For background on the Capacity Market, see our updates on Electricity Market ReformCapacity Market Amendments and the 2015 auction parameters

Capacity Market Consultation

On 15 October 2015 DECC issued a consultation on reforms to the Capacity Market.  Almost all of the reforms being consulted on will take effect from next year's auction round, in 2016 (i.e. not the December 2015 round for which the prequalification results have just been released).  This article concentrates on the changes that DECC propose in order to make secondary trading on the capacity market easier.  For more detail on the other reforms, see our article, More reforms to the Capacity Market. 

Secondary trading

DECC note that an appropriate secondary trading market allows the management of risk relating to non-delivery and penalty exposure during periods of planned and unplanned outages whilst compensating for any uncertainty regarding over delivery rates.  It is key to maintaining liquidity in the market.  The consultation makes a number of proposals about secondary trading, to address stakeholder concerns over competition and broadening the capacity available to those unable to deliver in periods of stress.

There will be four types of secondary trading, with a new Window 2 type of obligation trading being proposed:

  • Volume reallocation – parties can reallocate excess output to another CMU after a stress event
  • Obligation trading (window 1) – for medium to long term cover.  CMU 'B' can trade its obligations to CMU 'A'; CMU 'A' can take on obligations up to a maximum of its de-rated capacity.
  • Obligation trading (window 2) – for short-term cover of maximum 5 weeks.
  • Financial trading – to fill any gaps not covered by reallocation and obligation trading.  It is normally a private bilateral agreement between two parties, reallocating any over delivery from one party to the other with shortfalls incurring penalties at pre agreed rates providing both cover and a route to market during stress events.  It works a bit like an insurance policy so B pays a fixed fee to A and in return, A pays B an amount if B becomes liable for a penalty under its capacity agreement.  The Government does not propose to intervene in this market at this stage.

This table in Annex 1 of the consultation is a useful summary:

Click here to view the table

Proposals to make secondary trading easier include:

Changes to penalty caps

Revisions to the way monthly penalty caps and annual penalty caps are calculated when obligation periods of less than a full year are traded.  The recommended revisions would make it harder to trade obligations for very short periods as the penalties would be higher, so the Government foresees obligation trading only being used to cover longer periods of unavailability, with volume reallocation and financial trading offering adequate cover against shorter periods of unavailability.

Opening up obligation trading

At the moment, obligation trading is in reality only available to prequalified plant without a capacity agreement that chooses to remain open, or a new build plant that comes online early.  This makes the pool of potential transferees very small so the Government proposes to open up obligation trading to allow transfers (up to a maximum of five weeks) above de-rated capacity for all CMUs except interconnectors in a period (window 2) closer to real time.

Extending volume reallocation

Volume reallocation is currently only available to any CMU holding a capacity obligation and delivering in excess of its obligation in times of stress.  The Government proposes to make volume reallocation available to be transferred to any party that is eligible to participate in obligation trading who has pre-registered with the delivery body for the purpose of participating in volume reallocation – including plants that do not hold a capacity obligation for that period. 

To access over delivery rates and reallocation trading, an acceptable transferee must meet the existing eligibility criteria plus:

  • New build CMU must have met the substantial completion milestone
  • A copy of the distribution connection agreement (where relevant)
  • DSR CMU must have a DSR test certificate with a proven capacity at least equal to the volume of obligations they wish to take on.

This helpful diagram explains how it would work:

Click here to view the table.

DECC estimates that this will bring an additional 7GW of capacity into the scope of the secondary market.

Comment

Given the recent press coverage of the narrow supply margin for this winter, due in part to the lack of new thermal generation coming on-line, the capacity market is set to become more significant.  We will not know the true impact until 2018 when the first capacity is called upon, but the secondary market will play a big part in the overall success of the capacity market, so these reforms that increase access to the secondary market are to be welcomed and represent a real opportunity for investors.