Innovative Energy Consultancy Ltd
Innovative Energy Consultancy Ltd

Capacity market under review

The Capacity Market (CM) is a government scheme to ensure that demand for electricity can be met at all times.

The CM was introduced by the UK government in 2014 as part of its Electricity Market Reform package. It was put in place to respond to new challenges faced by the electricity market which the government said “posed significant risks to security of supply”. These challenges included the rapid closure of a significant amount of existing supply in the 2020s, barriers to entry for some technologies and an increase in intermittent and less flexible capacity.

How the CM works

The CM was designed to incentivise sufficient investment in generation capacity, that the required supply is secured at minimum cost, and to minimise design risks and complement decarbonisation. It allows new electricity generators, interconnectors and Demand Side Response (DSR) providers – such as businesses with the ability to either reduce their demand or use onsite generation – to bid into annual, competitive auctions, either one year (T-1) or four years (T-4) ahead of the delivery year.

Successful bidders secure a capacity agreement which obliges them to generate electricity when the system is stressed, such as at times of high demand or unplanned outages. Capacity agreement holders are paid the auction’s clearing price for each de-rated kilowatt (kW) of capacity they have committed to make available throughout the delivery year in case of system stress. Capacity agreement holders face financial penalties if they fail to deliver electricity, or reduce demand, when required to do so.

Auctions so far

In July the government announced the next round of auctions, expected to take place next year, with 4.6GW for a 2019-20 T-1 auction and 46.3GW for a 2022-23 T-4 auction.

The previous CM auction in February cleared at a record low price of £8.40/kW – far below previous T-4 auctions. This led to criticism that the mechanism is struggling to drive investment in new capacity, however the auction still delivered 50.4GW capacity of a 49.2GW target.

Eight CM auctions have been held since December 2014, with all but one meeting or exceeding target capacity.

New proposals

On 8 August the government began its review of the CM in line with its five-year statutory requirement under the Energy Act 2013. The reviews are aimed at ensuring the CM adapts to the most pressing current issues. In addition, the regulator Ofgem carries out an annual process to receive and respond to industry requests for changes to CM operational rules.

In launching a call for evidence as part of its review process, the government set out its position on the state of the CM. It said that it believed the scheme’s objectives remained as valid as they were when the scheme was introduced and that it did not foresee the need for fundamental changes. Overall, the government’s intention is to enable evolution rather than revolution.

Priority issues the government believes need to be addressed include whether renewables such as wind and solar, including unsubsidised renewables, should be allowed to participate in the CM. Including them would fit with the intention of the CM being technology neutral and would open up the market to greater competition. However, there would also be challenges including the approach to de-rating, in order to consider if it is fit for purpose.

The document also looked at the role of interconnectors and cross-border participation. The government sees them as a positive contributions to energy security and boosting competition in CM auctions. However, there are concerns over the possible impact of simultaneous stress events across different markets (for example still conditions could occur across Europe and therefore affect wind output across the continent) and that it could mean the chances of large gas plants clearing auctions reduces. The government said it was contemplating changes to the de-rating methodology to ensure that interconnectors are not over-rewarded and altering methodology, which could allow more CM contracts to be awarded to new generation.

Another issue under examination is behind-the-meter generation and the problem of “double payment” (CM revenue and avoided CM levy charge) being gained. Previous feedback has shown that the removal of CM embedded benefit has not prevented this. The government will therefore consider this issue further.

It has also been suggested that the de-rating factor for DSR should be linked more closely to the technology type of its components, which could tackle accusations that short duration batteries behind-the-meter can masquerade as DSR in order to benefit from a higher de-rating.

Opportunities

The closure of both the Renewables Obligation to support large-scale renewables and the Feed-in Tariff for small-scale renewables, could mean that the stable revenue that the CM can provide may be of interest to those with or considering renewables projects.

However, estimated prices are expected to remain low, meaning the CM is unlikely to stimulate large amounts of risk-averse capital to be deployed on new renewables build. On top of this, renewables have low de-rating factors and higher non-delivery penalties.

It is therefore likely that projects will still need investment stimulus from Power Purchase Agreements or a revenue stabilisation mechanism. National Grid’s optimistic Community Renewables scenario from its Future Energy Scenarios predicts that the CM will not drive significant additional deployment by the mid-2020s.

One way to make renewables more viable could be through hybrid sites, whereby different technologies – such as wind and batteries – operated together but not necessarily located on the same site. This could mitigate possible sterner non-delivery penalties for renewables projects by helping address intermittency issues. The government said it supports hybrid sites participating in the CM more widely, but that there is work to be done on how best to de-rate them and to change the legislative framework to allow for it.

The government document also suggests that penalties for those that do not meet their CM obligations are set too low and that strengthening them could open up new commercial opportunities via incentivising “effective secondary trading strategies and encourage renewable developers to look closely at the viability of hybrid projects”.

Conclusion

The proposed changes to the CM appear unlikely to have a major impact on the scheme and the fundamentals driving the future clearing price. Nuclear, coal and older CCGT are still set to retire in the mid-2020s and price-competitive DSR, storage and reciprocating engines therefore remain available to deploy.

Despite this, the government’s call for evidence provides a valuable opportunity for businesses to put forward their views, particularly with the government stating “we need to consider how the CM can better support technologies such as DSR”. Views can be submitted until 1 October.