Executive’s view: Mark Somerset

Independent gas-fired generators are losing money, yet government needs them to build plants to keep the lights on. The current market structure may not resolve this; the CMA should investigate why.

Any Ofgem referral to the CMA that emerges from the current consultation process will increase existing uncertainty as actors on the energy stage await outcomes ranging from tinkering to wholesale restructuring. Having read Ofgem’s 120-page State of the Market Assessment, what immediately jumped out to me is how little regard it paid to the electricity generation sector: a mere five pages. What does that say about the generation sector – do the regulator and government believe that it is functioning effectively and already operating in the best interests of consumers? Do they believe that generators are earning a reasonable economic return that justifies continued operation of their existing plant and will attract investment in new plant? Recent reforms on liquidity and cash-out suggest the authorities do recognise the need for change – which of course is welcome.

But is such change sufficient? Today gas-fired generators cannot cover their operating costs. In addition, there is no visible price signal in the forward wholesale market that supports economic operation of the existing gas-fired fleet and independents cannot secure profitable contracts. With no retail arm to support them, the outlook is bleak. Gas generation, singled out by the Department of Energy and Climate Change (Decc) and Treasury as the key transitional fuel to a decarbonised future, is loss-making and ­provides no positive investment signals.

Many believe that the UK faces the tightest capacity margins for many years in the coming winters. Tightening margins, combined with Ofgem’s final decision to introduce sharper cash-out prices and the implementation of market-making obligations from 1 April should in theory support independent gas-fired plant earning a ­reasonable economic return in this period – or at least ­covering their fixed operating costs, right?

Wrong. Winter 14 and Winter 15 forward prices barely support daily peak economic operation of the existing gas-fired generation fleet. It is worth repeating this – forward prices do not support the continued operation of the existing gas-fired generation fleet in the UK over a period where this plant will almost certainly be needed to meet peak demand. This is a particular issue for the independent sector (ie non-integrated), whose plants represent around a third of the gas-fired generating capacity in the UK and who rely upon a properly functioning wholesale market with a robust reference price along the curve to persuade their owners to invest and, most importantly, to stay invested in the UK.

Why are forward prices so depressed? Market concentration among the vertically integrated utilities remains high. If a firm’s domestic peak demand can be met from its own generation fleet, then why bother transacting in the market? Imposing market-making obligations upon the verticals is a welcome first step to try to improve liquidity in the forward market.

It is a troubling time for independent investors as they try to weigh up improving UK market fundamentals for gas plant (as coal plant closes under the Industrial Emissions Directive) against depressed forward prices in determining their investment plans going forward. This “missing money” may not appear until the capacity market in late 2018. Unless existing independent plant can earn a reasonable economic return, these investors will think very hard before building the new gas-fired plant that margin forecasts dictate will be required by the end of this decade.

Now, add in huge uncertainty around the capacity market’s first capacity auction (in particular the price at which it clears), scheduled for December 2014. Again, the backdrop could not be more difficult for existing independent plant as it weighs up what return it needs from the energy market (with none visible) in combination with capacity market payments (available four years hence) to justify continued operation until the first delivery year in 2018. What will investors do? Some may tough it out (supporting the cost base) or sell at rock-bottom prices. Some may cut and run, ie eliminate or reduce fixed costs through closure or mothballing. Needless to say, the latter will not improve security of supply.

I believe the fact that at least 9GW of UK capacity is on life support is not understood by government, the regulator or the system operator. This will undermine security of supply and investability in UK plc.

We are seeing a radical restructuring of an energy sector where subsidised must-run wind is killing margins available to the independent gas-fired fleet. Let’s start with the fixed cost base. Take transmission costs. National Grid forecasts a 15 per cent annual increase for generators to 2018/19, but even it acknowledges that this forecast is uncertain. As it stands, generators have no control over transmission costs other than through reducing firm transmission entry capacity – which can only be done by giving over a year’s notice to National Grid.

Then we have business rates, historically a significant proportion of the fixed operating costs of a power station. But huge uncertainty exists as to their future level. Some independent gas-fired generators have yet to agree the rateable value for their stations for the period prior to 2010, let alone the current period. An enduring ­methodology must be agreed.

All of which uncertainty brings me back to the CMA investigation. The referral has to be comprehensive in scope or risks an outcome that ignores key parts of the energy chain and therefore fails to address key areas of competition. The CMA investigation’s scope has to be sufficiently transparent for all of us involved in the sector to hold ­decision-makers to account and to rebuild trust, otherwise it runs the risk of achieving little and, while good in intention, will be limited to offering sticking plasters when we need major surgery.