My Lords, I am grateful to the noble Baroness for her comments by way of introduction and for taking us through the instruments that we face today, and for the contributions of noble Lords from all sides to this debate.
Here we are again. I seem to remember that for most of last summer we were working through very similar topics and subjects. Now we see some of the detail flowing from that primary legislation before us.
I want to start by making a couple of general points before considering the instruments in more detail, when I will have a number of questions for clarification. First, this is our first opportunity to discuss the energy market reform package since the finalisation of the Energy Act. Between then and now, something quite significant happened in the Budget, when it was announced that the carbon price floor, which was a fundamental part of the EMR package, was to be frozen. Noble Lords will remember that during the passage of the Bill, that topic was debated at length, and we received many reassurances from department officials and from the noble Baroness, both in the House and in meetings, that the carbon floor price was integral, because that was to ensure that we move towards a low-carbon economy. However, the ink had scarcely dried on the Act before we saw a fundamental change announced in the Budget—there was no mention of it in the Pre-Budget Report, which I thought was quite odd—simply bringing it in.
That serves to highlight something that we have all commented on, which is that that instrument is not a firm policy. It is not bankable or something that investors can take into account as a material policy, because it is subject to change at the whim of a Chancellor. I think that we are less than two years into its operation and it has already been fundamentally changed.
My first question is: what impact did that decision in the Budget have on DECC’s dynamic dispatch model? By that I mean: how has it changed the forecasts that DECC now uses for capacity and what does it do to the fuel mix? If that is perhaps too complex an issue to go into here, I would welcome a note on this, because it is fundamental in thinking through how the EMR hangs together.
That leads me to my second general point. This is an incredibly complex set of regulations and, at some point, you have to try to take a step back and see how they all affect each other. It is a yarn of wool; you pull one end and the other gets affected. We are making a massive intervention in the market and this afternoon we have had something of a philosophical discussion, in which noble Lords have expressed differences of opinion over whether we should be more state-governed or more market-governed. What we have at the moment is, potentially, the worst of both worlds. We have a hugely state-driven system but with no power for the state to deliver. The state is entirely dependent on private entities coming forward to invest in this market. They will do so only if they feel they have clarity and confidence, and can understand the rules that they are being asked to apply. So we have a lot of micromanagement from government but no ability for government to make anything happen without the private sector. This morning Peter Atherton, a renowned commentator, stated after listening in on the budget announcements about the CFD:
“We are now in a world of staggering complexity, micro management and second guessing by the state”.
I am afraid that that is quite an accurate portrayal of where we are today.
We have also seen, just this week, that we have had state aid clearance. That was welcome although, as I understood it, there was a queue of state aid clearances with Hinkley as number one, then the rest of the CFD and then the capacity mechanism. We have not had a decision on Hinkley yet but we have on the capacity mechanism and have had the renewables part of the CFD cleared. Should we infer from that that there is something of a delay on the Hinkley decision? Can the Minister explain why we have received these judgments slightly out of the order in which we thought they were being considered and when we are likely to see pronouncement on Hinkley?
I mentioned that this is complex and that we need to take a step back to look at how all these parts interrelate. I now want to say something in relation to how these two major planks of the EMR package that we are considering today interrelate. Obviously, we have CFDs, which are there to bring on low-carbon capacity and to give guaranteed payments over a period of years to ensure that we can get capital-intensive projects away. We then have a capacity mechanism
which, to give a shorthand definition, is designed to try to keep the lights on. However, there is something of a conceptual gap between these two mechanisms. I would really like to hear more from the Minister on that.
The reason that there is a gap is that CFDs reward low-carbon capacity. We are told that they will do this at some point through competition, where price will determine it. At the moment, it is not quite clear what the determinant is between somebody getting or not getting a CFD, so it is administratively decided. Nevertheless, that is the system. Then there is the capacity mechanism, which is designed to reward those people who are able to provide firm power and maintain system availability. In order for the capacity mechanism not to double reward, the decision has been taken that anybody receiving a CFD will not be eligible for the capacity mechanism. That essentially means that there is a class of CFD-eligible technologies which are firm—they provide you with available, predictable and, more importantly, dispatchable power—but are not being given any reward for that element.
To clarify: if we consider biomass or CCS, they are very different to wind or solar in that they can be fired up at will and used to meet spikes in demand. They therefore have an inherent value that is not rewarded through the capacity mechanism or the CFDs. How does the department value that element of capacity—the firm, low-carbon power that is coming on? I would appreciate an answer to that question.
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To look at the slightly bigger picture, taking a step back, the other, key, interrelated issue is that we now have capacity mechanism that is designed to help to bring on new plant. However, the definitions of new plant are quite broad. There seems now to be a slight inconsistency with what you have to do to qualify as a new entrant in the capacity mechanism—which is defined as spending a certain amount of money—and the definitions of new entries or new plant under the EPS. I know we are not debating that today, but we will see regulations come forward to implement the EPS—the emissions performance standard. However, noble Lords will remember that we had quite a considerable debate about the potential for coal generators to qualify under the capacity mechanism for quite lengthy contracts.
It recently came to my attention that analysts now say that it is perfectly possible for existing coal plant to reach that £250 per kilowatt threshold and bid for 15-year contracts. Will that happen? I do not know. Could it happen? Absolutely. What is the Government’s back-stop policy, should that be the case? What happens if the 14 gigawatts of coal which is still undecided as regards what it will do to comply with the industrial emissions directive decides that its best option is to fully fit and retrofit and make itself compliant, and spends that 250 kilowatts and bids for a capacity payment? What will happen then? How will that be compatible with our carbon targets and our desire to set the decarbonisation target in 2030? Therefore that is a serious concern.
On a related point, you will not see those triggers— the decision to determine what a new plant is by the amount of money you spend—in any of the detailed
regulations here. It appears in chapter 2, paragraph 11 of the capacity regulations. Those are all caught up in the auction parameters. However, the parameters appear to be set by the Secretary of State; there appears to be no consultation; and I am not clear as to how early or late they can be changed. How does the Secretary of State determine the parameters that are set out in chapter 11, on page 18? They are quite fundamental to how that capacity mechanism will reward or allow different plant to come in. We know that some of the thresholds have already been published, but they are not statutory instruments and so are subject, I think, to change by the Secretary of State. How much flexibility is there, and how late in the day can they be changed?
Turning to the capacity mechanism in a little more detail as regards what it seeks to achieve, I understand—we had lengthy debates about this—that it is trying to do two things. First, it aims to ensure that we have sufficient generation on the system to enable us to have a secure supply, but it also recognises that simply building new plant and holding existing plant open is one way of doing that. Another way of doing that is by bringing demand down—demand management. However, this is meant to be a mechanism that incentivises both.
As we are in an oversupplied market at the moment, where we have 56 gigawatts of plant that is potentially eligible for the capacity mechanism, but an auction that has been set at only 52.3 gigawatts, there is an obvious overhang of qualifying thermal plant that will not get an auction contract. In the four-year in-advance auction we are very likely to have overbidders. If that is the case, the T-1 auction—the one year in advance auction, which is when you see the demand-side bidding—could be squeezed out by thermal plant that is still looking for a contract. Perhaps this is due to my inability to decipher this from the regulations—maybe it is here—but I want reassurances. Is it the case that there will definitely be capacity for the demand-side response to bid into, or can it be squeezed out by capacity that is still looking for a contract?
In thinking about the choices we have made about the capacity mechanism, my concern is that this is a solution that works under certain circumstances but does not properly reflect the world we live in today. Paying everybody and having an auction that pays everybody up to a certain limit is little-island thinking. It does not really work if there is a high degree of interconnection. That has been one of the problems—how we treat interconnection.
It also does not work when one is going through a period of quite rapid transition to a low-carbon economy because the pie gets ever smaller as we go forward. You are never actually contracting for the full market: each time a contract is awarded the pie shrinks; every time a CFD is awarded, more of the capacity is outside the pie. Therefore, it is a very cumbersome and complex solution. It reflects an old way of thinking about electricity supply: we are an islander nation, we can only rely on what we generate on our shores, and it is all about building things and keeping things on the system. I do not think it was designed for the nature of what we are doing today, which is investing to reduce demand, and that should have been our first and
foremost priority. Actually, what we have done now is over-reward incumbents and existing operators for fear of the lights going out, which I think has been an overplayed element of this EMR debate.
I will talk a bit about consumers and how they will be protected through these changes. Obviously, we have a capacity mechanism now that is taking money and recycling it in the market. The theory was that any moneys raised would be compensated by a fall in wholesale prices as prices got less spiky as we got more secure. Have the Government assessed whether we will actually see wholesale prices falling in the near term? I ask in particular because the cash-out arrangements for the settlement arrangements are changing to make them more price-reflective, which means that wholesale prices could get spikier.
My fear about our capacity mechanism is that the benefits we should see in terms of prices going down might be eroded by those changes to make the cash-outs more price-reflective. I am sorry that it was a very complex point but it is important because this will not be cheap if we do not see a reduction in wholesale price. If we were simply to see large amounts of money going into existing incumbents to help them retrofit their plant but no reduction in wholesale, that would not be a good result for the consumer. I should maybe apologise again as it is perhaps my lack of understanding of all the detail, but I am interested in how we ensure that moneys are paid back to the consumer, so that the consumer does see a benefit. I would hate there to be a hidden windfall arising from this.
That relates to another area where I am afraid I am going to ask for clarification—penalties. One of the big discussion points about whether or not the capacity mechanism would entice new entrants or keep people in the market was the degree to which they would be penalised for not being available. I confess that I have looked at the regulations and I think I understand how it works but I would welcome clarification. I understand there are two termination fee levels and that they are triggered under different parameters, and that somewhere in Schedule 1 the answer lies. Schedule 1 terrifies me. It is probably the most complex piece of regulation I have ever set eyes on so I would like clarification on how the penalties will operate now and what that means in terms of incentives created or not created.
My last point on the capacity mechanism is that it is very complex and we will need a review. I was heartened to hear—I apologise if I have misunderstood but I think that the Minister implied this—that there would be a review after the first auction and that that would be subject to potential changes and consultation. I strongly support that concept. The first one is clearly going to be a dry run. In a way, I can understand why some of the parameters will be subject to change: it is complex, we may have got it wrong and we may get an outcome that we were not anticipating.
The outcome, I fear—I hope that I am proved wrong—is that we will see a lot of inefficient, very old coal plant seeing the capacity mechanism as a nice, quick way of having a refurbishment paid for by competitors and bidding for those 15-year contracts.
I am sure that people will tell me that they have consulted the industry and that it says nothing of the sort. Let us hope that that is true, but it would be more by accident than by design because, as I see it, there is nothing in the capacity mechanism rules as they stand that would prevent them doing so. As we have discussed previously, we do not have a back-stop policy and we do not have a carbon price floor escalator. We have a carbon price floor that is being discounted by everyone because it has already been changed once, and we have an EPS which does not line up with our new definitions of new plant under the capacity mechanism.
I have a few points to make on CFDs. They are obviously the flipside—this is where we try to encourage people to enter the market. I have a quick question on the definitions. We previously had a debate about what I think are called onshore-offshore wind farms. They are wind farms that are out of UK territory and so are offshore, but they are onshore in terms of being in Ireland. Are they eligible? I could not tell from the first regulation.
I think that noble Lords have alluded to concerns about the allocation of budgets under the allocation framework and the fact that this is non-regulatory. Therefore, there is a feeling that this could be subject to quite a high degree of political interference. I hope that that is not the case. We have all received representations from certain sectors saying that the budgets are too small for the established technologies. It has been pointed out to me that the early CFDs—the eight or so that were administratively set—have received a budget of around £1.2 billion, yet only £50 billion extra has been made available for all the other established technologies. That worries me and I hope that, as we have a bit more time to digest this, we will be able to interrogate that budget-setting process a little more closely.
On the standard terms of the contract, which relates to the third statutory instrument, I have a general question which touches on the reference by the noble Lord, Lord Oxburgh, to CCS. I understand that CCS is eligible for CFDs but I wonder whether the standard contract is suitable for them. Again, I am sure that we will come back to this, but CCS does not yet have a published strike price. We need early clarity on how CCS is going to be accommodated under the CFD process, how much headroom it will have and whether the contract needs to be specifically changed for CCS.
The fourth regulation relates to the supplier obligations. My question there is the same as it was on the capacity mechanism. If suppliers overcharge in order to have enough money to pay for obligations under the CFDs, how can we ensure that that money comes back? How can we ensure that Ofgem is on it, and that the money does not just get squirreled away somewhere?
That is about it for now. This is a very complex area. It is good that we have returned to it but I still have fundamental worries. I echo what the noble Lord, Lord Deben, said: obviously something needed to change. We need to see market conditions that allow us to invest in big capital-intensive projects. That could have been done in different ways but this is how we are doing it now, and the Government have the support of the Opposition in this. However, as with
everything, the devil is sometimes in the detail. I hope that my comments have been helpful and I look forward to hearing the Minister’s response. Obviously, if she is not able to respond because of lack of time or the level of detail, I shall be very happy to receive a letter.
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