We now know the provisional results of the UK Government’s first Capacity Market auction – a key part of the new Electricity Market Reforms.
The Government believes its reforms, which will change the existing market structure and mean a greater degree of central control over what is built, where and when are the best way to tackle the energy ‘trilemma’.
The package of reforms includes the Capacity Market, the Carbon Price Support mechanism, Contracts for Difference, and the Emissions Performance Standard. Each of these components will work together to deliver the UK Government’s long-term objective for the sector- for it to provide affordable, secure, low carbon electricity. We support this objective and the Government’s reform package.
The Capacity Market is the mechanism through which the UK Government plans to maintain secure electricity supplies i.e. keep the lights on; and it’s been designed to do so at the lowest cost to consumers.
Why is change needed?
The GB electricity market is currently an ‘energy only’ market. This means electricity generators receive income for the electricity they generate as one payment. However generators actually provide two services:
1) Energy – MWh of electricity generated to meet demand at any given time; and
2) Capacity –MW of capacity in power stations which gives the electricity system the ability to reliably produce electricity when required by consumers.
Providing this ‘capacity’ service i.e. keeping a power station open regardless of whether it is generating electricity or not, incurs substantial costs. SSE spends £100’s million each year just to keep power stations ready to generate. This is what it costs to provide capacity to the system. These ‘fixed’ costs include ongoing operation and maintenance, upgrades to ensure safety and reliability, business taxes, network connection costs and salaries for the people who work there.
The price companies like SSE receive for the electricity they generate is meant to reflect the provision of both services – the provision of capacity to generate electricity and the production of electricity itself. But in recent years the income that generators have received has not been doing this, making some stations unprofitable. Indeed SSE’s coal and gas-fired power stations were loss making in the first half of this financial year.
This situation is not likely to change in the future. Forecast future revenues are both low and increasingly unpredictable as a result of changes to the electricity generation mix.
As a result generators have found it increasingly difficult to invest to keep some existing stations open, or to build new stations. To make these investments businesses need to be confident they will earn a sustainable return but as things stand in the current market, they aren’t.
With existing stations closing or being mothballed, the capacity margin - the measure of how much excess capacity there is on the system to provide security of supply for customers - have fallen. And with no new like-for-like capacity coming forward National Grid has highlighted that the capacity margin– has fallen. This year’s winter margin is 6.4%, the lowest it has been in some time. If this continued then we would quickly reach a point when supply wasn’t always able to meet demand.
The UK Government’s solution, which I agree with, was to introduce the Capacity Market. This will change the way generators are paid for the two services they provide, giving them more certainty to make the investments needed to keep the lights on.
What has happened?
This week the government auctioned a number of ‘capacity’ contracts for the year 2018-19. The auction was designed so all forms of capacity could bid for these contracts.
This was to ensure the auction delivered the cheapest price for bill payers – no matter what the fuel or technology type.
The contracts announced today will require generators to be available to the system, at times when the National Grid needs it. If generators successfully provide this service then they will receive payments. If they fail to do so then they will face financial penalties. They will continue to sell the electricity generate in the energy market.
The aim is to give generators the certainty they need to make the investments needed to keep existing plant open, and build new plant; and give customers the certainty that when they flick the light switch on in the morning the power will be there.
How much will it cost?
People will, rightly, question whether these payments are justified and if they’re value for money, particularly as the costs will be passed through to consumers via a levy on bills. I believe the answer to both questions is yes, and I’ve set out some reasons below.
Firstly, as I’ve explained, the stations successful in the auction are obliged to provide capacity when the system is ‘under stress’, ie when demand is at risk of exceeding supply. If they don’t they will pay a large financial penalty. The payments are therefore for providing a service. If this service is not provided then, quite rightly, generators will be penalised.
Secondly, as I’ve already highlighted, providing capacity does have a cost. It costs SSE £100’s million each year just to ensure its stations remain open and available to the National Grid.
Thirdly, the auction was designed so that only those generators which were willing to provide capacity at the lowest cost have been awarded a contract. Customers can therefore be sure they are paying the lowest possible price.
Finally, the Capacity Market reflects a change to the way generators are remunerated: they will now be paid separately for the services – energy and capacity - they provide. However this doesn’t mean a large additional payment on bills: it is anticipated, for a number of reasons, that the wholesale price of electricity will fall as a result of the Capacity Market’s introduction. The Government has forecast that this should offset most of the cost of paying for capacity, meaning the additional levy on bills should, in theory, be relatively small.
By introducing a new capacity service, and paying for it separately, the Capacity Market will provide certainty: to customers and the Government, who can continue to rely on a stable, secure supply of electricity; and to generators, who can plan for the future and make the investments needed to keep the lights on.
For more information about the provisional results please visit: https://www.gov.uk/government/statistics/capacity-market-location-of-provisional-results
For another explanation on how the Capacity Market works, see our inforgraphic.