1. Introduction

The Department of Energy and Climate Change (DECC) is planning to introduce a capacity market in Great Britain as part of its Electricity Market Reform (EMR) package. EnerNOC commissioned NERA to investigate the circumstances in which the rules surrounding the participation of DSR would increase the costs of the capacity market to British consumers.

DECC's objective is to increase security of supply for British electricity consumers by offering market participants a payment in exchange for taking on an obligation to generate at times of system stress, backed up by a penalty for non-delivery. National Grid will allocate capacity agreements through two auctions, four years and one year ahead of the period of delivery (the T-4 and T-1 auctions respectively). The first T-4 auction will be held in December 2014 for delivery in the winter of 2018/19.

All capacity that is not otherwise receiving support under government programmes is eligible for support from the capacity market. However, the arrangements for that support differ:

  • All capacity is eligible to enter either the T-4 or the T-1 auctions. DSR is eligible for additional support between 2015 and 2017 through Transitional Arrangements (TAs). The TAs allocate contracts to DSR as well as obligations to deliver security of supply before 2018/19. However, any DSR provider which has received support in a T-4 auction may not participate in the subsequent year's TA.
  • Existing capacity and DSR can only obtain one-year capacity agreements. All companies investing in refurbishment or new plant above the minimum expenditure levels defined by DECC can obtain longer term agreements of three to fifteen years if awarded an agreement in the T-4 auction.

Our analysis is not attempting to be a complete description of the possible evolution of the capacity market or the role of DSR. In particular, we have not been asked to examine the likely evolution of the costs of DSR or the quantity of DSR that is likely to become available. Instead, our scenario-driven approach illustrates that changing the rules on eligibility for the T-4 auction and on contract length may decrease the costs to consumers if:

  • DSR displaces more expensive capacity in the T-4 auction;
  • More DSR is available than National Grid currently anticipates; and/or
  • The capacity procured at the T-1 auction is lower than National Grid currently anticipates.

Our modelling shows, that in these circumstances where customer bills are reduced, the magnitude of these savings is up to £359 million per year.

This report proceeds as follows:

  • Chapter 2 describes the British capacity market and the role of DSR within that market;
  • Chapter 3 describes the circumstances in which changing the rules for the participation of DSR in the capacity market would reduce the cost of the capacity market to British electricity customers and examines the effect of those scenarios; and
  • Chapter 4 concludes.

2. The Role of DSR in the Capacity Market

This chapter introduces the British Capacity Market. In particular, it describes the economic motivation and history behind its creation, discusses the effect DSR can have in the capacity market and describes some of the rules which govern the market, with emphasis on those which specifically affect DSR units.

This chapter proceeds as follows:

  • Section 2.1 describes the economic theory behind the need for a capacity market in Great Britain;
  • Section 2.2 describes existing capacity markets in the United States, particularly with respect to the role DSR has played.
  • Section 2.3 describes the two types of auctions which will procure capacity and states the announced parameters for the upcoming auction;
  • Section 2.4 discusses rules which disincentivise DSR units from participating in the T-4 auction;
  • Section 2.5 explains who will fund the capacity market; and
  • Section 2.6 discusses the potential negative impact of excluding DSR units from the T-4 auction.

2.1. The British Capacity Market Seeks to Ensure Security of Supply

In Great Britain, wholesale electricity is currently provided by an energy-only market. Energy-only markets are in principle capable of delivering a generation mix that is both allocatively efficient (demand is met at least cost every half hour) and dynamically efficient (sufficient investment takes place to ensure future demand is met optimally). Because generator capacity is limited, prices in an energy-only market will occasionally rise to the "Value of Lost Load" (VOLL) in times of scarcity. At those times, demand is met by an efficient mix of generation and load-shedding. Such "price spikes" are needed to offer peaking plants and other generators the opportunity to recover their fixed costs.

In practice, market failures mean that energy-only markets may not encourage efficient investment in generator capacity. Significant political and regulatory risk diminishes the value to investors of markets that rely on prices rising to VOLL. Regulatory and political institutions tend to react adversely to price spikes, and many energy market rules explicitly cap wholesale prices below the level of VOLL. Even if such explicit caps are absent, as long as regulators remain averse to price spikes, market participants will face a risk that regulators intervene to prevent high prices from occurring. This threat of regulatory intervention places an implicit cap on prices. Any cap on prices (whether explicit or implicit) creates a problem of "missing money" – a shortfall in the revenue required to cover the cost of investing in generator capacity.

Limited participation by consumers (the demand-side) in energy markets is likely to compound this problem. The limited scope for consumers to participate in energy markets means that the demand curve for electricity is very "inelastic", i.e. demand does not respond to price movements. Inelastic demand makes electricity prices more volatile, heightening the regulatory and political risks surrounding the reliance on high prices, diminishing expected revenues and deterring investment. An inelastic demand curve also facilitates the exercise of market power, which invites more regulatory interventions. Limited participation in the associated market for long-term contracts means that the forward curve of prices does not give investors reliable signals about the future need for capacity.

As a result of these market failures or potential market failures in the current energy-only market, the Department of Energy and Climate Change (DECC) is introducing the Great Britain Capacity Market. The capacity market is designed to correct under-investment due to "missing money" by making an additional payment to capacity providers. The objective of this "capacity payment" will allow firms to recover the fixed costs of providing capacity without the need for large price spikes and unreliable service. Renewables and capacity in receipt of other forms of support are excluded from the capacity market.

2.2. DSR Can Compete With New Supplies to Offer Capacity

Capacity markets are not a new concept and several have existed in the United States since the late 1990s - particularly in California, the Upper Midwest, New York, New England and the Mid-Atlantic States. Each capacity market operates with its own set of rules which define the responsibility for procuring capacity obligations, the form of the obligation to provide capacity as well as the eligibility rules for participation.1 Some markets are decentralised, whilst others rely on centralised auctions.

The main participants in US capacity markets by volume are existing generators, but US markets also feature the participation of other sources of capacity which may be lower cost than new investment. Energy storage facilities, which convert electricity into storable energy and back, provide an alternate source of supply-side capacity. On the demand-side, the major source of non-generative capacity is from demand-side response units (DSR). DSR providers contract with customers to reduce their consumption at times when the system's generator capacity is near its limit. This lowers the demand for energy at peak times and easing the strain on the grid.

For example, the Pennsylvania, New Jersey and Maryland market, PJM, operates in parts of 13 states between North Carolina and Illinois. PJM shares some similarities with the capacity market in Great Britain, including consisting of centralised auctions held every year with delivery several years in advance.2

DSR has played a major role in the PJM market, which has attracted nearly 15,000 MW of demand resources.3 For the upcoming delivery year of June 2015-May 2016, nine per cent of auctioned capacity is made up of DSR.4 The influx of DSR in PJM, in part, "postponed the need for costly new generation investments by almost a decade, while capacity market prices were generally far below the cost of new entry. Overall, this PJM experience strongly demonstrates the benefits of maintaining resource adequacy through non-discriminatory procurement".5 By competing in the capacity market and securing capacity agreements, DSR exerts downward pressure on the capacity price and displaces more expensive alternatives to the benefit of consumers.

Some market participants have questioned whether DSR is providing a service that is equivalent to the service provided by generators, and have argued that "DSR fatigue" from frequent dispatch may make DSR an unreliable alternative. However, in practice, the evidence suggests that "demand resources have performed well and there is no evidence yet that these concerns will occur".6

2.2.1. The T-4 auction will procure most of the capacity

National Grid will allocate contracts to provide capacity using capacity market auctions. National Grid will hold two capacity auctions in advance of each "capacity year":7

1. The primary auction occurs four years before the commencement of the year and is known as the T-4 auction. DECC chose the schedule to give enough time for parties awarded capacity agreements to build new capacity that matches their capacity obligation for that capacity year. The lead-time was also chosen to be short enough to avoid excessive uncertainty on capacity needs. DECC intends the design of this auction to be particularly advantageous towards new gas-fired plants.8

2. The secondary auction occurs the year before the commencement of the capacity year and is known as the T-1 auction. DECC intends this auction to give enough time to fill any remaining capacity requirement with DSR and existing generating plants, but is close enough to delivery that DECC can increase or decrease the capacity target with adequate certainty of capacity needs. Due to the short lead-time, generators cannot build new plant after being awarded a capacity agreement. This auction is not available to capacity market units (CMUs) which were awarded a capacity agreement in the year's T-4 auction.9

In advance of a capacity year's T-4 auction, the Secretary of State responsible for the auction will announce a total amount of capacity required, and a proposed split between the T-4 and T-1 auction. The Secretary of State will also announce a set of prices and quantities which define the capacity market's demand curve. Both auctions will operate as a descending clock auction in which bidders withdraw capacity as the price drops until the amount of capacity remaining roughly equals the desired amount for the auction. 1011

2.2.2. The Structure Of The T-4 Auction For 2014 Has Been Published

As described in the Section 2.2.1, the Secretary of State has defined the following auction parameters which define the demand curve for the auction:12

  • The target capacity for the 2014 T-4 auction is 50.8 gigawatts (GW), with an additional 2.5GW set aside for the 2017 T-1 auction;
  • The price that the auctioneer is willing to pay for this target level of capacity is the "net cost of new entry" (i.e. the capital and other fixed costs of a new entrant generator, net of profit from the energy market) or "net CONE", which DECC estimates at £49/kW/year (in 2012 prices);
  • The price cap (from which the price initially descends) is £75/kilowatt (kW)/year;
  • The auctioneer will procure capacity within a window of plus or minus 1.5GW of the target capacity. At the price cap level, the auctioneer would purchase 1.5GW less than the target (49.3GW) and at £0/kW/year it would purchases 1.5GW more (52.3GW).

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