INTRODUCTION

Background

In December 2010, the UK Government launched a consultation process concerning proposals to reform the electricity market. The Energy Secretary described the proposals as a "seismic shift" – and they are, both politically and economically. The proposals aim to deliver the Government's key energy objectives, namely: security of supply, decarbonisation and affordability. The new market framework aims to make low-carbon investment more attractive, encouraging the cost-effective delivery of secure supplies of low-carbon energy from sources such as renewables, nuclear and fossil power stations equipped with carbon capture and storage (CCS) technology.

Underpinning those proposals, is the hope that the UK will become a more attractive country in which to invest. The Government estimates that £110bn (approximately $171bn) in capital investment will be needed by 2020. Of this, £70-75bn (approximately $108-116bn) will go towards investment in new generation capacity, while the rest will cover existing and smart grid infrastructure.

Process

The consultation process currently under way ends on 10 March 2011, except for the consultation on carbon price support (please see "Carbon price floor" section below) which ends on 11 February 2011. Legislative proposals to implement the electricity market reforms will be launched in an “Energy White Paper” in Spring 2011. The Government aims to take news powers in primary legislation “from 2011 onwards” with an aim for the reforms to be in place by 2013/2014.

KEY PROPOSED REFORMS

Carbon price floor

Carbon price support, through a carbon price floor, aims to encourage investment in low-carbon technologies. Introducing a carbon price floor will give greater certainty around the additional cost of fossil generation, thereby making low-carbon power generation more attractive.

The current carbon trading system is the EU Emissions Trading System (“EU ETS”) which has been in place since 2005. In that time, the price of carbon under the EU ETS has fluctuated dramatically, particularly in the early phases, making it hard to factor carbon costs into an investment case. A large part of the power generation industry in the UK is subject to this cap-and-trade system with 98% of emissions associated with UK electricity generation being covered by the EU ETS. The EU ETS has created a market in carbon where EU carbon allowances (EUAs) can be traded. From 2013, the EU ETS emissions cap will tighten each year, which should put upward pressure on carbon price. Despite this, the government believes that more certainty about the carbon price is required and that “there is a strong rationale for complementary measures to the EU ETS so as to provide greater certainty”.

On that basis, a carbon price support mechanism will be introduced from 1 April 2013. It will be achieved by removing existing Climate Change Levy exemptions relating to fossil fuels used in UK electricity generation and by reducing the amount of fuel duty that can be reclaimed when oil is used to generate electricity. The tax rates (“carbon price support rates”) will take into account the average carbon content of the fuel in question. The Government’s preferred option is to introduce the carbon price support rates at a different level from the main CCL rates.

Three illustrative carbon price scenarios are set out in the Government’s Consultation Paper. In two of these, the amount of carbon price support starts at £1/tCO2, whilst in the third it starts at £3/tCO2 – in each case, on top of the prevailing EU ETS price. This support rises to target a combined carbon price (support plus EU ETS) of, respectively, £20/tCO2, £30/tCO2 and £40/tCO2 in 2020 rising, in each case, to £70/tCO2 in 2030. These figures contrast with the price of carbon in the last 12 months, which has fluctuated between £10 and £14/tCO2. Final decisions on the carbon price support, including the initial levels, will be announced during the March 2011 Budget. In the meantime, the Consultation Paper states that the Government would “welcome views on the appropriate level of the carbon price over the long term”.

The Government hopes that introducing a floor on the carbon price will increase long-term certainty about the costs involved in running polluting power plants. However, there is also public concern that supporting the carbon price will increase retail electricity prices and that this will primarily affect low-income households.

The Government’s intention is to include these proposals in the 2011 Finance Bill, with secondary legislation to follow.

Feed-in tariffs

Feed-In Tariffs (FITs) were introduced in April 2010 but currently only benefit small-scale electricity generators (below 5MW). The Government now proposes FITs for large-scale generators. The current preferred option is to introduce these FITs by means of a "Contract for Difference" model whereby the Government provides varying levels of support depending on market electricity prices: it would provide support when market prices are low and generators would repay when prices are unexpectedly high. In practice, this would mean that generators sell their electricity into the market, and will then either receive a top-up payment or may have to repay revenues. The top-up payment (or repayment) would be calculated as the difference between the average wholesale market price and the agreed tariff level.

The aim is for the new FITs to provide increased revenue certainty to low-carbon generators, thereby encouraging investment in low-carbon electricity generation. The new FITs would benefit all forms of low-carbon sources, including nuclear but the Government indicated that the FIT could be set at different levels for different technologies. Currently, there is no indication of the levels at which the FITs could be set. The Government is considering various alternatives, in particular premium FITs which could apply to more costly technologies.

Capacity payments

The proposal is to offer payments to power generators for building flexible reserve plants in order to ensure security of supply. Power reserves will be particularly important in the light of the increased amount of intermittent and inflexible power generation.

The Government has indicated that capacity payments could also extend to imports of electricity from European countries and could also cover demand-reduction measures, such as commitments to reduce demand at times of peak demand or intermittent supply.

The Government's current preference is to introduce a volume-based system whereby an obligation would be placed on a central body to maintain a set capacity margin. This body will run tenders for any additional capacity needed to make up the shortfall between the level of spare capacity provided by the market and the centrally-determined margin. This targeted approach would benefit specific generators and could create opportunities for large-scale storage devices.

The Consultation Paper does not specify the extent to which an existing plant (possibly with additional investment) could count as standby capacity but the White Paper may provide further details on this point.

Emissions performance standard

The proposal is for an emissions performance standard to apply to new power stations, which will be designed to set a limit to the amount of CO2 emissions. There already exists a requirement that no new coal-fired plant is built without being carbon capture and storage (CCS)-ready and this new proposal would reinforce the existing requirement.

For now, new gas-fired plants will not be subject to these measures. The Consultation Paper states that the emissions performance standard will be set at a level that will only affect coal-fired plants – though in the long-term the UK will need gas-fired plants to be equipped with CCS technology in order to meet the Government’s decarbonisation objective.

COMMENTS

These proposed reforms will help Britain meet some of its legal obligations - in particular, its commitment, under the 2009 EU Renewable Directive, to increasing to 15% by 2020 its energy consumption from renewable sources (which would mean around 30% of its electricity consumption coming from renewable sources) and also its commitment, under the Climate Change Act 2008, to reducing greenhouse gas emissions by 80% before 2050 (compared to 1990 levels).

But today, many power stations are reaching the end of their operational life and it is estimated that around a quarter of all generation capacity must be replaced by 2020. It is hoped that the Government’s proposals will encourage the private sector to replace that capacity and invest in capacity to achieve the doubling of demand by 2050.

Regarding renewables projects, the Government proposes that accreditation under the current Renewables Obligation (RO) regime remain open until 31 March 2017. Projects built after that date will benefit from the new Feed-In Tariff system. Pre-2017, any project that is accredited under the RO scheme will continue to receive support for up to 20 years (so potentially until 2037). However, the Government is consulting on whether, pre-2017, generators can opt into the FIT scheme instead.

These reforms, in particular the Feed-In Tariffs, should go some way to making investment in new nuclear more attractive – though some uncertainty remains regarding the costs of construction, decommissioning ageing nuclear plants and disposing of nuclear waste. In the light of the scale of these costs, the Energy Secretary recently declared that, in future, new nuclear plants should be subject to watertight agreements that ensure that these costs do not fall upon the public.

What these proposals mean for investors will be clearer once the process is more advanced – for now, the consensus is that these reforms are much needed and, indeed, the short twelve-week consultation timetable perhaps indicates the Government’s keenness to implement them. The Government is aiming to create a stable regulatory framework which gives investors greater certainty on their long-term rate of return from low-carbon generation. Much will depend upon the more detailed proposals which will be contained in the “Energy White Paper”. That White Paper will be eagerly-anticipated for those in the power generation industry and we will be reporting in due course on any key reforms relevant to them.