On Capacity Markets not working – it’s worse that you might think…

IPPR has published a report this week which tells us ‘why the Capacity Market is not working, and how to reform it’. A very good piece of work, which is well worth a read. I’m not going to go into an exposition of the report and its findings, because you can do that for yourself here. I’m sure the authors of the report were too busy putting the finishing touches to their opus to notice a question I put to the Minister of State for Energy in the last DECC oral questions before Easter Recess. I asked her, since the Department has not published an impact assessment for its latest consultation on proposals to ‘reform’ the capacity market and bring forward a year’s new capacity purchase this winter, what she thought the cost to bill payers of this would be, and whether she thought it would have the effect of actually procuring more long term contracts for new power stations (the original main purpose of capacity auctions).
This last part is, after all, primarily why the capacity auctions are not working, which is that, so far, auctions have succeeded in procuring precisely no viable 15-year capacity contracts to ensure the building of new gas-fired power stations. Ministers have been, how shall we say it, a bit (inadvertently) misleading in their portrayal of the situation. The Secretary of State said in Parliament a month ago that 12 gas fired power stations had been ‘commissioned’. The Minister of State told the house last Thursday that, since 2010, ‘six new combined cycle gas turbine have been commissioned’. Well, setting aside for a moment the apparently extremely elastic definition of ‘commissioned’ apparently in use, what we ought to focus on is who is actually financially closing on projects and starting to build them, which is, in my book, how you get to ‘commission’ a power station (i.e. get it to produce electricity).
Well, yes, there are a number of planning permissions for sites out there, and there are companies who have, over a period, expressed some interest in putting some bricks on those sites. But in reality, only one power station currently is nearing ‘commissioning’ (Carrington, in Manchester). One other, Trafford, received a long-term capacity contract in the first capacity auction, but seems at present to have no serious investment coming in, which I understand was the purpose of the low bid into the auction, and doesn’t look like it will go ahead any time soon. So I will be attempting to clear up the small matter of Ministers’ use of the English language after Easter Recess, but the reality, whatever is whistled in the dark, is that there are no new power stations firmly ‘commissioned’ as a result of capacity auctions.
Bid image.jpg 
And this is at a time when the Government has set the requirement that a number of new gas-fired power stations be commissioned as a prerequisite for the final closure of all coal-fired power stations by 2025, and is faced with the closure, or mothballing, of further gas and coal-fired power stations right now.
So, I didn’t get an answer at all to my first question, which I knew more or less (and more on that below) and I did get a firm assurance from the Minister that all is well, because ‘old plants are struggling to continue’ and ‘by bringing forward the Capacity Market, we are giving them the certainty they need to ensure security of supply’. So no answer, really, to the second part either.
Indeed, as the IPPR report points out, running a capacity auction that sprays around money to all-comers (including coal and nuclear power stations) in order to get them very kindly to agree not to close and be available to supply power if it is needed, isn’t a difficult task in its own right, provided you relax the rules so that everyone can get a piece of the pie. And that you purchase sufficient capacity so that lots of existing power plant ‘clears’ the auction at a relatively low clearing price, but at a high overall price for customers. IPPR estimates that so far, £2.8 billion has been spent on ensuring that this happens.
The central problem with the design of the process though, is that an auction which gives out free money like this almost inevitably ‘clears’ at a price way below that which investors in new plant (who have to do something – i.e. build a plant at their eventual risk) can get a foot in the capacity door.
And it is made worse by the design of the auction, which roughly works on the basis that a desired amount of capacity to be procured (whether old or new) is announced and then everyone (existing and new capacity) bids what they think they can do the job for. The auction then winds down with new lower bids until the right amount of capacity is reached at the lowest bid price. The bid that gets in through the door last then establishes the ‘clearing’ price, which everyone else, whether they bid half that amount in the first place, miraculously then gets as their ‘capacity’ price. And those low bidders, who know they can’t lose if they have plant with very little outstanding debt on it, pull the clearing price down in the process, and further slam the door for new plant, which will have debt attached to it.
So, with this rather barmy design on board, the Government is then faced with the prospect of trying to work out how to raise the ‘clearing’ price sufficiently in future auctions to bring new plant developers through the door. At the moment, due to gas and electricity prices and the longer term prospect of being unlikely to be able to run plants at anything like their theoretical capacity, it is fundamentally uneconomic to build and operate new plant, so that price difference will be quite large. Some commentators suggest ‘clearing’ prices would need to be £25-30 higher than the current level of £18 to get any new development into the process.
The new proposals to ‘reform’ the Capacity Market try to fix that by consciously trying to drive the ‘clearing price’ up by purchasing more capacity in an additional early auction. And of course if the ‘clearing price’ goes up substantially, then so does the amount of ‘free money’ spraying around the system to everyone else, other than those new plants which may or may not be commissioned for the future. And so does the cost to bill payers of the whole sorry process, since all this is financed by a levy on companies just like the levy for renewables that the Government is so worried about currently. Some estimates put the additional cost of the new auction at about £2 billion with a corresponding increase of £20 on customer bills… and all for a process which just might, but probably won’t, procure any new capacity, which is what the original idea was all about.
I have for a long time been advocating that, when the process all started, it should have been engineered on the basis of a strategic reserve of capacity outside the market (i.e. the government essentially purchases the potential output of some older plant and holds that in reserve for difficult times) rather than trying to persuade the market to perform somersaults through the capacity auctions we have now. A notable side effect of the Government’s latest proposals will be that the modest foray into ‘strategic reserve’ territory by National Grid, with its far cheaper contracts for plant to act in this way – known as the ‘contingency balancing reserve’ – will be axed in order to make way for the new auction.
It is right of IPPR to point out just how unfit for purpose the present system is, but I wonder to myself whether even the remedies that they propose to reform the system might not be enough, and whether the design is even more broken that the report lays out.  I rather think we will need to go back to some basics about how the market will work for the future and what role Government should have in ensuring that plant is procured under the running and eventual decommissioning terms implied by the decarbonisation of the system that the Government still says it is committed to. But hey, I’ve run out of space for a readable blog note: perhaps more of that at a later date.   


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