel engines have unfair advantages in the CM due to how they are treated in the main energy market. We think there may be merit in these concerns, and reasons why it could be hoped, but also expected, that diesel will play a smaller role in future.

There are concerns over the potential impact on local air quality. The CM is technology neutral, and as such any type of technology is allowed to participate provided it is otherwise in compliance with relevant legislation—so it would not be appropriate to set specific emission limits within the CM eligibility criteria. However, Government are not complacent, and plan to take swift and appropriate action to avoid any disproportionate impact on air quality from diesel engines via new environmental legislation introducing appropriate emission limit values for air pollutants for new generators, where these could significantly contribute to harmful levels of air pollutants and the exceeding of air quality limit values.

DEFRA will consult later this year on options which will include legislation that would set binding emission limit values on relevant air pollutants from diesel engines, with a view to having legislation in force no later than January 2019, and possibly sooner. These limits would apply to generators or groups of generators with a rated thermal input equal to or greater than 1 MW and less than 50 MW^[1]—irrespective of their number of hours of operation during any given year.

Small distribution-connected generators are receiving increasing revenues from “embedded benefits” which include avoided transmission network charges. Some of this is justified because they offer system benefits such as avoided network reinforcement costs. However Ofgem has previously expressed concerns that these arrangements are not fully cost reflective; and hence “embedded benefits” may over-reward distribution-connected generators such as diesel reciprocating engines. Moreover, the proportion of generation connected at distribution level is increasing and so is the impact of flows from the distribution network on the transmission network.

Ofgem is therefore concerned that these charging arrangements could be having an increasing impact on the system, including distorting investment decisions and leading to inefficient outcomes in the CM. Ofgem is therefore reviewing whether it would be in consumers’ interests to change the charging arrangements for distribution-connected generators. Ofgem will set out their conclusions and a proposed way forward on this matter, potentially including initiating changes to the charging regime, in the summer. Ofgem will need to consider carefully how and when any changes should be implemented, including whether any transitional arrangements are required, and will aim to provide clarity on their direction of travel before prequalification for the next CM auction.

Consultation

Implementation of the policy positions outlined above requires a variety of regulatory and non-regulatory action:

Some changes we are now making to our delivery assurance regime reflect the outcome of a recent consultation. The consultation also discussed a number of other incremental improvements and simplifications to the CM design. I am publishing today the Government’s full position on the outcome of that consultation exercise.

Some further changes to the delivery assurance regime and other areas and, crucially, the ability to hold the proposed additional auction for delivery in 2017-18, are discussed in a separate formal public consultation document I am publishing today.

Changes to auction parameters, including the amount to procure, do not require new regulations. Instead they will be determined as usual by the Secretary of State, in the light of expert advice, in summer, before prequalification starts for the next auction. Specific proposals for the parameters (e.g. precise volume targets) are therefore not discussed in the documents I am publishing today, but the intention to purchase more capacity, and earlier, in that auction forms an important context when considering what I am announcing today as a whole.



^[1] The existing industrial emissions directive applies to 50MW+ generation.

[HCWS560]