Strategic reserve as a capacity remuneration mechanism (CRM)

 


 

 

Pursuant to the European Commission's consultation document on generation adequacy, capacity mechanisms and the internal market in electricity (consultations ended on 07.02.2013) strategic reserve is among Capacity Remuneration Mechanisms (CRM) the "most basic" instrument. 

 

In turn, the EFET Discussion Paper "Design Principles for Capacity Mechanisms" of February 2013 seems to be burdened with internal contradiction: on the one hand it expresses concerns that the “spare capacity overhangs the free development of market prices and companies' investment decisions in capacity (the so-called slippery slope), which will also damage the value of the remaining assets” on the other hand the said organisation notes that "[t]he essence of the strategic reserve approach is that the energy market remains largely unaffected and that the energy market remains the sole driver for new investments. This also means that the strategic reserve approach cannot be adopted as an enduring solution if there is a strong conviction that the energy only market does not provide a sufficient level of adequacy: i.e. that capacity must be priced explicitly."

 

The above discrepancy illustrates the dilemmas the European Member States are facing when designing such schemes.

 

Pursuant to ACER the most significant problems are:

 

1) the price at which strategic reserve is offered into the market,

 

2) rules for the strategic reserve’s activation,

 

3) exact impact of the strategic reserve on market prices (which may be limited in case of relatively stable prices due to high amounts of hydro generation).

 

The more general description of the strategic reserve schemes can be found in the above-mentioned European Commission's consultation document on generation adequacy, capacity mechanisms and the internal market in electricity.  

 

The European Commission’s view is that under the strategic reserve system:

 

“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."

 

Also ACER in its analysis of 30 July 2013 "Capacity remuneration mechanisms and the internal market for electricity" observes that in a strategic reserve scheme, some generation capacity is set aside to ensure security of supply in exceptional circumstances, which can be signalled by prices in the day-ahead, intra-day or balancing markets increasing above a certain threshold level.

 

 

 

Strategic reserve pursuant to ACER's analysis of 30 July 2013 "Capacity remuneration mechanisms and the internal market for electricity"


Strategic or ring-fenced reserves are essentially generating units that are kept exclusively available for emergencies (e.g. when the market is not able to cover demand) and are called upon by an independent body (e.g. the TSO).

 

The strategic reserve is intended to operate only when the market does not provide sufficient capacity and should therefore be dispatched at a price above a reference level signalling scarcity. In theory, the reserve should only be dispatched at a price close to VoLL (value of lost load) in order not to interfere with the market even in tight conditions. In this case the natural price formation on the market is not affected and generators receive the same investment incentive as if there were no strategic reserve.

 

Capacity for strategic reserves is procured through a tendering procedure for a specified amount of capacity (in MW), for example on a year-to-year basis. The strategic reserve may consist of existing or - provided the auction takes place well in advance of when the contracted capacity should be available - new generation built for the purpose of reserve capacity and may include demand resources. The latter are normally obliged to reduce electricity consumption sufficiently fast to a specified level when called upon. The specification of the amount and type of capacity (e.g. peak units) or demand resources may be based on a so-called reliability study.

 

The compensation schemes for the providers of strategic reserves are specified in the tendering documents and may vary from case to case. These schemes may involve direct payments, payments in the form of an option or mixed forms. Strategic reserve contracts contain also provisions for notification time, duration of activation, etc.

 

The costs of the strategic reserve schemes are typically covered through system charges included in the transmission tariff. Hence, they are passed on to consumers of electricity. In theory, the revenues, when dispatching the strategic reserves, should cover the costs.

 

 

 

As follows, the common feature of strategic reserves is that the amount of capacity to be set aside to achieve the desired degree of adequacy and dispatched whenever due is set by an independent body, for example the Transmission System Operator ("TSO").

 

Moreover, the capacity to be set-aside is procured and the payments to this capacity determined through a (typically year-ahead) tender and the costs are borne by the network users.

 

Commission Staff Working Document Accompanying the document Report form the Commission, Interim Report of the Sector Inquiry on Capacity Mechanisms ({C(2016) 2107 final}, 13.4.2016 SWD(2016) 119 final, p. 149) has formulated the final conclusion that strategic reserves, provided they are accompanied by market reforms that directly and credibly target missing money and provided the capacities are held truly outside the market, can be appropriate transitional measures.

 

Even if the reserve alone does not address underlying market or regulatory failures, if well designed it has the potential to be a relatively non-distortive insurance policy while required reforms are made.

 

As a strategic reserve is unlikely to trigger investment in new generation capacity it does not appear, however, to be suitable in a market requiring such investment.

 

 


 

 

 

Strategic reserves

 

As described in section 3.1.1, in a strategic reserve mechanism the top up capacity needed on top of what the market is expected to provide is contracted and then held in reserve outside the market. Capacity in strategic reserves generally does not participate in the market and is dispatched only in case the market does not clear, i.e. when there is a danger that demand will outweigh supply.

 

Examples of strategic reserves (excluding interruptibility schemes) exist in five of the Member States included in the sector inquiry: Belgium, Denmark, Germany, Poland and Sweden. All of the reserves are designed to keep existing power plants operational, so that they can be deployed when needed. Only Germany plans to include new generation capacity in its revised network reserve. Only the German network reserve is dispatched more regularly, namely in times where internal grid congestion does not allow for the transmission from generation centres to demand centres.

 

6.2.2.1 Ability to address capacity shortages

 

While strategic reserves ensure that back-up capacity is available, the security of supply benefits they deliver may be off-set by their impacts on capacity that remains in the market.

 

Strategic reserves can be designed to maintain capacity in specific geographic areas where a potential shortage has been identified. As described in more detail in sub-section 5.2.2.5, some strategic reserves contracted capacity located in specific regions within the respective Member States. As with other targeted capacity mechanisms, this enables the strategic reserves to target a local generation adequacy problem without the need for a mechanism to remunerate capacity elsewhere in the market. However, as with a tender, a strategic reserve cannot address the underlying issues that originally prevented local investment and appropriate incentives may need to be provided by electricity prices (see sub-section 5.2.3.5 of this report).

 

From a timing perspective, strategic reserves can be seen as transitional measures in the sense that they may delay the closure of some generation capacity. Hence, if there is a credible reason why there is a transitional generation adequacy problem – for example because sufficient new merchant investments are underway but not yet complete, or longer term reforms require time to implement – a reserve could be appropriate as it offers an immediate option to prevent existing plants from shutting down. In view of the objective of strategic reserves, generally there is no need for very long contracts (see sub-section 5.2.2.4).

 

6.2.2.2 Possible competition distortions and impact on market structure

 

Strategic reserves are typically called to supply electricity when market prices increase above a certain threshold. Consequently, they tend to limit the ability of electricity prices to increase in moments of scarcity and risk reducing incentives to invest in capacity which might, in turn, aggravate the initial capacity shortage. Hence, similarly to tenders for new capacity and targeted capacity mechanisms, they may induce a crowding-out effect on investment, reducing their ability to address a potential capacity shortage. As explained in sub-section 5.4.3.3, this concern could be minimised through a design that ensures the reserve is only dispatched when the market fails to clear and setting market prices, in these instances, to an appropriately high price cap. Even if the reserve is only dispatched when the market fails to clear, investors have expressed the credible concern that the reserve represents an additional regulatory risk because the national authorities may be tempted to change the rules and dispatch the reserve more often, for example in response to a prolonged period of high electricity prices. Such a design is also required to ensure that strategic reserves do not distort cross border markets (it should be noted in this context that it is the Commission's intention to develop, in the context of the market design initiative, a regional framework for the effective sharing of resources also in situations when markets may not deliver solutions (e.g. in emergency situations affecting various neighbouring countries)).

 

In addition to the crowding-out effect, a strategic reserve may affect market structure if it creates incentives for plants to announce closures that would not otherwise have taken place, because the expected profitability for a certain plant is higher within the strategic reserve scheme than outside the scheme. As a result, the strategic reserve can in this case accelerate exit from the market. Belgium provides a good example of how a strategic reserve can trigger this effect. Many troubled generators announced their closure (legal precondition to enter the reserve) in order to be able to enter the reserve so that the demand for the reserve increased substantially from the first to the second year after its introduction (the 'slippery slope' effect described in Box 3 in sub-section 5.4.3.3). This reduced the scope of the competitive market. Moreover, in particular gas-fired power plants (which in Belgium the main production segment where the smaller competitors to the incumbent are active) risk being drawn into the growing reserve.

 

Another source of concern arises from the potential ability and incentive of an incumbent with presence in the strategic reserve to withhold capacity in the market to trigger a price increase and the activation of the strategic reserve, provided that its profits from activating the reserve outweigh the cost of withholding capacity. Finally, an additional source of concern can relate to the exercise of market power may arise when the candidates to be integrated into a strategic reserve are very few. In this case, it can be that the tender for the reserve is not sufficiently competitive, which would reduce the ability of a strategic reserve to cost effectively address a transitional generation adequacy problem.

 

6.2.2.3 Conclusions on strategic reserves

 

Strategic reserves may be appropriate transitional measures in situations where for example the completion of new capacity or transmission infrastructure or the implementation of market improvements are underway and expected to address underlying generation adequacy concerns. However, the reserve alone does not address underlying market or regulatory failures, and may exacerbate the problems preventing sufficient capacity investments in the market outside the reserve.

 

As a strategic reserve is unlikely to trigger investment in new generation capacity it does not appear to be suitable in a market requiring such investment.

 

Commission Staff Working Document Accompanying the document Report form the Commission, Interim Report of the Sector Inquiry on Capacity Mechanisms {C(2016) 2107 final}, 13.4.2016 SWD(2016) 119 final, p. 114 - 116

 

 

 

 

Conclusions on strategic reserves

 

Based on the information gathered by the Commission during the various stages of this inquiry, it can be concluded that strategic reserves, provided they are accompanied by market reforms that directly and credibly target missing money and provided the capacities are held truly outside the market, can be appropriate transitional measures. Even if the reserve alone does not address underlying market or regulatory failures, if well designed it has the potential to be a relatively non-distortive insurance policy while required reforms are made.

 

As a strategic reserve is unlikely to trigger investment in new generation capacity it does not appear to be suitable in a market requiring such investment.

 

Commission Staff Working Document Accompanying the document Report form the Commission, Interim Report of the Sector Inquiry on Capacity Mechanisms {C(2016) 2107 final}, 13.4.2016 SWD(2016) 119 final, p. 149

 

 

 

Winter Energy Package approach to the strategic reserve

 

 

Article 2(2)(v) of the Proposal for a Regulation of the European Parliament and of the Council on the internal market for electricity (recast), 30.11.2016, COM(2016) 861 final 2016/0379 (COD)

 

'strategic reserve' means a capacity mechanism in which resources are only dispatched in case day-ahead and intraday markets have failed to clear, transmission system operators have exhausted their balancing resources to establish an equilibrium between demand and supply, and imbalances in the market during periods where the reserves were dispatched are settled at the value of lost load.

 

 

The Proposal for a Regulation of the European Parliament and of the Council on the internal market for electricity (recast), 30.11.2016, COM(2016) 861 final 2016/0379 (COD)) envisions the specific rule that the strategic reserve can only be used where, among others, imbalances in the market, during periods where the reserves were dispatched, are settled at the Value of Lost Load (VoLL) (Article 2(2)(v)).

 

If adopted, this would significantly restrict the use of strategic reserves  in the EU electricity markets.

 

 

 



Last Updated on Thursday, 08 June 2017 12:34
 

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