REC 34-15 Energy UK response to DG Comp investigation of Investment Contract (early Contract for Difference) for Lynemouth power station biomass conversion 10 May 2015 About Energy UK Energy UK is the Trade Association for the energy industry. Energy UK has over 80 companies as members that together cover the broad range of energy providers and suppliers and include companies of all sizes working in all forms of gas and electricity supply and energy networks. Energy UK members generate more than 90% of UK electricity, provide light and heat to some 26 million homes and last year invested over 11 billion in the British economy. Introduction Energy UK welcomes the opportunity to respond to the consultation on the European Commission s Opening Decision for the state aid investigation of the Investment Contract (early Contract for Difference) for Lynemouth power station biomass conversion. This submission is intended to assist the European Commission in its assessment of the case. We urge the European Commission to reach a decision in a timely manner to ensure that there is clarity for investment decisions dependent on the CfD. This response is primarily focused on the case for Electricity Market Reform in addressing the specific market failure to provide an economic rate of return on investment in new low carbon and thermal generation, and the appropriateness of the Contract for Difference instrument for incentivising investment in low carbon electricity generation, including the conversion of coal fired stations to biomass. The success of the EMR legislation, including the financial instrument chosen, to support low carbon generation is vital for the industry and for the UK to meet its carbon targets. Whilst appreciating that this consultation is focussed on the state aid case for the Lynemouth Power Station conversion to biomass Investment Contract, many of the issues raised have wider implications for low carbon investment generally under the EMR framework. As a trade association, it is evidently not appropriate for Energy UK to have a position on the merits of specific projects and therefore we have not responded to the European Commission s view on the commercial agreement reached between the UK Government and Lynemouth Power on the Investment Contract for Lynemouth power station. 1 of 6
Executive Summary The UK s development of a low carbon electricity generation mix includes biomass, nuclear, renewables, and CCS, with the intention of delivering the common EU objectives of decarbonisation and security of supply, at an affordable cost. Energy UK strongly supports Electricity Market Reform (EMR) set out in the Energy Act 2013, as it is vital to addressing the specific market failures for investment in low carbon technologies and generation capacity needed for security of supply whilst also seeking to maintain affordability for consumers. Using biomass to fuel power stations has been part of the UK s energy mix for some time. The continuing role of biomass power stations as part of the energy mix in the UK has been confirmed following consultation. Biomass conversions are seen as a transitional technology in the UK with support for generating capacity ending on 31 March 2027. Energy UK believes that the Contract for Difference (CfD) is an appropriate and proportionate market-based instrument for attracting the level of investment required into low carbon electricity generation projects, at the least cost to consumers. The CfD has been subject to wide consultation in the UK and is now embedded within the UK legislation. Prospective investment in new low carbon generation is now resting on the successful implementation of the CfD. High upfront capital costs and exposure to long-term wholesale price volatility are the primary barriers for investment in renewables and in low carbon generation. The purpose of the CfD is to be a market-based instrument that mitigates wholesale price uncertainty and investment risk, thereby reducing the cost of capital. It also prevents overcompensation provided strike prices are set at an appropriate level. The CfD holders retain a number of risks including; construction delays and cost overrun, fuel cost increases and the requirement to sell their power into the market. EMR impacts retail prices, as the costs of CfDs and the Capacity Market are paid for via a supplier obligation and so are passed through to the end customer. However, EMR does not significantly distort competition in the electricity wholesale or retail markets or negatively impact on trade between Member States. Furthermore, we believe that the benefits of EMR, in terms of meeting common UK and EU objectives, outweigh any distortions. Lastly, the totality of anticipated CfD support costs are capped by the UK Government. 2 of 6
Consultation response 1. Common objectives pursued through chosen energy mix 1.1 The UK is committed to achieving the common EU objective of decarbonisation and energy security at the lowest possible cost. This has been reflected in support for ambitious greenhouse gas (GHG) reduction targets. In addition to supporting the proposals for a new 40% EU target for GHG reduction by 2030 on the 1990 baseline, the UK is committed via its Climate Change Act to achieving an 80% reduction in GHG by 2050 on the 1990 baseline. 1.2 Energy UK believes that a stronger and more predictable EU carbon price via the marketbased EU Emissions Trading Scheme still has the potential to be the most affordable means of decarbonising electricity and other sectors. We support the European Commission in proposing structural reforms to that end. However, even with the reforms proposed and given the expected challenges in reaching agreement on them, the current low carbon price seems unlikely to strengthen in the short to medium term, with the result that the ETS will not be the main driver for investment in low carbon electricity generation for a considerable time. Given the current concerns around affordability and consumer bill impacts, there is also uncertainty about the sustainability of very high carbon prices in the foreseeable future. Therefore, as with other EU Member States, the UK has had to put in place additional support mechanisms to attract the timely investment necessary to meet the 2020 targets. Delays will simply make decarbonisation costlier in the long run. 1.3 Security of supply is also a common EU objective and the UK in particular is currently facing a severe tightening of capacity margins due to power station closures and the lack of a sufficiently high wholesale market price to attract new investment into thermal generation. Energy UK supports the EU internal energy market, and agrees that interconnection can play a greater role in EU-wide security of supply. However, this will not negate the unprecedented challenge the UK faces in terms of needing to replace an ageing fleet of plant with new, low carbon generation, requiring investment worth tens of billions of pounds between now and 2030, plus the flexible generation needed to back up intermittent renewables through a capacity mechanism. Potential investors into the UK energy market face huge uncertainty around future wholesale prices. Without EMR, the financial instruments it contains and the capacity mechanism, the current energy market will fail to deliver this investment. 1.4 Energy UK supports the development of an energy mix to meet the UK s future needs, which includes a portfolio of low carbon technologies biomass, nuclear, renewables and CCS, along with gas-fired power as back-up. Developing such a mix should ensure that the UK can decarbonise at an acceptable cost without being dependent on the success of any specific technology. 1.5 Using biomass in power stations produces clean, renewable, energy. Biomass conversions can deliver rapid, large scale, cost competitive, low carbon energy on demand, which means that the use of biomass for power generation will contribute towards the decarbonisation of the UK supporting the Government s climate change targets. 1.6 The converted plant will generate sustainable, low-carbon energy and it will support security of energy supply in the UK by providing 395MW to the National Grid. The power station would be operating at baseload further supporting diversity and security of supply. Furthermore, to qualify for support under the CfD the plant will be required to meet Fuel Measuring and Sampling/Sustainability (FMS) arrangements, Sustainability Criteria and Renewable Qualifying Multiplier (RQM) calculation 3 of 6
methodology as set out under Annex 7 of the CfD standard terms and conditions. 2. EMR addressing market failure to provide an economic return on investment in low carbon generation 2.1 Energy UK strongly supports the UK Government s view that the energy market by itself will not deliver the level of decarbonisation, security, diversity and affordability of supply required to meet EU targets and the needs of the UK public. 2.2 Energy UK supports the EU Emissions Trading System (EU ETS) as a key policy tool for meeting Europe s longer-term greenhouse gas objectives. However, EU ETS does not currently provide a high enough and steady price to make low-carbon investment attractive. Further, there is insufficient confidence that the structural reforms agreed and which take effect in the near future will be sufficient. Therefore other measures need to be explored and implemented. 2.3 Many sources of low-carbon energy, are characterised by high upfront capital costs and exposure to long-term wholesale price volatility, which means that the energy market will not deliver the required investment without a much stronger carbon price. Therefore support schemes are needed to provide an appropriate and proportionate incentive for investment. This is the approach being taken by several EU Member States. 2.4 Energy UK supports the UK Government s Electricity Market Reform (EMR) package of measures, which have been legislated for in the Energy Act 2013, as being essential to attract the required level of investment into low carbon electricity generation projects and ensure security of supply in the most affordable way possible. The Contract for Difference (CfD) is the main instrument designed to address the absence of appropriate signals from the market and will attract investment into low carbon generation in a manner that is consistent with state aid rules. We set out more information on the appropriateness of the CfD further on in this response. 2.5 The Capacity Market (CM) is aimed at addressing the problem that capacity is not reliably valued (known as the missing money problem) at the level required for an acceptable level of security of supply. The CM is not, however, focused on achieving decarbonisation objectives, and is instead designed to ensure there is capacity to complement low carbon generation. (It should be noted that plant in receipt of CfDs will not be eligible for capacity payments). 2.6 The Carbon Price Floor (CPF) which is part of the EMR package (but was implemented by Her Majesty s Treasury in 2012) was designed to ensure a rising and predictable carbon price reflecting the rising marginal cost of decarbonisation as cheaper options are deployed first. However, at the 2014 Budget on 19 March the UK government announced that the Carbon Price Support level will be capped from 2016/17 until March 2020. This makes it clear that investors cannot invest solely on that basis, since they cannot rely on governments sticking to the original planned trajectory when the costs impact on economic competitiveness and consumer bills. 2.7 There has been a specific market failure to provide an economic return on investment in low carbon generation in the UK, since liberalisation of the electricity market 20 years ago. A large surplus of capacity, coupled with uncertain political support, were the main barriers for several years. UK wholesale electricity prices can be volatile, meaning investors face huge uncertainty around future wholesale prices. This risk is then priced into the cost of capital for low carbon projects. 4 of 6
3. Appropriateness and proportionality of the CfD 3.1 Energy UK believes that the CfD is an appropriate and proportionate market-based instrument for attracting the level of investment required into low carbon electricity generation projects in the most affordable way possible. Minimising the risks to that investment will reduce the cost of capital. The CfD achieves the investability objective by mitigating wholesale price volatility and the uncertainty over the price per MWh that a low carbon generator will receive. The CfD is also a legally enforceable, long term contract between the holder and a single counterparty body, which provides significant protection from political risk and further reduces costs of capital. 3.2 Before and during the consultation that preceded EMR, both the CfD and a premium FiT were considered. The conclusion of that consultation was that the CfD was the instrument that best removes the wholesale price uncertainty by providing a degree of revenue stability through a variable top up of the difference between strike price and wholesale price As the Premium-FiT does not remove the wholesale price uncertainty, the premium would have to be set higher to reflect the higher cost of capital. The added benefit of the CfD over the P-FiT is protection against overcompensation and better value for money for consumers, provided the strike price is set at the right level. Under the CfD regime payments are only paid out to generators when the Wholesale Reference Price is below the Strike Price, with reverse payments being made to consumers when the Wholesale Reference Price is above the Strike Price. 3.3 The CfD is a market-based instrument that still requires the CfD holder to sell their power into the market to receive payment and also maintains the basis risk. Intermittent renewables generators will sell their power using an intermittent reference price, which will be the GB day-ahead hourly price. Baseload low carbon generators such as biomass will use a baseload reference price based on the season ahead price. Developers in receipt of a CfD still face risk in relation to construction costs or schedule overruns, volume risk (i.e. the amount of electricity produced may be less than anticipated due to outages) and fuel cost risk. Therefore the CfD does not provide a guaranteed level of revenue for developers and profitability will be determined by their ability to manage the risks highlighted. 3.4 In the case of biomass conversions, these risks are magnified by the finite date for the end of support under the CfD/Investment Contract of 31 st March 2027. The delay in commencement of biomass conversions due to the delay in State Aid approval has effectively reduced project lifecycle to around 10 years as opposed to 12 years assumed in calculating administered strike prices. 3.5 Administrative Strike Prices have been set by the UK Government using independent expert analysis to reflect the estimated lifetime costs of constructing and operating the plant, to ensure an adequate return whilst avoiding overcompensation. The 4. Impact on competition and market distortion 4.1 CfD plant are still required to sell their power into the market and take part in the balancing mechanism. Also the UK is committed to developing a greater role for interconnectors and non-gb capacity, and their participation in the Capacity Market is being actively progressed. Energy UK does not therefore consider that the CfD will significantly distort the electricity wholesale or retail markets or negatively impact trade between Member States. Furthermore, we believe that the benefits of EMR in terms of meeting common UK and EU objectives outweigh any distortions that may arise. 5 of 6
4.2 There would be an impact on retail prices as a consequence of the costs arising from CfDs, which are paid for via the supplier through a supplier obligation. These costs are spread equitably across all suppliers, as has been the case to date with the other support mechanisms such as the Renewables Obligation (RO) and small scale Feed in Tariffs (FiTs). The overall cost of low carbon support schemes (RO, small scale FiTs and CfDs) are capped by the UK Government s Levy Control Framework (a cap rising up to 7.6bn by 2020/2021). Energy UK is supportive of delivering the carbon targets in the most efficient manner to minimise costs to consumers. We expect that the UK Government will continually analyse and balance the conflicting objectives and ensure that developers are not making excessive returns on their investments. 4.3 It is also important to note that there would be a cost to consumers associated with not decarbonising power supply over this period in terms of continued exposure to fluctuating gas prices. There is also a threat to security of supply, and the prospect of price spikes as a result of tight capacity margins. For further information please contact: Kyle Martin Energy UK Charles House 5-11 Regent Street London SW1Y 4LR Tel: 020 77471834 kyle.martin@energy-uk.org.uk www.energy-uk.org.uk 6 of 6