The return of the capacity market

After the capacity market was reapproved by the European Commission last week, Tom Grimwood explores the implications of its return and whether its year-long suspension will have any lasting effects on the scheme.

Love it or loathe it, the capacity market is back.

It’s coming up on a year since the European Court of Justice sided with Tempus Energy in overturning a 2014 decision to ratify the mechanism as compliant with state aid rules, thereby rendering it illegal.

Following an eight-month investigation conducted at the behest of the court, the European Commission approved the scheme for a second time on Thursday (24 October), paving the way for its return.

The most pressing concern for the energy industry is when the payments from suppliers and to capacity providers will resume.

In a written statement delivered to parliament last week, business and energy secretary Andrea Leadsom said the “vast majority” of the payments to providers will be made in January 2020. The suspension of the capacity market has collectively blown a £1 billion hole in their finances.

According to analysis published by the ratings agency Moody’s, the worst affected company in absolute terms is EDF, which has been left £308 million short by the freeze. Next comes RWE, which is down £204 million, and SSE, which is down £151 million.

But the firm breathing the deepest sigh of relief may well be Intergen, which of the companies that Moody’s examined was by far the worst affected on a proportional basis, losing more than 40 per cent of its operational revenue for the current financial year – or £39 million.

For comparison, SSE and RWE – respectively the second and third entries on the list – were deprived of less than 10 per cent of their operational revenue.

Impact of reinstatement on funds from operations

Source: Moody’s

There was no date given in Leadsom’s statement for when collections from suppliers will commence.

However, Audrey Gallacher, director of policy at Energy UK, said a letter sent by the minister on Friday to the delivery and settlement bodies instructing them to resume the operations they suspended during the standstill should trigger a pre-agreed timetable for collecting the charges.

If the process proceeds according to this schedule: “Suppliers will be getting an invoice on 14 November, and they’ve got until the 21 November – five working days – to pay that invoice.”

“If they don’t pay that invoice, then the Electricity Settlements Company will do a default supplier list – so it will name anyone who hasn’t made the payments,” adds Gallacher. “And then, because it’s a creditor, it will go out and actively get that cash off anybody who hasn’t paid.”

She continues: “Any money that is not collected by 13 December is then subject to mutualisation.”

For the uninitiated, mutualisation is the process by which any unpaid bills are recovered proportionally from all suppliers that are still operational. Last year, the mechanism was activated for the first time for the Renewables Obligation (RO) scheme, after suppliers collectively failed to make nearly £60 million in late buy-out payments.

Unlike with the RO, capacity payments are collected from suppliers on a monthly basis. They are also worth a lot less on a per-kilowatt-hour basis. Cornwall Insights’ forecast for the current year puts the cost of the capacity market to suppliers at 0.39p/kWh – less than a sixth of its 2.6p/kWh forecast for the RO.

However, the suspension of the capacity market means the bill for the best part of a year will all come due at once.

Robert Buckley, head of retail at Cornwall, says most companies should be well prepared for this: “All the conversations I’ve had over the last 12 months are that people have been separately accruing the capacity market payments in the expectation that they would have to make them, and often that’s involved the payments going into separate accounts, or certainly being accounted for separately.”

On the other hand: “The track record of non-payment of other things suggests that some people may have a problem.”

Gallacher says the government has had its finger on the pulse of suppliers: “Up until now suppliers have encouraged to collect the money. They’ve been getting shadow invoices, if you like, so that there isn’t any surprise about what the ultimate bill would be.”

“Throughout the summertime, BEIS conducted an exercise to assure themselves that suppliers were collecting that money,” she explains.

“Now, they didn’t contact all suppliers because of course there’s about 60 suppliers in the market, but they contacted suppliers that cover about 90 per cent of the market and 90 per of the customers and they satisfied themselves that the money is there.”

Regardless of whether or not any more suppliers go under, the mutualisation process does seem likely to be activated. As Moody’s pointed out in its comments, Toto is far from the only firm to have failed during the suspension.

In total, 12 suppliers with more than 900,000 customers have ceased trading. They were not required to hold the payments in a separate account, meaning they have probably been lost and will need to be recouped from the rest of the sector. Moody’s roughly estimates the bill at less than £20 million.

Supplier failures during the standstill

Source: Moody’s, Ofgem figures

Another, slightly less pressing issue is whether there is any risk to the capacity market from further legal challenges.

Frustrated at ministers’ efforts to keep the scheme partially running – encouraging suppliers to make voluntary payments, advising capacity providers to continue complying with their agreements, and holding or arranging two replacement auctions – Tempus Energy applied to the High Court in March for judicial review of the government’s actions in an attempt to enforce the shutdown.

The firm was successful, with the start date set for 11 November. It’s not clear what effect the reinstatement of the capacity market will have on the case, although it’s hardly likely to help.

Tempus also has a two-month window in which it can file an appeal against the European Commission’s latest decision.

But with the executive having undertaken the in-depth investigation which the court said it should have done originally, the procedural grounds for an appeal have become much weaker. “Any appeal will likely have to be against the substance of this decision itself,” notes a briefing from KPMG.

Responding to the announcement in a statement, Tempus Energy nevertheless accused the commission of having “rushed through” the reapproval of the capacity market, “ensuring the energy industry can rip off consumers to the tune of £1 billion a year.”

With National Grid forecasting a 13 per cent supply margin for the coming winter, the company said it is “ludicrous to suggest consumers should be paying for subsidies to keep the lights on”.

Tempus did not say whether it plans to continue the fight, merely stating that it will be “studying the judgement” before commenting further.

A question for the longer term, assuming it’s here to stay, is whether the suspension will have any lasting effects on the capacity market and its rules.

Certainly, the government has made a number of commitments as part of the reapproval, for example, to review the contract lengths available to different technologies and the minimum size for capacity market units.

Whether its hand was forced or it would have considered these changes anyway is difficult to say from the outside. They were all touched upon in its first five-year review of the capacity market, which was published July.

The inability to access the 15-year contracts available to new build generation and create units of less than 2MW were both key complaints of Tempus, which claimed these arrangements left nascent technologies such as a demand-side response (DSR) unable to compete on a level footing.

Alistair Martin, the chief strategy officer for fellow aggregator Flexitricity, says it’s “great” to have the capacity market back: “Our customers are now going to receive the payments for the service that they have delivered”.

But he also strongly welcomes the government’s commitments: “It’s not exactly as if they made an undertaking there, but they’ve clearly opened that page of the book and are beginning to study the options there.”

“However, it was arrived at,” he adds, “we’re looking forward to seeing detail and getting demand response much closer to trading on an equitable basis.”

Tempus has called for the 2MW threshold for capacity market units to be lowered to 100kW. In its briefing on the reapproval, KPMG said it would be “surprised” if the government did reduce it to this level.

Any benefits would have to be weighed against the “operational burden” on the delivery body, and few participants actually took advantage of the lower thresholds in the few transitional auctions designed specifically for DSR.

The briefing also argues that longer contract lengths will have a limited impact given that the accompanying thresholds for capital expenditure will probably remain in place and “prove too high for DSR”.

It additionally warns that longer contracts could create an incentive for batteries to move behind the meter and disguise themselves as demand-side response in order to benefit from more favourable de-rating factors.

The government has also committed to allowing foreign capacity to participate in auctions. The EU’s new clean energy package may have eventually required this anyway, but the briefing suggests this is likely to be the most consequential of the government’s pledges.

“Once this commitment is implemented, we do not believe that interconnectors will continue to be eligible to participate in the capacity market,” it explains.

“This will impact interconnector revenues and could potentially have some impact on the attractiveness of future interconnection projects, coming as it does on the back of the uncertainty caused by Brexit.”

The suspension of the capacity market may be over, but it will be a while before its full effects are known.