EMR heralds greater government intervention in UK power

Of all Europe's power markets, the UK has led the way when it comes to market liberalisation. But more recently, the country has been changing tack. This year, the UK electricity sector is set to undergo major structural change, as the  government's long-awaited Electricity Market Reform (EMR) comes into effect. First proposed in consultation form as far back as December 2010, EMR is an attempt to respond to three knotty problems: ensuring the country continues to have a sufficient supply of power, while making sure that supply is both clean and affordable.

As one of the first countries in Europe to face a capacity crunch at a time of challenging green targets, the UK will be watched closely as it rolls out regulations that could prove to be a blueprint for power market reform across the European Union (EU). The most notable and contentious element of EMR is the level of government intervention involved, which has not been seen in the UK power market since the early 1990s, say market observers.

"This is the most significant change to the market design in the UK since privatisation and fundamentally changes the way in which decisions are made," comments Tom Glover, UK-based head of commercial asset optimisation at RWE Supply and Trading, the trading arm of German utility RWE. "For 20 years, it's been the market deciding, and market players gaining or losing depending on the actions they take in the market."

Now, EMR is set to introduce four main initiatives aimed at distorting market economics in favour of low-carbon technologies – such as wind and solar – and flexible capacity, including natural gas-fired peaking plants. Specifically, these include a contract-for-difference (CFD) market to incentivise low-carbon generation; a capacity market to help address the problem of intermittency associated with renewables; a carbon floor price; and emissions limits for new power plants. If everything goes according to plan, all four of these measures should be in place by the end of 2014 (see box).

The UK government believes this level of intervention is necessary to ensure a steady supply of affordable, green electricity in the years ahead. That steady supply is urgently needed, note many industry observers. Around one-fifth of the generating capacity that was available in 2011 needs to be shut down by the end of this decade due to old age or non-compliance with low-carbon rules, according to the Department of Energy & Climate Change (DECC), which is responsible for EMR. At the same time, UK demand for electricity is set to increase between 50% and 80% by 2050. The country is bound by primary legislation to reduce greenhouse gas emissions by 80% in 2050 compared with 1990 levels, and is eager to raise the proportion of electricity generated from renewables to 30% by 2020. DECC puts the cost of the investment needed to achieve these goals at £110 billion ($180 billion).

This is the most significant change to the market design in the UK since privatisation

Until EMR comes into force, market participants say it is difficult to calculate the impact of the new framework on the power market. Electricity companies complain this uncertainty is making long-term planning and investment decisions very challenging.

"It is difficult for anyone to make any decisions until they know what the market is going to look like," says Mary Teuton, London-based EMR project manager at RWE. She says her company is supportive of the major proposals and wants to see them implemented as soon as possible. "Once you decide to intervene, you may as well intervene properly and robustly," she says.

Palpable impact

Despite this uncertainty, firms agree that EMR will have a palpable impact. "Any sort of government intervention will inevitably distort markets," notes Peter Willis, a partner at London-based law firm Bird & Bird. "One of the concerns about EMR is that it creates an artificial market for renewables and base-load [power] through the CFD mechanism and another artificial market for peaking plant through the capacity mechanism, with the risk that the free market is squeezed into an ever-shrinking band in the middle."

The success of EMR hinges on the UK government getting the level of financial support just right, say market participants. If there is insufficient support, not enough new capacity will be built. But if there is too much support, EMR could prove unduly costly to consumers and might also fall foul of European Commission (EC) rules on state aid, which usually prohibit selective government support for industry, except in specific circumstances.

"If artificial mechanisms are being introduced [by EMR], the EC will want to see minimal distortion of the EU energy market and as much scope as possible for market forces," says Willis.

On December 18, 2013, the EC launched a consultation on new guidance for state aid relating to energy projects, which is due to come into force in July this year. Despite this, lawyers say interventions of the kind envisaged in EMR are likely to be judged on a case-by-case basis.

To some extent, the reforms are already under scrutiny. On the same date as the consultation was launched, the EC announced an in-depth probe into an investment contract awarded by the UK government to French utility giant EDF's Hinkley Point nuclear power station in the west of England. The contract, which was agreed in October 2013, guarantees EDF a minimum price for power through a CFD – in effect, an early form of the instrument proposed in EMR. In a statement, the EC said it would investigate whether the investment contract was necessary for the building of the plant and said it had "doubts that the project suffers from a genuine market failure".

Such reservations could yet prove fatal for the Hinkley Point deal. "If the EC decides that it is illegal state aid [and] above the absolute minimum that is necessary to produce this level of security, then the CFD will be prohibited and the deal won't go ahead," says Willis.

Elsewhere, the EC is also scrutinising proposals for a UK capacity market – and it will need to be similarly satisfied that there is no more support than necessary. "The EC is clear that support for new generation or to keep existing plants open will be permitted only if alternatives, such as demand-side response, are insufficient," says Willis. "The UK has actually done a lot of homework on assessing the need for a capacity mechanism and is in quite good shape to make its case to the EC on this issue, but the EC will also be concerned to ensure the rules are technology-neutral and don't favour UK generation."

As well as specific concerns over state aid, there are broader worries that the increasing level of intervention within EMR puts it at odds with EC plans for a single electricity market. The EC remains committed to bringing European power markets together into a unified, liberalised whole – a vision that could mean further amendments to EMR in future, market observers warn. On the other hand, some participants believe that as more European countries begin to experience the same challenges faced by the UK, the approach embodied by EMR may become commonplace across Europe.

These differences mean the fate of EMR might well be a harbinger of things to come. "The current tensions may simply be revealing a more fundamental clash between liberalisation and decarbonisation agendas across the EU," notes Malcolm Keay, a senior research fellow at the Oxford Institute for Energy Studies, in a March 2013 report. "As decarbonisation targets get tougher and more expensive, and momentum towards a single European market gets stronger, the strains are only likely to increase."