GB Energy Market Structure

1. GB Energy Market Structure David Newbery DECC workshop London, 4th September 2014 http://www.eprg.group.cam.ac.uk Imperial College London 1 1

2. Outline Drivers of business models Benefits and costs of different business models Justification and criticisms Future drivers of change Security, affordability, sustainability and the EU How to allocate risk and incentivize investment? Imperial College London Newbery 2014 2 2

3. Drivers for electricity short-term volume and price volatility => need to contract very durable capital, high ratio of capital to variable cost=> confidence in future pricing and/or long-term PPA non-storable, subject to congestion => LMP, complex transmission charges/contracts (FTRs, etc) QoS and SO: value varies over space and by millisecond => specify contracts for inertia, fast FR, various reserves (1,2,3, up/down), reactive power, ramping constraints, black start, ... Other objectives: carbon, renewable targets not commercial => long-term contracts, undermine credibility of future spot prices Interconnectors part of TEM but countries acting as autarkies Future policy uncertainty, inefficient pricing, turbulent policies Imperial College London Newbery 2014 3 3

4. Theory and reality Efficient pricing of electricity requires Prices varying in response to S&D each second Australia has 5 minute pricing in real-time market Frequency response needed in 1-5 seconds Tender auctions may be cheaper than spot markets for some services Contracts needed to hedge risk and incentivise responses Investment needs forward prices for 15-20+ years Or ability to predict confidently and hedge Investment needed is either capital-intensive (low-C) or has low capacity factors for balancing intermittency = risky How to allocate risk to incentivise and reduce cost? Imperial College London D Newbery 2014 4 4 4

5. GB incentives Lack of pool encouraged vertical integration balancing mechanism opaque, poorly designed with energy-only market => self-balance fairly sticky domestic customers provides quasi-LT hedge => discourages merchant entry RES + high gas prices discourage flexible CCGT CPS + EPS discourage coal => capacity crunch => CRM ROCs volatile, wind exposed to imbalance contract with Big 6 or face high WACC => CfDs Connect and manage + uniform pricing => locate in Scotland=> congestion=> bootstraps £2b Imperial College London Newbery 2014 5 5

6. Other possible structures SMD in the US has LMP, ISOs + unit commitment with central dispatch, capacity auctions with obligations placed on LSEs, ISO involved in transmission planning Other states keep to regulated cost-of-service utility model to minimise cost of new build SEM is trying to adapt gross pool + unit commitment and central dispatch subject to BCoP + CRM with TEM LA has moved to LT capacity auctions for new build ISO or SO? Energy-only, capacity markets or Pools? SB, PPAs or LT contracts? Extent of regulation? Imperial College London Newbery 2014 6 6

7. EU Standard Market Design? Central dispatch in voluntary pool SO manages balancing, dispatch, wind forecasting LMP + capacity payment =LoLP*(VoLL-LMP) Hedged with reliability option (RO) => reference prices for CfDs, FTRs, balancing, trading Auction/tender LT contracts for low-C generation Financed from state investment bank Credible counterparty to LT contract, low interest rate CfDs when controllable, FiTs when not, or Capacity availability payment plus energy payment Counterparty receives LMP, pays contract Free entry of fossil generation, can bid for LT RO To address policy/market failures Imperial College London D Newbery 2014 7

8. Costs and benefits Investment needs low WACC => Predictable policies & markets or long-term contracts? => efficient risk allocation and management Who can control imbalance risk? Not wind But need incentives to offer ancillary services Efficient location and congestion management Can this be left to TNUoS and redispatch or is LMP needed? Trading on Euphemia –3-part or “complex” bids? Retail supply – why not a regulated default supplier? Markets incentivise but challenging to get prices right Imperial College London Newbery 2014 8 8

9. Future drivers of change Innovation => competitive contracts for RDD&D LCNF & NICs OK but SET-Plan needs dedicated funding CCS as demo – but is the funding well targeted? Hinkley Point – to learn how to do nuclear – but pricey! EMR: why fix strike prices and not auction? Why over-procure capacity before learning about supply? Smart meters why universal? Why so complex and costly? Low-C policies (ROs, CfDs, FiTs, CERT etc) why charged to electricity consumers? Why not raise VAT? Unclear objectives => lack of coherence, piecemeal policy Imperial College London Newbery 2014 9 9

10. Conclusions Low-C investment is durable and capital intensive needs stable credible future prices to invest or guaranteed contracts for cheap finance EU policy is a messy 27-state compromise neither stable nor credible Each country searching for best solution some mix of contracts and capacity markets Gains from cross-border trading higher with RES share reserves, renewables to reduce investment rapidly evolving environment for utilities Imperial College London D Newbery 2014 10 10 10

11. GB Energy Market Structure David Newbery DECC workshop London, 4th September 2014 http://www.eprg.group.cam.ac.uk Imperial College London 11 11

12. Acronyms BCoP Bidding Code of Practice – to bid at short-run variable opportunity cost CCGT Combined cycle gas turbine; CfD Contract for difference CRM capacity remuneration mechanism; EMR Electricity Market Reform FiT Feed-in tariff FR Frequency Response FTR Financial Transmission Right ISO Independent System Operator LMP Locational marginal price or nodal price LoLP Loss of Load probability LSE Load Serving Entity = retailer LT Long-term PPA Power Purchase Agreement QoS Quality of Supply RES Renewable energy supply RO (C) Reliability Option or Renewable Obligation (Certificate) SB Single Buyer SMD Standard Market Design (the US model) SEM Single Electricity Market (of island of Ireland) SO System Operator TEM Target Electricity Model WACC Weighted Average Cost of Capital VOLL Value of Lost Load 12