The UK's great energy shake-up

This week the UK government issued its draft Energy Bill, proposing a remarkable shake-up of the way it structures its energy market.

For some, the restructure might almost look like an abandonment of free market principles, with the government putting in place a range of measures to buttress the price signals provided by the electricity and carbon markets.

This should be of considerable interest to us here in Australia, because the UK's deregulated electricity market was a major inspiration and influence over the Australian eastern states' National Electricity Market. Also it should be noted that this restructure is being implemented by a Conservatives-led government, so this has nothing to do with some kind of ideological opposition to free markets. 

In short, this restructure involves the following core elements intended to buttress electricity and carbon market price signals:

-- Implementing an Emissions Performance Standard of 450kg of CO2 per megawatt-hour generated that in effect bans any new coal fired power plants, unless they have carbon capture and storage fitted.

-- Phasing out their market-based renewable energy target, and transitioning it into a fixed price regime.

-- Replacing their renewable energy target with feed-in tariffs using ‘a contract for difference'. Under this regime, investors in renewable, carbon capture and storage, and nuclear energy generation will receive the price they achieve in the electricity market plus a ‘top up' to an agreed feed-in tariff level.  However where the market price is above the agreed level, the generator would be required to pay this back.

-- Establishing a market for acquisition of generating capacity (megawatts), not just energy (Megawatt-hours). This involves paying an electricity generator to simply have their power station available just in case it is needed, but they get paid even if they don't actually generate any electricity.

-- While not part of the energy bill, the floor on the carbon price rounds out these set of market buttressing initiatives that was part of the overall Energy White Paper policy package.

For some in the Australian bureaucracy this is likely to look like economic heresy, but it is borne of the need for practical answers to some major challenges the UK faces. I don't think the UK government would suggest that the past structure of the energy market was inadequate for keeping the lights on. However, it is inadequate when they look forward, due to some very ambitious targets they have for reducing carbon emissions. 

Unfortunately the European Emissions Trading Scheme (which is dictated by EU-wide decisions rather than just the UK), is not providing the kind of clear, stable, bankable price signal about the kind of electricity generation investment that is clearly required to meet the UK's, and indeed Europe's, emissions reduction intent.

Everyone knows that to meet the UK and European emissions reduction targets beyond 2020, the only electricity generation which makes sense has very low carbon emissions. But the current EU emissions permits at under A$10, combined with electricity market prices simply, won't support that type of investment.

Current market prices suggest investors should be building coal-fired power stations, which would be completely incompatible with government carbon reduction targets. Also the volatility in the EU carbon price makes financiers of nuclear power plants, with their huge upfront costs, especially nervous.

Finally the need for investment in new electricity generation in the UK is becoming especially urgent. A fifth of the UK's current power stations are likely to come out of service by 2020 due to EU-wide stringent air quality emission controls (not related to CO2) and the old age of nuclear reactors.

This has left the UK staring down the barrel of a gun, and they chose to give up market purity in the practical interests of lower risk of electricity supply shortages. In essence all of the changes above help to remove a degree of uncertainty for investors in power generation and it is hoped will make them more willing to invest to address this huge supply shortfall.

The feed-in tariffs with contracts for difference guarantee investors in nuclear, CCS and renewable energy a set price for their electricity generation irrespective of movements in carbon and electricity markets. Also investors in gas know they can't get undercut by someone who might be crazy enough to build a new coal-fired power station without CCS. The floor price on carbon further assists investors in gas that they can't get undercut by existing coal fired power stations.

Lastly the introduction of a capacity market will also provide greater investor confidence for gas-fired power generation. According to the UK Government:

“These changes to our market create an investment challenge, in particular for plant such as gas which can alter its output to meet demand. This is because low carbon plant has lower operating costs, meaning fossil-fuel plant will operate less often than now and be less certain of its revenues. This could lead to under-investment and uncomfortably low levels of reliable capacity.

The introduction of a Capacity Market will provide an insurance policy against the possibility of future blackouts – for example, during periods of low wind and high demand – with the aim of ensuring that consumers continue to benefit from reliable electricity supplies at an affordable cost.” 

Pure markets at a theoretical level are generally best. But the real world often intervenes to make the theoretical impractical.

In Australia's case I would be very wary of introducing all of the changes occurring in the UK, particularly a capacity market. Australia has too much electricity supply capacity rather than not enough, making the need for such changes less urgent. But a belts and braces approach to addressing carbon emissions makes good sense considering the high level of political uncertainty in this country. Putting all your eggs into the one basket of a pure emissions trading scheme is not sensible in this highly uncertain environment.