UK: UK Energy Update: Light At The End Of The Tunnel

1. BACKGROUND

We reported in two previous issues on the UK's draft Energy Bill (please refer to the Energy@Gowlings Newsletters dated 7 September 2012 and 16 January 2013).

The purpose of the reforms to be introduced by the Energy Bill is to deliver secure, affordable and low-carbon energy by supporting investment in new generating capacity and upgrading transmission networks. It is estimated that over the next decade, the UK electricity sector will need around GBP110 billion of capital investment.

The reforms could not come at a more critical time. Ofgem, the UK energy regulator, has warned that the risk of power blackouts by 2015 has increased because excess capacity in the UK energy market has reduced, partly due to several gas generators being taken out of service. Ofgem has forecast that electricity margins will be as low as 2% by 2015-16. Although it does not consider supply blackouts "imminent or likely", their probability would rise from one in 47 years now, to one in 12 years in 2015-16.

The UK government hopes that the new reforms will unlock the investment required to boost the UK's energy generating capacity. The challenge will be to achieve this soon enough to solve the energy shortfall and meet the UK's decarbonisation targets.

The Government has now provided further detail concerning some of the measures it intends to implement in order to attract investment in the UK's energy sector as part of the "Electricity Market Reforms" ("EMR"). This note summarises the key developments on EMR.

2. KEY ANNOUNCEMENTS

a. Publication of draft strike prices

(i) Overview

Contracts for differences ("CfDs") are a key part of the EMR. In effect, CfDs are a new form of support for renewables, which until now, have been supported by means of the Renewable Obligations system (for larger projects) and feed-in tariffs (for smaller projects).

The CfDs will be available to generators of low-carbon energy: new nuclear and Carbon Capture and Storage ("CCS") as well as renewables.

The "strike price" mechanism under a CfD means that the generator will receive the difference between the agreed strike price and the electricity market price (if the strike price is above the market price) or will pay that amount (if the market price is above the strike price).

The aim of the strike price is to reduce price volatility for companies investing in low-carbon projects and, consequently, offer them more certainty in respect of their return on investment and access to cheaper financing.

(ii) Pricing

In terms of pricing CfDs, the intention was always that strike prices would be set at the level necessary to support each particular technology. The Government has now published the draft strike prices in respect of renewable technologies for CfDs entered into between 2014 and 2020, as set out in the table below:

Ultimately, the renewable strike prices aim to help the UK meet certain environmental targets and economic goals, namely: make renewables contribute more than 30% of total power in the UK by 2020 and turn the UK market into one of the most attractive for developers of wind, wave, tidal, solar and other renewable energies.

The Government has made it clear that, as these technologies develop, the capital costs of projects will reduce and, accordingly, the strike price for projects commissioned in later years will be reduced. For instance, for CfDs entered into in 2014/15, generators of offshore wind will be guaranteed to receive GBP155 per MW/h whereas this will be reduced to GBP135 for CfDs entered into in 2018.

(iii) Timing

The launch date for CfDs is scheduled for around mid-2014. However, this could be delayed because the CfD model constitutes state aid and, as such, needs to be approved by the European Commission. The Department for Energy and Climate Change ("DECC") has said that the approval process could take about 18 months and has not yet begun.

DECC believes that CfD support for renewables such as onshore and offshore wind is likely to be approved sooner than aid to nuclear and CCS technology. Nonetheless, a utilities analyst has warned that the approvals process "is a pressing issue for low-carbon generators other than nuclear".³

b. Capacity Market

(i) Overview

The Government hopes that the Capacity Market ("CM") will encourage investment in new gas plant and other flexible capacity to maintain a sufficient supply margin from winter 2018 onwards.

As was originally envisaged, the Government will run the first CM auction in late 2014.

Ministers will decide on the amount of capacity for which capacity agreements are to be auctioned, based on analysis from the System Operator.

The CM will be technology-neutral – most existing and new forms of capacity will be eligible to participate⁴

Participants in the CM will bid to provide the amount of electricity capacity projected to be required. If successful, they will enter into a "capacity agreement".

(ii) Capacity agreements

The term of the capacity agreement will be one year for existing plants, except those requiring major refurbishments which may benefit from a term of up to three years. Longer agreements are expected to be available for new plants.⁵ Generators will receive payments for agreeing to make capacity available and deliver electricity when required, and face financial penalties if they fail to do so.

Large energy consumers will also be able to receive payments if they agree to reduce their energy demand at times of system stress.

(iii) Timing

The start of the CM next year is subject to the Energy Bill becoming law (scheduled for July 2014) and to receiving state aid clearance by the European Commission.

The first payment under the CM regime will not be made before 2018. Some energy suppliers have warned that, as a result, they may have to shut uneconomic plants. The Chief Executive of Scottish and Southern Energy (SSE) stated: "With Ofgem today warning on security of supply in the coming few years, it is vital that we strike the right balance between keeping existing plant open and making the market economic for new plant – unfortunately, the CM [as it stands] doesn't address the immediate problem".⁶

It is envisaged that the need for a CM will be reviewed every five years.

3. NEXT STEPS

Timing: The Energy Bill is currently before Parliament. Royal Assent is expected before the end of this year, for legislation to come into force in July 2014.

Government will publish the draft CfD during August 2013 and will be engaging with stakeholders over the summer. The final contract will be published in December 2013, alongside the final strike prices, and implemented through regulations laid before Parliament in 2014.

As for CM, Government intends to consult in the autumn on its proposals on the design of the CM and will draft secondary legislation to implement them, ahead of the legislation coming into force next year.

The Government is keen to send the message that investment is both required and will be facilitated by the new measures, including the EMR.

In the words of the Chief Secretary to the Treasury, "we are ready to unleash the energy revolution our country needs...Industry asked for certainty. We've given it. So now they need to get on with it".⁷

Footnotes

^{1. Based on biomass contracts ceasing to pay in 2027.}

^{2. For larger hydro projects, DECC will consider how best to price CfDs and the appropriate length of contracts on a case by case basis.}

^{3. Stephen Hun, utilities analyst at UBS.}

^{4. DECC has stated that the exceptions to this will be in respect of capacity supported by CfDs, FITs or Renewable Obligations and interconnected capacity. Please refer to its report of June 2013, "Electricity Market Reform: Capacity Market – Detailed Design Proposals".}

^{5. Government is still considering the term length for new plant and will consult on this later in 2013.  Please refer to the DECC report of June 2013, "Electricity Market Reform: Capacity Market – Detailed Design Proposals".}

^{6. Financial Times, 28 June 2013.}

^{7. Speech by Chief Secretary to the Treasury, Danny Alexander, "Investing in Britain's future".}

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