UK Capacity Market impact on prices and price volatility06 Feb, 2012
We are sceptical of the UK government’s motivations in introducing a Capacity Market (CM), as we set out in a recent article. The CM appears to be being used as a blunt and heavy instrument to address a range of issues with the power market rather than being targeted at correcting for specific market failures. There is however a genuine threat of a UK capacity crunch later this decade, primarily as the result of ongoing policy uncertainty. A capacity mechanism, if effectively implemented, is one way to address this problem as Centrica articulates in its consultation response:
‘there is a need to introduce a capacity mechanism to ensure adequate security of supply given the increasing uncertainty on the framework of the UK generation portfolio due a range of factors, largely driven by Government policy.’
In this article we explore the impact of introducing the CM on pricing and volatility in the UK power market. We will then follow with another article examining the potential implications for plant operators and investors.
Why worry about a Capacity Market at all?
Given all the uncertainty surrounding its design, it is tempting to park the CM in the in-tray and worry about it when there is a little more clarity. At the earliest, CM implementation appears to be years away and it is not certain whether it will be implemented at all.
But in our view the impacts of the CM will be felt much sooner. Uncertainty around design and implementation of the CM (and EMR policy in general) is likely to result in an immediate investment hiatus for new gas plant and may well result in the mothballing or closure of a number of older CCGTs. As nervousness increases mid decade with the approach of the scheduled LCPD plant closures, the government is likely to call on its insurance policy and proceed with CM implementation. So it is worth considering what this may mean for market pricing and generation returns.
Impact on market prices
Predicting the specific nature of the CM impact on market prices and price volatility is difficult, because the government has left most of the elements of the CM open for the detailed design phase through 2012-13. Given the variety of potential CM designs there is little point in second guessing the design process, but there are some broad conclusions that can be drawn.
By introducing a Capacity Market the government is attempting the challenging task of unbundling the capacity component of the market from the energy (or commodity) component. Ultimately, the success of the design will be driven by how clean a separation is achieved. The detailed market rules will need to ensure that there are clear and predictable incentives for market participants to respond to. Any ambiguity or unexpected interactions between the energy market and capacity market will increase the risk of introducing inefficiencies that may invalidate the primary objectives the Government is trying to achieve.
Currently generators must recover their fixed and variable costs across the wholesale energy and balancing markets. With the introduction of a CM, a portion of plant fixed costs will be recoverable through availability payments. So at the highest level, introducing the CM will result in the transfer of generation margin from the energy market into a separately administered capacity market, with a corresponding fall in wholesale power prices. Any fall in prices is likely to be observed in both spot prices and along the forward curve. So the design and implementation of the CM will have important implications for the dynamics of the traded market.
It is important to note that a fall in wholesale power prices does not necessarily mean a fall in customer bills. Customers will also pick up the tab for the CM. In our view it is likely that the total costs to the consumer will rise given the complexity inherent in the government predicting the level, type & location of capacity required. This is not a criticism of DECC, but a recognition that historically, liberalised power markets have been more cost efficient at allocating resources than the government departments they have replaced.
Impact on price volatility
The impact on market price volatility is more complex. With the introduction of a CM, thermal plant will continue to dominate price setting in the energy market and will continue to make profit maximising decisions as they optimise their plant. So the spot energy market will still go through periods of extreme volatility representing scarcity of generation resource. The government emphasises a reduction in market volatility as a result of the CM, but it does so in anticipation of the dampening effect of a greater volume of capacity on the system. If this transpires, then the reduction in volatility would be manifested across the entire forward volatility term structure, although it would be reasonable to expect spot volatility to fall by a greater extent than the volatility of forward maturities.
The government’s Capacity Market announcement may have quite the opposite effect on volatility over the years leading up to its implementation. While the power market is currently experiencing overcapacity, it is becoming increasingly clear that the UK is suffering a generation investment hiatus driven by policy uncertainty. Thermal plant investment is particularly adversely impacted by the uncertainty surrounding the CM. A stagnation in generation build and the mothballing and closure of older plant may see a sharp fall in the power market capacity margin by the middle of the decade, with an associated increase in volatility. Under these conditions the transition to the CM may not be a smooth one.
While it is interesting to explore the broader impacts of the CM on market price dynamics, the ‘devil will be in the detail’ of the design. Most relevant for generators will be the structure of the total return that they can earn across the energy, capacity and balancing/ancillary services markets. We look in more detail at the impact of the CM on generation owners and investors in an article to follow shortly.