THE NEW POLITICS OF ENERGY – CONFLICTS AND RESOLUTION

25th June 2015

In a speech given to the IMECH GAS TURBINE CONFERENCE in London on 24 June, Taylor Keogh’s associate Clive Moffatt argues the need to address the shortcomings of EMR and underpin the central role of gas in delivering affordable and secure energy.

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Good morning. Well, the lights have not yet gone out and a Tory majority means that we have been spared the negative consequences of Labour’s energy price freeze, draconian decarbonisation targets and the removal of Ofgem. We now have a Government that says it is committed to “delivering a low carbon economy at least cost to the consumer linked to the objective of increasing market competition”. This is easier said than done.

 
Whether we like or not we now live in an “administered” energy market where regulatory risk is ever present. Any change in the regulation and rules impacting on investment in one form of power generation has implications for the rest of the generation mix. And with focus across the EU on decarbonisation and supporting renewables it is gas generation that has been marginalised.

 
I will argue today that for operators , investors (particularly those active in the gas to power chain) and industrial and residential consumers there is probably as much financial uncertainty surrounding energy policy now, as there was when the Electricity Market Reform (EMR) programme back in September 2010.
What began as a policy focused primarily on incentivising the decarbonisation of the electricity market has turned into a somewhat schizophrenic mixture of incentives and penalties designed to try and combine the carbon reduction objective with the desire to reduce costs to consumers and ensure security of supply. Amber Rudd cannot wave a magic wand to make this “Trilemma” suddenly disappear.

 

 
HEADLINE UNCERTAINTIES

 
Some headline examples of conflicting political messages and persistent uncertainty include the following:
• The adoption of legally binding C02 targets across the EU has meant that gas has been marginalised and some 25 GW of existing gas generation plant EU is likely to be retired in the next two years and another 100GW is at risk because of continuing demand destruction, renewable production, cheaper coal and a plethora of energy efficiency measures.

• In the UK, there is still a lack of clarity on future renewable and new nuclear generation – and this combined with the uncertainty over the likely contribution of interconnection capacity and demand side reduction makes forecasting future capacity prices post 2020 and beyond very difficult. The level of subsidised capacity (renewables and new nuclear) operating outside the capacity market has a direct impact on auction clearing prices.

• The new Minister is on record as supporting the new nuclear programme but concerns are growing about the technical and economic viability of the Hinkley project. Treasury taking a stake in the project could reduce financing costs but with the overall bill now estimated at £24.5bn the time has probably come to re-consider whether the UK should continue down the nuclear route. However it is financed, the cost of new nuclear to the consumer will be significantly greater than incentivising the construction of new CCGTs to provide cost effective security of supply.

• In terms of progressing with the construction of new conventional gas generation – some significant potential barriers remain. The scope and terms of long term contracts under the UK Capacity Market are still subject to debate both in the UK (eg the argument about Price Duration Curves) and in Brussels ( eg the argument for allowing DSR to benefit from long term contracts). This uncertainty impacts negatively on the forecast capacity price and investor confidence.

• Not surprisingly given the overhang of existing fossil fuel and the inclusion of existing nuclear capacity the clearing price in the first Capacity Market Auction (£19.40 kw) was significantly below DECC’s estimate (£49k/w) of the net cost of new entry CCGT, despite the entry of some new plant. Given the current dynamics in the market, the prospect of the next auction in December 2015 clearing above £25k/w is unlikely.

• Further regulation and rule changes could seriously undermine the ability of the UK Capacity Market to offer a credible, consistent and market signal for new gas generation investment which in turn would put in jeopardy the delivery of the £20bn of new capacity which DECC say is needed before 2030 to keep the lights on and support intermittent renewable generation.

• In Brussels, the EU jury has still to make up its mind on whether the proposed new nuclear subsidy to EDF is justified, whether DSR should receive 15 year capacity contracts and last but by no means least the EU (having spent years trying to set a single market) has just launched a review to examine what it fears are highly divergent capacity mechanisms under consideration (ex UK at the moment) across the EU.

• Finally, only a few weeks ago the G7 group declared that there should be no fossil fuel generation after 2050. A bold statement of intent indeed. 2050 is 35 years away and I strongly suspect that the desire to fuel economic growth and concerns about affordability and security of supply will result in some watering down of this objective with gas by necessity being deemed a low carbon fuel.

 
The art of good government is to manage expectations and the inevitable conflicts or “trade- offs” between different policy objectives. Unfortunately, in the case of energy, the last Government was very slow to recognise that trying to square the circle on carbonisation, security, competition and affordability would be very difficult and certainly very costly. As Amber Rudd prepares to draft her first Energy Statement one hopes for a change in emphasis away from decarbonisation and renewables to security of supply and affordability.

 
A major overhaul of energy policy would seriously undermine investor confidence but some new thinking and a lot more clarity are needed to resolve a number of key potential policy conflicts and come up with a long term stable and predictable investment environment. Furthermore, it is not too late to begin to unpick the myriad of regulatory incentives and penalties and place more reliance on much simpler market mechanisms to deliver affordable and secure energy.
In my view there are SIX key policy conflicts or “trade- offs” where greater clarity and long term commitment are required:

 
SIX KEY POLICY CONFLICTS

 
A PRICE v QUANTITY
Every Minister would love to be able to control both the quantity and price of both carbon and generation capacity but it is impossible to do both at the same time without there being serious unintended consequences. This policy confusion is reflected in the debate over the allocation, term and level of renewable subsidies, capacity payments and price of carbon ie the Carbon Support Price (CSP).

 
B SHORT v LONG
The Government accepts and continues to defend the argument that that long term subsidies are needed to incentivise investment in renewables and nuclear power but in the case of the capacity mechanism there appears to be a desire (partly prompted by EU rules on State-Aid ) to minimise the incidence of long term contracts. This ambivalence over 15 year contracts is reflected in the proposal to discount capacity payments to equate them with one year contracts for existing plant. (Price Duration Curves) Yet without long term contracts developers cannot raise the funding required to build new plant and the cost to the consumer would be greater.

 
C DEMAND v SUPPLY
Politicians and DECC have for some years accepted the lobbyists arguments that there is significant potential for efficient and reducing demand at times of peak demand (eg Ofgem’s estimate that potentially 4GW of demand could be withdrawn at times of stress) This despite all the evidence to the contrary about how energy demand reacts to price and real incomes and both residential and industrial inability and unwillingness to cut – or promise to cut – demand significantly at times of system stress. This belief in the high impact value of energy efficiency combined with overestimates of the base and peak demand contribution of renewable energy , interconnection capacity, new nuclear and underestimates of the impact of higher economic growth on overall energy demand serves to undermine the scale of level of new conventional gas capacity the market needs to deliver by 2030.

 
D CARBON v AFFORDABILTY
The Government has decided to opt for a significant level of long term subsidies for different low carbon technologies (inc nuclear).However the budget for renewables and new nuclear post 2020 has yet to be decided. Combining the current £7.5bn renewable allocation with new nuclear would result in a massive increase in the Levy Control Framework budget unless Treasury decide to fund new nuclear separately ,which given the overall deficit reduction target (£30bn) is unlikely. Meanwhile the overhang of existing old fossil plant combined with a freeze on the CSP is inhibiting the pace of new investment in essential new gas generation.

 
E NUMBERS v COMPETITION
The last Government’s decision to proceed with a CMA review of the energy market implies some action is likely on intervention in the wholesale and/or retail market. Some additional Regulatory control over retail prices is likely and the prospect of unbundling generation and supply is still on the agenda – though now less likely with a Conservative Government. The case for the enforced “unbundling” of generation and supply has never been proven in theory. Simply creating more independent suppliers could actually increase rather than reduce retail prices and the reduce investment in new generation.

 
F VOLATILITY v SECURITY
In September 2014, Michael Fallon the then Minister of Energy, ruled out any intervention to support new investment in gas storage even though DECC’s consultant report concluded that under most risk scenarios the benefits of more storage in terms of physical security and reduced energy price volatility would exceed the costs. Fallon argued that the UK had ample suppliers via pipelines and LNG but it is in the short term (4-6 weeks) where we the UK is most vulnerable. With imports at 60% of demand and rising and Centrica’s Rough facility (accounts for 70% of UK storage) coming to the end of its working life – more storage is required and more fracking (where output is not demand following) does not obviate the need for more short-term flexible gas storage.

 
THE ROAD TO RESOLUTION – FIVE POLICY RECOMMENDATIONS

 
So, what can be done to address the shortcomings of EMR and underpin the central role of gas in delivering secure and affordable energy? And what should Amber Rudd consider including in her first Energy Statement this September?

 
Briefly, my suggestions would be:
(1) place the focus of energy policy on security of supply and affordability with less emphasis on decarbonisation. Decarbonisation should be addressed through a meaningful carbon price mechanism that is agreed across the EU. Revenues from a higher carbon price should be used to fund tax breaks to energy intensive users, new technologies and fuel poverty.

 

(2) if no EU wide agreement is possible the UK should opt for “soft” targets for UK decarbonisation linked to a policy to reduce over time ie next 15 years all subsidies to renewable and nuclear energy and replace with a steeper trajectory for the price of carbon. ie fix a range of FITs (no Cfds) (for a stipulated range of technologies) and an overall LCF budget and let the market decide what technology to build. In the short term this would help underpin the capacity market mechanism by accelerating the retirement of old fossil fuel plant and would in the medium term allow all forms of generation to compete in market without price guarantees and subsidies.

 

(3) re-consider the case for new nuclear and confirm the medium term requirement for a significant level of new investment in conventional gas generation to meet base and peak load demand and underpin the role of long term contracts for new plant and remove potential barriers to entry for new gas plant eg Price Duration Curves and stricter CO2 emissions targets ie no CCS required on new plant built after 2030.

 

(4) before the CMA reports at the end of the year, make it clear that the Government does not favour any “unbundling” of generation and supply which could deter future investment in new capacity and lead to the creation of a large number of sub-optimal supply businesses and increase costs to consumers. Instead the focus should be on trying to underpin the efficient operation of the wholesale market via the re-introduction of the Electricity Pool .This would create a reliable and transparent spot price with market exchanges facilitating forward trading and could as before be designed to include a capacity payment element.

 

(5) re-open the case for intervention to underpin the demand for new UK gas storage to secure short term supplies and minimise the impact of shortages on both gas and electricity price volatility. The current gas security standard should be extended to embrace industrial users and power generators and DECC should evaluate the costs and benefits of introducing a form public service obligation on importers. Research by industrial users suggests that a PSO mechanism designed to deliver an extra 5bcm of new storage would cost all consumers no more than an extra 1p per therm.

 
Balancing the needs of decarbonisation, affordability and security remain is extremely challenging. However, the Government needs to recognise that gas is the cheapest and cleanest way of securing these collective policy goals and its pivotal role should not be marginalised in favour of less reliable and more costly options (eg new nuclear, off-shore wind and demand-side reduction (DSR). Nor should steps be taken to increase the cost of investing in conventional gas generation (eg stricter CO2 targets). A greater reliance by Government on market mechanisms such as the CSR will in the longer term deliver a more equitable outcome in the interests of investors, developers and consumers.

 
CLIVE MOFFATT

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