10 August 2016

EMR: a review of the Contract for Difference and Capacity Market schemes

This article was written by Ian Wood, Energy & Infrastructure partner, and paralegal Robert Broom. 

Electricity Market Reform (EMR) is embodied in the Energy Act 2013 and is a UK government policy designed to (i) incentivise investment in secure, low-carbon electricity, (ii) improve the security of GB’s electrical supply, and (iii) improve affordability for consumers . 

The reforms introduced to the UK electricity market were imperative due to the coming together of a number of factors including: (i) the UK’s commitment under the Climate Change Act 2008 to reduce greenhouse gas emissions by 80% (relative to 1990 levels) by 2050, (ii) the UK’s need to replace approximately 19GW (20-25% of its power generation) by 2020 as existing power stations reach the end of their operational life, (iii) the UK’s obligation under the EU’s Renewable Energy Directive 2009/28/EC to produce 15% of its energy from renewable sources by 2020  and (iv) the phasing out of coal-fired power stations in the UK. Nearly 7 GW of coal capacity is expected to be taken offline from April 2016  and the remaining coal plants will be completely phased out by 2025 . In addition, coal fired generation without carbon capture and storage (CCS) is becoming more and more difficult as the Industrial Emissions Directive 2010/75/EC (which superseded the Large Combustion Plants Directive 2001/80/EC) takes effect.  

The Energy Act 2013 introduced a number of mechanisms, in particular: (i) Contracts for Difference (‘CFDs’), which will provide long term revenue stabilisation for new low carbon initiatives, and (ii) a Capacity Market (‘CM’), which will provide backup for intermittent and inflexible low-carbon generation sources , by awarding payments to generators in exchange for a guarantee that they will provide power to the grid when required. The CFDs will replace the Renewables Obligation (‘RO’) , the main existing support for renewable energy by 2017.   

The CFD Scheme 

The CFD is a long term (15 year (excluding nuclear)), bilateral contract between a low carbon electricity generator and the CFD counterparty, the Low Carbon Contracts Company (the ‘LCCC’), which is wholly-owned by DECC (which from July 2016 has become part of the Department for Business, Energy & Industrial Strategy). Under the terms of the CFD, (please refer to diagram 1 below) if the ‘reference price’ (i.e the price that the CFD calculates as the market price  that a generator should be able to obtain for its output) is lower than the ‘strike price’, then the generator will receive the difference from the LCCC, whereas, if the reference price is higher than the strike price awarded, the generator will be required to pay the difference to the LCCC. The CFD contract will provide stability of revenues to generators by removing their exposure to volatile wholesale electricity prices . The cap on spending for electricity policy schemes, including the RO, feed-in tariffs (‘FITs’) and CFDs is detailed in DECC’s Levy Control Framework and stands at £7.8bn for 2020-21 (in 2011-12 prices). 

Diagram One

Whilst the CFD Scheme removes a generator’s exposure to wholesale electricity prices, it does not, however, guarantee an income for the generator, as the generator will still need a route to market PPA to sell its power. The generator retains the risk of not being able to find a route to market PPA for its power at the CFD reference price. Should the CFD reference price be higher than a route to market PPA price, then the generator’s income will be less than the strike price , this is because the generator will only get paid the top up between the CFD reference price (not a lower PPA price) and the strike price.  Top-ups are funded through a charge imposed on electricity suppliers called ‘the supplier obligation levy’. Suppliers will generally pass though these charges to their customers. The CFD protects consumers by ensuring that generators make a payment to the LCCC when the price of electricity goes above the strike price . EMR Settlement Limited (please refer to diagram 3) will carry out the settlement of CFDs on behalf of the LCCC .

With consumer affordability being a key objective of EMR, one can question the recent news from the former Energy Secretary, Amber Rudd, that onshore wind is not expected to be allocated a CFD under the next round of the CFD scheme , a move that according to research commissioned by Citizens Advice would cost consumers at least GBP 500 million . According to a report by Policy Exchange, replacing 1GW of onshore wind with the equivalent amount of power from offshore wind would increase the cost to consumers by between GBP 75-90million each year . If (as expected) offshore wind takes the majority of contracts in the next auction, customers will be encouraged by the lower than anticipated strike price for this renewable technology in previous actions. For the two offshore wind projects awarded CFDs in the first auction, the agreed strike prices were GBP119.89 per MWh and GBP114.39 per MWh, much lower, than the strike prices for earlier CFDs for offshore wind projects (e.g Scottish Power’s Beartrice project and Dong Energy’s Hornsea project were agreed significantly higher at GBP 147.42 per MWh) . It will be interesting to see what parity can be met with the strike price for onshore wind (which from the first auction round, for most projects, stood at GBP 82.50 per MWh) in order to save costs for consumers. It is yet to be determined how the development of onshore wind will be impacted by the lack of subsidies such as the CFD and the RO. The RO was closed to onshore wind when the Energy Bill 2016 received Royal Assent on 12 May 2016 . It is likely that onshore wind projects will be either scrapped or put on hold as can be seen by RWE Innogy’s recent decision to delay GBP 1bn of UK onshore wind projects . 

A further issue has been the uneconomical strike prices for Solar PV, from the five successful projects in the maiden allocation round; two have since collapsed after being deemed uneconomical at strike prices of £50 per MWh . It has been calculated that in order for a solar park to be commercially viable, the strike price needs to be at least £80 per MWh and preferably over £90 per MWh . In addition, the RO for new solar PV generating capacity greater than 5MW was closed on 31 March 2015 and to solar PV generating 5MW or less, the RO was closed on 31 March 2016 . With confirmation from Amber Rudd that solar will be excluded from the next CFD allocation round, solar, which currently represents 12% of renewable electricity capacity in the UK  will have to stand on its own two feet. On a more positive side, the solar industry will undoubtedly benefit from the fact that installed costs are estimated to have fallen by around 50% in recent years . 

Capacity Market Scheme  

The aim of the CM Scheme is to encourage sufficient capacity to “prevent the lights going out” by providing backup for more intermittent and inflexible low-carbon generation sources. The EMR Delivery Body (National Grid) runs auctions one and four years ahead of the delivery year. Successful applicants receive an agreement for a specific obligation and price per MW  and are to be paid monthly payments based on the auction price, their obligation and the time of the year. The scheme is funded by way of a “capacity market supplier charge” imposed on suppliers, with such charge being based on the supplier's market share (as detailed in s 6 of the Electricity Capacity (Supplier Payment) Regulations 2014). This capacity market supplier charge will be used to meet the cost of making capacity payments to capacity providers. The capacity market settlement body is called ‘the Electricity Settlements Company’ and its key functions are to make capacity payments and to retain overall control of the CM settlement process and accountability to Parliament. EMR Settlement Limited will deliver settlement for the CM on behalf of the Electricity Settlements Company (please refer to diagram 3).  

Under the CM Scheme, payments are made to the generators (who are capacity providers) in return for guaranteed system capacity. Participants that over-deliver in times of system stress (and notify National Grid of this intent) will receive over-delivery payments, but only if other units fail to respond and are charged penalties . If capacity providers fail to provide power (please see point 2 in the chart titled ‘stress events occur’ in diagram 2), then a penalty will be imposed. Capacity providers can mitigate the risk of penalties if they are unable to meet their obligation by: (i) trading capacity obligations and (ii) volume reallocation. Capacity providers with an active capacity obligation may (subject to certain conditions) transfer that obligation to another party; the original holder will then no longer receive capacity payments and has no exposure to penalties if there is a system stress event . Following a stress event, volume reallocation allows capacity providers who have over delivered to transfer excess output of a CM provider to a separate CM provider.

A March 2016 report by the Institute for Public Policy  criticised the CM by stating that it provided a lifeline to several old coal-fired power stations, which received a total of GBP 373 million in subsidies from both auctions , thus working against decarbonisation. Furthermore, the report argued that the CM provided poor value for money in that nuclear power plants, which would have been open without subsidies, have received subsidies amounting to GBP 153 million in 2018 and GBP 136 in 2019. Furthermore the CM has been challenged by Tempus Energy, an electricity supplier, at the European Court of Justice on the basis that it favours generation over demand side response technologies. The former can bid for up to 15 year contracts whilst the latter are restricted to one year contracts; Tempus Energy argues that it should never have cleared EU state aid rules . Tempus Energy furthermore argued that the CM will result in higher energy bills and subsidies to fossil fuel generators .

Looking ahead, the  former Chancellor George Osborne has confirmed in March this year that GBP 730m will be dedicated to the next wave of CFD auctions for offshore wind and ‘other less-established technologies’ – double the amount put into the first CFD auction . It is thought that this may lead to a doubling of the UK’s offshore wind capacity with a further 10 GW in the 2020s, on top of the 10GW expected by 2020 . Therefore, it is almost certain that more budget will be allocated to higher cost renewables in the hope that these technologies will become more cost competitive with other cheaper renewable technologies. As for the CM, whilst it does have its place as an insurance policy against the possibility of future blackouts, there is a strong case that reforms will be needed to align it with decarbonisation and customer pricing objectives.

Diagram Two

Diagram Three

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