Capacity mechanisms: The price of security of supply

Rising security of supply concerns and tightening capacity margins have led many Member States of the European Union (EU) to introduce or plan to introduce capacity mechanisms¹, prompting a sector investigation by the European Commission. However, the Commission’s final report reveals that often insufficient consideration has been given to the design of capacity mechanisms in many Member States. As a result, the Commission has proposed some principles to inform the design and implementation of capacity mechanisms throughout EU, which also serve as a useful benchmark for capacity mechanisms globally.

In this briefing, we examine the rise of capacity mechanisms and the hallmarks of a successful capacity mechanism.

In Europe, as in other mature power systems, capacity margins are tightening; a lot of the old generation fleet is facing closure having reached the end of life (particularly aging coal and nuclear plant), or is decommissioning as a result of carbon reduction or environmental protection policies (particularly coal). Typically, in these markets, the penetration of intermittent or variable renewable power is also increasing.

As the generation mix changes, so too must the system adapt to ensure demand is met, system security is maintained and so system operators are considering how best to maintain system security and capacity margins. Some system performance requirements will be met by dispatchable renewable generation, storage and demand-side response. Interconnectors will also have a role to play, making capacity available but without adding to the capacity installed. They are, however, relatively expensive and not a short-term fix. There will also be a place for synchronous, flexible, lower carbon power plant (such as gas combined cycle gas turbines) in the future energy mix.

However, in many jurisdictions new conventional power plants are not being built. In Europe, the main reasons for this have been examined the European Commission in its Final Report on the Sector Inquiry on Capacity Mechanisms² (the Sector Inquiry). The staff working document accompanying the final report³ highlighted a number of factors which were delaying investment, particularly for new gas-fired plants:

• low power prices and lower running hours of fossil fuelled plant have affected their profitability

• gas-fired plant have not benefited from EU Emissions Trading System price decreases to the same extent as coal (which has higher emissions). This, together with other factors, has resulted in lower coal prices, whilst gas prices have remained higher, affecting the merit order

• the missing-money problem: the market is unable to incentivise investment in adequate generation capacity because investors fear future revenues will not cover their fixed costs and will not remunerate their investment sufficiently.

As a result of these challenges, an increasing number of power markets are establishing capacity mechanisms or tendering for other back-up power services in order to ensure that the system is sufficiently flexible to cope with the changing nature of generation and demand. Markets are increasingly looking to new gas-fired generation and nuclear power, particularly as policy-makers turn away from coal-fired power plants in search of less carbon-intensive generation.

The Commission examined 11 Member States – Belgium, Croatia, Denmark, France, Germany, Ireland, Italy, Poland, Portugal, Spain and Sweden – and found no less than 35 previous, existing or planned capacity mechanisms. Spain alone has four. The different approaches to capacity mechanisms used and proposed to be implemented in different Member States can be broadly categorised as follows:

Leaving aside the debate over the impact of these schemes on the internal energy market, a striking finding of the Sector Inquiry is that “many” capacity mechanisms were designed without assessing whether or not there was a security of supply problem in the first place. In addition, nearly half the Member States surveyed did not define what level of security was or is required. In a number of cases, prices were not set competitively, which may mean that consumers are over-paying for their power. These findings have led the Commission to conclude that a number of existing capacity mechanisms have major shortcomings.

The Commission endorsed market-wide capacity mechanisms (like those introduced in the UK and France, and planned in Ireland and Italy) as being “likely to be the most appropriate form of intervention” where there is a long-term risk that there will be insufficient investment in capacity. In contrast, schemes like Germany’s proposed strategic capacity reserve – the more common type of capacity mechanism in Europe – “must be transitional measures, which accompany market reforms and are phased out as soon as the reforms take effect”.

Despite the Commission’s insistence that capacity mechanisms should not distort electricity market prices (actual or forecast), the reality is that, once introduced, there is a risk that they reduce electricity market prices, meaning that investment in capacity is less likely to be able to be sustained by market prices alone. As a result, the importance of a robust adequacy assessment together with careful design of the capacity mechanism cannot be understated.

Capacity mechanisms in the EU will continue to be subject to scrutiny by the Commission because of their impact on competition in the EU internal electricity market and because they often involve State aid. In light of the findings of the Sector Inquiry, the Commission will be scrutinising new capacity mechanisms and pressing Member States to reform existing schemes. Member States and investors alike will be benchmarking their existing schemes against the Commission’s core recommendations to assess the likelihood of regulatory reform. The Commission’s core recommendations are set out below:

• Resource adequacy concerns should be addressed through market reforms first. Suggested reforms include engaging in demand-side response, making hedging products available to generators to reduce revenue risk and thereby encourage investment, ensuring that imbalance charges reflect the cost of balancing actions, and having appropriately sized charging zones so that consumers are faced with the true cost of energy.

• A rigorous adequacy assessment is essential. The Commission is proposing a pan-EU harmonised approach to assessment of security supply risk, based on the value of lost load and expressed as a function of loss of load expectation or expected energy not served. At the moment, the national grid operators have a tendency to over forecast lost load especially for the renewables energy generators, which results in larger capacity auctions than the system actually needs.

• Competitive price-setting amongst a wide pool of participants will deliver best value to the consumer.

• Capacity mechanisms should not distort electricity market prices.

• Penalties must be sufficiently robust to incentivise delivery of contracted capacity. Non-delivery increases costs to consumers because it has to be produced in shorter time-frames.

• For long-term risks, market wide capacity mechanisms are the most appropriate instruments.

• As a transitional measure whilst market reforms are implemented, a strategic reserve may be an appropriate solution, although in the longer term this may only aggravate the missing money problem, by acting as an effective cap on electricity market prices. The reserve should be held outside the market.

• Cross-border participation can reduce the long-term costs of EU security of supply and create incentives for continued investment in interconnection or foreign capacity. Where interconnectors are scarce, they should receive the majority of the capacity remuneration (and vice versa).

Because of the requirement for State aid approval, Member States proposing new schemes have in practice been taking these recommendations into account, even before the publication of the final report. For example, over the last year, the Commission worked with the French authorities to agree a number of adjustments to the proposed French decentralised obligation scheme which will become operational in 2017⁶. The scheme will now facilitate the entry of new market players, by awarding certificates four years in advance of delivery and for a 7 year duration. The scheme will also be open to foreign capacity.

Germany is also planning to introduce two new strategic reserves, in addition to the existing network reserve which targets the north-south imbalance during winter months. A new capacity reserve will be introduced from 2018/2019 onwards to cover situations where there is a shortfall in supply from renewable generation (especially in the winter). 2 GWs of capacity will be procured by the transmission system operators by means of a competitive procedure. In addition, a so-called lignite reserve is planned. This mechanism covers eight lignite plants that will be taken out of active service from 2019 and then kept operational for four further years before finally decommissioning. This mechanism was controversial as the overall costs for final electricity consumers of EUR 1,600,000,000 are substantial, but the Commission accepted this mechanism in May 2016.

In Greece, the transitional electricity flexibility remuneration mechanism, a targeted capacity payments model which compensates gas-fired and hydro power plants for the provision of flexibility services to the Greek interconnected electricity system, is required to be replaced by April 2017. However, the newly proposed permanent capacity mechanism, using a central buyer model, has not yet been approved by the Commission.

The Polish Government is also currently planning to introduce a market-wide, central buyer capacity mechanism as a priority due to the need for a significant volume of new power generation in Poland. The detailed proposal for the design of the Polish capacity market, announced in July 2016 and  outlined in draft legislation published in early December 2016, shares many of the characteristics of the British model. Following the publication of the EU Winter Package the Polish Government declared that its intention is to implement the Polish capacity mechanism before proposed new European rules become effective, which could limit access of coal fired power plants to capacity mechanisms.

Whilst the British capacity market is mentioned as a comparator in the Sector Inquiry and was the first scheme to receive State aid approval, surprisingly the European Commission did not examine the scheme as part of the Sector Inquiry. The final report coincided with the T-4 auction in which prices rose to £22.50 kW/Yr (2015/16 prices), as the UK Government procured 52.425GW, 6.072GW more capacity compared to the previous year’s auction⁷. However, despite the increase in capacity procured, prices did not rise as high as expected. As a result, the auction did not secure the volume of new build gas fired power plant which the UK Government had wanted and delivered a high proportion of small, distribution connected, generation, as well as new build contracts for storage and unproven demand-side response. The results raise the perennial questions of whether market mechanisms can procure large-scale investment in new capacity, and whether, in the smart networks of the future, complex networks of distributed smaller scale generation is a viable alternative.