Some considerations about the UK capacity market’s “price-taker threshold”

ISPI Energy Watch – Maggio 27, 2015

The European Commission (EC) has recently launched a state aid sector inquiry on Member States’ capacity mechanisms (CMs).

According to the press release, the goals of the investigation can be summarized as follows: to ensure the compliance with state aid rules and to promote competitive and market-based CMs. Otherwise, the document says, the completion of the internal energy market might be jeopardized.

The inquiry will involve eleven countries: Belgium, Croatia, Denmark, France, Germany, Ireland, Italy, Poland, Portugal, Spain and Sweden. Some of them have already implemented a capacity mechanism in the form of capacity payment or strategic reserve. Some others rely at present on an energy-only market solution but have recently approved or discussed the adoption of a CM for the foreseeable future (see here for an overview).

The UK is not included in the inquiry given that its capacity market, currently running, has been already approved by the EC in the light of state aid rules. Nonetheless, a more detailed insight into the UK capacity mechanism leads to some considerations about whether its ability to promote generation adequacy in a competitive and cost-effective manner may be involuntarily jeopardized by some of its features. Namely, a specific characteristic of the mechanism, the so-called “price-taker threshold”, appears to deserve an accurate analysis (for a description of the UK CM see a previous ISPI Energy comment). The latter represents the value up to which existing generating units (power plants – coal, nuclear, CHP, biomass, hydro, CCGT, OCGT – and storage) may bid in the auction.

According to the 2014 Impact Assessment on CM, this threshold aims at balancing two goals: “to avoid that existing power plants exercise market power to set a high price in years where new entry is not needed” and “to set an appropriate incentive to promote the participation of the existing power plants”.

First of all, it should be noticed that thresholds might represent a reference parameter promoting coordination among auctions’ participants. This is more likely as: (i) the threshold’s value remains unaltered over subsequent auctions so to facilitate participants’ learning; (ii) auction is not significantly competitive. Auctions’ contendibility is here intended as the volume of qualified capacity bidding into the auction compared to the target capacity to be procured for a given delivery period. As stated in the mentioned 2014 Impact Assessment, “below the price-taker threshold, competition between existing generators should still provide some downward pressure on bidding behavior – with existing plants incentivised to bid in close to their marginal cost if they think that the auction is sufficiently competitive”.

However, if auctions are not sufficiently competitive, the price-taker threshold may become the landing place for the clearing price. This might likely happen if the majority of participants involves existing generating units which, being obliged to bid lower than the price-taker threshold, set the clearing price. The result might be thus a clearing price far from the marginal costs of power plants at the expenses of electricity bills.

The spark between auctions’ clearing price and existing generating units’ marginal costs depends by the level at which the price-taker threshold is set. To this aim, the “history” of the price-taker threshold might provide food for thought.

To this purpose, it shall also be noticed incidentally that the notorious and effective transparency and accountability that characterize British regulatory and antitrust authorities is a valuable aspect that represents a best practice and encourage an informative debate promoting a continuous improvement of the mechanism.

The price-taker threshold has been set at the value of 50% of the expected Net CONE (Cost of New Entry) of a CCGT (Combined Cycle Gas Turbine) power plant, which DECC (Department of Energy and Climate Change) estimates to be equal to £49/kW. In principle, the considered Net CONE was that of an OCGT (open cycle gas turbine) power plant and equal to £29/kW. As the 2014 Impact Assessmentdeclares (p. 52) “In the October 2013 Capacity Market Impact Assessment, Net CONE was based on the level at which a new build large scale OCGT was expected to be able to bid into the first auction. However, we now believe that it is unlikely that large scale OCGT will be able to be built in time for the first delivery year (2018/19). Therefore, for the first auction, Net CONE is based on the estimated level at which new build CCGT will bid into the Capacity Market. This takes account of energy market revenue and ancillary service payment. The result is that Net CONE has increased from £29/kW to £49/kW.”

To this aim, it might be interesting to better understand the motivations behind the untimely construction of OCGT power plants given that, according to DECC, the lead time for the construction of CCGT power plants is significantly greater than that of OCGT power plants.

Moreover, it is interesting to notice that according to the DECC Dispatch Model mentioned in the 2013 Impact Assessment “in the first two auctions over 90% of plants should not need to bid in more than £12/KW year into the auctions, though over time the cost of the most expensive existing plants becomes increasingly marginal against the cost of new entry” (see Figure 1, below).

ptt

Figure 1: The chart shows modeling of the distribution of how existing plants may bid in the capacity auction. The dotted yellow line represents a price-taker threshold equal to the 50% of the Net CONE of an OCGT power plant. Source: UK Government. Impact Assessment 2013 on CM.

In addition, according to Figure 1, a price-taker threshold of £25/kW appears to become a critical value in influencing auctions’ participation only by 2027.

The indication coming from the DECC Dispatch Model seems also to suggest that the Carbon Price Floor is not a key variable in affecting power plants’ decision to participate into the capacity market. To promote investments in low-carbon generation, the UK Government introduced in 2013 a tax rate, the Carbon Price Support, aimed at filling the gap with the low and volatile ETS carbon prices. For 2014 theCPS has been set at £9.55/tCO2 to reach a Carbon Price Floor of £16/tCO2. The CPF is expected to increase at £2/tCO2 per year and to reach £30/tCO2 in 2020, rising to £70/tCO2 in 2030 (2009 prices). For the delivery period 2018-2019 it is thus expected to be equal at about £24-26/tCO2.

Given the well-known accountability and transparency that inspire every legislative and regulatory procedure in the UK, it would be thus worth to clarify the reasons behind the occurred changes in the value of the price-taker threshold. This might stimulate a worthwhile debate that might bring the UK, as often, to represent a reference standard in energy markets’ regulation. Any further insights into the pioneering experience of the UK may provide useful considerations for the new CM initiatives and debate at the European level.

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