Clive Moffatt founded Moffatt Associates in 1988 and has over 30 years experience in international research, marketing and communications.
There is probably more uncertainty in the energy market now than there was four years ago when the Government launched its ambitious Electricity Market Reform (EMR) programme. This continued uncertainty has a lot to do with the delays in publication of essential detail, such as the proposed design of the capacity market. In addition, in recent weeks, market confidence has been further undermined because of concerns over the imminent Competition and Markets Authority (CMA) review of the energy market and by diverging political announcements on the future of UK energy policy.
At the outset of the EMR debate, the role of gas was marginalised and the original proposals were fundamentally flawed because they focused almost exclusively on creating price incentives to stimulate investment in new nuclear and intermittent wind and solar generation.
The Government has concluded that at least 26GW of new gas plant will be required by 2030 and this is probably an underestimate because it understates the likely growth in demand and overstates the impact of energy savings. The capacity market ,expected to start in December, is essential to (a) ensuring the continued operation of existing plant (b) underpinning new investment and (c) encouraging competition from independents and new entrants.
However, there is a serious risk of major delays. The political scenario summarised below is not a forecast but an illustration of what could happen to further undermine investor confidence:
By the end of June, the Climate Change Department finalises most of the important capacity market details but Ofgem fail to complete full details on governance and rule changes which its decided to hold over to after the first capacity auction.
The European Commission begins a formal “State Aid” review of the draft secondary legislation and conclude that they have grave concerns about market distortion and the combined impact on the EU internal market of the level of support being offered to EDF on Hinkley, renewables and via the capacity market.
Secondary legislation and start of the capacity market auction are therefore delayed until DG COMP has done a fuller review. The review comes back positive and the capacity auction is re-scheduled for Q1 2015 .
But by this stage there is significant disagreement within the Coalition on the future direction of energy policy with the Conservatives questioning C02 targets and the cost of subsidies for renewable generation. It is therefore decided to hold up the implementation of the Energy Act until after the General Election on 9 May 2015.
Weeks before election day, Labour agrees terms of a post-election pact with the Liberal Democrats. UKIP splits the Conservative vote, Labour form a Government and immediately announce fundamental reforms to the Energy Act, including a five year price freeze and the ownership unbundling of the “Big Six”.
All the above is of course hypothetical but any indication that we might be “going back to the drawing board” would not be a positive outcome for investors, generators or consumers. So assuming that things go according to plan, what do existing and new gas generators really want to see in place before the end of June 2014.
Existing gas plant faces a challenging time between the time of the first capacity auction and the 2018 delivery date when capacity payments start to be paid. Current relative fuel costs means that it is still cheaper to burn coal and the Government’s recent Budget decision to freeze the Carbon Support Price at £18 from 2016 until 2020 will extend the profitable life of existing coal plant for another year.
For portfolio players, this C02 freeze is less of a problem than for independent gas generators. Keeping the lights on will require existing fossil plant to be available as long as possible and with coal generation dropping to 16 per cent of total generation by 2018 and eventually (2025) to zero, the short term focus has to be on keeping existing gas generation in operation.Once the capacity market is in play (c2018) then existing plant will benefit from capacity payments based on the auction clearing price set by the cost of essential new investment .But, to encourage competitive bidding the auction has to facilitate independents and new entrants.
On this issue, there are several key commercial parameters that need to be confirmed in the next four weeks and sanctioned ultimately by Brussels:
A contract length for new plant of at least 15 years. DECC’s press announcement last week to opt for a 15 year contract term for new plant is a major step in the direction. Twenty years would be preferable because it would further enhance the ability of IPPs to raise debt and equity finance.
Furthermore, a 20 year contract (OCGT) is 18 per cent cheaper than a 15 year term which is 37 per cent cheaper than a 10 year term. Even if the capacity market policy is short-lived, longer terms reduce the level of deadweight payments to existing plant and thereby the cost to consumers of the capacity market.
DECC’s confirmation of an auction cap of at least £75/kW is also to be welcomed but given uncertainty over equipment costs, exchange rates and financing costs this may be too tight if contract length is restricted to 15 years.
Furthermore, for CCGT developers a £75/kW cap would be a financing challenge in the absence of greater market liquidity or long term off-take agreements which allows them to hedge variable market revenues.
DECC has also finally got the message that a severe penalty regime would be an absolute barrier to raising project finance. The decision last week to go with monthly caps of twice the value of monthly capacity payments is a major step in the right direction.
Regarding contract risk the decision to allow “grandfathering” on key commercial terms of the statutory capacity contract will make project financing easier. Furthermore DECC’s decision to set down clear criteria for evaluating future changes to the capacity market rules will help underpin investor confidence.
Finally, as we head towards the election what should be the future direction of UK energy policy?
As a consultant who was heavily involved in the original Electricity Pool after the industry was rightly privatised by a previous Conservative government, I conclude briefly with my advice to a subsequent Conservative Government:
(1) Focus on security of supply and affordability and place less emphasis on decarbonisation;
(2) Remove quantitative legal targets for C02 emissions and replace with “soft” targets linked to a long term gradually rising trajectory for the price of carbon as the Chancellor proposed in his 2011 Budget. However, this needs to be negotiated across the EU to avoid the UK energy sector and UK businesses more widely from becoming less competitive. This would allow all forms of generation to compete in a market with the phased removal of price guarantees and subsidies;
(3) Use revenues from the carbon tax to fund tax breaks to energy intensive users and fuel poverty payments which should be brought into the benefits system where they belong;
(4) Do not be tempted to impose a price freeze on retail energy prices. This would be counter-productive in terms of anticipatory market price rises and could undermine the competitive position of independent suppliers;
(5) Do not embark on a lengthy and costly process of unbundling the “Big Six” into separate generation and supply businesses. This would further delay new investment and could simply end up creating a group of sub-standard supply businesses and increase consumer bills;
(6) Re-instate an electricity pool type system to create a reliable spot price with transparent market trading;
(7) Leave the existing regulatory authorities in place but have a serious examination into increasing Ofgem’s powers and reach from day one. Replacing it as well as setting up a new organisation to oversee energy policy, as has been suggested in some political quarters, to sit alongside DECC and National Grid to look at long term issues will simply generate more market uncertainty.
Overall, the next Government should concentrate on creating a framework for a truly innovative and competitive market that gets the best deal for the consumer; failure to do so could lead to a revolt by an electorate who are already struggling with their energy bills.
This article is based on a speech delivered at the annual IDGTE luncheon.