Competition on capacity, CfDs and services is the energy market’s future. Excluding low-cost renewables will drive up costs

Gordon Edge of RenewableUK says a recognition of how the new energy market works presents a solution to the government’s dilemmas on Contracts for Difference

Government objectives for energy policy are that it must be secure, sustainable and affordable; decarbonisation must be delivered at minimum cost; and the government wants to be able to step away from the controlling role in the power market it has taken (through Electricity Market Reform (EMR)) by the middle of the next decade.
Like all high-level policy objectives, these are easier to say than deliver. Is it even possible to deliver all of them at the same time? Only if there is clear recognition of how the power market is changing. Clarity on this will allow the shorter-term steps that need to be taken to be identified, in a coherent vision of where we are going. But assumptions about how the electricity market works will have to be challenged.

Least-cost is legitimate

We need to be clear that solving the so-called trilemma is a completely legitimate aim. Government has rightly set out the requirement to meet objectives for security of supply and decarbonisation at least cost. Given the huge strides that wind and solar power have made in cost reduction, it is increasingly clear that meeting this requirement entails a significant and growing contribution from these technologies. The question that must be urgently addressed by the government is how to secure the appropriate cost-effective volume of these technologies, alongside the appropriate volume of other technologies to ensure system reliability. There are market solutions to this issue, but these require a recognition that the structure of the market for power is changing fundamentally and needs to be managed differently.

Onshore wind should be able to achieve Contracts for Difference (CfD) strike prices of £70-75/MWh or even  … direct competitiveness with new entrant gas cost.

There has been considerable cost reduction in both onshore and offshore wind, and further progress is anticipated. Onshore wind should be able to achieve Contracts for Difference (CfD) strike prices of £70-75/MWh or even less in future rounds, which implies a levelised cost of energy (LCOE) under £70/MWh and direct competitiveness with new entrant gas cost. The strike prices achieved by offshore wind in the first CfD allocation round show that the £100/MWh LCOE target by 2020 is close to being achieved, and research undertaken for the Offshore Wind Programme Board (see Links, below) indicates that progress is continuing in all the key areas needed to meet and exceed that target. A question remains, however, about how these low-cost supplies will be secured in the face of significant change to the power market.

Costs are falling

It was recognised by the government as far back as 2010, in the Department of Energy and Climate Change (Decc) and the Treasury’s Energy Market Assessment, that the requirement to decarbonise our power supplies led to a need to provide investment mechanisms to overcome the high-capital/low operating cost structure of many low-carbon technologies. Over the following five years, this insight was turned into the main tools of EMR: CfDs and the capacity market (CM). As time has passed, it has become clear that these tools, alongside enhanced markets for ancillary system services, will be important revenue streams for generators. The wholesale market will not alone provide the necessary income, but will be key to ensure efficient dispatch of generation.
As decarbonisation of our electricity supply is a legally binding commitment, the government envisaged an investment-enabling mechanism to support a new generation of high capital cost, low running cost schemes. This led to the creation of CfDs, which stabilise power revenues while ensuring consumers are not overpaying in the event of high power prices.
Since intervening in the market in this way ensures a high share of renewables and therefore a high proportion of our power from low marginal cost plant, it also has the effect of deflating the wholesale price. For fossil capacity, which burns fuel and thus is lower down the merit order, future output will be limited by the overall need to decarbonise, so its load factor will be low.
In addition, since much of the low-carbon power is from wind and solar capacity, whose output varies, other generators will face further uncertainty about both price and volume of output. Together, these factors make investment difficult (for example in new combined cycle gas turbine (CCGT) capacity, although the decarbonisation imperative limiting output is the dominant factor here).
In the move to a decarbonised power supply, there is therefore a complementary role for the CM to ensure security of supply. However, the more the CM drives investments, the more those investments will take place regardless of low wholesale power prices.
It is also the case that due to the technological changes in the power mix, for instance with fewer synchronous generators providing inertia, then ancillary services will become a more important part of generators’ revenue. This may further deflate the energy-only price.
Through entirely necessary long-term action by the government to promote decarbonisation, the wholesale price will become increasingly defunct as a carrier of value that can support investment alone, though it will retain an important role as an efficient dispatch signal. Furthermore, the wholesale power price currently fails to take into account the full social cost of carbon emissions. As long as the wholesale price does not reflect the full cost of emissions, it cannot create the necessary investment signal for low-carbon generation.

Three income streams

In future there will be three main income streams for power generators: energy, either through wholesale market income or a long-term contract such as a CfD using the wholesale price as the reference; capacity, through the CM; and ancillary system services, which will have a strong regulatory component but increasingly will be sourced on the open market.  Using competition to procure the required amounts of each of these three commodities, at efficient prices, the overall cost to the consumer is minimised.

In future there will be three main income streams for power generators: energy, either through wholesale market income or a long-term contract such as a CfD; capacity; and ancillary system services,

Given the factors deflating the energy-only price, plus relatively limited access to the capacity and ancillary markets, mature renewable technologies that are denied access to CfD allocation will be unable to attract investment even though they can provide power at the cheapest overall cost, and particularly so as without the revenue stabilisation benefit of the CfD they will not be able to access low-cost capital.

Mature renewable technologies that are denied access to CfD allocation will be unable to attract investment even though they can provide power at the cheapest overall cost

A key consideration in this new market environment will be to ensure that generation that is procured at the cheapest cost in one of these three markets does not increase costs in another to the extent that the consumer is a net loser. This is a live debate for the mature renewables of onshore wind and large-scale solar, which, despite their clear cost advantage in producing low-carbon MWh, are viewed by some as imposing additional system costs to the extent that this energy cost advantage is wiped out. However, this is not true for energy-based contracts that are awarded to generators at a strike price that is lower than counterfactual investment, after all costs and benefits have been accounted for. Contracts awarded under this level will deliver a net benefit to consumers.

The new normal

The Committee on Climate Change has examined this question and concluded that the appropriate counterfactual is investment in unabated CCGT plant. Its assessment is that after applying the Treasury’s own social cost of carbon, and taking into account a factor for the system costs of wind, then at a strike price of £80/MWh in 2020 onshore wind becomes a net benefit to the consumer. This accounting ensures that any rise in the overall value of the CM or ancillary service markets that might be needed to ensure system adequacy and stability as the capacity of onshore wind rises does not outweigh the benefit of cheap energy from onshore wind. Onshore wind that can be delivered under this price should not thus be constrained or excluded from the CfD, as its presence will deliver the lowest cost power that meets the needs of the energy trilemma.
With the rising social cost of carbon beyond 2020, that breakeven point rises to £90/MWh, giving rise to the prospect of offshore wind being brought down in price to meet that benchmark and thus also becoming a net benefit. But the fact remains that without the CfD to support investment in these technologies, those benefits cannot be obtained.
It should be clear from this discussion that there is no going back to some market Eden, where government sets some ground rules and then companies invest in and operate power plants on the basis of income from an energy-only wholesale price. If the government’s intention to step away from the market by 2025 is based on this idea, then it will fail to realise it. If, however, the government recognises this emerging market structure as the ‘new normal’, then it may be able to achieve its aim.
Someone will have to specify amounts to procure in the investment markets of the CfD and CM: perhaps this can be devolved to an enhanced system operator, who would be given the objective of achieving a certain carbon intensity and security of power supply and thus a need to procure energy and capacity. Over time it may even be possible for contracts for energy and capacity to be signed by commercial actors alone, but this is a way off.

Someone will have to specify amounts to procure in the investment markets of the CfD and CM: perhaps this can be devolved to an enhanced system operator, who would be given the objective of achieving a certain carbon intensity and security of power supply

The government cannot step away from the market unless it recognises these inexorable shifts in how value will flow in the system. With recognition that exclusion from the CfD is not removal of subsidy but denial of access to the market, resolution of the government’s current issues with the CfD becomes obvious. The
trilemma is resolvable. Do we have the wisdom to take the path that is opening up before us?

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