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The government has now announced its electricity market reforms, in an attempt to address the £110bn worth of investment identified as being required between now and 2050 as a quarter of the UK’s generating capacity closes down.
 
The scale of this challenge is significant and, given the financial crisis, there has possibly never been such a challenging time to seek funding. Investors’ risk profiles have shifted away from that of unproven technologies and expectations of returns having increased. This increase in expectations is the result of covering the higher perceived risk and the higher costs of capital, even at a time of the base rate being at historic lows.

The measures announced include a new scheme of long term contracts, in the form of Feed-in Tariffs with Contracts for Difference (FiT CfD). These should help to provide some degree of price certainty for investors by topping up to a pre-agreed price level. This therefore ensures that it is easier for an investor to calculate the return on a project.

However, the consultation document also states that the FiT CfD would be a “two-way mechanism that has the potential to see generators return money to consumers if electricity prices are higher than the agreed tariff”. It is important therefore that the reference price is one that allows for sufficient return in line with investors’ expectations. The government has also recognised that such a scheme would need to operate slightly differently for intermittent and base load power generators. Some concerns were expressed as to the complexity of such a system.

The second announcement follows the continuation of a carbon price floor that was announced in the Budget 2011:

“Following consultation, a carbon price floor for electricity generation will be introduced from 1 April 2013. The carbon price floor will start at around £16 per tonne of carbon dioxide and follow a linear path to £30 per tonne in 2020 to drive investment in the low-carbon power sector. The carbon price support rates for 2013-14 will be equivalent to £4.94 per tonne of carbon dioxide.”

A minimum carbon price may have some positive impact because it should help to address uncertainty within the carbon market for investors. By guaranteeing that a minimum cost is going to be incurred by businesses there will be more incentive to invest. However, this will not eliminate all uncertainty. There is still some degree of policy uncertainty concerning the exact details of phase 3, and there is still the possibility of the EU tightening its emissions targets.

The question is, where should one set the minimum price? What price level would be required to reduce reliance on fossil based generation and facilitate renewables investment? Industry estimates vary from €40-70 per tonne, and whilst the Environmental Audit Commission has asked for a minimum price of €100/t, it is important to remember that the carbon price has never exceeded €40/t. This suggests that the proposed price of £16 per tonne unlikely to guide significant additional investment.

The third measure announced was an Emissions Performance Standard, which will set “a limit equivalent to 450g CO2/kWh at baseload to provide a clear regulatory signal on the amount of carbon new fossil-fuel power stations can emit.” This will help to give a clear indication to electricity providers as to where investment needs to occur without pre-determining the technology or methods through which investment takes place. Technologies such as carbon capture and storage (CCS) will be essential if a new fleet of coal power stations were to be built in the UK. It is however important to remember that technologies such as CCS are still some way from being fully commercialised, and so significant funds will be required to bring such technologies into place on full-scale generation facilities.

Finally, the white paper looked at setting up capacity mechanism to help ensure the security of supply. This means ensuring diversification of supply, operational security to ensure supply and demand are balanced, and resource adequacy which means how to ensure there is sufficient reliable and diverse capacity to meet demand (e.g. during winter).

As the diversity of supply increases and renewable technologies introduce greater degrees of intermittency into the system, this makes the process of balancing the system more difficult. As balancing uncertainty increases so too does the need for a sufficient amount of capacity to balance the system when supply and demand are misaligned.

It is for this reason that the capacity mechanism is proposed to help address the issue of resource adequacy. The capacity mechanism is not intended to replace operational reserve but provide a mechanism to deal with sufficient fluctuations. The paper outlines that further details on the technical aspects of a capacity market will be published by the turn of the year, when further consultation with the industry has taken place given the generation and investment implications such a mechanism could have.

While the white paper will help to address some concerns of investors, it potentially underestimates the scale of the investment challenge ahead. If the UK is to meet its 2020 and 2050 targets investment needs to be occurring on a more significant scale across the industry in terms of generation, grid upgrades and demand management systems.

The UK needs to bring forward significant investment in CCS technologies, which are still in their infancy.   This will require significant funding to get them to the scale of full demonstration projects in order to secure the future provision of base load power.