Why the UK's new energy master plan sets an example for the rest of Europe

January 17, 2013 | 00:00

Why the UK's new energy master plan sets an example for the rest of Europe

The UK once set the trend for the rest of Europe with the liberalisation of its energy market. Now, with a series of new legislative and policy proposals, London seems to be turning back the clock on liberalisation and returning to considerable state intervention in the energy market. Many observers have criticised the UK for having "lost faith in the market". But according to Robert Hensgens, the UK government deserves credit for its ambitions and the way it faces up to the twin challenges of the energy transition and security of supply. Although he is critical of the UK's unilateral approach, he believes London may well once again be leading the way in Europe.

Liberal Democrat Energy Secretary Edward Davey
(c) The Telegraph/ Reuters
The UK government's Electricity Market Reform, introduced to Parliament on 29 November in the form of a new Energy Bill, has been widely criticized by industry representatives and academics as heralding an unwarranted policy move from "market" to "state". Yet the government certainly had good reasons to come up with a radical reform package. First of all, the Kingdom is expecting serious problems with security of supply in the near future. An estimated 20 GW of coal and nuclear plants, offering stable base load capacity, will be phased out at the end of this decade. That amounts to roughly a fifth of total generation capacity. An equally important reason is that the UK is serious about carbon reduction. It was the first country in the world to legally anchor carbon reduction targets with its groundbreaking Climate Change Act. (So far it has only been followed by Mexico.) What the reform package is meant to do is to bring forth the huge investment needed to make the energy transition happen and ensure security of supply, whilst keeping electricity affordable.

This impressive ambition is matched by equally impressive measures. A Carbon Price Floor will underpin the European Emission Trading Scheme (EU ETS). Emission Performance Standards will ensure that no new coal plants are built without Carbon Capture and Storage. A complex auction-based capacity mechanism will be introduced in the power generation sector to ensure backup supply for intermittent renewable energy. Finally, and perhaps most importantly, a range of low-carbon technologies, including not only renewable but also nuclear energy, will be eligible for government support through the so-called Feed-in Tariffs with Contracts for Difference.

It is undeniably true that once this package is implemented, investment in the energy industry will be to a large extent Government-led. The majority of expected investment over the coming years, in low carbon technology, will be government supported through Contracts for Difference. The remainder, gas-fired generation, will be incentivised by an industry wide capacity mechanism. The relative competitiveness of technologies is consequently becoming more dependent on government decisions. Indeed this can be seen as a move away from the liberal idea that the government should only take care of carbon pricing and not interfere directly in the energy mix. The question is: are there good reasons for this loss of faith in the market?

The Government to guide investment

Actually, there are - at least when it comes to investment. The fact is that large amounts of money are needed to realise the energy transition. The UK government estimates that 110 billion pounds needs to be invested until 2020, or twice the historical investment rate in the electricity industry. Diverse

It is undeniably true that once this package is implemented, investment in the energy industry will be to a large extent Government-led
organisations such as the European Climate Foundation, the European Investment Bank and industry association Eurelectric, have all concluded that it will be extremely difficult to get market players to invest these kinds of sums. Current market conditions are tough because low demand has led to small spreads. Utilities are struggling to maintain healthy credit ratings and are focusing on strengthening balance sheets rather than investing. In addition, the financing of normally viable projects is difficult because of the ongoing deleveraging in the financial sector. New financial regulations, such as the Markets in Financial Instruments Directive, could further negatively affect the room for investment.

In addition to these difficulties, there are two more fundamental reasons why a government-guided investment program may be required to support climate policy. The first is that, with governments attempting to properly price carbon and stimulate renewable energy, the regulatory risks in the electricity market have become prohibitive. In a recent Eurelectric survey of 44 CEOs from the energy industry, regulatory risk was classified as the most important risk, even before market risk. The EU ETS in its current form is widely thought to be unsustainable, which has led many countries, frustrated with the low carbon prices, to implement or propose national repair measures, like coal or gas taxes and carbon price floors. The fear of the sudden introduction of such nationally inspired measures scares investors, delays investment and drives up costs.

There are also strong doubts in the market about the regulatory commitment to carbon pricing. Pending a credible long-term solution for the EU ETS, national governments have hardly any way to implement measures that are robust enough to drive investment. Instruments that target the price of carbon or fossil fuels affect dispatch decisions, but do not offer enough regulatory certainty to drive investment as long as there is European uncertainty over the carbon-trading scheme. The carbon price floor introduced in the UK is no exception. The only way to escape the regulatory commitment problem, and to reduce the cost of regulatory uncertainty, is for the government to fully take over the risks and engage in private, bilateral contracts with generators that cannot be changed over time - like the proposed Contracts for Difference.

The second reason for more government guidance is that realising the energy transition is taking more active coordination than many had perhaps anticipated. Locations for wind parks and carbon storage sites, for example, must be actively created and assigned. Grid connections must be developed. Many countries are still in the process of formulating societal preferences on political questions like how many wind parks and storage facilities can be placed in citizens' backyards, whether technologies such as nuclear power and shale gas are acceptable and how much dependency on foreign imports is tolerable. All of these questions are strongly interrelated, because the balance of the electricity system (ensuring that demand matches supply) is precarious. Therefore, the government needs to ensure that these various concerns are addressed in an integrated, long-term fashion, rather than being left at the mercy of short-term and fragmented forces.

Criticism: the end of the market?

So there do appear to be good reasons for governments to take a more active approach in guiding investment in the energy industry. The next question is whether the reform measures proposed in the UK are a good way of going about this. The UK reform package has led to fierce criticism from industry, politicians and academics. Their criticism roughly falls into three categories: the reform would end the market as primary driver for dispatch decisions, lead to government failure in investment and will drive up the costs for consumers and business. Is the proposed cure worse than the disease?

Probably the most frequently heard criticism, especially from within the energy industry, is that the reform package would effectively end the liberalised electricity market due to its distorting effects on prices and the merit order (the order in which plants are switched on and off). However, it is not necessarily the push for investment as such that is distortive; that depends on the way such a push is designed. As long as generators are confronted with their real marginal costs, crucial information about how much electricity costs at specific times and in specific places will be retained and dispatch will be efficient. In this regard, the volume-based Contracts for Difference do have a potentially distorting effect, manifested in the phenomenon of negative prices, especially as volumes grow. Just as important, however, are cost-reflective balancing and transmission regimes that confront renewable generators with the costs of the intermittency they bring into the system. Traditionally the UK has resisted, more than other countries, the political temptation to implement distorting measures that positively discriminate renewable generation in the system.

A second criticism is that direct government support will lead to the wrong technological choices and to higher costs, because the commercial risks of investment are taken away from investors. Oxford economist Dieter Helm, for example, has called the Contracts for Difference "a lobbyists' paradise".

Whilst it is true that "government failure" will inevitably arise, the costs need not be dramatic

However, taking over the risks of investment is of course exactly the point in the face of the carbon related regulatory risks that obstruct investment to begin with. Whilst it is true that "government failure" will inevitably arise, the costs need not be dramatic. Again, the design details are crucial. Even in a system in which the government sets support levels, it is possible to incentivise renewable electricity for the lowest price per MWh, as long as the number of potential projects exceeds the budget. In the Dutch system (SDE+) for example, lower support levels are incentivised by a higher likelihood of acceptance. If administered support levels are replaced by a system of competitive tendering, as the UK intends to do in the near future, the problem can be reduced further.

The risk of government failure is related to a more general criticism, namely that the market reform will drive up costs for consumers and business too much, too fast. Some economists argue that large-scale support for the deployment of low-carbon technology is too expensive and that a focus on innovation to realise cost reductions is preferable. However, whilst these are economically sound arguments, they ultimately reveal a different goal (slower energy transition) rather than a better way to reach the same goal. If one agrees that, already in 2020, the UK will need to meet both its carbon target and budget and its 15% renewable target, more is needed than just funding R&D in the hope that a groundbreaking technology will miraculously become available. Being in a hurry will undeniably increase the cost of transition, but there is plenty of evidence to suggest that we do need to hurry up. Incidentally, the Committee on Climate Change, an advisory body to the UK government, estimates that the annual household energy bill will be £100 higher in 2020 due to support for low-carbon technologies, which seems a manageable increase.

UK again leading the way in EU electricity markets?

So what does the reform in the UK mean for other European energy markets? Is there anything to learn from the country that once set the example for liberalised markets throughout Europe, but now seems to diverge from its original path? There is some good and some bad news.

The good news is that the UK may have found a way to combine government guidance, to ensure society gets where it wants to be on time, with the innovative forces of the market, to ensure it gets there more efficiently. Investment is needed throughout Europe, and the regulatory risks surrounding carbon pricing together with tough industry conditions provide a case for risk reduction through a temporary, government-guided push for investment. The main challenge will be to ensure that prices keep reflecting market fundamentals rather than an increasingly complex body of regulation, but the UK seems, more than any other country, up to this job. In addition, the UK shows leadership in coordinating infrastructure and spatial planning. The development of a regulatory regime for offshore wind and its interconnection is a good example. The transparent and market-based mechanism underlying this regime has made the Kingdom an attractive place to invest for offshore developers. Something similar could happen with its program for Carbon Capture and Storage.

The bad news for Europe is that the UK's approach is strikingly unilateral. Already, the divergence in climate policies, in the form of different renewable support systems and national taxation schemes, is posing a serious threat to the European energy project. With its intention to unilaterally implement an

Already, the divergence in climate policies, in the form of different renewable support systems and national taxation schemes, is posing a serious threat to the European energy project
industry wide capacity mechanism, the UK is adding a new dimension to this divergence. Whether capacity remuneration mechanisms are needed is an important question, but it is one that should be addressed multilaterally. Countries in the North West European market, including the UK, should put more effort into regionally harmonising their climate and capacity measures. For example, increased interconnection capacity and further market integration would allow the UK to benefit from the excess gas-fired capacity in the Netherlands, making for a more efficient way to improve security of supply than by building its own backup capacity.

Although the ongoing reform of the UK electricity market certainly is in many ways open to criticism, at the end of the day, the UK Government deserves more credit for its policies than it is currently getting. Making its decisions in the messy realm of domestic and international politics, rather than the textbook world of economically optimal policy, it has managed, virtually as the first country in the world, to formulate a master plan to establish the energy transition. It is fair to say that its integrated, long-term approach sets an international standard of best practice. Given its old generation fleet a plan was perhaps needed more so in the UK than in other countries, but its dedication to decarbonisation is impressive. With the right dose of government guidance in investment, and sufficient eye for retaining the market as the main driver for prices, the UK may well be successful in pulling both the industry and climate policy itself out of their slump. If it does, in some years from now, we will perhaps realise that with its bold and brave reform, the UK was once again leading the way in European electricity markets.

 

Robert Hensgens (robert.hensgens@nuon.com) is an economist with extensive experience working on competition policy in regulated industries, especially in energy markets. He is currently employed as regulatory affairs advisor with Nuon, part of Vattenfall in the Netherlands and previously worked for the Dutch Ministry of Economic Affairs. The opinions expressed in this article are strictly personal and do not necessarily reflect his employer's viewpoints or policies.

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