The UK capacity market and security of supply

25 Jun, 2012

We have not addressed the proposed UK Capacity Market for the last few months, awaiting further details on policy design since the government’s initial announcements last December.  Some further information was published by DECC in late May alongside their publishing of the Draft Bill on Electricity Market Reform (EMR).  But the announcement of these details comes against a backdrop of increasing criticism from within the industry, academia and the media, of the complexity and uncertainty associated with EMR. 

The government has re-emphasised the two key objectives of its EMR policies as part of its latest publications: decarbonisation and security of supply.  But the additional details the government has published on the UK Capacity Market look set to undermine rather than strengthen security of supply.

New details on the Capacity Market

The Annex on Capacity Market Design and Implementation provides some further clarity on the government’s thinking in relation to the Capacity Market design.  For example:

  1. The government is mindful to exclude low carbon plant covered under the Fit/CfD mechanism from the Capacity Market, which in practice means that it would be focused on remuneration of thermal capacity
  2. It is the government’s intention to focus on contracting total capacity volume (against a target) not specifically contracting for flexibility.

These may be sensible decisions in the context of EMR as a whole, but it is worth nothing that 1. will reinforce the increasing separation between remuneration of low carbon capacity and thermal plant and 2. illustrates the ‘blunt instrument’ nature of the Capacity Market solution in providing an adequate level of fast response flexible backup.  Published details on market design are still light in the Annex, but DECC presents a reasonable overview of key design issues that will need to be resolved through the consultation process into next year.

In our view the key issue that overhangs the Capacity Market design is the risk around political involvement in its implementation and operation.  The government again restates its intention to use the Capacity Market as a security of supply ‘insurance policy’, with the decision whether or not to implement it still firmly in the hands of politicians:

“The timing of the first capacity auction will be decided by Ministers on the basis of the security of supply outlook. We are retaining this discretion on whether and when to run the auction, and when the first delivery year will be, to ensure we only intervene in the market if it is necessary and cost-effective to do so. Ministerial decisions on when to run the first auction will be taken with a view to striking a balance between providing certainty to industry and ensuring that the security of electricity supply outlook warrants intervention.”

This creates substantial and unnecessary risk for investors in thermal power plant as we set out here.  But the government adds further political risk in its latest announcement.  If the Capacity Market is implemented, then the setting of the required capacity level will also be a political decision:

“the decision on the volume of capacity to be contracted through each auction process will be taken by Ministers. Ministers will take the final decision on the volume of capacity to contract for after the auction has been run so they can consider the trade-off between system reliability and overall cost, and determine the efficient volume of capacity to contract for”

Even more concerning, DECC’s paper recognises the capacity level decision will be made not just in the context of security of supply, but taking into account cost sensitivities around customer bills:

“we would expect Ministers to retain scope for their annual decision on the amount of capacity to contract for to vary from the reliability standard to ensure that costs and reliability can be balanced – so if, for example, the costs of achieving the standard were perceived to be disproportionately high, Ministers would retain the option of procuring less capacity in a particular year to ensure that consumers are protected from excessively high costs.”

Injecting this level of political influence into the operation of the UK power market is completely inconsistent with the principle that has supported private sector investment to date: independent regulatory oversight of a clearly defined market framework.  By compromising this principle the government risks an investor crisis of confidence.

Investment in new thermal plant

In putting forward the Capacity Market framework proposed, the government appears to misunderstand the factors that drive private investment to support security of supply in a liberalised energy market.  The government can not expect investment to be forthcoming if it retains the political flexibility to make sweeping changes to the market mechanisms used to remunerate thermal power plant.  

Politicising the decision making process around implementation and operation of the Capacity Market is likely to create unacceptable regulatory risk for thermal plant investors.  Forward gas plant generation margins (spark spreads) are already weak and will increasingly be squeezed by the government’s carbon price floor as it increases through this decade.  If on top of this investors do not know whether they face a reformed energy market or the addition of a politically influenced capacity market, it is difficult to see how any substantial capital investment commitment can be made.

In practical terms, the policy uncertainty that remains around thermal plant investment in the UK favours owners of existing flexible thermal assets.  It also suggests that if new investment in flexibility is not forthcoming over the next few years, thermal plant value may increasingly be recognised through the provision of balancing services given rising stress on the transmission system as intermittent renewable output rises.  As we have set out previously, in this enironment an interesting investment case can be built around existing flexible UK gas capacity.