A great deal needs to be done to ensure that a workable capacity market is launched as planned later this year, argues Clive Moffatt
The EMR proposals were fundamentally flawed because they focused almost exclusively on creating price incentives to stimulate investment in nuclear and renewables. Not enough attention was paid to the critical role of gas generation in supporting regular supply (to compensate for the enforced closure of coal plant and inevitable delays in new nuclear) and meeting peak demand.
Taking nuclear and renewable generation effectively out of the market undermined the prospective return on gas generation. This revenue uncertainty has been compounded by a negative spark spread, the unwillingness of big six suppliers to commit to long term off-take agreements and the prospect of significantly lower load factors with more renewable energy on the system.
It was evident several years ago that some form of revenue underpinning for gas generation would be required given the extent of administered price intervention that had already taken place. However, it is really only in the last 12 months that the government and DECC have stopped describing the proposed new capacity market as a policy tool to be used “if required”.
The government now says that at least 26GW of new gas plant will be required by 2030 – 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 ensure the continued operation of existing plant, underpin new investment and encourage competition from independents and new entrants.
Existing gas plant faces a challenging time between the time of the first capacity auction and the 2018 date when capacity payments start to be paid. It is still cheaper to burn coal and the government’s recent decision to freeze the Carbon Price Floor at £18 from 2016 until 2020 will extend the profitable life of existing coal plant for another year. For portfolio players this CO2 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 the short term focus has to be on keeping existing gas generation in operation. In this context, the new Supplementary Balancing Reserve (SBR) to be operated by the National Grid at times of stress could have a key role in the next four years, although NG may need to commission more than the 1GW estimated for the next two winters. At least the government can now blame National Grid if the lights go out.
From 2018 existing plant will benefit from capacity payments based on the auction clearing price set by the cost of essential new investment. The auction also has to facilitate independents and new entrants.
On this issue, there are several key commercial parameters that need to be confirmed by the summer and sanctioned by Brussels.
New plant needs a contract length of at least 15 years and DECC’s decision on that timeframe is a major step in the right direction. Twenty years would be preferable because it would help independent projects raise debt and equity finance. A 20 year OCGT contract is 18 % cheaper than a 15 year term, which is 37% cheaper than a 10 year term. Even if the capacity market is short-lived, longer terms reduce the level of deadweight payments to existing plant and thereby the cost to consumers.
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. That cap will be challenging for CCGT developers, in the absence of greater market liquidity or long term off-take agreements which allow 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. Its decision to use monthly caps of twice the value of monthly capacity payments is another major step in the right direction. Now we need to know how the penalty rate and stress period will be calculated and there remains a strong case for allowing periods of planned maintenance.
The decision to allow “grandfathering” on key commercial terms of the statutory capacity contract will reduce risk and make project financing easier. I also strongly support DECC’s decision to set down clear criteria for evaluating future changes to the capacity market rules.
One key criterion should be encouraging competition in the electricity generation market. My advice would be to re-instate the electricity pool system to create a reliable spot price with market exchanges facilitating forward trading.
Clive Moffatt is an energy markets consultant
This article is taken from the May issue of New Power
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