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Coal and the UK Electricity Market Reform: Analysis

World Coal,

The UK Government has embarked on a fundamental reform of the UK’s electricity markets. This is in response to the view that key shortfalls will otherwise arise in target levels of investment in low carbon generation and that risks to electricity supply security are increasing. Following a policy paper published in 2011 that set out its proposals, the Government is now in the process of introducing legislation to enact its proposed reforms. This will have an important impact on the future technology mix represented in the UK’s generation capacity.

Reform proposals

There are four key components to the Government’s reform proposals.

Contracts for Difference for low carbon generation

Contracts for Difference (CFDs) will be introduced and provide support to low carbon generation. The CFDs will be a contractual arrangement between the UK Government or a party acting on its behalf and each low carbon generator, under which the generator will receive the difference between the UK wholesale electricity price and target unit revenue agreed to in advance. The target unit revenue will initially be set through negotiation or central administration, depending on the technology. However, there is an aspiration to move to technology-specific auctions towards the end of the decade and then, perhaps, to inter-technology auctions in order to achieve ongoing low carbon generation development at least cost.

The CFDs will be “two-way” for most technologies. This means that if the electricity price is below or above the target unit revenue level, then the generator will pay or receive the difference, as appropriate. But, it is possible that one-way CFDs will be used for flexible generation. The calculation of the reference electricity price will vary between technologies to reflect their generation characteristics, particularly for wind generation.

There will be a transition phase, during which projects can still qualify for the existing Renewable Obligation scheme (which is currently used to support renewable generation). However, the option to qualify for this will end in 2017.

Emissions performance standard

An emissions performance standard will be introduced such that new power plants will be subject to a maximum amount of CO2 per MWh produced that they are permitted to emit. This maximum amount will initially be set at 450 g/MWh; this is a standard that a modern gas-fired combined-cycle gas turbine will meet, but that an unabated coal-fired power plant will not. This effectively means that new coal-fired power plants without carbon capture and storage (CCS) capability cannot be built in the UK. The policy is explicit that future limits will not be introduced that apply retrospectively to power plants already built.

Carbon price floor

UK power generators already have to purchase EU allowances to cover their carbon emissions from generation. As already set out in the 2011 budget, the UK will impose an additional tax on carbon emissions from power generation in order to ensure that the total tax per tonne of CO2 paid by generators rises in line with a minimum trajectory. This minimum price is targeted to rise from £16/t of CO2 in 2013 to £30/t of CO2 in 2020.

Capacity mechanism

The Government is concerned that inadequate market signals exist to incentivise companies to build or retain sufficient power plants on the system that provide adequate capacity to cover for future fluctuations in wind output and demand spikes. The initial Government proposal was for a targeted capacity mechanism, under which only power plants built in response to a tender for additional capacity would receive a capacity payment. However, the Government has reacted to the concerns expressed by stakeholders during the consultation process and is now intending to implement a market-wide capacity mechanism. This will provide a capacity payment to all generation capacity on the system (or at least to all capacity selected in the capacity auction process). The intention is that the combination of profits from electricity sales in the wholesale market and the capacity payments will induce sufficient capacity to be built or retained to provide a satisfactory plant margin over peak demand.

The impact of electricity market reform

Electricity prices

An explicit intention of the Electricity Market Reform (EMR) is faster investment into low carbon power generation technologies that are currently too expensive to be developed in the UK without some additional support. Therefore the costs of electricity production will go up, certainly in the short term.

In the long term, it is possible that investment into low carbon generation will reduce the exposure of the UK to potentially significant spikes in fuel and carbon costs. Particularly in the case of carbon prices, the Government expects steep rises post-2020. Therefore, it is claimed that long-term electricity prices will be lower as a result of the policies contained in EMR.

Low carbon generation investment

Although many players within the UK electricity market are now accustomed to the Renewable Obligation system for supporting renewable investment, there is a recognised need to attract additional capital into the industry. Estimates of the aggregate funding capability of the existing large players within the UK electricity market suggest that this is well short of the level that will be needed to hit future carbon targets.

New investors are likely to be more comfortable with stable and simple mechanisms. Therefore the CFD approach, whereby the Government largely removes wholesale market risks from investors and the headline terms of the deal are easy to understand, is likely to boost the level of capital committed to the sector.

Despite this, attracting new investors at the level required will be challenging and there are some difficult balances to be struck. Measures to attract new investors may not always be welcomed by the established players, so increasing finance from new sources may come at the cost of it reducing from elsewhere.

Security of supply

Historically, the UK electricity market has performed well in terms of bringing forward new investment and ensuring that there is more than sufficient capacity to cover peaks in electricity demand. However, the rate of regulatory change is currently so fast, and the impact of new legislation on the viability of existing and new power stations so significant, that it is hard to guarantee that this will continue to be the case in the absence of an explicit process or mechanism to achieve it.

The proposed all-market capacity mechanism (combined with CFDs) does offer a potential solution to this, although the effectiveness of the mechanism will be hugely dependent on details of implementation that are not known as yet. A key issue will be how investors in conventional generation are persuaded that the market arrangements offer an ability to earn an appropriate return on long-term investments against competition from supported low carbon generation (particularly given the potential impact of low carbon generation with very low variable generating costs on market electricity prices).

Carbon emissions

The EMR package will reduce UK power sector carbon emissions. However, in the short term, reductions in UK emissions will be offset by higher allowed emissions in other parts of the EU because the UK power sector is just one part of the overall capped emissions within the EU Emissions Trading Scheme (ETS).

In the longer term, the extent to which EMR-related emission reductions reduce total carbon emissions depends on whether lower UK emissions are factored into future EU emissions targets.

Electricity market operation

The EMR proposals mean that the revenues to new, low carbon power generation will be largely determined by the UK Government (or its appointee) when it decides on the target revenues that CFDs will be based on. As the portion of UK generation covered by these contracts increases it will erode the ability of electricity suppliers to differentiate themselves and compete through different fuel mixes and electricity sourcing. An electricity market where the revenues to generators are largely determined by the Government (absent any competitive auctions that may be difficult to establish) is fundamentally different to the market now, although it will take a long time for this change to happen.

Utility financing

One of the issues raised with regard to renewable and nuclear investment in the UK is the limited ability of the existing large electricity suppliers to fund the huge investment that will be needed to meet future targets. However, the structure of the low carbon contracts may actually change the nature and risks of these businesses and hence increase the ability to raise finance. The CFD approach offers generators stable revenues from what will be an increasing share of their generation portfolios. This will transform the risk profile of the power companies and move them from a merchant risk category closer to a regulated utility category, with a consequent step change in the feasible debt leverage of the companies.

Implications for coal-fired power generation

New coal-fired power plants without any CCS capabilities will not be allowed in the UK. This follows directly from the new emissions performance standard. However, this is almost a formalisation of a de-facto restriction that has already existed; it has been impossible to obtain planning consent for unabated coal-fired power plants, which have in any case faced substantial public opposition.

Existing coal-fired power plants will see their competitive position deteriorate as lower variable cost generating plants are added to the system and as higher effective carbon emission costs favour gas-fired generation.

The Government continues to see CCS as a key element in the long-term decarbonisation of the power sector. Attempts are ongoing to develop a framework that enables initial CCS demonstration projects to achieve commercial viability. These projects, with full or partial CCS, would comply with the emissions performance standard; however, any unabated part of the capacity would be subject to the growing impact of the carbon price floor.

Overall, the EMR measures will adversely impact coal-fired generation in the short to medium term. A recovery in this position will be contingent on successful demonstration of CCS, together with the development of a material CO2 transport and sequestration capability and infrastructure.

Written by Robin Cohen, Deloitte LLP, UK.

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