Electricity Market Reform is the biggest thing on the industry’s agenda and the Government issued its long awaited consultation paper in December.
It is widely recognised that the current market arrangements have been successful in delivering reliable and competitively priced electricity but are not appropriate to encourage the level of future investment required to meet the UK’s carbon reduction commitments.
UK Electricity & Gas leader Steve Jennings and PwC’s industry experts Ronan O’Regan and Karen Dawson discuss some of the issues and challenges of the proposed reforms.
UK Electricity & Gas leader Steve Jennings and PwC’s industry experts Ronan O’Regan and Karen Dawson
Steve: Electricity market reform - one of the biggest issues on the industry’s agenda right now. The government issued its Consultation Paper in December, and I think it’s widely recognised that the current market arrangements have been appropriate for securing reliable electricity supplies which have been competitively priced, but it’s also widely recognised that the current arrangements won’t be suitable to encourage the amount of investment that’s required in the UK to meet the carbon reduction targets. Ronan, to start with, it would be helpful if you could summarise the key components of the consultation paper, and whether you think those arrangements and those components will be appropriate to secure the amount of the investment that’s required.
Ronan: Sure Steve. There are four pillars that underpin the government’s proposals, and they relate specifically to the introduction of Carbon Price Support Mechanism, the introduction of a Revenue Stabilisation Mechanism which will either be through a premium FiTs, or the preferred option being a CfD fit. The introduction of a targeted... the introduction of a capacity mechanism, and the introduction of emissions performance standards. The key issue from an investor’s perspective is really, how do these proposals stack up in terms of providing a stable environment that’s going to allow the levels of capital that is required to deliver the up to 200 billion of investment required over the next ten years? However, there’s a huge amount of details still be worked through, so we’re waiting to see what comes out in the White Paper in late springtime, and that will provide more granularity on the detail underpinning the proposals, and indeed how they’ll get implemented.
Steve: And are these proposals enough? Is this package of measures sufficient to encourage the huge levels of investment required?
Ronan: Well I mean the proposals need to be seen in the context of a wider range of proposals or reviews that are being pursued by Ofgem and Decc, and they include a review to the balancing mechanism, to make sure that it’s sending appropriate price signals, a liquidity review in the wholesale markets, a review of retail markets, and actually, quite importantly for renewables, the review of the banding that’s going on at teh moment. And in some respects, that’s more important to existing renewable developers in terms of investment, rather than the outcome of EMR which will affect investments further down the line.
Karen: That’s a very good point Ronan, and I think it’s very similar for the big six, in terms of for the outcome of Ofgem’s liquidity review. If the proposals mean that the big six are going to have to place a far larger proportion of their output into the short term markets, that’s going to cause more volatility in pricing, it’s going to cause them more operational issues with their optimisation. It’s probably going to change their views on investment planning, and that would come out to the timescales of the EMR. So in terms of how the EMR is going to fit with that, that’ll be the thing that’s important.
Steve: With a change of this magnitude and significance, inevitably there will be winners and losers, and I’d be interested in your perspectives from talking to the industry, about who stands to gain from these changes, and who potentially is most at risk.
Karen: I think the clear short-term out and out winner has got to be existing nuclear plant, who stand to gain quite a significant windfall from the Carbon Support Mechanism.
Ronan: And likewise, you look at the existing renewable sector. That clearly will also take the benefits associated with potentially higher wholesale prices on the back of the Carbon Price Support Mechanism. But looking a bit further ahead, developers on the renewable side who are looking at participating in a CFD option tender process from 2017, are potentially exposed to a much higher level of risk than there would be under the proposals... under the current market arrangements.
Karen: And from the perspective of losers, then it’s the thermal plant. Coal plant has already got a limited lifespan, particularly with the need to input in CCS if that’s going to happen. And perhaps a change in the running patterns coupled with EU directives, mean that plant are going to change earlier than originally anticipated. And the CCGTs planned for the middle of this decade, the timescales under which they’ll come into service have got to be uncertain. Will these plant quality for the targeted capacity mechanism? Will they be able to run sufficiently to get the revenues that they need to get the returns that are acceptable? I think all of those things are uncertain, and with both the thermal sort of issues, there’s got to be challenges and questions for security of supply.
Steve: Yes. Can I just come back to feed-in tariffs, Ronan, for a second? Because clearly they’re critical to encourage an appropriate amount of investment in non-fossil fuel generation, but getting the pricing of those is going to be absolutely critical, and that must be a real worry for the industry right now.
Ronan: Well it is. I mean price is clearly a very important dimension of whatever is finally implemented, but we need to understand where the government are coming from in terms of their motivation. So they are very much motivated by: yes, price certainty is important because that’s going to attract new levels of investment, but also, you know, having a competitive process is the one way the government can ensure that they’re delivering least cost from a consumer perspective. And on that note, they should also be quite concerned about ensuring, you know, that they can deliver a lower cost of capital for developers, because that will contribute to, you know, delivering low cost projects. On the investor side, investors, yes, they like to see, you know, revenue certainty, but probably more important for them is certainty in the process around which they’re going to access a CFD, and that’s the fundamental challenge that government have, is to try and strike this balance between, you know, giving the certainty that, you know, investors need on the one hand, and trying to ensure a competitive process through an auction mechanism which has got some inherent challenges.
Karen: And we’ve got a lot of experience of: how do we actually get a successful auction structured and set up? You’ve got to make sure that you attract the right people to the action in the first place. The process for the auction has got to be clear. The timescale at which projects can actually come to the action is important, and there’s a risk that investors are going to have to put in too much equity before they can place their projects up for auction, and that’s a very big change to the risk profile. So getting that balance right, as you said Ronan, is critical to making sure that we get the right amount of capacity through for both the renewables and the targeted capacity auctions.
Steve: Good point Karen, some real issues here, and clearly the government has got its work cut out to turn this Consultation Paper into primary legislation in 2012, and the industry has got to start preparing itself as well. It has a huge programme of work, because these changes will impact on all parts of their organisations, from trading and optimisation, investment planning, risk management, right through to financial management. Karen and Ronan, thank you very much.