The Energy Bill, EMR and price fixing – a toxic combination.

Today we heard that renewable energy targets for 2030 have been abandoned and finally it is clear to me why the draft energy bill has a wholly new system for subsidising renewable energy when the old one was working very well. The trouble is the existing renewable obligation certificates (ROCs) are designed to meet targets and if we don’t have a target they simply don’t apply. Unfortunately the replacement system - Feed in Tariffs with Contract for Difference (CfDs) - gives considerably less certainty for renewable energy generators' investment. Also, we have heard a lot recently about price fixing in energy markets which, if it continues, will have a very serious interaction with CfDs.

I would have posted earlier on the Electricity Market Reform proposals in the Energy Bill except that quite frankly I have been having trouble understanding it all. I hope reading this will make it easier for you.

EMR has 4 new mechanisms replacing ROCs (which I will explain later). In order of increasing complexity we have:

The emissions performance standard

This a maximum rate of carbon emissions per unit electricity generated which any new power station is allowed. The initial level is 450g/kWh which means that new gas power stations are fine but new coal power stations would need carbon capture and storage as well to qualify. There are exemptions, which I won’t go into. Existing power stations are unaffected.

The carbon price floor

This is a fudge which is supposed to help the EU Emissions Trading Scheme (ETS) work better. The ETS is a cap and trade system which means that a certain number of allowances to emit carbon dioxide are issued and companies trade amongst themselves to buy more allowance if they need them. The cap is reduced over time and consequently emitters have to either reduce emissions or pay more for increasingly scarce allowances. In practice the ETS has not worked well and the cap is so high that the carbon price is risibly low – around £12/t CO2. The carbon price floor is an increasing minimum price to top up the ETS price and the proposed level is £30/t CO2 by 2020 . Our current electricity supply comes out at about 500g/kWh so that price floor would mean the carbon price in 2020, if our carbon emissions had not improved, would be 1.5p/kWh. The price we pay for our domestic supply is about 14p/kWh, up more than 1p already on last year. I can’t see this price floor making much difference for consumers even if it works as advertised, though it might have an impact on industrial electricity users who pay as little as 8p/kWh at the moment.

The capacity market

This is a completely novel mechanism designed to support reliable generation capacity as opposed to intermittent renewables. When the wind is blowing wind power is potentially cheap because the only marginal cost to the turbine owner is a little wear and tear on the machinery. Gas power stations have higher costs because they have to pay for their fuel. In a perfect market therefore wind power, when it is available, will always be cheaper then gas. However, we still need other power stations for when the wind isn’t blowing. Even sitting idle the gas power stations and others have some costs and if they are only being used 20% of the time it will take 5 times as long (in practice even longer) to pay back their capital costs. No-one will build or maintain gas power stations if the payback time is 100 years. Therefore, the capacity market is required to motivate owners of gas power stations – or any other sort of power station that can turn on reliably when asked. Every so often somebody will do a forecast of how much capacity is required and run an auction to see who will supply it most cheaply. The winners in the auction get capacity agreements so that they get paid for availability whether they are actually needed or not.

Interestingly there are a number of different ways to supply capacity other than power generation. The capacity market could also benefit companies running energy storage facilities or even companies which can reduce demand – because reducing demand has the same overall effect as generating more. A large energy user could enter a capacity agreement and promise to reduce their demand when required.

The capacity market is so novel it is hard to know what problems will arise. One sensitive issue is the lead time between capacity auctions and when the contracts start. If this is too short it won’t leave enough time for a new plant to be built and installed. If it is too long then it will be difficult to predict the level of capacity required.

The Feed in Tariff with Contract for Difference (CfD)

The current Feed in Tariffs (FiTs) benefit small generators like me, with solar panels on my roof. The generator tariff is a fixed price which you get paid for every unit you generate. Under the current rules the tariff you get when you install your equipment is guaranteed, index linked, for some number of years. This means you can make a sensible decision about whether to make your investment based on how much you expect to generate and therefore how much you will be paid.

FiTs are very successful at what they were designed for which is to unlock investment and build markets in renewable energy products. However many people think the FiTs are unethical because people with money to invest benefit while everyone else gets higher electricity bills and Ii would be fairer if the FiTs were paid through our taxes rather than our bills. Another criticism is that they are ridiculously expensive, because there are different tariffs for different technologies which are designed to set a similar rate of return across all. Solar PV gets a high tariff because the panels are relatively expensive compared to wind turbines.

The FiTs are only for small producers up to a maximum of 5 MW which is a single big wind turbine or a few small ones. The CfDs will be for all low carbon producers including nuclear power stations. Instead of a generator tariff there is a strike price, which is almost but not quite a guaranteed price for power generated. The differences are subtle but important:

1. The subsidy actually paid is the difference between the reference price (probably a day-ahead market price) and the strike price. If the reference price is higher than the strike price then the generator will have to pay back the difference! 
2. This price is for electricity which is actually delivered to the grid – before you get paid you have to find a buyer for your power. 
3. Most generators sell their electricity well in advance at a fixed price through an over-the-counter trade with a supplier. This will usually be at a lower price than the reference price which is for the relatively liquid short term market. If the reference price is high then the difference between that and the strike price is low so the generator gets paid less. There is no price guarantee.

Confused? Here is an example. These numbers are chosen purely for illustration. Suppose the strike price for wind power is 6p/kWh. I am a wind turbine owner and I have a contract to supply to Powerco Ltd at 3p/kWh. On a particular day the reference price is 4p/kWh. That means I actually get paid 3p/kWh from Powerco + (6-4) = 2p/kWh through CfD. Total 5p/kWh. If I wanted to take a risk and sell my power on the open market I could possibly get 6p/kWh but there is no guarantee that I will find a buyer so I need to be very careful about that decision.

What concerns me most is that it is in the energy suppliers’ interests to ‘fix’ the reference price high if they can, so the CfD top up is lower. In the example above, If the reference price is ‘fixed’ to 5p/kWh I only get 4p/kWh. The CfT subsidy is paid jointly by all the suppliers so it is in their mutual interest to keep the reference price up.

The CfT system still has all the features which are criticised in the FiTs. It is expensive, with different strike prices for different technologies (though these haven’t been set yet  so we don’t know what they will be or how they will change over time – yet more uncertainly). It is paid for by energy bills so arguably unfair, and it isn’t even a guaranteed price for the low carbon generators so their investments are still risky.

How does this compare the system it is supposed to replace – the Renewable Obligation Certificates?

Renewable Obligation Certificates

Schemes to reduce carbon emissions work either by penalising carbon emissions or subsidising renewables and they are all either politically or economically sensitive, or both. The ROC scheme was relatively robust in comparison.

Cap and trade schemes like the EU ETS are economically sensitive. In a recession, when industry is in decline and making less stuff they also emit less carbon which means the carbon price becomes very cheap. In practice there is always a recession on the horizon even if we aren’t in one now so there is little incentive for industry to invest in low carbon technology. Carbon tax schemes on the other hand are politically sensitive. Assuming you have a target of X% reduction in carbon emissions it is impossible to work out what price level is needed to hit that target without going over, in which case the government becomes very unpopular for putting our bills up unnecessarily.

The Renewable Obligation Certificate scheme was designed to help the industry meet targets of X% renewables each year and it does that very well. Suppose we want 20% of electricity to be renewable – then for every 5 MWh of energy supplied, the energy companies have to buy 1 MWh of ROC. They can buy ROCs from low carbon energy generators which have delivered energy or from the government at a fixed (and increasing) buy out price. The money raised from buy outs is distributed among the generators who qualified for ROCs. This scheme is economically robust and tied closely to the target. If the target is exceeded then ROCs become very cheap and the renewable energy companies get less subsidy but if the industry is under target then the energy companies have to buy ROCs at the buyout price and this is paid out to the renewable generators so they can invest in more plant.

Under the ROC scheme the renewable energy subsidy is paid by the energy companies – just as with the FiTs and with the CfDs. However, there is a clever fudge which means that the more expensive technologies get more subsidy without increasing the cost to the suppliers. This is done by setting an ROC multipler for each technology. Currently 1 MWh of offshore wind gets 2 ROCs instead of 1 and there was a proposal to lower the onshore wind subsidy to 0.9 ROCs/MWh.

Renewable generators still don’t have price certainty under ROCs, because if the renewable energy industry is over target the ROC price will drop. However, at least this will only happen if the industry is over target.

A market without targets.

The ROC scheme was unpopular but the CfD scheme does not mend any of the issues that made it so and it has new problems of its own. In an economic environment without renewable energy targets the CfD scheme puts gas and low carbon generation in direct competition. The renewables benefit from CfD, though the strike prices are as yet uncertain and even when they are set the whole scheme is vulnerable to price fixing. The gas industry has a small additional cost from the carbon price floor but benefits from potentially lucrative capacity contracts.

Competition in the energy industry can never work well because the lead time to build new power stations is much longer than the timescale over which fuel prices are predictable and the payback times for upfront capital costs are even longer. The CfD scheme produces an illusion of market competition which in practice will handicap the renewable industry because they are the more vulnerable to uncertainty. The level of investment in renewables under the CfD scheme, even if markets are well regulated, will be critically dependent on the strike prices set, which will therefore be politically sensitive for decades to come.