Is the capacity auction a good deal?

The new year has brought a new billion pound question for the UK energy sector: has the government’s recent capacity auction proved to be the best means to secure supply margins for the end of the decade?

The UK government finalised the results of its first capacity market auction on Friday (2 January), raising investor eyebrows with a lower-than-expected payout price of £19.40 per kilowatt per year to secure 49.3GW of power supply for 2018/19.

The reverse auction cleared after three days of steadily declining bids from participants, falling far below the £25-40/kW predicted by analysts and including a mix of capacity that was distinctly skewed towards plant that already stood the best chance of weathering the difficult years ahead.

The auction was designed to provide the UK’s beleaguered conventional generators a guaranteed return for their plant in exchange for security of supply as the power sector makes the transition to a low carbon future. In addition, the government said the auction would bring forward much-needed investment in new gas-fired power as well as demand-side technology options.

However, the weaker price guarantee, although welcomed by government as more affordable for consumers, has also diluted the intended benefit to the market, while pricing out the more expensive investment options the UK sorely needs.

Through the auction more than 60 per cent of the £1 billion guaranteed payment mechanism will be paid to operators of existing generation units over those investing in new plants or demand-side response.

Although each household will pay just £11/year as a result of the policy, Labour shadow energy minister Tom Greatrex argued that “flaws in the detail of the capacity market’s implementation mean that consumers are being short-changed”.

“Existing nuclear power stations have secured 16 per cent of the market, despite the fact that they are unable to respond to peaks in demand. Demand Side Response [DSR], widely seen as a means of reducing the cost of this policy, has been squeezed into less than 1 per cent of the market. Interconnectors, which the government has recognised could reduce costs, will be included in 2015 but were excluded this year – no compelling reason has been given,” Greatrex said.

Energy policy professor at Exeter University Catherin Mitchell said the government had “fallen for” energy company warnings that without an additional payment they would be unable to survive in a market increasingly distorted by rising renewable energy subsidies.

“The vast majority of payments under the capacity market will go to the large, well-known generators. They have done a great job in persuading government that unless customers pay this extra amount it would be uneconomic for them to keep the power plants running and the lights will go out,” Marshall said.

The lower auction outturn also undercut higher bids from developers of new plant and demand-side response technologies, with around 43 per cent of pre-qualified new-build capacity failing to secure a contract through the auction, making up just 5 per cent of the end result.

Of existing plant taking part in the auction, 37 per cent dropped out during the three-day auction process but will still make up 63 per cent of the auctioned market.

By technology type the biggest loser at auction was DSR, which saw more than 70 per cent of pre-qualified capacity fail to secure a contract. DSR will make up less than half a per cent of the capacity market while gas-fired power stands at 45 per cent and with coal and nuclear capacity at 18.7 per cent and 16 per cent, respectively.

The government’s decision not to offer contracts longer than one year to DSR was criticised by the burgeoning industry, with market newcomer Tempus Energy launching legal action against the government late last year.

However, analysts have warned that even those generators successful at auction will continue to face challenging market conditions towards the end of the decade because of the low clearing price.

“The challenge for asset owners and project developers is that this capacity auction has not provided the cure to the challenging economics,” said Baringa partner Phil Grant.

“A clearing price of £19.40/kW is below the annual fixed costs (such as salaries, connection costs, insurance, ongoing maintenance) of the majority of generating plant. This implies that to remain economically viable in 2018/19, generators must be looking to make money elsewhere,” Grant added.

Deutsche Bank said in a research note that the auction result was “disappointing”, adding that there could be a negative impact on the revenues and earnings of utilities with power stations in the UK.

Deutsche Bank said the lower clearing price could negatively affect its earnings estimates for RWE by up to 10 per cent, and for Drax and SSE by more than 5 per cent.

Grant said the low price level meant generators may need additional support – either from further capacity payments or higher wholesale prices – to avoid having to shut down capacity.

Mothballing plant in the interim period before payments begin is one option open to generators. But combined with potential closures from those plants that failed to secure a contract, the UK could find it is still battling shortfalls in supply over the near term.

In the longer term, if the government’s auction continues to bring forward only meagre volumes of new gas-fired power capacity then inevitable shutdowns of the old plant currently supported by the auction could leave further gaps to fill in the 2020s.

The contracts will, however, offer generators some certainty to plan for an ever more uncertain energy future, according to EY.

“I would suspect there’s an even greater degree of confidence now as the auction shows the mechanism can support many different types of capacity – including investment in new CCGTs – and drive a competitive capacity price which will not necessarily push up consumer bills,” said EY senior economic advisory executive Anthony Tricot.

With Europe’s governments mulling similar steps to safeguard their respective thermal fleets, many people will be watching keenly to see what the impact of the auction is on the UK’s energy utilities over the rest of the decade.