Jury still out on capacity market

In this Market View, Paul Exley and Matt Lewy of Baker Botts consider the recent Tempus judgment of the European Court, its impact on the UK’s electricity capacity market and the implications for potential investors.

Last November European courts took everyone by surprise by suspending the UK’s capacity market on the grounds that the European Commission had cleared the scheme on state aid rules without due scrutiny. It was a victory for the complainant, Tempus Energy, a primarily UK-based energy technology and systems provider who said the capacity market unfairly discriminated against demand-side response (DSR) providers in favour of fossil fuel generators.

Because of the suspension, payments due under capacity market contracts already in place cannot be made, and no further auction rounds will be held. Further auction rounds for contracts that can run for up to 15 years were due on 5 February 2019, but these have been postponed.

Following dialogue with the UK government, the Commission lodged an appeal against the ruling in January this year. The process is likely to take at least six months, and the outcome will not necessarily be that the capacity market (at least in its current form) is reinstated and the suspension lifted.

In tandem with the appeal, the Commission announced in February that it is to open a full, formal investigation into the capacity market. It is not clear how long this will take, and the Commission has indicated that it intends to focus on DSR.

Addressing the differential treatment of DSR, one of the key justifications for offering new generators longer contracts (up to 15 years) was the high level of capex entailed in taking a greenfield project to operational commencement. This often involves a high level of project financing, which in turn is often only viable in the event that stable, long-term revenues can be predicted. Hence the need for a longer contractual award.

While the implementation of DSR does involve capex expenditure, the scale of capex involved is often lower than for greenfield generation projects. However, it is not entirely clear that this justification will satisfy the Commission, and indeed equivalent capacity markets (such as in France, Ireland and Belgium) do not treat DSR differently to generators.

In order to try and reassure the market while the situation is unresolved, the UK government has stated that there is no current shortage of capacity, and that while the Tempus judgment is unfortunate, it is merely a procedural issue that should be remedied during the course of 2019. The government has also indicated that:

• potential participants in future capacity market auctions should prepare for forthcoming auction rounds;

• the 2019, T4 auction round may be replaced with a 2020 T3 round (for the same delivery years but truncating the timetable);

• it intends to run a one-off T1 round later in 2019 (again truncating the timetable) with payments due to successful bidders to be made after state aid approval is granted (or the Tempus judgment successfully appealed);

• top-up payments due under pre-existing awards will be forthcoming if the current capacity market suspension is ended (in lieu of payments that cannot be made to participants during the standstill period).

In response, on 5 March Tempus Energy lodged a claim for UK judicial review, with the primary aims of requiring capacity market payments made to successful bidders during 2016 and 2017 to be clawed back; and preventing the government from holding any form of capacity market auction while its state aid approval is under consideration.

While it is difficult to predict the next steps for the capacity market, in broad terms at least three possible outcomes seem likely.

First, that the capacity market is granted state aid approval in its current form, potentially during the course of 2019.

Second, that the Commission or courts take a pragmatic approach, such that the capacity market is required to make certain changes going forward – to the treatment of DSRs and potentially areas – but is not required to revisit awards already made.

Third, that the suspension is upheld, such that an entirely fresh capacity market application is required, and each of the previous auction rounds are annulled. This scenario may be coupled with a successful UK judicial review application by Tempus.

In either of the first two scenarios, the government could act as planned: by holding its next set of auction rounds on truncated timetables and making top-up payments to participants under current contracts.

The third scenario is probably the worst case, at least from the perspective of an investor, because payments already made to successful bidders would need to be clawed back and the underlying contracts would effectively be rescinded. New auctions would need to be held using an updated and revised set of rules.

In the worst case scenario, or in the event of a significant delay in any final decision, it is possible that recipients of suspended (or annulled) awards may decide their projects are not viable, leading to project closures or cancelled investments.

Wider ramifications

As part of its wider energy strategy, the UK is currently tendering for the latest round of renewable energy contract for differences (CfDs) through an auction process. Around £60 million has been allocated for award to certain categories of “less established” renewable technologies during May 2019, which it is expected will (as with previous CfD rounds) mostly benefit offshore wind.

Further, this month the government announced a sector deal for offshore wind, which includes injecting £250 million into an offshore wind growth partnership with the aim of procuring one-third of UK electricity generation from offshore wind by 2030. This increasing dependence on intermittent wind reinforces the requirement for a form of capacity market to ensure supply.

As regards Brexit, it is worth noting that unless the UK leaves the EU on a no-deal basis, it is likely that a transition period will last until at least the early 2020s, during which time EU rules would apply, including those relating to state aid.

Paul Exley, partner, corporate practice, and Matt Lewy, senior associate, corporate practice, at Baker Botts