Coming to grips with the new UK Capacity Market
As part of its ongoing Electricity Market Reform package, the UK government has recently announced its intention to legislate for a market wide capacity mechanism or Capacity Market. Details were released in a ‘Technical Update’ to the EMR policy in December, but the document’s title does not do justice to the importance of its contents. The Capacity Market involves a fundamental redesign of the UK electricity market that will impact the risk and return on all types of generation assets. Uncertainty around its introduction is also likely to result in a further stagnation in UK generation investment.
January 16, 2012
The UK government’s Electricity Market Reform (EMR) policy announcements in July 2011 were characterised by unanswered questions. The policy outlined a range of intervention measures but was light on numbers and detail. The most serious omission was information on the nature and timing of the introduction of a capacity mechanism to support security of supply. Details were to follow in a much anticipated sequel, just in time for Christmas.
After an industry consultation process covering some high level concepts for a capacity mechanism, the government announced in mid December its intention to legislate for a market-wide capacity mechanism or Capacity Market (CM). Details were released in a ‘Technical Update’ to the EMR policy in December, but the document’s title does not do justice to the importance of its contents. The Capacity Market involves a fundamental redesign of the UK electricity market that will impact the risk and return on all types of generation assets. Uncertainty around its introduction is also likely to result in a further stagnation in UK generation investment.
Capacity Market overview
DECC has only provided an outline of the CM design, leaving the detailed design open for further industry consultation through 2012. The key elements of the CM structure that DECC has announced are as follows:
- The capacity mechanism will be market wide, rather than a ‘strategic capacity reserve’ covering only a portion of capacity
- DECC will have responsibility for estimating the total volume of ‘reliable’ (de-rated) capacity required on a forward basis, with the ability to call on input from the System Operator (SO) and Ofgem
- The SO will contract for the required level of reliable capacity via a central auction process, several years in advance of capacity delivery, with DECC’s intention to facilitate secondary trading of capacity between auction and delivery
- Capacity providers (including demand side response) will be able to offer capacity into the auction and if successful will receive availability payments, with a penalty system to incentivise capacity availability when it is required
- The cost of capacity payments will be shared across suppliers and therefore ultimately paid for by consumers
DECC is only tasked with delivering a detailed design of the CM and assisting with the relevant supporting legislation. Somewhat unbelievably, the government makes no commitment as to whether or when it will actually implement the CM. This decision is left in the hands of the Ministers based on a judgement of the security of supply environment. As a result investors are confronted by the ugly uncertainty of a market that may be fundamentally restructured at some undetermined point in the future to suit the prevailing political mood.
The indicative timeline for ‘implementation’ of the CM is shown in Chart 1, indicating that 2015 is the earliest date for capacity auctions.
Chart 1: DECC’s indicative timetable for the CM
Reasoning versus reality
In the Technical Update document, DECC recognises the scale of market intervention and redesign involved in introducing a Capacity Market. But rather than providing a well thought through justification for the CM, DECC sets out some high level reasoning based around a wish list of things it would like to see improved in the electricity market. While there are some valid concerns in this list, the document does little to explain how a CM will address these. For example:
- Two of DECC’s prominent concerns behind the implementation of EMR have been problems with the sharpness of market price signals and a lack of wholesale market hedging liquidity. But implementation of a capacity market will act to reduce market liquidity (particularly in flexible and peak products) as well as blunting price signals to deliver the specific types of capacity required.
- DECC claims that ‘at times when the wholesale electricity market prices peak to high levels, investors fear that the Government/regulator will act on a perceived abuse of market power, for example through the introduction of a price cap’. But it is a perverse logic that government intervention is required to counter the perceived threat of another sort of government intervention. Surely it would be more effective to clarify regulatory policy on price spikes rather than intervening to redesign the power market.
- DECC also expresses concern that ‘System Operator balancing actions (such as voltage reduction) are not fully costed’. But these are issues that require an overhaul of the balancing market price signals, not reasons to introduce a capacity market.
The reality behind such heavy handed intervention is summed up in a single sentence in point 110 of the document:
‘The Capacity Market provides an ‘insurance policy’ against a tight future electricity generation market resulting in higher levels of blackouts’
It is difficult not to view the CM as a political construct, a ‘Get out of Jail’ card for the government if fear (or public awareness) of security of supply escalates to politically damaging levels. This approach is inconsistent with the principle of independent regulation that has supported investment in the UK power market to date. Mixing political objectives with regulatory oversight will act to undermine private investment in a well functioning liberalised power market.
The impact on investment
The EMR package’s piecemeal policy intervention represents a combination of conflicting political agendas and a loss of faith in the ability of a liberalised wholesale market to deliver an orderly solution. But rather than making a determined shift towards a centrally planned solution, the government seems set on layering on complex intervention after intervention. This approach introduces market distortions that are difficult for anyone (regulators, investors, portfolio managers) to anticipate, analyse or manage. It also burdens investors with an increasingly untenable level of uncertainty and regulatory risk.
Empirical evidence of a post EMR investment hiatus is already emerging. At the same time weak spark and dark spreads threaten the closure of a number of older gas and coal plant. Investors in both new plant and life extensions of existing plant are confronted by uncertainty around if, when and how generation margins may be impacted by a Capacity Market which is yet to be designed. Ironically, uncertainty and risk around the introduction of a Capacity Market are likely to compromise rather than reinforce security of supply by the middle of this decade.
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