Winter is coming: why the UK needs to thaw investment in new capacity

This year the balancing reserve may well be called upon to see us through winter, and margins will grow ever tighter as capacity is taken offline. Jillian Ambrose reports.

National Grid’s winter outlook report covers familiar territory for the energy market. Yes, supply margins will be tighter than they have been. And yes, National Grid is equipped with the tools to balance the system should cold wintry weather tighten its grip on already meagre margins.

However, this year’s report comes with two important caveats regarding its ‘last resort’ measures: National Grid’s balancing reserve is less likely to be merely ‘precautionary’ this winter; and in the coming years this trend will continue.

So whereas once the balancing reserve was for a “worst case scenario”, this year the worst case is expected to be the actuality. And the years to follow are expected to be worse still.

“While there should still be sufficient capacity available to cover demand, there is now very little ‘fat’ in the system to absorb unexpected events,” warns Jefferies analyst Peter Atherton.

“More concerning is the situation the UK may face in 2016/17. [National Grid’s] emergency measures have been sufficient so far, and may be sufficient for the coming winter, [but] the dislocation in the UK power market is slowly eating away at security of supply. Further coal closures, or an unexpected event, could prove a tipping point,” Atherton says.

Ofgem has long predicted that the UK power sector would feel a squeeze over winter 2015/16 as older plant shuts down and new investment comes forward. But the pace of closure has accelerated with the UK now set to lose Scottish Power’s 2.3GW Longannet plant and 1.9GW Eggborough plant, and SSE’s 1GW Ferrybridge and 0.5GW Fiddler’s Ferry assets in less than six months.

These heavy losses will more than offset the expected rollout of new investment in renewable energy and gas-fired power.

Strategic reserve here to stay

The regulator now admits that a strategic balancing reserve will need to remain in place until the government’s capacity market is able to secure supply. The reverse auction is expected to deliver capacity from winter 2018 and beyond through its reverse auction. But now even these plans look doubtful.

Just a week before National Grid’s winter outlook it emerged that Carlton Power’s planned Trafford gas-fired power plant has still not been able to secure the investment needed to drive the £800 million project forward, despite stubbornly holding firm in the reverse capacity market last year as the price dropped well below analysts’ expectations.

The auction finally concluded at £19.40/kW after three days of sinking pricing levels, which vindicated the government’s insistence that the auction would deliver the lowest cost to consumers, but at a price so low that it leaves generators in trouble.

Unless the situation changes soon, the Trafford plant will not be available to supply power by its contracted 2018 start date. Although a specific case, it raises important questions over why mechanisms designed to thaw investment in UK energy have yet to warm up.

Critics warned last year that the auction would needlessly reward existing power plant – which would have been available to the market even without a contract – and fail to bring forward investment in much-needed new capacity.

Analysis from Cornwall Energy suggests that the auction level is almost half what a new-build gas project would need. A report from the analysts shows that a minimum clearing price £35/kW is necessary to support large-scale new CCGT, “and that is being optimistic on wholesale market revenues”, Cornwall Energy said. “So we are not particularly surprised Trafford is struggling.”

The failure of the capacity auction to ensure that investment will come forward by the end of the decade has already prompted action from the government.

Under proposed changes to the auction it will now be harder for developers to drive the price down lower than a level they can truly afford in the hope that investors come to their rescue later. Large-scale developers will be required to tell the government ahead of the auction what their lowest possible price is, to prevent them from bidding lower on the day.

If they are still able to compete for long enough to secure a contract, they will face post-agreement tests at the five-month and 11-month marks, where they will be required to show evidence of investor support. Failing these targets will come at a steep price. Under the government’s plans, developers that fail the post-auction tests will lose their contract and will be banned from future auctions for a period of three years. This will apply to both the development company and any person responsible for the project at director level.

The prospects for CCGT

So what hope for new gas-fired power capacity in the upcoming auction this year? The answer, in short, is bleak.

Cornwall Energy says new-build gas plants could struggle because existing capacity continues to exceed the total sought by the government. Although there have been capacity closures announced in both gas and coal since the last auction, Cornwall says “these have come from plant that did not trouble the auctioneer in the last auction”.

In addition, 2.4GW of cheaper interconnector capacity and 3GW of smaller embedded plant has pre-qualified, with 7.5GW of existing coal plant still remaining.

The government may be betting that eventually the UK’s remaining coal fleet will follow the 6GW about to close their doors, which could allow market auction prices to maintain levels high enough to make gas investment viable. But even this gamble might only pay off in the early 2020s ahead of a planned new nuclear revolution by the middle of the decade.

National Grid may well be ready to weather the coming winter. But without a clear, workable road towards securing investment in much-needed thermal capacity the operator could find itself faced with a steady succession of increasingly difficult winters to contend with.