UK “capacity market” is not a market – it’s state aid (£1 billion/year)

Energy Post

The UK is the first country in the EU to have started a “capacity market”. Under this scheme, the UK government offers payments to electricity suppliers for making “backup capacity” available. The first auction, held in December for capacity in 2018/2019, has resulted in contracts for £931 million for UK power generators. According to Mike Parr, Director of energy consultancy PWR, most of this money is wasted. He says the scheme is overgenerous because it covers the entire 49 GW of capacity in the UK rather than just the 6 GW peak capacity that needs to be covered. It also fails to encourage new-build generation and demand response.

When is a market not a market? When it is a “capacity market” in the UK.

In December last year, the UK announced the results of its “Capacity Market” (CM) auction. The idea behind the auction is to ensure that the UK has enough generators connected to its power network to meet peak (winter) demand. A key intention of the auction was to encourage new build generation. A number of other EU member states are considering CMs and thus there is a lot of interest in what is happening in the UK. The CM was allowed by the EU’s competition authorities (DG Competition) in mid-2014 (on the basis that it is not state aid).

Winners of the auction were awarded contracts to provide a specific amount of power at 4 hours’ notice (for at least 4 hours) to National Grid, the national transmission system operator . The first auction covered the year 2018/2019. The government wanted commitments from 49GW of power generation which corresponds to the forecast maximum demand in the UK in 2018/2019. The auction resulted in a price of £19.4/kW. The cost (to electricity rate payers) will be about £931 million for 2018/2019. Similar costs may be expected in the years thereafter.

Perverse result

The first question that arises is why the government auctioned for the entire power generation capacity the country needs rather than just the part it may be short of at any one time. Peak power demand in winter in the UK occurs between 1600hrs and 2100hrs weekdays. Power demand varies over a winter day between a low of 30GW (2300hrs to 0600hrs) and the evening peak of 49GW. During the day demand is around 43GW. The actual “peak” is thus roughly 6GW above day-time levels. As we will see, because the auction tendered for the whole of the 49GW and not just the peak element of 6GW, this produced a perverse result.

DECC needs to answer this question: “why did demand response get 1 year contracts and new generation capacity get 15 years”?

Of the 49GW of capacity procured, 44 GW already exists and has been signed up under one-year contracts. A further 3.1GW of existing capacity was contracted under 3 year contracts. 2.6GW of new capacity won 15-year contracts, thus getting £684 million over the term of the contract (i.e. not just for 2018/2019, but over 15 years). Furthermore, there are additional payments for producing energy.

The reason the auction attracted only small amounts of new build was because the final price (£19.4/kW) was low. The reason the price was low was because any generator could bid and because DECC decided it wanted to have the whole 49GW block bid for – not the part that was the peak above the normal winter daytime demand.

Winners and losers

So who where the winners – and losers? EdF bid in part of its nuclear fleet (which would run anyway) and will be given roughly £150m in 2018 for doing what it would have done anyway (i.e. run its power stations). Drax, another large station, won £26m for doing exactly what it would have done anyway. The large utilities trousered around £698 million for doing what they would have done anyway.

Other winners included providers of STOR (Short Term Operating Reserve) services to National Grid. STOR is used by National Grid in time frames of up to 2.5 hours and has a 5 minute to 22 minute call-up time. Clearly, anything that can provide STOR is also able to meet the CM conditions. Key point: STOR providers now get paid both for STOR and for CM.

There were also some losers. Demand response got just 174 MW of agreements with one year contracts. According to the team of the Department of Energy and Climate Change (DECC) that set up the rules, the auction would be “technology neutral”. (Source: private conversation with DECC. See also this policy document.)

That being the case, DECC needs to answer this question: “why did demand response get 1 year contracts and new generation capacity get 15 years”? Both take time and effort to set up, neutrality should mean that both are equally rewarded.

DG Competition should have seen that a perverse result would happen with respect to the capacity market auction, given that DECC tendered for the whole 49GW and that all generators were allowed to take part

Other losers include the UK population. In 2018, each UK household will write a cheque for £15 (residential demand is roughly 33% of UK demand, there are around 20 million residential properties & 33% of £931m is around £310m) which will go mostly to generators that would have generated anyway.

DG Competition could have and should have seen that a perverse result would happen with respect to the CM auction, given that DECC tendered for the whole 49GW and that all generators were allowed to take part. The money being provided to the large generators thus looks like…. state aid, albeit it is the UK Tories volunteering the UK population to provide it. Was this a case of the European Commission pandering to the whims of UK Tories?

At this point it is worth noting that Ofgem (supposedly the UK “energy regulator”?) estimates that demand response could reduce UK peak demand on a winter weekday by up to 4.4GW. Notice how this is not far off the 6GW that constitutes real peak demand. Put another way, if 4.4GW of demand response was used plus the 2.6GW of new generation there would be more than enough generation to meet peak demand. Furthermore this would cost less than £130 million per year. The £15/year free gift from households to existing generators would then turn into roughly £2/year for funding a mix of new generation and demand response. This seems a reasonable amount to ensure that the “lights stay on” even when there is high demand.

Legal action

Tempus Energy, a UK-based provider of demand response services, has announced it will go to the European Court of Justice with a claim that the UK capacity market unlawfully prioritizes fossil fuel generation over demand response. If it wins, the hope is that the European Commission’s DG Competition will have to hold a formal inquiry into the UK CM. Given the perverse result, the question is, why has DG Competition not already, and on its own volition, re-opened the case?

All of the above raises a number of governance questions with respect to the UK’s ability to organise an energy policy focused on its subjects (known as citizens in other countries). It also raises the question, “was the CM deliberately designed to provide state aid to incumbents?” Given that DECC is 50% staffed by people seconded from power companies, and that these same power companies directly benefit from the auction, the conclusion is that DECC supervises the UK power industry for the benefit of power companies not UK citizens and that the UK’s CM is state aid.

Source: Energy Post. Reproduced with permission.