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I can change – what’s wrong with the Capacity Market (and what we need to do to fix it)

Emma Burns Emma Burns Senior Consultant
14th February 2020

The return of the Capacity Market (CM) after its legal hiatus in November 2019 was a relief to many owners and developers of generating capacity in GB. But I think it’s time to ask whether it’s really the best tool to reach net zero at lowest costs to consumers.

The CM was designed by government as a transitional mechanism to address forecast security of supply issues. These were first identified by Ofgem in its 2009 Project Discovery, and one solution to address them was a government-designed CM – a mechanism to provide reliable revenue streams to reliable capacity, and help the lights ‘stay on’.

The need was identified more than a decade ago though and the market has moved on apace. Its time we had asked ourselves whether the CM really is delivering for customers.

Make it easy for me, Dance with me until I feel all right

The standstill did one thing: demonstrate the importance of the revenue stream as an investment signal to generators. We heard of numerous projects that were put on hold or cancelled in GB in 2019 citing they had been impacted by the CM standstill (as well, admittedly, as a plethora of other regulatory uncertainty).

The CM has always been a different kind of revenue stream. Compared to volatile wholesale prices, doomed embedded benefits and tricky network charges, the CM is the only revenue that guarantees a payment for up to 15 years. Obligations are tradable, both before and after the fact, and the risk of facing penalties is low.

The CM was designed as a mechanism to return the ‘missing money’ required to recover long run marginal costs for a generating asset. I don’t argue with the principle of long-term support for flexible assets, but I do question whether the best way to do that is with a clunky, costly, complex, physical mechanism like the GB CM.

I can change, I can change, I can change If it helps you fall in love

Given resource constraints in light of standstill, BEIS’ five year review of the CM felt fairly light. I think it was a missed opportunity to ask some of the big questions about whether the CM is the right tool to support investment as we face net zero.

Although I am not BEIS, I’d like to present my alternative (and admittedly late) 5 year review of the CM:

  • The CM is clunky, physical and administrative – this unnecessarily increases participation costs and barriers to entry. In the early debates, financial ‘reliability options’ were an alternative idea to the more physical mechanism that we have now. Instead we have a physical CM, with rules that are a complex mess, and the processes and systems that sit behind them don’t instil confidence, and are slow to change. A key barrier to a simpler, more financial model was the lack of a clear reference price for the value of real time energy.
  • There are too many different organisations responsible for different parts of the CM – the regulations sit with Government, the rules with Ofgem (with support of the industry), the administration with the Electricity Settlements Company, the operation and systems changes with National Grid EMR Delivery Body and EMRS, with key inputs from National Grid ESO. Just writing that is complicated. Think about what that means for how well the CM works.
  • The CM is not a signal for flexibility – by design, the CM is a tool for adequacy, rather than flexibility. This is reflected in the design, with weak penalties and long notice periods to deliver.
  • The CM does not synergise with net zero – the CM does not consider the carbon implications of capacity adequacy; this is evident in the new build capacity of small-scale fossil fuel reciprocating engines. This is compatible with the goals of the CM, but will not be sustainable in the move to net zero.

This is the time

I realise we are where we are with the CM, and we may not be able to expect any fundamental change in the next five years. But if I were in charge of the CM, these are some of the changes I’d like to see:

  • Sharpening the penalty regime – to create proper signals for flexible capacity, we need to reconsider the CM penalty regime. However, this must be balanced by the need to ensure investor certainty, to it will be key that this risk can be effectively managed.
  • A robust reference price for energy to allow a more financial ‘reliability option’ based CM – arguably much of the administrative clunkiness of our CM is related to the fact that we never had a reliable real-time price for energy. With greater wholesale market and balancing reform, we could create a meaningful reference price for the real-time value of energy.
  • Stronger carbon signal – we need to think how we can shift the playing field more towards low and zero carbon pricing in CM auctions, whether that’s through some form of enhanced carbon price, or through Low Carbon Quotas (coined, to my knowledge, by Ed Birkett).
  • Governance and rule changes – we need to improve decision making and the speed of change on the CM and supporting systems and processes. Hopefully the new CM Advisory Group, to be introduced later this year, will help drive the right kind of change faster.
  • Reduce the administrative burden – the existing processes are inadequate and fraught with issues. We need to get serious about improving end-to-end operational efficiency of the scheme. Pre-qualification should be extended, and we should be working towards a single registration system across all services – CM, wholesale, balancing, etc.

And this is just the start of the change we need to see. More fundamentally, we need to consider how and when we transition away from the ‘transitional’ CM mechanism (we only have approval for 10 years State Aid under European Legislation, if that still matters). But that’s a blog for another day.