Brussels review into capacity subsidies may still force reform

The European Commission has launched a review of whether subsidies promoting electricity generating and distributing capacity breaks European Union (EU) state aid rules. And while for the moment, it would appear the UK system is not under significant threat, the conclusions of the resulting report and subsequent detailed EU-wide state aid guidance may still force reform in Britain.Brussels review into capacity subsidies may still force reform in Britain.

The European Commission has launched a review of whether subsidies promoting electricity generating and distributing capacity breaks European Union (EU) state aid rules. And while for the moment, it would appear the UK system is not under significant threat, the conclusions of the resulting report and subsequent detailed EU-wide state aid guidance may still force reform in Britain.

The focus of the review are capacity mechanism subsidies designed to ensure that electricity supplies meets demand at all times – the Commission wants to ensure that these are paid “without distorting competition or trade in the EU single market.”

This is of critical importance as the EU develops its Energy Union strategy. Its key aim is to create a truly effective EU-wide market in energy, with producers trading electricity and gas across national borders, at a market price that reflects true production and distribution costs, encouraging investment in interconnectors.

To gather its evidence in the new inquiry, letters have gone out to 11 countries (Belgium, Croatia, Denmark, France, Germany, Ireland, Italy, Poland, Portugal, Spain and Sweden) asking for information proving that their ‘capacity mechanism’ subsidies do not unduly favour particular producers or technologies, or create obstacles to trade across the EU’s national borders. Other countries maybe included at a later date.

The review will collect the views of national energy authorities, electricity generators, suppliers, network operators and demand response providers. A Commission note said the result would be to create state aid guidance that can “promote competitive and market-based capacity mechanisms that complement the internal energy market rather than divide it; and ensure member states respect state aid rules when designing and implementing capacity mechanisms.”

“In some cases it might be more efficient to invest in improving electricity grid connections between EU countries than to build new power stations,” noted Commissioner Margrethe Vestager, in charge of competition policy, who launched the probe.

A more limited review of the UK capacity market staged by the Commission last year indicates that the Commission found much in the British system that it favours, and many of its elements may be included in the forthcoming Brussels guidance. The UK scheme “embraces the principles of technology neutrality and competitive bidding to ensure generation adequacy at the lowest possible cost for consumers, in line with EU state aid rules,” said the Commissioner responsible at the time, Joaquín Almunia, last June (2014).

Brussels noted that UK capacity mechanism auctions “will be open to existing and new generators, demand side response (DSR) operators and storage operators” and that the UK had also committed to opening the participation to new interconnectors as of 2015.

An official at Britain’s Department of Energy & Climate Change (DECC) argued that the UK scheme would “ensure enough capacity available to meet peak electricity demand in the future” and do so fairly.

However, Frank Gordon, senior policy analyst at the Renewable Power Association, which represents British renewable energy producers and promotes the use of renewable energy in the UK, does have concerns about the British system. Indeed, he stressed, that unhappily, the UK had excluded renewables from its capacity market and as a result the capacity market “incentivises keeping old polluting forms of power generation, coal and gas plants,” he said.

“We’ve publically stated our concerns about the capacity market: it doesn’t support renewable energy, it doesn’t support storage and basically it’s keeping open old polluting form of energy production,” Gordon said. The Commission conclusions might, conceivably, push the UK to change its system to incorporate renewables. Certainly, said Mr Gordon, it was “interesting that they’ve opened an investigation into European capacity markets and that’s not necessarily a bad thing for renewables.”

Whether the new probe will impact specifically on the state aid case into Lynemouth, where the Commission is looking into aid for a plan to convert the coal-fired power station to biomass also remains to be seen.

Brussels last month (April) released a formal request for more information on this particular case from all interested parties, including a detailed brief of its concerns. This gave more detail about the Commission concerns that the UK government might have underestimated the potential profitability of the converted plant when calculating how much subsidy is needed: “Calculations show that the IRR [internal rate of return] is significantly affected by the initial assumptions used in the financial calculations. For example, according to estimates based on UK data, if thermal efficiency and load factor were to increase by 5 per cent and fuel costs decrease by 5 per cent, the IRR (on post-tax real basis) would increase from 7.9 per cent to 16.8 per cent.”

And such predictions are hard to make, the Commission note stressed: “The input parameters such as thermal efficiency, load factor and fuel costs are estimates and as such prone to a certain margin of error…to lead to potential overcompensation.”

Brussels also detailed how the Lynemouth plant could distort global wood pellet markets should its conversion and hence later benefit from excess subsidies. This is because Lynemouth pellets would have to follow “well-defined specifications” and would “be imported mainly from the southeast United States, west Canada, and Russia”.

While pellet production in these regions has been growing rapidly, the volumes required by Lynemouth would risk “distorting competition”, not just in the utility market for such pellets but also for other users, such as pulp and paper or board manufacturing.

As a result, the “Commission cannot conclude whether the expected environmental benefit of the measure will outweigh the potential negative effects on other market participants,” said the note.

While the Lynemouth decision may come before that of its more general state aid inquiry, future specific cases will be impacted if the latest probe sparks a formal reform the 2014 EU guidelines on state aid for environmental protection and energy (2014/C 200/01).

Such new guidance could lead to the Commission ordering a reduction, change or elimination of all capacity mechanism subsidies. Under EU treaty rules, the Commission can impose unlimited fines if countries ignore such instructions, subject to an appeal at the European Court of Justice.

A Commission note sent to Utility Week said the inquiry “will also support future policy and legislative initiatives by providing a clearer picture of issues in this area. In particular, the Commission is considering the development of an EU-wide harmonised [legislative] framework for assessing the adequacy of the electricity system, and its ability to meet demand”.