Major reform is afoot as the United Kingdom’s coalition government seeks to transform the United Kingdom into a “greener” and more competitive economy, while also ensuring the country’s future energy needs. Proposals to reform the electricity market promise to be the biggest shake-up in the sector since privatisation in the 1980s.

The White Paper on Electricity Market Reform (EMR)
In July 2011, the UK government published its much anticipated White Paper on Electricity Market Reform (the “White Paper”) alongside its Renewables Roadmap. The proposals set out in the White Paper herald a transformation of the United Kingdom’s electricity market, with a package of measures designed to kick-start investment of £110 billion in UK energy infrastructure over the next 10 years. This goal represents more than twice the rate of investment seen in the past decade.

The proposals seek to tackle the “three Cs” of the United Kingdom’s new energy policy: carbon, cost and continuity of supply. In other words, the framework aims to achieve the government’s objective to transition the United Kingdom into a low-carbon economy—including meeting the EU target of 15 percent renewable energy by 2020—but do so in an affordable way, whilst also ensuring continuity of supply.

The key elements of the government’s reform package are:

Carbon Price Floor
One of the linchpins of the EMR is the introduction of the world’s first Carbon Floor Price (CFP) to reduce investor uncertainty and to provide a stronger incentive to invest in low-carbon generation. On the negative side, implementation of the CFP could add £3.2 billion to UK industry’s annual energy bills by 2016, according to government estimates.

At the moment, the supply of electricity (among other things) to non-domestic consumers is subject to the Climate Change Levy (CCL); that is, to a tax. The supply of fossil fuels to generators is currently exempt from the CCL.

It is proposed that, from 1 April 2013, supplies of fossil fuels to generators would become liable to the CCL. The rate of CCL would reflect the carbon content of the fuel in question.

Precise CCL rates would be determined two years in advance based on the difference between a target carbon price and the market carbon price. The current target price is £15.70/tCO2 in 2013, rising to £30/tCO2 in 2020 and to £70/tCO2 in 2030. This is significantly higher than the current price of carbon under the EU Emissions
Trading Scheme.

The changes to the CCL will mean that each kWh is to be effectively subject to three carbon taxes: the CCL on supplies to generators, the CCL on supplies to businesses, as current, and the CRC Energy Efficiency Scheme on energy consumed by participating businesses. The government has agreed that the CFP should be subject to exemptions for energy-intensive industries, but precisely what that means has not yet been decided.

Feed-in Tariff with Contracts for Difference
New long-term contracts—Feed-in Tariff with Contracts for Difference (FiT CfD)—are to be introduced. These FiT CfDs will replace, over time, the current incentives mechanism for large renewables projects, known as the Renewables Obligation.

Under the Renewables Obligation, electricity suppliers are required to demonstrate that an increasing proportion of the electricity supplied comes from renewable sources. They do this by surrendering Renewable Obligation Certificates (ROCs). ROCs are issued to renewable electricity generators and can be sold together with or separately from the renewable electricity. The government does not believe that this system has brought forward the scale of investment in renewables sources of electricity that is required.

The new system involves FiT with CfD. A FiT CfD is a long-term contract between a low-carbon electricity generator and a central counterparty (whose identity is yet to be confirmed), under which payments are made by reference to a strike price specified in the contract and a market-reference price for the duration of the contract. The strike price is the price at which the government determines there should be a subsidy. The market-reference price is intended to reflect the actual price at which electricity from a given renewable source is sold.

The government proposes to tailor the design of the FiT CfDs for different generation types. In a two-way FiT CfD, where the market-reference price is below the strike price, a payment is made to the generator. However, when the reference price is above the strike price, the generator makes a payment to the contract counterparty.

No electricity is traded under the FiT CfD; the key to its success is the mechanism under which the market reference price is set. Problems will arise when the generator cannot achieve the reference price in selling the electricity to third parties. This is because the guarantee is not triggered by the actual sale price of the electricity under a power purchase agreement, but rather by the general, possibly average, market price (hence, market-reference price) at which such electricity is sold.

The government has acknowledged the need for more certainty and detail around how the FiT CfDs would function. However, the government has yet to unveil further information about the proposal.

Emissions Performance Standard
An Emissions Performance Standard (EPS), set initially at 450g CO2/kWh per annum, is to be introduced at baseload. The EPS will serve as a cap on the carbon dioxide that new fossil fuel power stations (apart from carbon capture and storage demonstration plants) can emit. It is expected that the EPS will come into force in mid-2013.

The EPS aims to prevent the most carbon-intensive (i.e., unabated coal) power stations from being built.
It will be subject to regular reviews to monitor its impact and to consider whether the EPS should be modified. The government has indicated that any changes in the level of the EPS will not apply to plants consented to under the framework for a specified period.

Capacity Mechanism
Ensuring the security of the United Kingdom’s energy supply is one of the government’s key challenges for the future. This is critical given that approximately one-quarter of existing generation is scheduled to close, and that a significant proportion of new generation (e.g., wind) will come from potentially intermittent and less flexible sources.

A capacity mechanism is being considered, including demand response as well as generation, to address these concerns. The government is seeking further views on the type of mechanism required and will report on this around the end of the year.

In the 2011 Budget, the government announced that it would introduce a carbon floor price to take effect on 1 April 2013.

With regard to FiT CfDs, it is envisaged that primary legislation will be presented to Parliament in 2012. FiT CfDs will be developed and finalised during 2012-2013, and the first contracts will be signed in mid-2014.

The EMR White Paper includes a reassurance that the government “supports the principle of no retrospective changes for low-carbon investments.” In view of this, there will be a programme of detailed transitional arrangements to help ease the transition to the new arrangements.

New Institutional Framework
Details of the institutional framework supporting the electricity-market reform project are still to be clarified. These include whether there will be a new authority to oversee the area. A decision on which organisation will be responsible for delivery of the FiT CfDs is expected around the end of 2011, once the capacity mechanism design has been decided. The government will also need to ensure that legislation implementing the EMR reforms is consistent with the wider, ongoing process of EU electricity-market integration and liberalisation.

Key Challenges
It is clear that the White Paper represents a massive shift in UK energy policy. Indeed, the government is still working on the detail associated with these changes. That said, the following themes are emerging:

  • The scale and urgency of investment required in new low-carbon generating capacity in the United Kingdom is unprecedented. What investors want, above all, is clarity and predictability. Paradoxically, the need to spur investment has resulted in a wholesale policy shift: with the abolition of the United Kingdom’s main renewable incentive—the Renewables Obligation—and its replacement with a wholly new mechanism, the FiT CfD. Not only is there a shortage of detail on this key proposal, but implementing it (and its consequent need for new institutional arrangements) will be no mean feat.
  • In an attempt to allay concerns over policy certainty, the White Paper makes clear that incentives under the existing regimes will be protected for plants that have already been commissioned. This principle will also apply moving forward so that investors will be insulated against future policy changes. The precise way in which “grandfathering” and, in the case of the Renewables Obligation, “vintaging” will work, however, has not been determined.
  • The changeover from the Renewables Obligations to FiT CfDs may, depending on the particular drafting, trigger change-in-law provisions in existing Power Purchase Agreements or finance documentation. Investors in existing projects should be checking this now.
  • The White Paper makes clear that the level of support available under the FiT CfD is fiscal expenditure and, thus (subject to grandfathering), will be subject to the short-term consideration of Budgets and Spending Reviews.

Planning for the Future
At the start of his leadership, Prime Minister David Cameron said he wanted the coalition administration to be “the greenest government ever.” The last year has borne witness to this goal to the extent that the White Paper on Electricity Market Reform is only one of a myriad of policy papers and commitments issued in this sphere.

It is clear that further development of the Electricity Market Reform proposals is eagerly awaited by investors and businesses, for whom there is considerable work ahead in responding to the opportunities and challenges presented by the new regime.