Capacity for confusion

Mark Bartholomew and Jan Ole Voss say the British and German governments need to clarify details of their proposed capacity markets or risk investors staying away until they do

The UK government’s stated objectives for the electricity market are to decarbonise generation and achieve security of supply while keeping prices affordable. Electricity Market Reform (EMR) will introduce incentives for the step change in the rate of investment required to achieve these objectives. The forthcoming Energy Bill (due to be introduced in Parliament next month) will provide the necessary enabling powers to implement EMR.

In the years since privatisation in the early 1990s, the market in Great Britain has maintained an adequate generating capacity margin and security of supply has not been a significant concern. Currently, the system in Britain has more than enough installed generating capacity to meet peak demand even without a specific capacity incentive. While the Department of Energy and Climate Change (Decc) does not on this basis consider there to be any immediate risk to security of supply, it has identified the potential for a shortfall towards the end of the decade and aims to insure against the risk of the lights going out. A capacity market is therefore part of the EMR proposals.

Concern over security of supply is not unique to Britain. Similar concerns exist in Germany, Europe’s biggest electricity market. As in the UK, the German trading arrangements do not include a capacity mechanism and there is now growing support for this to change. In March the German Ministry of Economics published a report that concluded it would be “challenging” for the current market to support the necessary level of investment required in the future.

Roughly one-fifth of generation capacity in Britain is expected to close over the next decade. Nuclear power stations are reaching the end of their economic lives and the Large Combustion Plants Directive is forcing some fossil fuel plant to close. At the same time, electricity demand, which has been subdued in recent years as a consequence of the financial crisis and ensuing recession, is expected to rise as the economy returns to growth. It is likely that demand will increase substantially over the medium term, particularly if electricity is to play a major role in decarbonising the transport and heat sectors.

The German market has a similarly healthy capacity margin at present, although there are regional disparities. As in Britain, this is expected to erode as a consequence of market conditions and the closure of fossil fuel power plants. The German position is exacerbated by last year’s decision to withdraw all nuclear plant from service by 2022 in light of the Fukushima disaster and it has been suggested that a substantial proportion of the installed non-renewable capacity in Germany will need to be replaced in the next few years.

Given that both Britain and Germany have wholesale markets in electricity, it is not unreasonable to ask why the market cannot be relied on to bring forward the necessary generation capacity and why government intervention is thought necessary?

One answer might be that, in both markets, further flexible gas-fired generation is likely to be required and market conditions may not support this investment. Decc expects the level of nuclear and wind generation to increase in Britain, and this will mean more flexible generation will be required to balance the network. Similar considerations apply in Germany, given the relatively greater penetration of renewable energy in that market – currently more than 20 per cent.

However, in both markets gas-fired generation is likely to be dispatched less often as renewable and nuclear capacity increases, given that combined cycle gas turbines have higher marginal running costs. The resulting uncertainty over revenues will make it more difficult for investment in gas to be justified.

The detailed design of the proposed British capacity market has yet to be completed, but Decc has indicated that it will be based on capacity agreements to be allocated through a central auction process run between four and five years ahead. The auction will be open to generation (and demand resources) generally rather than creating a strategic reserve.

A broadly similar structure for a capacity market in Germany was set out in the March report. Whether or not the German government moves forward on the basis of this particular structure, clearly there has been a significant shift in German policy, which had previously been against intervening in the market in this way.

In Britain, Decc is developing the detailed design of the capacity market with the aim of being ready, if needed, to run the first auction in the autumn of 2014 for delivery in the winter of 2018/19. The lead time could be shortened to achieve first delivery in the winter of 2015/16 if deemed necessary.

While this approach maintains flexibility as to when the capacity market will be introduced and the detailed form it will take, the House of Commons Select Committee during its recent pre-legislative scrutiny on the draft Energy Bill commented that the “…deferral of a firm decision to implement a capacity market creates uncertainty and risks a hiatus in investment”. To mitigate the risk, the committee recommended that the forthcoming Energy Bill should clarify in what circumstances a capacity market would be introduced.

Some commentators on the German market have suggested that the continuing debate about a capacity market may encourage some investors to adopt a “wait and see” approach. It may, therefore, be that, having started a debate about capacity markets, there comes a point at which implementation becomes unavoidable to ensure continued investment.

Mark Bartholomew is a partner at SGH Martineau in London and Jan Ole Voss is a lawyer with Becker Büttner Held in Berlin

This article first appeared in Utility Week’s print edition of 26th October 2012.

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