February 23, 2017

How can the government reboot the capacity market?

On 14 February Toshiba announced that it was no longer willing to take construction risk on the Moorside nuclear plants. This puts thousands of new nuclear jobs in the rural Cumbrian constituency at risk - anything but a Valentine’s Day gift.

In forcing capacity providers to compete on price alone, the capacity market is tilted overwhelmingly in favour of the status quo

Copeland is perhaps the only place in the country where energy policy ranks alongside health and education in the minds of voters and Toshiba’s decision may play a role in the outcome of the close by-election currently being fought there.

It could even feature in the footnotes of future political histories if, as some are predicting, the campaign results in the first by-election gain by a governing party since 1960. However, beyond these local issues, it also highlights a wider problem: the UK’s dwindling pipeline of new power generation.

The UK’s energy supply faces two challenges. Firstly, our existing fleet of coal, gas and nuclear generators are coming to the end of their lives.

Secondly, the rise of renewable generation presents challenges in balancing supply and demand. In 2014 the government introduced the capacity market to try to combat these twin factors. However, so far it has failed to secure the innovative new capacity the country needs.

How does the capacity market work?

Under the capacity market, the government awards payments to capacity providers in exchange for a guarantee that they will deliver energy at times of system stress.

Contracts are awarded through annual auctions. There have been three main auctions so far where participants bid to provide capacity for four years in the future (a fourth auction was held at the start of the year but was only open to bidders able to provide capacity one year ahead, thereby making it unviable for new-build to bid).

These three auctions have cost consumers around £4bn. However, the vast majority of the awards have gone to existing conventional generation, including heavily polluting coal and diesel. Indeed, in the most recent auction a mere 4 GW of the 52.4 GW awarded went to new-build capacity.

Market failure

The main reason for this is that the capacity market is a blunt instrument.

It is technology-neutral and fails to take into account externalities such as emissions or the embedded benefits associated with new-build and innovative technologies. In an auction based purely on price, new-build has no chance of competing with decades-old generating stations that recovered their construction cost years ago.

If the government wants to encourage new-build and new technologies, it will need to refine the auction. It could do this by allowing different prices for new-build and existing technologies or introducing stricter environmental prequalifications.

No one is advocating that the government picks winners. However, in forcing capacity providers to compete on price alone, the capacity market is tilted overwhelmingly in favour of the status quo.

As the UK moves towards a more flexible, responsive and smart 21st century system, the government’s continued support for 20th century solutions will be damaging both to the environment and our economic competitiveness.