OPINION: Lesson from the Capacity Market debacle: put your trust in markets, not regulation

Filippo Gaddo, head of economics, business and investor advisory at Arup, considers the implications of the European Court of Justice ruling that the Capacity Market represents unjustified State Aid

 

On 15 November the European Court of Justice found that, in granting State Aid approval, the Commission had not completed sufficient research into the impacts of a Capacity Market on the internal energy market. The GB Capacity Market has been placed into a period of suspension for both current payments and future auctions. Payments for the delivery year 2018/19 were worth almost £1 billion to the industry. Two of the monthly payments had already been paid.

The suspension is a period of uncertainty for energy investors and developers. Expected revenues from long-term Capacity Market agreements have underpinned the business models of new and existing generators for the last five years. Payments already made to participants in the Transitional Arrangements, the Early Auction and some payments already made in relation to the T-1 and T-4 2018/19 are at risk of being recovered, although BEIS is taking no steps to do that, and hopes that it can be avoided.

National Grid says it will complete prequalification for the 2019 auction in case it is required and  published the CM registers for the now indefinitely postponed T-4 and T-1 auctions on 16 November. BEIS has committed to re-obtaining State Aid approval, but there are no timescales or guarantees. It intends to run a T-1 auction to serve as a replacement, and the 2019 T-4 auction could be wrapped up as a T-3 auction in next year’s round, if State Aid approval can be regained.

The length of a formal investigation is unclear and while the European Commission’s track record suggests that it would take 1 to 2 years, given the significance and wider reaching implications of the ECJ ruling it may be completed in les than a year. Any temporary mechanism, for instance a return to the supplementary balancing reserve previously procured by National Grid, would require State Aid approval.

There is expected to be very limited impact on security of supply or market prices over this winter as most capacity with capacity agreements should already be online – around 1GW of peaking plants. However, some coal-fired capacity and old inefficient gas-fired CCGTs may be at risk, as CM payments were important in plugging the gaps in their business cases. Therefore this ruling could accelerate decarbonisation of electricity, an outcome which is not normally lamented.

In the medium to long-term there could be an impact on security of supply caused by the uncertainty introduced by this ruling.  At the very least, developers and investors with projects with marginal IRRs, dependent on the CM revenues from agreements they already believe they had, should now halt these projects, if continuing and deploying capex would deliver a worse financial outcome. Some projects reliant on Capacity Market revenues may now no longer be viable.

Additionally, the perception of overall GB regulatory risk may have increased and non-energy market revenues are likely to be more heavily scrutinised by investors, slowing the development of new capacity.

The only outcome from the EC formal investigation which appears to rule out going back and reclaiming monies from participants would be one with no remedies and therefore this is the outcome that BEIS will hope for. Tempus was successfully able to highlight a number of ‘doubts’ as to the suitability of the GB CM with the EU internal market at the time when the EC gave State Aid approval, so any remedies are likely to address those doubts if they still exist.

The Capacity Market review is under way, so remedial measures could be included as part of it, for implementation in the CM rules next year – if the investigation is completed in time.

What now?

If we take this ruling in the context of introduction of the price cap, RIIO 2 discussion and pressure on regulated companies, Brexit, etc. investor confidence in GB energy infrastructure (renewables, storage, large thermal) could be affected.

This ruling could impact a number of energy infrastructure deals which were close to being closed, including recent sales of thermal generation portfolios, ‘shovel-ready’ gas-fired power projects or storage developments.The legitimacy of other Capacity Mechanisms and in the European Union and low-carbon subsidy mechanisms such as GB’s Contracts for Difference (CfD) may be now in question.

Investors should explore and seek to understand regulatory risk, and rethink the risk adjustment given to regulatory versus merchant revenues.

One potential outcome is that this ruling forces investors to embrace merchant over regulatory risk and trust more firmly in energy markets than hand-outs from the government.

First published in the December 2018 issue of New Power Report

 

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