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Burning Question

Keeping the lights on

14/05/2013

CMS Cameron McKenna LLP

Question

What is being done about the problems regarding electricity supply/demand in the United Kingdom?

Answer

Over the last few years the future of the electricity market has been much debated and many news articles have speculated about how 24-hour access to electricity may no longer be taken for granted. There is also growing concern that, at least in the short term, the United Kingdom might not be able to ensure 'security of supply' (ie, suppliers will not at all times be able to meet the country's demand for electricity), so that forced black-outs may be the only option at peak times. Consumers' right to affordable energy against a forecasted steep rise in energy prices is also a debated issue and many have estimated the overall costs increase that households are likely to experience on their energy bills.

Understanding the facts behind these statements and how the United Kingdom is working to address such issues at a commercial and legal level is complicated.

The Energy Bill

According to the UK Energy Statistics released at the end of March 2013 by the Department for Energy and Climate Change, total UK energy production in 2012 was 10.5% lower than in 2011. Imports were at a record high, while total energy consumption rose by 2% from 2011. High gas prices meant that in 2012 coal (currently the cheapest energy source, but also one of the most polluting) accounted for 39.5% of all electricity generated and that electricity generated by gas fell to a still significant 27.5%. Encouragingly, renewables' share of electricity generation grew by 2% to a first-time total of 11.5%. The same statistics also show that domestic gas and electricity prices have been relentlessly increasing.

In response to these figures and following extensive research/consultation, on 29 November 2012 the Energy Bill was introduced into the House of Commons. During the committee stage, further evidence was taken from experts and interest groups outside Parliament and every clause of the bill was scrutinised prior to being agreed, changed or removed. The committee stage concluded in February this year and the amended Energy Bill was re-published in readiness for the report stage, which will give all MPs an opportunity to consider further changes to the bill. There is no set time period between the end of the committee stage and the start of the report stage, and a date is yet to be fixed.

The stated aim of the Energy Bill is to "reform the electricity market to deliver secure, clean and affordable electricity".

"Secure" electricity

The main reason that energy availability has become an issue is the drastic reduction in generating capacity that will take place within the next 10 years as a result of the closure of existing power plants. These older plants currently account for 21% of the total generating capacity in the United Kingdom and include old nuclear power stations due to reach the end of their operating lives and coal-fired power stations due to be shut down to meet environmental commitments. Another factor affecting security of supply is the ageing infrastructure, particularly the electricity grid, which was not set up to manage and transport energy generated from an increasing number of smaller and geographically remote power sources, such as renewables (eg, wind farms, biomass and solar). The electricity network needs to be strengthened and expanded where new power stations are to be connected,  (eg, to carry electricity from offshore generating installations).

One of the mechanisms proposed by the Energy Bill to address possible shortfalls in generation is the capacity market, which is meant to ensure a sufficient margin between generation and demand at all times. Capacity providers (primarily generators, but also energy storage providers and those who agree to reduce their electricity consumption on request at a particular time - so called "demand-side response") will participate in a capacity auction and enter into agreements where they commit to make a certain amount of capacity available when requested under the capacity market mechanism. In return, capacity providers will receive a payment for providing reliable capacity when needed, but will be penalised if they fail to do so.

In order to make the capacity market/auctions effective, the correct conditions need to be created and work is ongoing outside the strict boundaries of the Electricity Bill to ensure that all participants, including consumers, get on board. For example on 30 April 2013, the Office of Gas and Electricity Markets (Ofgem) published a consultation on creating the right environment for demand-side response. This work is complementary to other initiatives, such as the introduction of smart meters to households and small energy customers which the government is hoping to complete by 2019. Smart meters will allow customers to understand their energy consumption by providing accessible, real-time information on their energy usage.

"Clean" electricity

The United Kingdom is currently bound to a number of environmental commitments, including:

  • supplying 15% of the nation's energy from renewable sources by 2020 (a target imposed by the European Union); and
  • reducing greenhouse emissions by 34% (compared to 1990 levels) by 2020 and by at least 80% by 2050 (as opposed to the minimum 20% reduction by 2020 target set by the European Union).

As mentioned above, coal and gas-fired power stations are still the main source of electricity in the United Kingdom and it is essential to increase electricity generation from renewables and nuclear to meet the environmental targets. The Electricity Bill is introducing 'contracts for difference' (CfDs) as a new mechanism to support and incentivise investment in low-carbon technologies, including renewables, nuclear and carbon-capture-and-storage. CfDs are meant to offer certainty to investors and generators, who are allowed to work around the constantly fluctuating wholesale energy price by setting a 'strike price'. If the wholesale price is lower than the strike price, generators receive a top-up payment from suppliers. If  the wholesale price is higher, generators have to pay back the difference to the energy supplier, which in turn can pass the savings on to its customers. Many of the practicalities of the proposed CfDs (such as counterparties and allocation) are still being worked out and no final position has been reached to date.

Alongside CfDs, the Energy Bill is also introducing emission performance standards and legislation has already implemented a Carbon Price Floor (a tax on fossil fuels used in the generation of electricity that took effect on 1 April 2013), which should further incentivise the switch to low-carbon generation.

To the concern of some UK businesses, on 16 April the EU Parliament voted against a plan to raise the cost of carbon pollution across the European Union, which is currently set at about €3 per tonne of carbon emitted against the United Kingdom's £16 per tonne (which is set to rise to £30 by 2020). This could mean that UK-based energy companies may end up on an uneven playing field against their European counterparts, which will benefit from more favourable carbon taxes. The risk is also that companies will move new investments or even some or all of their high carbon dioxide emitting processes outside the United Kingdom. The government, which prioritised the need to create investment certainty and increase the rate of decarbonisation in the power sector above the level that can be delivered through the EU carbon price alone, intends to introduce measures to reduce the impact of the EU price level on those companies that, due to their international competitiveness, are most affected.

"Affordable" electricity

All these changes (and the many more planned to prepare the United Kingdom to meet its future energy needs) require considerable financial investment estimated at around £110 billion up to 2020. The costs will have to be borne by all parties involved, including businesses and household customers. According to the government's estimates - which are subject to significant uncertainties - there will be an increase in energy bills, but in the long term the measures should bring savings to consumers, particularly those who take advantage of the support offered to improve the energy efficiency of their homes.

In order to keep levy-funded spending under control, in 2010 the government introduced the Levy Control Framework, whereby spending caps are set in relation to a number of policies. If such caps are to be exceeded, the responsible government department must agree a plan with the Treasury to bring the spending down. The Energy Bill allows the secretary of state to set out the maximum costs of the scheme, while CfDs will fall under the Treasury's Levy Control Framework, which for 2020 has been set at £7.6 billion (in real 2012 prices). How the caps will operate annually in the interim period is yet to be confirmed, as is the level of flexibility that will be applied in practice.

Effective competition can also play a fundamental role in ensuring that the prices are the lowest possible. The EU Third Energy Package (European directives for gas and electricity markets) imposes strict unbundling requirements on energy companies, requiring the separation of ownership across the generation, transmission, distribution and supply sectors so that no one company can control the entire energy chain.

From a consumer's perspective, it is a significant advantage to have a choice of suppliers and easily comparable tariffs that make it possible to switch and easy to quickly identify the benefits of doing so. Ofgem, as the energy regulator, is in charge of protecting consumers' interests and promoting competition in the energy markets. Careful monitoring by Ofgem and the effective use of its powers will therefore be key to the ongoing successful delivery of energy savings to consumers.

Next steps

The Energy Bill has received a generally positive welcome by market players. However, it has attracted some criticism, most recently by renewables developers desiring more certainty and worried that too much attention is being diverted to nuclear and shale gas which, even if implemented today, will not be producing energy until after 2020 and should therefore not be a priority at this stage. Concern has also been raised at how many different issues the government is trying to address with this one piece of legislation, and whether it will be in a position to live up to expectations.

The consultation process is still continuing on many aspects of the Energy Bill and much is therefore still subject to change. However, in order to ensure that the planned reforms come into effect in good time to address the issues that they set out to resolve, it is essential that the Energy Bill and all other policies progress without delay. This inevitably limits the extent to which further data gathering, market testing and any consequential policy changes will be possible. The details are crucial and will therefore be the focus of all parties' efforts during the next phase.

Valentina Santambrogio is a fourth-seat trainee at CMS Cameron McKenna.


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