As air quality concerns grow, should we be giving diesel generation subsidy support and tax breaks?

Janet Wood asks:  is power market support too tilted towards diesel?


The big surprise of the inaugural Capacity Market (CM) auction was the large number of small gas and diesel-fuelled plants that sought – and won – ­contracts, mostly as new-build suppliers. Each of these sites is sized at up to around 20MW, although for diesel versions most would be “farms”, made up from an array of engines sized at 1MW or so.
That mounts up: last year in total around 1.5GW of such capacity won contracts, much of it as new-build for 15-year terms.
Ronan O’Regan, director and utilities consultant at PwC, said last year “the amount of small-scale new generation was not something that was anticipated by many people. It is quite possible that you will see lots more of this capacity bidding (and some might win) in this year’s auction. While peaking capacity is likely to be needed in the future to balance out intermittent generators, there could be a point where this crowds out new CCGTs [combined cycle gas turbines].”


“The amount of small-scale new generation was not something that was anticipated
by many people”

Anthony Tricot, senior executive in energy advisory at EY, said: “We don’t know how much will come forward. Last year it injected competition into the auction. The government was worried about the jump from low-cost existing plant to high-cost new build, but that class of new build is competitive in between and it means the supply curve was not hockey-stick shaped, as Decc had thought.”
How much similar capacity could be added this year? At this stage, we know little.
But indications are that this year’s new distributed generation entry is likely to be significant. Distributed generators have ambitious expansion plans. Last year there was around 400MW of such capacity that entered the auction, and exited without a contract. And a further 1.2GW sought to prequalify for the auction, failing in many cases because of minor administrative issues. We may expect at least some of that capacity to return this year.
Distributed generation covers several types of plant.
UK Power Reserve, one company that bid successfully for CM contracts for a number of gas-fired projects in last year’s auction, has announced ambitious new plans. The company’s current portfolio of 185MW of existing gas generation plant will exceed 500MW by 2018, as a result of CM contracts won in last year’s auction. It expects to enter again this year, and its pipeline of projects “could take the company to 1GW by 2020”.
But there is growing disquiet about the number of diesel farms being supported by both the CM and a suite of tax breaks.
UK Power Reserve chief executive Tim Emrich said for investors, it was diesel farms that were seen as “the next best opportunity for significant profits and low-risk investment tax breaks in the energy industry”, and one where the risk was largely placed with UK taxpayers and not investors. As a result, he expected to see at least 1GW of diesel farms and possibly as much as 3GW participate in this year’s auction – almost as much as has been added by including interconnectors.
Think tank The Canterbury Club set out the important advantages that accrue to such projects, thanks to tax rules designed to encourage entrepreneurs. For example, the government’s Enterprise Investment Scheme (EIS) is intended to help small companies access start-up finance by offering tax relief. The Canterbury Club said the scheme offers a range of tax reliefs that include:

  • 30% relief on income tax liability;
  • Any gains free from Capital Gains Tax;
  • Any losses offset against income tax.

In the past, renewable energy projects could ­benefit from the EIS, but chancellor George Osborne announced in his 2014 budget that future renewables projects would be excluded from the scheme. Oxford Capital summed up the reason, saying: “The Treasury has expressed a general concern about the use of EIS in combination with investments which it views as low-risk.”
Nevertheless, the scheme remains in place for other distributed generation and The Canterbury Group said: “The EIS scheme reduces the start-up costs for diesel farms, which allows them to pitch a lower price in the Capacity Market and still make a profit.”
In two examples, Foresight Group, in a prospectus published in July, said it was in advanced discussions on investing in 80MW of such small diesel and gas plant.
Plutus Powergen, focusing on diesel generation fleets, told New Power it expected to have projects totalling 150MW to bid into the 2015 auction. Plutus listed CM contracts alongside triad avoidance, back-up power, and short-term operating reserve (Stor) contracts as the major revenue streams underlying its projects.


“Using the Enterprise Investment Scheme and other tax breaks, coverage can be increased to 300%, all from taxpayers”

Emrich stressed that the larger gas generators (typically around 20MW in size) installed by UK Power Reserve do not take advantage of EIS and similar tax breaks. He said that since 2009 his company had been funded by one British bank and longstanding private equity investment “that has been with us from the beginning, in the absence of any subsidy”.
Emrich said the typical capital cost of a diesel plant would be at or near the £225/kW threshold for 15-year CM contracts and can be more than recouped with a CM price as low as last year’s (around £20/kW), which will bring in £400/kW over the life of the CM’s 15-year contract. That is effectively 160% “coverage” for investors’ capital expense, without starting up the plants. But Emrich says taxpayers are funding still better returns: using the EIS and other tax breaks, coverage can be increased to 300%, “all from taxpayer funding”.
Although there is a cap on investment eligible for tax breaks – £5 million per company – setting up “special purpose vehicles” to own single diesel farms allows one investment to be split into several, regardless of common ownership, so that each special purpose vehicle comes under the cap.


“Because the diesel capacity is in small units, it does not have to meet pollution standards for carbon emissions or other pollutants”

Emrich said such projects are “double dipping” on state aid, with CM payments and tax reliefs for low-risk energy assets, subsidised by taxpayers and consumers, despite the fact that diesel plant “will not contribute to the electricity mix on a day-to-day basis”. That’s because “diesel is not an economic producer of electricity” as the fuel cost is around three times that of gas.
What is more, because the diesel capacity is in small units, it does not have to meet pollution standards for carbon emissions or other pollutants such as particulates. The engines are not subject to the EU’s Emissions Trading System, and even the EU’s new Medium Combustion Plant Directive, which places strict limits on emissions from small engines, will not apply if, as expected, the engines operate for only the equivalent of a few days in the year.
Emily Agus, senior development and environmental engineer at Ramboll, noted that the 2014 Capacity Market auction would result in an increase in carbon and other emissions. Decc’s response was that their infrequent use would mean that did not present a problem. However, that may not be the case as their share of generation grows.
Agus said as large central generation closes “the specific emissions of the ‘successful’ capacity is likely to continue to increase if smaller units are expected to run for longer hours. Would this change a view that emissions from these plants don’t count as they don’t run for long hours?” She asked: “Although we have the ‘lowest possible cost’, does this equate to the best value?”