How to keep supplies secure

Is the capacity mechanism still an appropriate way to ensure security of electricity supply in the GB market?

The government has released a consultation paper that requests feedback on the capacity mechanism (CM) and whether it is still considered an appropriate approach to ensure security of electricity supply in the GB market. The consultation includes multiple sets of questions, but the overarching lines of enquiry are:

Will the CM still be needed in the future?

To what extent has the CM achieved its objectives?

Do the objectives of the CM remain appropriate?

Can the CM’s objectives be achieved in the future in a way that imposes less regulation?

Initial comments on these points below highlight fundamental questions that should be addressed as part of the review, including areas where wider issues should be considered.

The future

A mechanism will continue to be needed to enhance security of supply and to provide a predictable revenue stream for new entrant plant against which investments can be financed. The current capacity mechanism has a number of weaknesses.

By providing an additional revenue stream to a specified quantity of capacity, the CM is clearly enhancing security of supply. However, the focus on capacity rather than energy raises two issues.

First, if we have a winter with tight margins and electricity prices are very high for a sustained period, it will be interesting to see the reaction as power plant that have been paid for their capacity for a number of years then make significant profits when their capacity is actually needed.

Theoretically, the probability of high spreads on energy will be factored into capacity market bids, but given uncertainty about future peak pricing it is hard to estimate the extent to which this has actually happened. It is difficult to envisage option contracts being entered into in any other sphere where there is no contractual limit on the price paid when the option is called.

Second, the capacity mechanism does not take into account CO2 emissions resulting from the contracted mix of plant. One might argue that it is not intended to do so and that emissions are accounted for elsewhere. However, the reliability of carbon price signals from the EU Emissions Trading System is unclear, and the contracts for differences (CfD) mechanism must be revised to cater for future challenges. The design of the CM fails to address gaps in the current mix of market mechanisms. An alternative form of auction could be envisaged to address these shortcomings.

The objectives

The CM has attracted new capacity and facilitated investment. However, there have been issues with non-delivery and bias towards particular technologies. It is possible that the capacity mechanism has in some cases merely highlighted existing market issues by making the relative economics of different plant transparent. However, the offer of a stable revenue stream linked to one characteristic of new plant (capacity) distorts investment decisions.

Still appropriate?

Security of supply is important and, in a rapidly evolving market, measures to enable ongoing investment and sufficient capacity are appropriate. However, the role of the CM should be assessed as part of a holistic review of government contracting and market mechanisms, which also includes CfDs and transmission pricing.

Less regulation?

Scarcity pricing and the interaction with regulation in power markets is complex. There is no perfect approach, and even if there were, investors would have justifiable concerns about their ability to rely on a hands-off approach when markets are tight and prices very high. There are also financing benefits for contracted capacity. This combination of factors suggests that a contractual basis for new capacity there are do see ­possible options to rationalise the mix of contracting approaches that the UK government currently employs.

An alternative solution

Fundamentally, the CM is contracting for energy at times of system stress. Meanwhile, CfDs are contracting for energy at a variety of times, dependent on the output profile of the different low-carbon generation technologies. Contracting for energy from CCGT would support project financing and recognition of the CO2 emissions benefits they bring to the system regardless of fluctuations in the actually imposed carbon price. Contracting for firm energy from interconnectors would clarify their relationship with the GB power market.

A single auction format could be used to offer zero-subsidy contracts to all technologies, with contracts linking payments to the future delivery of energy as appropriate to the technology in question. This has parallels to the “equivalent firm capacity” idea proposed by Dieter Helm. However, attempting to translate all technologies into a capacity offer seems unnecessary, will involve excessive transaction costs for the owners of intermittent generation and does not address uncertainty on carbon pricing and other regulations affecting spark spreads for energy sales.

If we accept that the problem is too complex to be solved by a single capacity clearing price, then contracts could be offered to all technologies on the basis of a whole-system cost minimisation with technology dependent payments. Potentially appropriate contract forms may be an availability based tariff, as used in India, or a two-way CfD benchmarked to an optimised operational pattern for each technology.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.