Law360, New York (November 04, 2014, 10:46 AM ET) -- On July 24, 2014, the European Commission gave its green light under European Union state aid rules for the implementation of a capacity market scheme in the U.K. The nonconfidential version of the decision was published on Oct. 3, 2014.

The European Commission's decision seems to have attracted only limited public attention so far, although it is highly important for a number of reasons. First, the decision marks the first-ever state aid ruling on the implementation of a capacity market in the EU and therefore sets a legal precedent. Second, the European Commission has for the first time practically applied the detailed provisions on capacity markets set out in the Environmental and Energy State Aid Guidelines, which entered into force in July after much controversy. The European Commission's decision, therefore, provides an important interpretation for other EU member states and stakeholders on the commission's reading of the new state aid requirements for capacity support mechanisms. Third, the decision allows capacity support measures to be restricted to only domestic energy markets. It could thus have ramifications on the evolution of the EU's internal energy market. These several points are taken up below.

European State Aid Law and the Concept of Capacity Markets

As the market share of subsidized renewable power grows in line with EU climate policy objectives, demand for conventional power plants continues to decrease. Notwithstanding, power from conventional plants remains crucial, including as backup for the intermittent energy production from renewable energies. A large number of EU member states are therefore considering the introduction of so-called capacity markets (i.e. financial support schemes to ensure certain levels of conventional energy production). The aim is that operators of conventional power plants receive compensation in return for guaranteeing to make (or keep) power generation capacity available, regardless of how much power they produce. The idea seems logical, although the concept remains highly controversial not least because it appears to run counter to free and competitive energy markets and because of its potential to impede crossborder energy trade.

In light of the above-mentioned “side effects,” the European Commission has sought to bring the design of capacity markets into line with its efforts to complete the EU's internal energy market. Besides the publication of nonbinding recommendations, the European Commission has devoted a whole chapter of its new EEAG to state aid measures that support the availability of power production capacity. These provisions are meant to ensure that: (1) market interventions by EU member states are reduced to a minimum and (2) capacity markets are implemented in a harmonized way so as to provide a level playing field across the EU's internal energy market.

Conditions for Capacity Markets Under the EEAG

As a prerequisite for the introduction of capacity markets, the EEAG foresees that EU member states have to demonstrate market intervention is necessary. To this end, they have to properly analyze and quantify the generation adequacy problem they intend to address. This “necessity assessment” must take due account of a variety of factors, inter alia the production of electricity from variable energy sources, the potential for demand side response measures to alleviate the problem, the effects of network interconnectors to neighboring countries and regulatory failures.

In addition, the EEAG impose certain requirements on the design of capacity market schemes. For example, they have to be technologically neutral and be open to both existing and future generators, to DSR measures and to storage solutions. Also, the financial support must be allocated through competitive bidding processes and must foresee mechanisms to avoid an abuse of market power. In addition, the EEAG prescribe that compensation may only be granted for making generation capacity available but not for the delivery of energy in case of emergency situations. Finally, the EEAG provides that, in order to promote the emerging EU's internal energy market, capacity markets must be open to generators from other EU member states, so-called interconnected capacity, where the capacity can be physically provided to the member state implementing the measure and the obligations set out in the measure can be enforced.”

U.K. Capacity Market

The U.K. capacity market, which has been approved by the European Commission for a period of 10 years, enables the U.K. government to procure generation capacity via centrally managed auctions as of 2017 to 2018. The auctions will be open to all existing and future power generators, irrespective of their source of energy, unless they already receive state support. The auctions will also be open to storage operators and certain demand reduction measures. The quantity of auctioned capacity will be predetermined by the Transmission System Operator, verified by an independent expert panel finally decided by the central government.

The U.K. system foresees that there will be two auctions each year: a main auction will be held every year for delivery in four years' time. In addition, there will be a “year-ahead auction,” held in the year prior to the intended delivery year, which is meant to fine tune the amount of procured capacity when more accurate demand forecasts are available. All successful participants are awarded a “capacity agreement,” which entitles them to a steady capacity payment. The duration of these agreements varies: existing plant operators and DSR operators will have access to one-year agreements, whereas operators of refurbished plants will be entitled to three-year contracts. Operators of newly built plants will be eligible for capacity agreements of up to 15 years.

The U.K. capacity market scheme follows a so-called delivered energy model, which means that the capacity agreement holders are obliged to actually deliver electricity in situations where the power supply system is significantly strained. The obligation is enforced by penalties. However, the scheme allows for secondary trading so as to provide operators with the opportunity to reasonably manage the commercial risks that they assume. The capacity payments will be financed through a levy imposed on electricity suppliers, who are supposed to pass on the costs. The scheme foresees that a newly created state-owned entity, the so-called settlement body, is responsible for administering the financing mechanism.

The European Commission's Legal Reasoning

The European Commission first found that the measure constitutes aid in the sense of Article 107 (1) of the Treaty on the Functioning of the European Union in as far as it confers a selective economic advantage granted by an EU member state or through state resources, which has the potential to distort competition and trade between member states. However, in cases where levies on electricity suppliers are supposed to finance energy support measures, it might be questioned whether the aid is granted “by the state or through state resources.”

According to EU case law, the support must be “imputable” to the state, which is generally the case if the state controls the financial flows of the financing system to some extent, even if the aid is not granted directly by public authorities. In the case at hand, the European Commission reasoned that the capacity payments are granted by the state because the financial flows are controlled by an entirely state-owned entity, which was set up by the U.K. government. Notwithstanding, depending on the individual design of a capacity market, it is conceivable that the imputability to the state might be challenged, with the consequence that the measure might fall outside the scope of EU state aid scrutiny.

The European Commission went on to find that the measure is justified under Article 107 (3) TFEU as it satisfies the conditions set forth in the new EEAG. The European Commission based its reasoning at this point on the following aspects:

Necessity for Market Intervention

The European Commission found that the U.K. government has sufficiently demonstrated that the EU electricity market will be facing a generation adequacy problem as of 2017 to 2018. It underlined that the “necessity assessment” took due account of the potential of the U.K.'s interconnectors to neighboring countries and the U.K.'s demand side response potential. Furthermore, the European Commission stressed that the U.K.'s finding is in line with the generation adequacy forecasts of the European Network of Transmission System Operators for Electricity. In our view, it is likely that the European Commission will also take those forecasts into account with regard to capacity markets in other EU member states.

Design of the Measure

In addition, the European Commission decision contains some interesting considerations on the specific design of capacity markets. The European Commission's considerations on the duration of the capacity agreements are particularly noteworthy. Since the EEAG do not set out explicit rules on the duration of generation adequacy aid, it was uncertain what a justifiable timeframe for capacity payments could be, especially for new power plants, which generally have very high capital requirements. Only the European Commission's guidance on public market interventions in the electricity sector has stipulated that the duration of the aid measure should be no longer than the working life of the subsidized plant or facility. In the decision, the European Commission approved the graduated approach of the U.K. (i.e., a duration of one year for existing power generation plants and DSR measures, up to three years for refurbished power plants, and up to 15 years for new plants) and therefore sets an important legal precedent and guidance for other EU member states and stakeholders.

Noteworthy also is the European Commission's view on the U.K.'s remuneration mechanism. The European Commission notes that although the system remunerates primarily the service of making and keeping capacity available, the scheme follows a “delivered energy model,” whereby operators may face penalties if they fail to deliver electricity in case of system stress events. The model is not consistent with the EEAG, which provides that compensation may only be granted for making capacity available in order to ensure that balancing energy continues to be allocated via competitive balancing markets, instead of state support measures. Nonetheless, the European Commission approved the U.K. model based on the fact that the supply obligation arises only in situations where there is a shortage of capacity across the entire national electricity system, as opposed to regional shortages. In view of the European Commission, this limits the risk that generation capacity is inefficiently allocated.

Finally, the decision sheds some light on the EEAG obligation that capacity market schemes have to be open to generators from neighboring EU member states “where the capacity can be physically provided […] and the obligations can be enforced […].” Since there are a number of legal questions associated to both requirements, it was unclear how strictly the European Commission would apply the EEAG in these regards. For instance, the EU regulatory framework for crossborder energy trade provides that interconnector capacity has to be allocated through auctions, which makes it difficult to practically guarantee that electricity can be delivered across the border in case of system stress events. In addition, the enforceability of capacity market obligations in the participating state may imply that there is an intergovernmental cooperation agreement in place. This in turn would lead to the assumption that it is entirely up by the EU member states concerned to decide if the system will be open for cross-border participation or not. In the case at hand, the European Commission conceded that “it is not possible to include foreign capacity without implementing additional crossborder arrangements” and accepted that the U.K. capacity market is (initially) limited to the domestic energy market.

Conclusion

The European Commission's decision confirms that EU member state capacity market schemes may fall under the scrutiny of EU state aid law. In this respect, the decision provides practical guidance on the requirements for implementation of such support measures, in particular under the new EEAG.

The European Commission decision is thus equally important to public and private stakeholders in the energy sector. However, as the European Commission in principle approved the U.K. scheme restricted to only domestic capacity providers, the decision may complicate efforts to improve the conditions for crossborder energy supply. The design of other EU member state capacity markets will need to take into account these considerations carefully, balancing them with of their own special national market circumstances.