On 1 February Ed Miliband, the Energy and Climate Change Secretary, revealed that Government is contemplating serious reforms to the British energy market which will be detailed in the Roadmap to 2050 document due to be published in April 2010 alongside the Budget.

Two days later Ofgem, the regulator of Great Britain's energy markets, published a consultation paper setting out what it perceives to be the options for delivering secure and sustainable energy supplies for Great Britain over the next 10 to 15 years. Among the proposals is the introduction of a minimum price for carbon for those emitters caught by the EU ETS, set independently rather than by reference to the price of EU carbon allowances, and the return of some form of central capacity payment for power plants. The return to an electricity pool and replacing the Renewables Obligation by going back to centralised renewables tenders are also options for consideration.

Participants in the energy markets' capital intensive renewable, nuclear and carbon capture projects have generally welcomed the news that reforms are being considered. If taken forward by the current or a future Government, the reforms could radically reshape the generation mix for Great Britain.

In his comments, published by the Times on 1 February 2010, which were reiterated in a subsequent DECC press release, Ed Miliband stated that a more interventionist energy policy is required to encourage investment in low carbon technologies.

In the Ofgem consultation document, which presents the conclusions from Ofgem's Project Discovery, Ofgem puts forward five possible policy packages, ranging from proposals which would adjust and supplement existing market mechanisms through to proposals, such as the introduction of a central buyer of energy, which would require whole-scale market reform.

While the key theme of the proposals is a shake-up of the power market, a number of the proposals would also be applied to the gas sector.

The basic elements of the packages are described below.

Targeted Reforms

The key features of this package are:

  • the introduction of a minimum carbon price (set independently from the EU) to encourage investment in low carbon technologies;
  • improving price signals in the gas and electricity markets by reforming gas cash-out arrangements and, for electricity, by making the allocation of reserve costs more reflective of system tightness (such as by introducing a daily reserve market); and
  • improving demand side response and building on existing work in respect of smart meters and smart appliances by exploring specific market design issues relating to balancing and settlement (such as time of use tariffs, real time pricing and smart appliances allowing automated load shifting).

Enhanced Obligations

This package shares some of the features of the Targeted Reforms package, namely the minimum carbon price, improved price signals and improved demand side response.

In addition to these measures the Enhanced Obligation package also includes:

  • Enhanced obligations on suppliers: suppliers would be obliged to demonstrate that they had sufficient contracted supply to cover the future energy demand of their customers, assessed against pre-defined security standards;
  • Enhanced obligations on transmission system operators: the electricity transmission system operator could be required to purchase forward sufficient back-up and flexible generation to meet future requirements. The gas transmission system operator could be required to buy imported gas during an emergency, up to the point where it would be more economic to permit supply disruptions rather than buy gas;
  • Obligations on gas-fired power stations: currently 5 GW of the existing 26 GW of CCGT generation capacity, comprising predominantly older CCGT plants, can run on back-up fuel (distillate). This distillate effectively acts as another form of gas storage. An obligation could be introduced requiring all CCGT plant to have the capability of running on distillate for a specified number of days. Ofgem recognises that the measure would need to be phased in given the investment that would be required to retrofit plant;
  • Introduction of a centralised renewables market: the benefit of a centralised market for wind and other variable renewables would be that it would provide a market in which renewables generators could sell their output without the cash-out price risk. It may also increase intra-day liquidity. Ofgem considers that this approach could also allow the electricity transmission system operator to balance the system more effectively as it could take a holistic view of wind output, demand and demand side response, reserve requirements and the management of system constraints.

Enhanced Obligations with Renewables Tenders

This package builds on the Enhanced Obligations package with which it shares some common features such as the minimum carbon price, improved price signals and improved demand side response, enhanced obligations on suppliers, enhanced obligations on transmission system operators, obligations on gas-fired stations and a centralised renewables market.

However, this package would also involve replacing the Renewables Obligation (RO) for new large scale renewables with a tender process, akin to the NFFO tender rounds held in the 1990s. The sub-5 MW Feed-in Tariffs scheme, due to start 1 April 2010 would remain in place but arrangements for existing RO qualifying plant would need to be grandfathered (or bought out).

Renewables tenders could be technology neutral or technology specific. Ofgem feels that it is highly likely that if renewables tenders were to be introduced they would need to be differentiated by technology to some extent to promote investment in emerging technologies which may involve higher costs than known technologies (as is currently acknowledged via the banding in the RO).

A central entity would need to determine the amount of capacity in each tender, and also the timing of the tenders. Generators would bid into the tenders based on the additional revenue needed to earn an appropriate return on their investment over a reasonable period (Ofgem refers to 20 years in the consultation). The costs of the tenders could be levied to consumers via suppliers, as is the case with the RO, or via some other mechanism (which is not specified in the consultation document).

Renewables plant would sell output through the centralised renewables market (see the section on the Enhanced Obligations package). The only difference would be that if renewables were constrained off the system they would be compensated for the proportion of the tender revenue forgone (rather than for the ROCs they would have received).

Capacity tenders

This package would involve the introduction of tenders for all generation capacity as well as for new gas storage facilities and other gas infrastructure (such as gas ballasting facilities).

It would retain three features of the Enhanced Obligations package: improved price signals; improved demand side response; and the centralised renewables market. Notably, it would not involve the introduction of a minimum carbon price.

Ofgem proposes that tenders for generation capacity could comprise long term tenders for low carbon generation plant (including renewables), CCS and nuclear, and shorter term tenders for generation capacity more generally (and demand side response).

The low carbon tenders would be likely to be differentiated by technology and could be further sub-divided by location. This would have the advantage of allowing the co-ordinated expansion of the transmission network and gas storage infrastructure. The commitment period of the tenders might vary depending upon the technology, for example the typical economic lifetime of a nuclear plant could be double that of a wind farm.

A central entity would determine the volume of capacity needed to meet a specified security standard. All generation plant (new and existing) plus demand side response could offer into the auction and would be competing for the additional revenue they require above their expectation of wholesale market prices. Successful participants would receive the market clearing price for capacity, but would be penalised if the capacity is not available at the required times. Generators would sell their output in the intra-day market.

Tenders for gas storage and other gas infrastructure would involve the central entity determining the amount and type of new storage required several years in advance. It would then tender for the build and operation of this capacity. The central entity could also have a role in providing gas ballasting facilities where these become necessary to keep imported gas within Great Britain's quality standards. It (or National Grid) could tender for ballasting facilities and the costs could be socialised, or a ballasting service (or third party access) could be sold to gas shippers where ballasting is required.

Central Energy Buyer

This package represents the most radical departure from the current market arrangements and involves the introduction of a Central Energy Buyer (CEB). Ofgem has identified a key risk with this package that the CEB could make the wrong choices and over-contract at the expense of consumers. This would be the most complex package to implement and Ofgem has noted that it would raise issues regarding compatibility with EU law.

In the electricity market, one possible model for the CEB would see it acting as a broker, buying output from generators via a centralised dispatch mechanism, or "pool", and selling it to suppliers on standard terms. Long term contracts (Power Purchase Agreements) with generators would allow the CEB to determine the generation mix and provide returns incentivising investment via the pricing provisions.

To make the approach more compatible with EU law, suppliers and end users could be allowed to bypass the pool and purchase power directly from generators. The drawback of this would be that the CEB would have less direct influence over generation mix (which is one of the key rationales for this approach).

With regard to gas storage and gas infrastructure the CEB could tender for new storage, ballasting and import capacity infrastructure. It could also be permitted to enter into long term gas supply contracts (selling gas on to suppliers on standard terms).

Conclusions

All of the packages proposed by Ofgem in the consultation paper represent a significant departure from current energy policy. At the lower end of the scale this is because some of the packages propose the introduction of a minimum price for carbon, and at the higher end of the scale because parallels can be drawn between the Central Energy Buyer package and the pre-privatisation market structure of the 1980s and the market structure immediately post privatisation in the 1990s involving the electricity pool.

With the expected release of a Conservative energy policy statement, it is likely that energy policy will remain high on the political and legislative agendas both before and after the anticipated May 2010 general election.

The deadline for responses to the consultation is 31 March 2010. The consultation documents are available here.