Capacity market

May 2012

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Introduction

On 22 May 2012, the Government released the draft Energy Bill along with a raft of explanatory documents and impact statements. The intent is both to create the legislative framework to enable the EMR process to move forward and to provide a more detailed update on how the Government envisages key new elements to work in practice. One aspect of these is the Capacity Market that is designed to ensure future security of supplies. Key documents that have been released regarding the Capacity Market include:

This briefing note describes the key elements of the Capacity Market that we consider are relevant to the energy sector.

This is a fast-moving area of policy development. The Government is continuing to consult and will be providing an updated position in autumn 2012. As such, this briefing note is correct as at May 2012.

Progress

The Design and Implementation Update builds on the Technical Update issued by DECC in December 2011. Progress is limited and DECC are still at the stage of high level design of the mechanism. They will publish emerging design choices by the end of 2012, with design completed in March 2013. DECC will formally consult on the detailed design later in 2013. This reflects DECC’s view that the issue is not very urgent and the Energy Bill is drafted flexibly to give the Secretary of State broad powers to make electricity capacity regulations.

Although the timing of implementation depends on need, DECC states that if required, the first auction could be as early as 2014 for capacity to be available in 2018/9, or even by 2015/6 if required.

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Auctions

DECC will make forecasts of future peak demand (possibly based on a “reliability standard”) and, if there is a risk of a shortfall in capacity to meet that demand, the System Operator (which will administer the Capacity Market) will run an auction to contract for the total capacity required (at the end of 2010, 61GW) to meet that demand. DECC will not contract specifically for flexible capacity; existing mechanisms for managing system balancing (such as short term operating reserve (STOR) and other balancing services) will continue as at present. The auctions which are expected to be run will be open to existing plants as well as new ones.

Successful bidders at the auctions will enter into capacity agreements, committing them to generate the agreed amount of electricity when needed in return for regular capacity payments (as bid). The agreements will require assurance that physical capacity is in place and operators who fail to generate electricity when required will face penalties.

DECC is minded to exclude participation by plants receiving a CfD, in order to avoid over-compensating them, but they acknowledge that it may be possible in the future when CfD strike prices are set by auction.

Secondary trading of the capacity obligation will be allowed, subject to conditions.

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Features still outstanding/ to be decided

DECC is still considering the design of the auctions. Features that need to be decided include:

  • auction model (pay-as-bid or descending clock, etc.);
  • duration of capacity contracts and whether new capacity will have longer contracts (to support their investment) than existing capacity (which is likely to be contracted on an annual basis) - this issue is expected to be decided by the end of 2012;
  • lead times (how far ahead of the delivery year the auction should take place) - currently 4-5 years is favoured;
  • pre-qualification criteria, in particular to have assurance that any new plant participating in the auctions will be built on time to deliver the contracted capacity;
  • how demand-side response and interconnected capacity can participate;
  • what restrictions there should be on secondary trading of the capacity agreements and whether secondary auctions should be introduced;
  • the payment model (see below);
  • the penalty regime (see below); and
  • the interaction with Ofgem’s significant code review (SCR) on electricity cash out arrangements.
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Contractual counterparty and payment

The costs of making capacity payments are to be funded by all electricity suppliers. DECC is currently considering two models, either:

  • a multi-party agreement (like BSC) between suppliers and capacity providers under which payments would be administered by a settlement agent; or
  • payments to be received and made by an intermediary (central counterparty).

DECC is working with the System Operator and Ofgem to consider which of these options would be preferable (although section 21 of the Energy Bill reflects the first option). Clearly counterparty creditworthiness is an issue that will concern capacity providers. However it is likely that the cost of capacity payments will be predictable, so the debate regarding whether the agreements are financial instruments, derivative accounting and the impact on suppliers’ balance sheets may not be relevant (or at least not so important) as it is in the case of CfD difference payments.

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Penalty regime

Clearly a capacity provider that fails to provide capacity when required must expect to pay a penalty. DECC has not decided how that is to be calculated, but is considering two options:

  • an administrative approach, under which there are fixed rules to calculate the amount of any penalty and physical checks to ensure that capacity is available; or
  • a market-based penalty, which requires payment of the difference between the price of electricity close to real time and the pre-set “strike price” set at a level between normal conditions and scarcity - suggested to be £500/MWh.

The former clearly has the advantage of certainty for capacity providers, which will enable them to price the risk in their auction bids. However DECC seems to be concerned about the level of administrative decision-making and checking it would involve. The latter may not be as effective at preventing back-outs and it exposes participants to uncapped liabilities which are likely to be reflected in their auction bids. DECC is therefore considering a hybrid model combining both approaches.

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