Gas Strategies’ response to the UK Electricity Market Reform Consultation with H.M. Governments’ Department of Energy and Climate Control (DECC), which was submitted to them prior to their 10th March 2011 deadline, is detailed below. This submission has been prepared in association with Carlton Power Ltd and Statoil (UK) Ltd. It also takes account of the concerns expressed by gas to power market participants who attended a recent seminar on EMR co-hosted by Gas Strategies and Hogan Lovells.

However, in light of the significant changes brought about by the Japanese earthquake and tsunami tragedy, we have reinforced our response in a letter of 14th March 2011 to DECC, which is available for download here.

We welcome debate around these issues. Please send your response to info@gasstrategies.com.
               

EMR – CREATING A FRAMEWORK FOR GAS
Reducing the risks of a low carbon generation strategy

Prepared by Gas Strategies in association with Statoil (UK) Ltd and Carlton Power Ltd

Introduction

In its blueprint for a secure and sustainable energy future, H M Government has proposed an Electricity Market Reform (EMR) package, in which gas is relegated to providing only a marginal support role for nuclear and renewable energy.

As currently formulated, this strategy could have serious and unintended negative consequences for the UK economy in terms of higher than expected energy costs and greater insecurity of supply. 

The EMR proposals contain more questions than answers and at this stage in the consultation process there is an urgent need for (a) a more robust cost/benefit impact assessment of the current proposals and (b) an evaluation of an alternative “pathway” to a low carbon future, which recognises the central role that gas has as a destination fuel and not simply a flexible stop-gap.

In short, in the current debate, there is a need for a “voice for gas”. The focus of this submission is strategic rather than detailed and its primary purpose is to highlight the potential risks of the EMR proposals, and how a blueprint which explicitly embraces gas could provide a more stable route towards achieving a secure and sustainable energy future for the UK.

 

Market Participants  

At a gas industry seminar on 8 February 2011, co-hosted by the consultancy Gas Strategies and the law firm Hogan Lovells, both DECC and Ofgem said they would welcome a concerted response from gas suppliers and generators to the EMR proposals.

This submission is in response to this request and has been prepared by Gas Strategies with the support of Statoil – the largest UK importer of natural gas as well as a wind and CCS developer – and Carlton Power – a leading independent UK developer of gas generation.

In addition, this submission draws on the views and comments of other participants in the gas to power value chain who attended the 8 February breakfast seminar. Those invited and attending included: Exxon Mobil, BG Group, AEP, Centrica, EDF, EON, RWE, Eni, Fieldstone Capital, Barclays Capital, Interconnector (UK), Intergen, Mitsui, Nord Pool, Oil &Gas Association, Scottish & Southern and South Hook Gas.

This submission reflects the collective views of those involved and not those of individual organizations unless stated. This submission is presented to DECC as a basis for a more detailed discussion on the issues raised.

 

Key Messages- Summary

More investment in gas plant, related networks and flexible storage will be needed to provide base and peak load supply to the system given the strong likelihood of delays in the implementation of new low carbon generation, the intermittent nature of wind power and the need to replace winter coal-fired generation that will come offline in 2016 as part of the Large Combustion Plant Directive (LCPD).

Gas is an affordable, abundant, efficient and clean fossil fuel and should be allowed to play a central role in the transition to a low carbon economy.

Market reforms must encourage investment in new gas generation fleet and infrastructure as well as low carbon generation to ensure that gas can provide the support role that is envisaged.

The ‘Big Six’ vertically integrated utilities should not be relied upon to provide the capital for all the generation capacity that will be required. In order for independent generators to invest, power market liquidity needs to be improved to allow generators and suppliers to contract medium term.

Some form of long term capacity or flexibility payment will be necessary to underpin revenues of and support project financing of new gas plant, where expected load factors are lower than current levels.

H M Government will benefit significantly from establishing a small but representative expert panel to advise on the market and to consider the commercial implications of particular reform measures, with particular reference to the role that gas will continue to play in reducing the risks of the transition to a low carbon regime up to and beyond 2020.

Failure to recognize and facilitate a central role for gas in the route to a low carbon economy will result in significantly higher and more volatile energy costs to the UK economy and consumer and particularly a further increase in fuel poverty, damage the operation of the UK wholesale gas market and threaten security of energy supply.

 

Market Record of Success

At the outset, it is worthwhile recording that in the last 20 years, the UK has led the EU in the creation of a viable and competitive market for gas supply and gas powered generation.

There are two principal reasons for the success of gas. First, the support shown by successive Governments and Regulators for the principles of a competitive energy market and second, the successful development and operation of a liquid and efficient wholesale gas market.

Despite its growing dependency on imported gas and the competition for such volumes from other markets (e.g. Asia and mainland Europe), there are still plentiful supplies of gas available. The UK has been an attractive destination for gas and downstream market participants have invested heavily in infrastructure to help ensure security of supply into the market.

In generation, gas now accounts for some 32% of total capacity and, despite the lack of wholesale electricity market liquidity (due to the growing dominance of the ‘Big Six’ vertically integrated utilities), there are still a significant number of independent players in the power generation market. Gas is also the obvious entry point for new entrants into the generation market.

Because it is relatively cheap to build; can operate at base and peak load and generates 60% less CO2 than coal, gas has already made a major contribution to helping deliver a low cost, low carbon energy for the UK consumer. However, as a consequence of the present EMR proposals gas will no longer play a key role in the UK energy market after 2030

 

Key EMR Assumptions 

In the EMR document, the idea of stimulating and accelerating investment in nuclear and wind generation is presented as the preferred and only way of meeting the twin policy objectives of increasing available capacity and reducing GHG in line with 2050 targets.

However there are four key assumptions that need to be challenged:

  • the combination of a higher carbon price plus FITs and the level at which they are set will be sufficient to meet the low carbon generation investment target;
  • the myriad of non-price factors e.g. equipment availability, planning permission etc will not delay the construction of new nuclear and large-scale wind generation;
  • the investment in new low carbon generation will, despite variable load factors, deliver adequate supply to meet expected electricity demand, and
  • if the wind does not blow, price signals in the market will be sufficient to ensure that there is adequate investment in new gas plant to ensure that gas power can fill any gaps in base and peak supply up to and beyond 2020.

If one or more of these assumptions is not met or only partially satisfied, then there are serious risks that the EMR will not deliver, bringing with it higher than expected costs and short term price volatility.

Below, we examine briefly the potential imbalance in capacity and supply and likely load requirements on existing and new gas capacity.

 

Adequacy of Generation Capacity

One of the key assumptions in the EMR document is that planned low carbon generation and gas capacity will be built as planned and on schedule and the proposed package of price incentives is designed to try and ensure that this happens.

However, there are a number of factors which could undermine this forecast such as:

  • non price constraints causing delays in the construction of new nuclear and wind power e.g. financial constraints, problems with new technology, equipment shortages and planning permission delays;
  • delays in resolving exactly what the structure, level and duration of the CPSR, FITs and capacity payments will be (including measures to improve electricity market liquidity) which could result in investment decisions and construction being delayed, and
  • general uncertainty over the long term future of UK gas.

In Figure 1 below we have presented the current forward expectation of total available generation by fuel type as prepared by the National Grid.

Existing, Under Construction and Planned Capacity

 

Source: Gas Strategies, National Grid 2011

The chart above assumes that 1.5GW of nuclear generation capacity comes offline in 2011 and 8.4GW of coal and 3.6GW of oil capacity comes offline in 2016 as part of the LCPD. The chart paints an optimistic picture of total capacity relative to average electricity demand.

However, in Figure 2 below, we have indicated the total average output in comparison to average demand assuming the impact of delays in new nuclear construction, a lack of investment in CCGT and wind power generation and the drop in availability/output of ageing fossil fuel plant.

To get from total capacity to average output we have made some assumptions on average load factor going forward. As most existing coal and gas are nearing 20 years old, we have assumed that average load factor of the existing coal and gas fleet will drop by 2% per annum post 2015 – i.e. gas from 66% in 2015 to 34% by 2030, coal from 43% in 2015 to 11% by 2030 – accounting for more flexible operation, plants coming offline and or drop in efficiency.

The results reveal a significant potential gap between average forecast demand and average available power generation.

Average Demand Compared to Average Power Generation

 

Source: Gas Strategies

This analysis is based on the following assumptions:

  • No new CCGT built apart from that currently under construction
  • Only 50% of planned wind capacity gets built
  • New nuclear gets delayed by 5 years, ramp up in 2022
  • All existing nuclear capacity benefits from continuing life extension throughout the period
  • Load factors are derived from historical power generation data (Coal=43%, CCGT=66%, Nuclear=58%, Wind=30%)
  • Gas Strategies’ demand forecast for Major Power Producers (i.e. excludes autoproducers)

 

Impact of Variable Wind Power

One of the biggest risks implicit in the EMR strategy is the reliance on wind power generation. The share of renewable energy sources in the electricity mix is predicted to rise from its current 7% to 30% by 2020. This is a major construction target but in the case of wind, available capacity and supply are not the same. Recent average wind load factors have been as low as 30% which raises concerns about the variability of wind. 

In addition to the variability of wind, it is worth noting that that the new nuclear power stations will be 50% larger and that a single failure will result in a loss of 1800 MW from the system. This has serious implications for the size and reliability of the short term operating reserve managed by National Grid.

Gas generators are faced with operating in a more volatile environment and managing short term variations in supply and demand will become increasingly difficult. The fact that wind power can vary significantly year on year aggravates revenue uncertainty over the both the short and longer term.

 

Potential Peak Load Gas Requirement

Figure 3 below indicates the uncertainty surrounding future peak output for CCGT. At times of the highest peak electricity demand, CCGT utilisation could vary by as much as 50% depending on when new nuclear comes online, whether coal is more competitive than gas and whether the wind blows.

Peak CCGT Load Factors Under Different Scenarios

 

Source: Gas Strategies

Assumptions/Scenarios:

EMR Outcome: Nuclear capacity coming on stream before 2020; relatively high load factor for wind generation; planned coal-fired generation more cost-efficient than existing and new gas-fired generation

Realistic Outcome: Nuclear capacity delayed until after 2025; low load factor for wind generation; planned gas-fired generation more cost-efficient than new coal-fired generation

If the EMR assumptions are met then CCGT peak output as a percentage of capacity falls from 80% to 19% by 2030. This percentage however could rise to 66% if one took a more realistic view that nuclear is delayed and that wind power, despite the increase in capacity, operates at a load factor of as low as 3% at times of peak demand - as it has in the past - and that for environmental reasons gas is preferred to coal as a source of peak supply.

This analysis shows that, despite there being a lot of uncertainty on peak requirement for CCGT, all the currently planned 17GW of new CCGT capacity is likely to be required and that further new investment in CCGT plant will be required because of (a) the continued growth in the proportion of variable wind power in the desired fuel mix and (b) the need for new flexible CCGT capacity to replace peak supply from existing coal and gas that will be over 20-25 years old.

Some 45% of CCGT capacity will be at least 20 years old by 2015 and 71% will be 20 years old by 2020 and 20% less efficient than state of the art CCGT. Given variable load factors, the absence of a reliable forward price curve for electricity and the competition for scarce investment capital, financing for new investment in CCGT will be extremely difficult (if not impossible) to obtain without some form of revenue under-pinning in form of long term capacity/flexibility payments.

 

EMR – Overview of Potential Risks

At this stage, the EMR proposals are short of the sort of detail (i.e. structure, timing and levels for the CPSR, FITs and capacity payments) which would enable a more quantitative assessment of the costs and benefits of the strategy proposed. However, below is a checklist of the risks where the likelihood and impact on energy costs and security of supply need further evaluation:

  • reduced effectiveness and efficiency of wholesale markets arising from creation of more centralised regulation and administered prices
  • potential reviews of subsidy regime as investors seek more robust state guarantees with consequent negative impact on energy costs
  • delays in essential new capacity investment due to uncertainties over timing and level of price incentives and the lack of regulatory stability stemming from “political” reviews of the EMR over time
  • failure of available electricity supply to meet actual demand due to delays in low carbon investment and intermittent nature of wind power
  • failure of UK market to attract sufficient long term supplies of gas and increased risk to security of supply, despite recent significant investment in LNG and pipeline import infrastructure
  • rising volatility in power prices as short notice and variable wind power translates in to a more volatile balancing gas price
  • lack of financing for new gas power investment because of continued absence of a robust forward price curve for electricity combined with unpredictable load factor
  • negative impact on indigenous gas production, network and storage investment and industrial supply of gas brought on by the higher environmental cost of UK gas and H M Government signalling a long term decline in UK gas demand

 

Reducing Implementation Risks

In recent months, there has been growing concern across the EU about the costs associated with pursuing 2050 CHG targets by relying almost exclusively on new low carbon technologies.

In February this year, the European Gas Advocacy Forum produced a series of optimized pathways for 2010 -2030 which demonstrated that a gradualist approach which allowed for a central role for gas would produce a number of significant potential benefits. These are summarized in Figure 4 below:

Benefits of the optimised pathways are lower costs, less risk, and a reliable and secure energy system

 

Source: European Gas Advocacy Forum, Making the Green Journey Work, February 2011

In November last year, Statoil conducted a similar study which focused on the UK using the DECC 2050 Calculator. The main assumptions behind Statoil’s “Pathway G” is that gas will continue to play a critical role in the UK energy mix, an environmentally beneficial switch from coal to gas and large policy driven demand side efficiency gains.

Starting from these assumptions Pathway G would:

  • achieve and surpass the desired reductions in GHG emissions – 55% by 2030 and 82% by 2050;
  • achieve the lowest investment cost – £58bn in 2030 compared to a range of £65-£230bn under other scenarios and £205bn in 2050 compared with a range of £265bn-580bn in 2050;
  • allow more time for the development and implementation of new low carbon technologies with 75% of this new investment taking place after 2030, and
  • lower annualized costs – £36bn in 2030 compared with a range of £52bn-£72bn and £75bn in 2050 compared with £100bn - £142bn across the other scenarios.

In connection with Pathway G, it is important to consider the role of the proposed Carbon Price Support Rate (CPSR). Any increase in the price of carbon will be passed on in higher electricity prices. The level chosen for the CPSR has a critical impact on the overall costs of EMR to the UK economy and consumers.

With this in mind the H M Government should consider as a first step the introduction of a transparent and realistic carbon price, allowing more time to consider whether and to what extent any new renewable revenuer incentives are required. Ideally, the carbon price should be determined by the EU ETS to avoid damage to the competitiveness of UK industry arising from relatively higher environmental costs.

 

Some Policy Recommendations

In this submission, we have outlined our key messages and also listed the specific transitional risks we consider require further evaluation before the proposed White Paper can be finalised.

In conclusion, we hope that in the coming months the H M Government will:

  • consider how it can positively encourage gas as a clean, efficient and cost-effective fuel which has critical role to play in smoothing the transition to a low carbon economy;
  • seek to preserve the value of a liquid functioning gas market, and
  • show that it has considered, given the existence of a strong global market for gas, how gas supply can continue to be available to the UK and if not what implications this might have for power consumers.

Finally, we recognize that what H M Government is seeking to do amounts to a complex and major overhaul of the UK energy market. However we are very concerned that the EMR has sent negative signals about the future of UK gas to suppliers, generators and the financial markets.

To avoid damaging markets and new investment, it is essential that there is clarity on the direction and content of UK energy policy as soon as possible. At the time of the last major upheaval (the creation of NETA) it was decided to create a series of expert panels to advise on the commercial implications of specific proposals.

We recommend that DECC establish a similar panel to advise on the commercial implications of particular reform measures with particular reference to the gas to power supply chain. Gas Strategies would be happy to consult with DECC about how such a panel might be formed and operate.

 

Next Steps

Gas Strategies is keen to work with DECC to devise practical and feasible solutions to meet UK energy and climate needs. We would welcome a meeting to discuss in more detail the issues raised in this “high level” submission.

Gas Strategies

March 2011