Introduction

Electricity market reform ( EMR ) has been billed as the biggest shake-up of Britain's electricity market since privatization in the 1990s. DECC’s White Paper on EMR is due in July, before Parliament’s recess. It follows DECC’s publication of its preferred package for EMR in its December 2010 consultation.

Whilst most have taken the view that the EMR proposals presage some welcome stimuli for large-scale investment in low carbon technologies, the uncertainty about the outcome of DECC’s consultation has contributed to a delay in investment in low carbon projects. At the same time, there are some significantly diverging responses to the EMR proposals, creating doubt as to whether the proposals will remain unchanged or be subject to a further process of change and consultation.

Change in law risk is not unique to EMR, but it is brought into sharper focus by the huge investment needed to achieve the policy objectives driving EMR at a time when availability of funding is constrained by the economic downturn. Here, the risk is not that the law may change; it is that it may not, or will not do so fast enough, or that the final policy objective is not yet defined.

To minimize the investment delay, the White Paper must provide sufficient detail about what the regulatory framework will look like post-EMR, for example by specifying the key terms for “contracts for differences” and capacity contracts, and the structural devices for their implementation.

The proposed regime must be robust and credible and the timeframe understood to ensure the estimated £200 billion of required investment is unlocked. It will be important to find the right balance between providing certainty about the regime to facilitate investment and providing enough flexibility to adapt to circumstances as they change over time.

If DECC really wants to accelerate the investment the Government craves, it may need to find innovative ways to implement EMR progressively, rather than (with the exception of carbon price support) all in one go in 2014.

Whilst we wait for the White Paper’s imminent publication, we set out five key issues from a legal perspective that we expect energy lawyers will look for.

A Brief Reminder

It is first worth reminding ourselves of the Government’s preferred package of reforms. It includes:

  1. carbon price support: the Treasury confirmed in the 2011 Budget that it will introduce a floor price for carbon by reforming the climate change levy so that fossil fuels used for power generation will no longer be exempt and will attract tax based on polluting characteristics, and reducing the amount of fuel duty that can be reclaimed by generators;
  2. feed-in tariff with a contract for difference ( FIT - CFD ): DECC proposes that a guarantee of long-term revenues for low carbon generation will be provided by making top-up payments under a contract for difference where the wholesale electricity price is lower than an agreed reference price. The FIT-CFD is DECC’s preferred option, but it also consulted on a premium feed-in tariff ( PFIT ) model as its preferred alternative (compared to a fixed FIT model);
  3. emissions performance standard: DECC proposes to introduce a regulatory limit on the amount of carbon dioxide released into the atmosphere from a source (or sources) of electricity generation; and
  4. capacity payments: DECC proposes to implement a targeted capacity mechanism under which payments are made to low carbon electricity generators for making capacity available. This is to incentivize the availability of sufficient generating capacity in the market to support the deployment of increasing amounts of intermittent (renewable) and relatively inflexible (nuclear) low carbon generation.

DECC recognizes that the success of EMR will depend in part on the success of measures to improve electricity wholesale market liquidity implemented as a result of Ofgem’s review of wholesale market liquidity. It will be important to understand its impact on EMR, particularly in relation to the FIT-CFD.

Five Key Legal Issues

  1. Who Will Administer or Operate the FIT-CFD Regime and the Capacity Payment Mechanism?

Central to EMR’s success will be the entities that will administer or operate the FIT-CFD regime (as the main direct measure to incentivize investment in low carbon generation) and the capacity payments (as the principal incentive for the availability of capacity).

Investors and industry stakeholders want comfort that these entities will have sufficient expertise to perform their responsibilities and that they will act in a consistent and predictable way to ensure efficient outcomes. Yet they will also need to be flexible to respond to changing circumstances. Stakeholders will also want to understand how the decisions taken by these responsible entities can be challenged. Effective challenge will help ensure robust decision-making and the form of challenge (whether judicial review, prescribed appeals process, contractual dispute resolution mechanism or otherwise) will be driven in part by who DECC gives the responsibility to.

There are precedents within the existing regime as to who might be given responsibility:

Ofgem

There may be synergies with Ofgem’s administration of the Renewables Obligation (RO) regime which make it a good fit for administering the FIT-CFD regime. Ofgem is a known quantity - investors and industry stakeholders may feel they can predict decisions Ofgem may take with some confidence. One issue to consider is whether its principal objective and general duties should apply.

DECC will also need to ensure that such a role will be consistent with Ofgem’s role as regulator, which has been separately reviewed by DECC.

NGET

The balancing mechanism is a key incentive for investment in spare capacity. As such, DECC may consider that NGET would be best placed to operate the capacity mechanism. Further, DECC may consider NGET has the experience and expertise to perform the complex calculations necessary to forecast capacity demand and availability.

If DECC decides to give NGET responsibility for operating the capacity mechanism, its role could be implemented through license amendments and, potentially, amendments to the Balancing and Settlement Code ( BSC ). The key will be to ensure that there are no conflicts between its new responsibilities and its existing ones (e.g. in relation to its short term operating reserve activities). It will also be necessary to consider whether Elexon is the natural choice to administer the arrangements, given its role in administering the arrangements under the BSC.

Would NGET’s price control need to be adjusted to accommodate any new functions? It is not clear that such a role would need to be economically regulated in the same way as its monopoly system operation functions. Indeed, DECC is not suggesting that administering either the FIT-CFD regime or the capacity mechanism should enable the responsible entity to earn a rate of return. Nevertheless, it would be possible to design the cost recovery arrangements for inclusion in the price control in a way that ensured that no profit was realized.

A New Special Purpose Administrator

There are precedents for giving responsibility to a new special purpose administrator – specifically, the NFPA responsible for administering the NFFO regime and the DCC proposals for the smart metering regime.

Having a new special purpose administrator will avoid any complications and constraints that might arise in integrating new responsibilities under EMR with existing ones if an existing entity is given responsibility.

The challenge will be to provide comfort to investors and industry stakeholders that any new entity will be creditworthy and have the experience and expertise to perform its responsibilities effectively and in a consistent manner. DECC could give initial guidance on how decisions should be taken, but should be cautious in doing so on a long-term basis. The risk is that the decision-making process could be seen to be susceptible to political interference and therefore harder to predict.

  1. How Will the FIT-CFD Regime and the Capacity Payment Mechanism Work?

Much debate about EMR to date has revolved around the best way to achieve DECC’s stated policy goals – e.g. is a capacity payments mechanism required right now or can existing demand response arrangements deliver? Should there be an auction process for setting the strike price for FIT-CFDs? How will the FIT-CFD arrangements accommodate different low carbon generation technology? These are fundamental concerns for investors and industry stakeholders which the White Paper must deal with.

From a legal perspective, the challenge will be to ensure that the final proposals are given effect appropriately. This requires careful consideration.

For example, if DECC rules out auctioning FIT-CFDs in the short term but wishes to enable a switch to auction arrangements at some point in the future, the legal regime will need to: (i) specify who makes the decision to switch; (ii) prescribe rules about how that determination is made – whether it is against strictly defined and exhaustive criteria or whether the decision-making body has discretion and what level of consultation (if any) is required etc. The legal regime may also need to set down rules now about what the auction process might look like or give powers to the relevant entity to design them. It will also need to establish the interim arrangements.

DECC must consider where in the legal framework the arrangements should sit (whether in primary legislation, statutory instrument, license, code, guidance, a combination or elsewhere). Depending on where an arrangement sits, the governance and change process (e.g. in terms of who needs to be consulted) and the consequences of breach (criminal, contractual or regulatory) will be different.

The challenge is to strike the right balance between providing certainty for the regime and providing flexibility to address changing circumstances.

  1. What Will the FIT-CFD Look Like?

A key legal document to be prepared will be the contract to be entered into between a generator and an as yet unknown public or private counterparty under which the generator will be paid a feed in tariff. DECC’s preferred solution is a CFD-FIT, although it is possible that it may revert to its second most favored option, a PFIT, in the White Paper.

It is clear from DECC’s consultation that the mechanism for setting the price to be paid under the FIT-CFD will be a critical area for further consideration in the White Paper. DECC’s proposal for an auction-based price-setting regime has to date drawn significant criticism. Whatever the pricing mechanism used, it will need to be capable of responding to events, such as market suspension or unavailability of price indices.

Risk allocation will need careful consideration. For example, issues such as failure of a generator to construct a new facility on time, or to ensure that it is fit for purpose, will need to be considered. Similarly, the impact of a force majeure event, future change of law or planned and unplanned maintenance on the generator’s right to receive payment under the FIT-CFD will also need to be considered. One view would be that the FIT-CFD should provide only a hedge against electricity prices generally and should not be a vehicle for more sophisticated risk sharing. Investors may take the view that they need the certainty that EMR will be implemented and remain unchanged and so need long-term protection against a range of risks.

The design of the FIT-CFD is also likely to be informed by the predecessor to the RO, the Non Fossil Fuel Obligation ( NFFO ). It will be interesting to see the extent to which the principles of the NFFO regime (for example, no penalty for a generator who wins at auction but subsequently fails to deliver its plant) will appear in the FIT-CFD.

  1. How Will EMR Interact with the Existing Regime?

DECC’s preferred package for EMR requires the introduction of new regulatory instruments into an already heavily regulated industry. This means that the White Paper will need to consider the extent to which the existing regulatory framework will apply to the new mechanisms, or will need to be modified to accommodate the new mechanisms.

DECC’s consultation touched on the proposed transition from the RO to the FIT-CFD. The detail of the proposed transition, including whether the RO and the FIT-CFD will be available between 2011 and when the RO is “vintaged” on 1 April 2017, was left for the White Paper. The White Paper will also discuss the implications for the England and Wales regulatory framework should Northern Ireland and/or Scotland decide not to modify their RO schemes consistent with England and Wales. It is not clear whether the Scottish National Party’s election victory in May will make this more or less likely.

The White Paper should contemplate the proposed interaction of the FIT-CFD and capacity payment proposals with the existing balancing mechanism regime set out in the BSC. It is not yet clear whether the mechanisms for data flows and trading units provided for in the BSC and Grid Code will be used for the purposes of the FIT-CFD and capacity payments. Even if the BSC and Grid Code mechanisms are not used and new mechanisms are created, it is likely that a degree of interaction will still be required. For example, data arising from the established mechanisms may need to be used to validate claims made under the FIT-CFD and for capacity payments.

The implementation of the capacity payments will also need to be considered in the context of the existing demand response solutions, including NGET’s short term operating reserve service and schemes designed to encourage demand response such as Ofgem’s Low Carbon London scheme. DECC has yet to indicate whether participation in the capacity payments regime will preclude participation in NGET’s short term operating reserve service (and vice versa).

  1. What Do I Need to Do to Prepare?

The White Paper is expected to be published in July 2011. It is expected that this will be followed by a period of consultation and then with publication of draft legislation. Consequently, the players in the electricity industry will not know until later this year the detail of the changes to the electricity industry, and the implications for their business.

However, the introduction of one of DECC’s elements of its preferred package has been confirmed. HMRC published its response to its carbon price support consultation in March, following the 2011 Budget, which confirmed the introduction of the carbon price floor on 1 April 2013. The immediate actions are for businesses that supply fossil fuel to electricity generators, and electricity generators who use fuel oil to generate electricity. The former will need to register for CCL in advance of supplies of fossil fuels to electricity generators made on or after 1 April 2013, if they have not already done so. The latter will pay a different rate of fuel duty, which will be set out in changes to the Hydrocarbon Oil Duties (Reliefs for Electricity Generation) Regulations 2005, due to be published in 2012.

Businesses should also note the proposed introduction of anti-avoidance legislation, which will have retrospective effect from 23 March 2011. This will be designed to deter companies from adopting unusual invoicing practices to avoid paying the new carbon price support rates on supplies that were previously not subject to CCL. As electricity suppliers generally pass through CCL to affected customers, and supplies of electricity remain subject to CCL, it is unlikely that many changes will be required to electricity supply contracts to accommodate the new CCL regime. However, electricity suppliers should check whether changes to pass through charges are expressly permitted by the terms of their contracts. HMRC has also indicated that some changes to suppliers’ administration arrangements for CCL may be required (to account for the new carbon price support rates and changes to the PP11 supplier certificate), although these are expected to be minimal. Counterparties to power purchase agreements should also check that their contracts contain provisions that describe the impact of a change in law, and that are wide enough to cover the proposed changes to the RO.

Conclusion

The challenges of successfully moving to a low carbon economy are well known.  The successful and timely implementation of EMR will be a crucial step to meeting them.

It is important that the forthcoming White Paper delivers sufficient detail about the future shape of the electricity regulatory regime to minimize any existing uncertainty that is now constraining investment in low carbon infrastructure. We will be issuing a further briefing once the White Paper is published on the extent to which this is achieved.