Capacity markets vs. Internal Electricity Market – will State aid weapon be used?
Friday, 23 November 2012 15:20

 

Capacity mechanisms attempt to ensure that electricity undertakings (often suppliers) assume the responsibility to provide or pay for generation capacity which they would not otherwise do, or at least not to the same extent, considering only their own commercial interests. According to the European Commission’s stance it is possible that such a mechanism constitutes a public service obligation and involve State aid. The above notwithstanding, UK prepares for capacity auctions from 2014 for delivery of capacity in the winter of 2018/19, if needed.

 

 

Therefore, European Commission underlines that such obligations must be clearly defined, transparent, non-discriminatory, verifiable and guarantee equality of access for electricity undertakings of the Union to national consumers. Furthermore, when introducing public service obligations, Member States must be able to show they are necessary, proportionate and transitional in nature.

 

State aid considerations

 

In general the Commission explains that it would not be appropriate to attach specific public service obligations to an activity which can be provided satisfactorily under normal market conditions. It further observes that obligations associated with capacity mechanisms will normally lie on suppliers or transmission system operators. However, generators will be the beneficiaries of the overall mechanism, receiving either cash payments or capacity certifications with a market value. Depending on design, payments to generators resulting from the mechanism could therefore involve State aid.

 

The test which the Commission applies to assessing State aid normally entails assessing if:

 

– The measure pursues a well-defined objective of common interest;

 

– The measure is targeted at a well-identified market failure, i.e. the aid is needed because of a persistent inability of market forces, within an appropriate regulatory framework, to lead to materially more efficient outcomes in the market or to address important other public policy concerns;

 

– The policy instrument is appropriate to pursue the objective as compared to other alternatives, i.e. there is an adequacy between the problems encountered (objective) and the aid measure, in terms of its efficiency and effectiveness.

 

All the above considerations can be found in the Consultation Paper on generation adequacy, capacity mechanisms and the internal market in electricity, European Commission published on 15 November 2012 (http://ec.europa.eu/energy/gas_electricity/consultations/20130207_generation_adequacy_en.htm).

 

Capacity – sparse and desirable asset?

 

Electrical capacity contracts emerge as a potential contentious issue. The above Consultation Paper contains points appearing controversial, like for instance the thesis, capacity physically located in a Member State should not be reserved for that Member State. As is further elaborated on this issue:

 

Any capacity mechanism should not act as a barrier to cross border trade or competition in the internal market by:

a. artificially altering trade flows or the location of production, in particular by:

- restricting the ability of electricity undertakings in the Member State to sell their electricity to customers elsewhere in the internal market, (i.e. capacity physically located in a Member State should not be reserved for that Member State).

- distorting the commercial behaviour of generators in the day ahead and intraday markets.

- distorting investment signals in the internal market leading to inefficient locational choices.

- distorting investment signals in the internal market leading to the displacement of new investment from one Member State to another.

b. distorting dynamic incentives/crowding out;

- The incentive on consumers or generators to respond to high prices at periods of scarce capacity should not be diminished.

- The mechanism should not undermine incentives on the electricity

market to deploy new techniques for demand reduction or electricity

storage and generation.

c. Creating market power or exclusionary practices;

- The mechanism should not strengthen or maintain the market power of incumbent firms.

- The mechanism should not act to maintain inefficient market structures or undertakings, acting to deter new entry.”

 

Models used for capacity mechanisms

 

The said Consultation Document in the first place differentiates between basic models used for capacity mechanisms. As a most basic capacity mechanism is considered a strategic reserve. Here capacity is procured, but kept for deployment in emergency situations generally by the transmission system operator. Often this reserve is made up of old plants which would otherwise be retired as uneconomical. The strategic reserve is withheld from the market or only bid into the market at extremely high prices. When it is dispatched by the transmission system operator during times of extreme scarcity it then also becomes the price setting plant meaning the strategic reserve effectively acts as a price cap in the market. Strategic reserves do not affect the market during normal periods and, because they are easily reversible, can be useful for supporting the transition away from fossil fuel based systems or facilitating nuclear phase outs.

 

Strategic reserves have interacted well with energy only markets where they have been used in Sweden and Finland, causing a minimum of distortion. Nonetheless, it is important that they be properly implemented – there must be clear rules as to when they can be deployed, in particular they should not be used to keep prices low, which could result in high emissions from inefficient old plants and discourage the development and deployment of new and more efficient technologies, including storage and demand side response. It is also important that such strategic reserves not be established in such a way that they reinforce the position of incumbents.

 

Other capacity mechanisms target generation capacity which continues to participate in the normal energy market. There are several varieties of such mechanisms:

 

(1) a capacity payment which is a fixed price paid for available capacity or

 

(2) a capacity market where either:

 

(a) the required quantity is centrally fixed and procured, for example by the transmission system operator, or

 

(b) based on their customer profile, suppliers are obliged to buy an administratively determined quantity of certified capacity from generators on a market parallel to the normal energy market.

 

Capacity markets can be based on financial hedges against high prices which provide a steady cash flow to generators, or as payments for physical availability. Different variants of capacity mechanisms have been widely used in the United States, with varying degrees of success in achieving their aims.

 

The UK system is likely to be based on a centralised capacity market, while Italy is planning to implement a system of reliability option contracts between generators and the transmission system operator, and Germany is providing for a system which would allow the regulator to approve contracts between transmission system operators and generators to ensure that generation capacity which is needed for grid stability reasons is not closed down.

 

Pursuant to the communication of the UK Government of 23 November 2011 capacity market is intended to provide an insurance policy for Government against future supply shortages, helping to ensure that consumers continue to receive reliable electricity supplies at an affordable cost in the face of an increased risk to security of electricity supplies towards the end of the decade. Package of decisions around the Energy Bill, which will in the near future  be introduced included among others:

 

- The creation of a Government-owned company to act as a single counterparty to give investors confidence to enter into new long term Contracts for Difference for low carbon electricity projects; and

 

- Powers to introduce a capacity market, allowing for capacity auctions from 2014 for delivery of capacity in the winter of 2018/19, if needed.

 

Potential detailed criteria to apply to capacity mechanisms

 

The key issue is that the said Consultation Document proposes a set of potential detailed criteria to apply to capacity mechanisms, as follows:

 

(1) The necessity for a capacity mechanisms should be clearly established in the context of:

 

a. The potential of the identified needs being met in the normal operation of the internal energy market, in particular:

 

- increased interconnection and in particular the completion of identified projects of Common interest.

 

- steps to encourage effective competition by addressing the position of dominant undertakings.

 

b. Alternative, less distortionary measures which could be taken, for example steps to improve energy efficiency or reduce electricity demand.

 

c. Removing barriers to the effective participation of demand in the electricity market.

 

(2) The effectiveness of the capacity mechanism addressing the identified market failure should be demonstrated and that it is additional to what would have occurred under normal market rules.

 

(3) The duration of the application of the capacity mechanism should be clearly limited and clearly specified,

 

a. the impact on the market of the introduction of capacity mechanisms should not make it difficult to reverse that decision in the future.

 

b. the necessity of retaining reinstating a capacity mechanism should be subject to review.

 

(4) Any capacity mechanism should be open to electricity undertakings operating in other Member States, to the extent they are able to make the electricity available in markets to which the capacity mechanism is established.

 

(5) Any capacity mechanism should not act as a barrier to cross border trade or competition in the internal market by:

 

a. artificially altering trade flows or the location of production, in particular by:

 

- restricting the ability of electricity undertakings in the Member State to sell their electricity to customers elsewhere in the internal market, (i.e. capacity physically located in a Member State should not be reserved for that Member State).

- distorting the commercial behaviour of generators in the day ahead and intraday markets.

- distorting investment signals in the internal market leading to inefficient locational choices.

- distorting investment signals in the internal market leading to the displacement of new investment from one Member State to another.

 

b. distorting dynamic incentives/crowding out;

- The incentive on consumers or generators to respond to high prices at periods of scarce capacity should not be diminished.

- The mechanism should not undermine incentives on the electricity market to deploy new techniques for demand reduction or electricity storage and generation.

 

c. Creating market power or exclusionary practices;

- The mechanism should not strengthen or maintain the market power of incumbent firms.

- The mechanism should not act to maintain inefficient market structures or undertakings, acting to deter new entry.

 

(6) To be non-discriminatory a capacity mechanisms should

 

a. be allocated after an open competitive bidding process.

b. allow demand response and energy efficiency solutions to bid into capacity markets on an equal basis to generation.

 

(7) Not be confined to any particular generation technology, i.e. being tech. neutral (insofar as the mechanism is directed towards security of supply concerns – this may not apply if other objectives are also being pursued).

 

(8) Capacity mechanism should be at least cost:

a. The direct costs imposed on suppliers or others electricity undertakings must be kept to the minimum necessary.

b. Persons providing capacity under the obligation must not be overcompensated.

c. Any selection process in the mechanism should be conducted in a transparent, open and non-discriminatory way which is market based.

d. The duration of any compensation to generators under the mechanism should be clearly justified.

 

(9) Costs associated with capacity mechanisms should be allocated to the beneficiaries of secure energy supply with different classes of consumers being treated in a non-discriminatory way.

 

On the basis of the consultation undertaken the Commission will consider whether additional measures are needed, at issue are for example a Commission recommendation on the design of capacity mechanisms, or eventually legislative proposals. The deadline for responses public consultation is by 7 February 2012.

 

 

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