Background

On 13 April 2016, the European Commission adopted its interim report and a staff working document on the sector inquiry into capacity mechanisms launched in April 2015. The proposals are open for comment until 6 July 2016, with an EC report on the results of the sector inquiry expected later this year. The results of the sector inquiry will also inform planned legislative proposals on a revised electricity market design in the EU. 

The report’s three main findings are as follows:

  • the Commission recognises that capacity mechanisms may be necessary if electricity markets fail to deliver sufficient electricity supplies. However, they should not be a substitute for market and regulatory reform;
  • there is concern that member states have not carefully analysed the need for capacity mechanisms before introducing them; and
  • capacity mechanisms in many member states seem to benefit specific energy operators because they are only open to specific technologies or to energy operators within the borders of the member state.

Why the sector inquiry?

The Commission considers that, when "introduced prematurely, without proper identification or in an uncoordinated manner, and without taking into account the contribution of cross-border resources, there is a risk that capacity mechanisms distort cross-border electricity trade and competition.” More specifically, they may favour certain types of generation and encourage investment within national borders when it would be more efficient to import electricity.

Preliminary findings in the interim report

Key questions the inquiry has considered are adequacy assessments used to determine the need for a capacity mechanism and design features of capacity mechanisms such as eligibility criteria, allocation and product design. 

Adequacy assessments: The Commission considers that there is a strong case for better aligning the methods used to determine generation adequacy and reliability standards across the member states. The current disparity between methodologies reinforces the national focus of most capacity support mechanisms. The Commission considers that EU-wide methodologies are likely to be an essential element in its forthcoming market design initiatives. 

Eligibility Criteria: The Commission recognises that eligibility criteria need to be balanced between encouraging development of new capacity and not being overly restrictive so as to lead to overcompensation. The sector inquiry has shown that selective mechanisms may lead to the development of additional mechanisms to compensate capacity that were initially excluded. 

Additionally, overly selective eligibility criteria risk over-compensating participants as the competitive pressure is weaker due to the limited participation. The Commission has found that there has been an overall tendency towards an open mechanism allowing participation by a wider group of capacity providers. This is likely to reduce the risk of over-compensation and distortions of competition within member states and in cross-border trade. 

Cross – border participation in capacity mechanisms: Cross-border participation is limited: few of the member states analysed in the inquiry allowed capacity providers in other member states to participate in their respective mechanisms. The Commission did note the inclusion of interconnectors in the GB 2015 capacity auction. 

Allocation process: In comparing administrative allocation procedures and competitive allocation procedures, the Commission favours competitive allocation stating that it is better at revealing the real capacity value. 

Capacity product: The EC stressed that only electricity prices, and not capacity mechanism penalties, could provide a signal for imports within the internal market. Member States should therefore ensure that electricity price signals are not replaced by capacity mechanism penalties.

Tentative conclusions in the interim report

The EC has proposed the following tentative conclusions:

  • Harmonised and more transparent ways of determining generation adequacy levels and reliability standards make the need for different intervention levels more objectively assessable.
  • The risk of overcompensation is higher in mechanisms using administrative price setting rather than competitive allocation procedures. These include price-based mechanisms offering market-wide and targeted capacity payments.
  • The risk for overcompensation is lower with capacity mechanisms involving competitive allocation procedures such as tenders for new capacity, strategic reserves, central buyer models or decentralised obligations.
  • Tenders for new capacity and strategic reserves may be appropriate to address a transitional capacity problem.
  • Central buyer mechanisms and decentralised obligation mechanisms could be appropriate options to address a longer-term and more general adequacy problem, depending on the level of competition in the underlying market. These two types of capacity mechanisms are better able to attract new capacity and allow direct competition between generation and demand response, thus creating stronger competition for capacity contracts and revealing the real economic value of capacity.
  • In all cases, capacity mechanisms must be carefully designed with specific attention to transparent and open rules of participation and a capacity product that does not undermine the functioning of the electricity market. In particular, electricity prices should continue providing a signal of scarcity so that electricity is imported from other Member States at the right times.

What this means for the GB Capacity Market

Although the sector inquiry excluded a review of the GB market which had been notified to the Commission and had received approval for the state aid separately, the direction of this enquiry is directly relevant for the GB capacity market. The GB capacity market was one of the first notified measures examined under the Environmental and Energy State Aid Guidelines 2014 and the interim report demonstrates the Commission’s evolving approach and application of the state aid principles. This is all the more relevant in the context of changes proposed for GB, which as part of the Government proposals recently consulted on, will require an extension to the existing State Aid approval for the GB capacity market. 

As would be expected, the Commission advocates the use of market mechanisms (open, cross-border, technology neutral auctions) to minimise distortions of competition. While the suggestion to open capacity mechanisms across borders is a welcome development and unlikely to prove controversial in GB, the Commission’s favouring of technology-neutral mechanisms is at odds with the EU’s commitment to carbon reduction targets. This may prove controversial, particularly against the background of the recent Paris Climate Change Agreement

In GB, where such a technology-neutral mechanism has been implemented, this has raised concerns about the potential overcompensation of diesel plant at the expense of demand-side capacity providers. The Commission’s tentative conclusions may therefore affect the assessment of potential plans in GB to exclude certain diesel generators from the capacity market. The UK government may seek to consider alternative mechanisms to support investment into new gas fired generation. The Commission’s comments in relation to technology neutral and inclusive competitive auctions will need to be factored into any plans by the UK Government to review and potentially restrict the ability of lower investment cost generation (e.g. diesel) to participate in the GB capacity market. 

Further consideration will also need to be given to the impact of interconnection. With the UK government seeking up to 9 GW of new capacity, the ability of generation connected to GB via such interconnectors will need to be examined in line with its objectives of transparent competitive auctions as well as of having the capacity market for the purpose of enhancing security of supply.