NIA - The Nuclear Industry Association - Electricity Market Reform

Electricity Market Reform

In late 2010 the Government proposed a new structure for electricity markets in the UK, described as the most radical reforms for 20 years. After consultation, detailed ideas were set out in a 2011 White Paper, Planning our electric future – a White Paper for secure, affordable and low-carbon electricity.

So – what happened 20 years ago? And why was radical reform regarded as important?

What we want from our electricity supply industry

We need four things from our energy (and electricity) systems:

secure and reliable supplies;
economically effective supplies;
environmentally acceptable supplies;
politically and socially acceptable supplies.

There are two challenges which underlie and complicate energy policy. First, it is rare to find any single policy that delivers on all of these requirements at the same time. Secondly, over time the relative importance of these four requirements can change.

In the post-war period, and especially during the 1970s and early 1980s, security of supply was the dominant worry in many countries. To take the UK as an example, the 1960s and 1970s were a period in which the reliability of energy supplies were severely threatened by the power of the coal mining unions and dependence on imports of oil and, to a lesser extent, gas (before North Sea reserves were identified). Measures to increase security of supply, for example by building a more diverse set of power plants, topped the energy agenda.

Command-and-control

In such circumstances it makes considerable sense to organise electricity supply centrally, in what is often called a ‘command-and-control’ structure. Some company or body – the Central Electricity Generating Board (CEGB) in England and Wales – is given a monopoly over generating electricity in a particular geographical area. Anyone wanting to buy electricity has to buy from this company (often through a local supply company which owns the local power wires and also enjoys monopoly powers). In return for being given ‘captive customers’, the generating company in question (which may be either state owned or privately owned) accepts a ‘duty to supply’ any customer who wants electricity. The practical effect is that these companies can invest in a range of power sources, including some which would not be economic in the short term, to make sure that the lights stay on, and can pass any extra costs on to their customers, who are not allowed to ‘shop around’ for a better deal. A government-appointed regulator is given the job of making sure that companies do not abuse their monopoly to make excess profits – usually there is a cap on such profits.

The inherent nature of electricity is an important issue. Electricity cannot be stored in significant quantities. So if we want the lights to stay on at times of peak demand – typically in the early evening in late January in Britain – then someone has to keep power stations available that might not generate for more than a few hours each year, if at all. In fact a ‘capacity margin’ (i.e. a greater amount of generating capacity over the predicted peak demand for the year in question) of about 20% is needed to make sure supplies will be maintained if demand is higher than expected (a particularly cold winter say) and/or if some power stations break down unexpectedly at times of high demand.

In a command-and-control system this is not really a problem, as the price of electricity over the year can be averaged out to make sure that the costs of keeping the lights on are met by the (captive) customers. However, the ‘duty to supply’ and the ability to pass costs through can sometimes lead to the generating company ‘gold plating’ secure supplies by creating higher capacity margins than are necessary, just to be on the safe side.

However, by the mid 1980s things were looking different. The UK had discovered a lot of gas and oil of its own and globally the countries that exported oil, known collectively as Opec, had lost much of their power. The presence of natural gas as an option also did a great deal to further reduce the power of the coal mining unions which had been severely dented by their defeat in the 1984/5 mining strike.

Liberalisation

As a result, security of supply became much less pressing and indeed looked quite stable, and the focus moved towards reducing the costs of generation. There was also a significant change in political sentiment, towards using competitive markets to deliver important services rather than the government providing them directly. As a result, ‘liberalisation’ of electricity supply systems was introduced, to a greater or lesser extent, in a wide range of countries, including the UK, Chile, New Zealand, Scandinavia, the Netherlands, Germany and several American States and Canadian provinces.

The main characteristics of liberalisation were the breaking up of the monopoly generating companies (the CEGB was divided into three competing generators, National Power, PowerGen and Nuclear Electric), splitting off the national grid (which has been owned by the CEGB) and allowing customers to buy electricity from a range of supply companies or directly from the generators. The introduction of competitive pressures generally makes companies more efficient and so reduces the costs of generation – though not necessarily the prices, which depend on a wide range of factors such as government taxation, how many competing companies are in the marketplace and how willing customers are to ‘shop around’.

Since companies were now competing for customers it was not possible to impose a duty to supply on any of them – any company given such a duty would be at great disadvantage compared to other generators. The danger arose that an insufficient capacity margin would be kept – after all it is a very expensive proposition to keep available, still more to build, plants which might only operate a few hours a year if at all. (Of course, in a pure market, if these plants do not operate, say because of a particularly mild winter with relatively low demand, they do not earn anything at all towards the cost of keeping them ready through the year.)

At first this may not be a problem. One of the reasons for liberalisation is often that the command-and-control system has built an overcapacity of generating plant, so in the early years of liberalisation there is usually enough plant on the system. In the UK this was boosted by the ‘dash for gas’ in the 1990s, whereby local power companies were encouraged to build their own gas-fired power stations, in part further to weaken the position of the coal mining unions.

But after a while capacity margins start to tighten – in the UK practically no new power stations of any description were built in the first decade of the 21st century, raising concern about what would happen when older coal and nuclear plants had to be retired through age. Furthermore, concerns grew about climate change – although mechanisms were introduced to penalise companies releasing large amounts of carbon dioxide, there was no certainty that these ‘market instruments’ would be severe enough to force power generating companies to follow a low-carbon route.

Growing concerns

By 2010, then, the government was increasingly worried about three interconnected problems.

First, there was a growing need to invest in power stations of some kind or another – something like 20 GW of capacity (a quarter of the UK total) was expected to reach the end of its life between 2010 and 2020, with another 15 GW over the following decade.

Secondly, even where plant was available it was not certain that companies would have sufficient incentive to keep enough plant available to deal with a particularly cold winter.

Thirdly, even when companies were considering building new plants, low-carbon sources such as renewables and nuclear power could look unattractive. Even if their economics would be favourable over the fifty or sixty year lifetime of the plants in question, the fact that they cost much more to build than a Combined Cycle Gas Turbine (CCGT) (though less to run) made them more risky economically. Since it would take much longer for the owner of a nuclear station or tidal barrage to get the original investment back and to start making a surplus, much more could go wrong in that time – e.g. major new discoveries of gas or coal, an entirely new technology coming along, power prices falling significantly or major changes in government policy.

Governments in the 1990s and 2000s had tried to address these challenges by giving very large subsidies to renewable forms of energy, but even so the government’s renewable target for 2010 was missed by a very wide margin (less than 7% of electricity generated by renewables that year against a target of 10%). There a real fear that insufficient new capacity would be built to cover the gap left by older plants coming to the end of their lifetimes. And what capacity was built was likely to be gas-fired, increasing Britain’s dependence of imports from Russia and the Middle East, not always the most reliable areas of the world.

Electricity Market Reform

The reforms to the market outlined in the 2011 White Paper are intended to address these challenges. They aim to create more long-term confidence that investment in new power stations, especially low-carbon sources like nuclear power and renewables, will lead to acceptable levels of profit for investors prepared to commit the necessary huge sums for long periods of time.

The main measures are:

a way of guaranteeing companies investing in low carbon electricity sources a predictable price for their power output (‘feed-in tariffs with contract for difference’);
a guaranteed minimum financial penalty for companies releasing greenhouse gases, mainly carbon dioxide, into the atmosphere, with the likely effect on climate change (‘carbon price floor’);
a maximum amount of carbon dioxide that could be released from a new power station per unit of electricity produced (‘emissions performance standard);
rewards for companies which have capacity available at times of high demand even if that capacity is not called on to generate and so makes money from selling the output (‘capacity mechanism’);
measures to make it easier for companies to enter the electricity supply field, so making it more competitive (‘market liquidity measures’).

More details are given below.

Feed-in tariffs with contract for difference (FiT CfDs)

The White Paper suggests replacing the current scheme of subsidy for renewables – the Renewables Obligation (RO) – with long-term contracts in the form of FiT CfDs. FiT CfDs will offer price support for all low carbon generation, including nuclear, with the expectation that they will provide clear and stable revenue streams attractive to investors.

The FiT CfDs will be ‘two-way’ – if market prices are lower than the ‘reference’ or ‘strike’ price then low-carbon generators will get an extra payment, but if the market prices become higher the low-carbon generators will have to pay some back. In effect this offers investors the comfort of a more or less fixed price, but at the cost of preventing them from making large profits when market prices rise significantly above that fixed price.

The carbon price floor

The White Paper contemplates the introduction of a carbon price floor for the emission of carbon (as was trailed in the 2011 Budget) with a floor price that will come into effect from 1 April 2013. It was announced that the Carbon Price Floor will begin at around £15.70 per tonne of carbon dioxide in 2013, rising to £30.00 per tonne carbon dioxide in 2020 and to £70.00 per tonne in 2030.

The proposed carbon price floor will impose a cost on the emission of greenhouse gases to give greater long term certainty to the penalty for running polluting plants. The rationale is to encourage investment in low carbon generation by acting as a disincentive for electricity generators to use relatively more polluting coal, gas and oil fired stations.

Emissions Performance Standard (EPS)

The Emissions Performance Standard is to be set at an annual limit equivalent to 450g of carbon dioxide per kWh generated for new power stations. This will provide a clear signal of the amount of carbon that new fossil-fuel power stations will be allowed to emit. The EPS is targeted at coal-fired power stations (CCGT in general already meets this standard) to reinforce the existing requirement that no new coal-fired power stations can be built without carbon capture and storage (CCS) technology.

A capacity mechanism for generators

In order to ensure security of supply the government will introduce a new capacity mechanism for generators – essentially a financial reward for back-up power plants. Two possible options have been suggested – a targeted mechanism focused on capacity which is used in certain extreme circumstances only, or a market-wide mechanism where all providers are given incentives to offer reliable capacity.

A new institutional framework

To support these new measures the White Paper proposes a new institution (or institutions) operating at arms length from the Government to administer, amongst other elements, FiT CfDs and the capacity based mechanism. Such new institution(s) will need to be accountable, independent, credit worthy, technically expert, commercially and financially skilled and value for money. The new framework would be designed to increase investor confidence in the operation of the market by ensuring that necessary resources are available and reducing any perceived interference of the government in how the market is operating from day to day (or year to year), while making clear that the government will continue to be responsible for setting policy.

Market liquidity

The White Paper identifies a number of barriers to companies wanting to get involved in the electricity market in the

and focuses on the low level of liquidity in the electricity wholesale market. The need for liquidity is of particular importance in the context of the FiT CfDs which depend, to a large extent, on there being enough competing companies for the market to work efficiently. Ofgem (the regulator) and the government will work closely together to increase market liquidity.