This article is from issue 707 from Energy Spectrum written on the 23 March 2020. For up-to-date news and insight on the energy sector, find out more about the full weekly publication at the bottom of this article.
A pivotal year for the Capacity Market (CM) draws to a close, with the first long-term auctions for capacity since 2018. But for once the CM is the least interesting thing happening in the market, and the scheme itself seems out of step with the net zero future. In this Energy Perspective, we look at the results, what we can learn about the future and what else is going on which impacts on the CM as it heads into the 2020s.
Three auctions were held in January, February and March 2020, for the T-1 (delivery year 2020-21), T-3 (delivery year 2022-23) and T-4 (delivery year 2023-24). The clearing price of the T-3 auction was £6.44/kW/year, with the auction procuring 45,058MW of de-rated capacity. The clearing price of the T-1 auction was £1.00/kW, procuring 1,024MW of de-rated capacity. The T-4 auction’s clearing price was £15.97/kW/year, procuring 43,748MW of de-rated capacity.
The first robin of spring
Like the last T-1 auction in 2018, this auction saw a low clearing price with many of the factors that led to previous record low prices still in play. Once again, there was a significant capacity surplus with over 3.0GW of capacity participating in an auction looking to procure 300MW. We can discern from the fact that more than three times the procurement target was awarded agreements was that the NEMO Link interconnector was the price setting unit. Under the clearing rules it could not have cleared otherwise. Without accounting for the NEMO Link interconnector, cleared capacity was 204MW, 96MW short of the 300MW target. This means that the NEMO Link interconnector almost certainly set the price at £1.00/kW causing the auction to clear, with other remaining capacity either bidding at or below £1.00/kW.
This oversupply, combined with the fact that the NEMO Link interconnector did not have a previous CM agreement in place for the delivery year, unlike other interconnectors, means the low clearing price is no great surprise. Perhaps the most interesting outcome of the auction is that around 204MW of capacity managed to clear in addition to the NEMO Link interconnector and, therefore, must have bid in at a price at or below £1.00/kW. Several new build plant, including gas reciprocating engines and energy-from-waste, accepted a price of £1.00/kW. These plant already have agreements for T-4 delivery years in the future and were willing to commission early to earn additional revenues ahead of their original CM agreement beginning.
The T-3 auction was the lowest ever capacity price cleared in a multi-year contract CM auction at £6.44/kW. 81.9% of successful capacity was existing, which indicates market conditions can keep most of the existing plant open. Questions should be raised about interconnectors with cap and floor agreements and exemption from wider market charges distorting CM, with all qualified new built projects winning agreements in this auction. The other main talking point from the auction was the success of new build renewables, with onshore wind projects able to build outside of renewable specific subsidy schemes for the first time. These projects were more successful than anticipated with five of the seven to take part in the auction being awarded agreements.
The expectations were that the T-4 auction would clear at a higher price than the T-3 held in February, with there being less existing capacity participating in the T-4 compared to the T-3. This was reflected in the results with existing generation accounting for 77.7% of total successful capacity against 81.9% in the T-3. For the first time since the first auction, new build CCGT was successful with Keadby 2 awarded a 15-year agreement. However, this was not a major surprise as SSE had already committed to building the plant.
What a surprise was none of the large Calon gas-fired generators winning an agreement, including Baglan Bay, Severn Power and Sutton Bridge. This could tell us that the market expects an eventual upswing in capacity prices as nuclear power stations retire and coal hits the 2025 barrier, but the eventual clearing price of that upswing is uncertain. New build onshore wind was once again successful in a CM auction, with three more projects awarded agreements, while these will benefit from a clearing price nearly two and a half times higher than that from the T-3 auction. Vattenfall’s South Kyle windfarm with a nameplate capacity of 234.8MW was the only windfarm not awarded an agreement in the auction. However, with the potential re-integration of pot 1 technologies – which includes onshore wind – in the next Contracts for Difference (CfD) allocation round, missing out on the CM could allow the project to participate in the next CfD round.
The success of interconnectors in these auctions is an indication of the competitive advantage given to interconnection by the cap and floor mechanism and other EU directives insulating interconnectors from network charges and allowing them to compete in the CM against generation and demand reduction. It was a requirement of the State aid given to the CM in 2014 that foreign capacity was able to participate. This was deemed to be too hard a problem at the time, given the day-ahead market coupling was in its infancy and the Trans European Replacement Reserves Exchange (TERRE) was still some way away. It was recognised as inefficient to not recognise the contribution of interconnectors to security of supply and, therefore, it was felt the links themselves could be allowed to participate as a stopgap measure.
This is something which will change in the future if and when foreign generation is able to participate in CM auctions. A condition of the updated State aid granted to the CM following the standstill period was the inclusion of foreign capacity. However, this is not a simple fix and will need to consider how to:
- Determine delivery against obligation, considering metering standards and data transfer.
- Avoid double payment and ensure providers are only providing capacity in one market.
- Account for available interconnection capacity across multiple markets.
These were the first auctions where renewable capacity was able to compete against traditional thermal capacity. In the T-3 auction, wind won agreements for 14.6MW de-rated and 196MW of nameplate capacity. In the T-4 auction, three onshore wind farms were successful in winning agreements with a total nameplate capacity of 142MW, de-rated to 10.5MW. The T-3 clearing price of £6.44/kW is equivalent to £0.2/MWh and the T-4 clearing price £15.97/kW clearing price is equivalent to £0.48/MWh. To put this in context of CfD auctions, this is equivalent to onshore wind farms accepting a small premium over the wholesale price. However, the CM has an additional risk to project finance, since the CfD protects against reduction in wholesale prices, while the CM is fixed and doesn’t reference any other revenue.
In the absence of an alternative subsidy, it makes sense for otherwise subsidy-free projects to enter into CM agreements, but it does not provide the long-term revenue protection renewable developers need, which the CfD or RO supplied. Therefore, in the absence of a mature market which can deal with large volumes of renewables though interconnection, demand response and interconnection, the CM will not be the driver of additional capacity needed for net zero.
If we are truly in the beginning of an upswing in capacity prices we should think about the demand and supply situation and whether or not we need to build new capacity. Looking at the 2019 Future Energy Scenarios, demand is expected to increase by 0.37% on average across the four scenarios – so we can increase the T-4 capacity procurement volume to 43.3GW compared to the target of the 2023-24 delivery year. We then need to remove the 1.8GW and 0.32GW of new build from the T-4 and T-3 auctions (capacity under multi-year agreements does not need to be procured again) – which gives us an expected demand at the next T-4 auction for delivery year 2024-25 of 41GW – this would be the lowest target procurement volume in a T-4 auction so far.
On the supply side, we know the nuclear capacity needs higher clearing prices to make life extension decisions, with Hunterston and Hinkley B opting out of the T-4 auction, while Heysham 1 and Hartlepool, representing 1.9GW of de-rated capacity, were unsuccessful in winning agreements. In addition, this is the last year coal-fired capacity can participate in the CM before the phase-out policy takes effect. This puts into doubt the remaining 1.3GW of existing coal generation (Ratcliffe) which was awarded agreements.
With potential closures outweighing any reduction in demand, we remain cautiously optimistic about CM prices continuing an upwards trajectory. While we don’t believe it will reach the £30/kW heights needed to build out new CCGT capacity without incentives from equipment manufacturers, it could be enough to entice cheaper peaking capacity. But if these auctions have taught us anything it’s that other drivers are more important in what capacity gets built, whether its support for capital costs or regulatory arrangements. Looking forwards there are a number of new schemes the ESO is pioneering to ready us for a net zero power system such as the stability pathfinder, reactive power pathfinders, constraint management pathfinder and new Frequency Containment products which will likely prove more compelling reasons to build new capacity.
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