Capacity Market impact on plant owners and investors

20 Feb, 2012

For better or for worse it is clear that a Capacity Market is now a reality for generation owners and investors in the UK and one which is likely to substantially change the structure of generation returns.  The impact on returns will be driven by a change in the dynamics of market pricing and volatility as we set out in a recent article

The key issue will be the structure of the total return that generators can earn across the energy, capacity and balancing/ancillary services markets.  But this will vary significantly across different types of generation assets. 

Impact on low carbon generators

Renewable and nuclear generation returns will predominantly be driven by government support mechanisms, specifically:

  • the Renewables Obligation (RO)
  • the soon to be implemented FIT/CfD mechanism
  • the carbon price floor.

These mechanisms reduce the exposures of low carbon plant to wholesale market pricing for energy and capacity.  The extent to which low carbon will earn a return in the Capacity Market is still an issue to be determined in the detailed policy design phase. But it is reasonable to assume that capacity payments will be a second order concern compared to issues such as RO banding and the level of CfD strike prices. 

The extent to which low carbon capacity will participate in the Capacity Market and the interaction between the Capacity Market and FIT/CfD mechanisms will be important issues for the government to resolve.  But the introduction of another complex policy mechanism means increased uncertainty and regulatory risk.

Impact on thermal generators

For thermal generators the Capacity Market is a big deal in that it involves a redesign of the market mechanism that will determine plant fixed cost recovery.  Thermal plants currently recover fixed costs via ‘infra-marginal rents’ in the energy market.  In plain English, a plant needs to earn a margin between the wholesale price it receives and its variable cost. 

A plant typically earns these margins (or rents) when other plants with a higher variable cost are setting the market price.  But an increase in the penetration of low carbon generation is eroding the margins that thermal plants require to cover their fixed costs.  Renewable generators are supported by payments outside of the energy market (i.e. the RO and soon the FiT/CfDs), but their intermittent ‘must run’ output acts to drive down market prices and the load factors of gas and coal plant. Renewable generation intermittency also acts to increase the volatility of thermal generator returns.

The government presents the Capacity Market as a boon for thermal generators as it allows them to transition from increasingly volatile returns in the energy market to more stable availability payments in the Capacity Market.  What they do not emphasise is that this reduction in market risk is offset by a substantial increase in regulatory risk.  Both risk around the design and timing of the introduction of the Capacity Market and risk around government ‘tinkering’ with the capacity market once it is in place.  It is also logical to expect the Capacity Market to reduce liquidity in peak and flexible hedging contracts in the forward market, adversely impacting the ability of both generators and suppliers to manage price volatility.

In terms of generation investment cycles, the Capacity Market acts as a soft floor for the ‘de-rated’ power market capacity margin, with knock on implications for market volatility given the inverse relationship between the two.  This has important implications for peaking plant investment/ownership because it reduces the potential upside from periods of pronounced capacity tightness (boom), while availability payments act to soften the impact of periods of capacity oversupply (bust).

Confronting the Capacity Market

Discussion of the Capacity Market is currently clouded by uncertainty.  But it is exactly this uncertainty and its adverse impact on generation investment that increases the likelihood that the Capacity Market will become a reality in the next few years.   This will fundamentally change the structure of market pricing and generation returns, particularly for thermal assets.  It will also impact generator hedging of asset returns. The implications of the Capacity Market for plant value and risk are a challenge for investors and owners to confront now, rather than when the Capacity Market is delivered. 

Relevant Articles:

UK Capacity Market impact on prices and price volatility

Coming to grips with the new UK Capacity Market