Energy support mechanisms

This briefing paper explains the need for energy support mechanisms and summarise the key subsidies currently in the UK electricity market.

The need for energy support in the UK market.
The need for energy support in the UK market.

Introduction to UK electricity subsidies

Under the Energy Act 2013, the UK electricity market underwent significant reforms to help deliver the low carbon and reliable energy supplies that the UK needs, while minimizing costs to consumers. These reforms, collectively referred to as UK Electricity Market Reform (EMR)1,2, introduced two key energy support mechanisms:

  • Contracts for Difference (CfD) – principle support mechanisms for encouraging development of low-carbon generating plant; and
  • The Capacity Market (CM) – principle support mechanisms for ensuring security of supply.

However, the subsidies introduced under EMR are just the most recent in long history of energy support mechanisms. This briefing paper explains why we need energy support mechanisms and provides a summary of the key subsidies that are currently in place. The paper is focused primarily on support mechanisms in the UK electricity market but also introduces the principal support mechanisms in heat and transport sectors.

The Need for Energy Support Mechanisms: wholesale price not high enough

The wholesale price of electricity in the UK fluctuates according to supply and demand but, in recent years, has averaged around £40/MWh. When compared against estimates for the Levelised Cost of Energy for range of technologies (see Chart 1 below)3 it is clear that the current wholesale price has not been high enough to justify investment in new energy projects.

An aging fleet of power stations

This relatively low wholesale price (in comparison to cost of constructing new generating assets) is largely reflective of the UK power sector which contains a large number of ageing power stations whose capital costs have long since been amortised. However, an ageing fleet of power stations coupled with large growth in forecasted demand means it is critical that the UK continue to invest in new low carbon, reliable forms of energy generation. Thus, energy support mechanisms play a critical role in encouraging the development of new power generation where the wholesale price alone would be insufficient to drive that investment.

Electricity Generation Costs, Department for Business, Energy and Industrial Strategy, November 2016
Electricity Generation Costs, Department for Business, Energy and Industrial Strategy, November 20163

The energy trilemma

The development of any new Energy Support Mechanisms must be clearly be cognizant of the challenges posed by the "energy trilemma"4. Three vital, but often competing, policy outcomes must be delivered:

  • Decarbonisation – carbon and other greenhouse gas (GHG) emissions from energy supply and use must be reduced in order to reduce climate change impacts;
  • Security of supply – an adequate security of energy supply must be maintained, including resilience to both short-term and long-term challenges; and
  • Cost – the cost of energy must be affordable for consumers.

There are two principle types of energy support mechanisms in the UK, which are focused on decarbonisation and security of supply. The latter element of the trilemma (cost) is generally addressed through the auction design, common to both types of support mechanism, which introduces free market competition as primary means for delivering lowest cost solutions.

Low-Carbon Support Mechanisms

Historically low-carbon sources of energy (e.g. renewables and nuclear) have been relatively expensive compared to traditional thermal generation, namely Combined Cycle Gas Turbines (CCGT) and Coal. In order to encourage the development of low-carbon sources, the UK has promoted three main support mechanisms:

  • Feed-in Tariffs (FiTs)
  • Renewables Obligation (RO)
  • Contract for Difference

A brief explanation of these support mechanisms is provided below.

Feed in Tariffs (FiTs)5

The Feed-in Tariffs scheme was introduced on 1 April 2010. Under this scheme, small-scale (less than 5MW) renewable electricity generators are paid for each unit of electricity produced. Electricity that is not consumed on site and is exported to the local transmission system receives an additional payment. The rates are banded by technology and size and are subject to review and adjustment as the technologies develop. In recent years the FiT tariffs have been reduced significantly as cost of renewable energy projects have fallen.

Renewables Obligation (RO) and Renewable Obligation Certificates (ROCs)5

The RO came into force in 2002, when it replaced the Non-Fossil Fuel Obligation as the UK Government's primary mechanism for supporting the development of the renewable energy industry. It requires electricity suppliers to submit ROCs to Office of Gas and Electricity Markets (Ofgem), the regulatory body, to show that a certain proportion of the electricity it provides has been generated from renewable sources.

Where suppliers do not have sufficient ROCs to cover their obligation, a payment is made into the buy-out fund. ROCs are intended to create a market, and be traded at market prices that differ from the official buy-out price. This naturally places a premium on renewable energy which can be sold with the ROC premium in addition to wholesale prices.

The RO scheme is being phased out and will be closed to any new generation after 31 March 2017. It is being replaced by a new support scheme, Contract for Difference (CFD) for low-carbon generation. However, generation which is accredited under the RO will continue to receive its full lifetime of support in the "vintaged" scheme after 2017 until the scheme closes completely in 2037.

Contracts for Difference (CfDs)5

Under the new CfD scheme, a low-carbon generator forms a contract with the government- owned Low Carbon Contracts Company (LCCC). The generator is paid the difference between the strike price – a price for electricity reflecting the cost of investing in a particular low-carbon technology, and the reference price – a measure of the average market price for electricity in the UK market. CfDs have been available since 2014, initially at set prices via CfD Enabling Contracts but more recently through competitive auction.

Supporters of the CfD regime cite several key benefits:

  • The CfD gives greater certainty and stability of revenues to electricity generators by reducing their exposure to volatile wholesale prices.
  • The CfD design means that, in theory, generators only receive the level of subsidy required to make the scheme viable, thus protecting consumers from paying for higher support costs when electricity prices are high.
  • The auction-style design introduces greater competition and CfD contracts are only awarded to the most competitive projects (thus providing further protection to consumers).

Another key difference of the CfD regime is that it is also open to other low-carbon sources (e.g. nuclear power) rather than just renewables. Hinkley Point C is the first new nuclear power station to be developed under the new regime and was awarded a CfD of £92.50/MWh (2012 prices index linked).

For further information on other low carbon and climate change support mechanisms, please refer to the ICE Climate change policy mechanisms5 briefing sheet which provides additional information on wider climate change support mechanisms including heat (Renewable Heat Incentive) and other demand side measures (e.g. the green deal).

Success in encouraging renewable energy generation

As illustrated by Chart 2 below, the low-carbon support mechanisms outlined above have been undoubtedly successful in promoting the development of renewable energy generation in the UK (notably in Solar photovoltaics (PV) and Wind Energy, which have seen dramatic increases in production since the early 2000s). Renewables' contribution to the UK electricity mix has risen from about 2% in the early 1990s to approximately 25% in 20166. In fact, in 2015 low-carbon sources of energy provided a record 46% of UK electricity supply.

Renewable sources of energy: Chapter 6, Digest of United Kingdom Energy Statistics (DUKES), DBEIS, July 2016
Renewable sources of energy: Chapter 6, Digest of United Kingdom Energy Statistics (DUKES), DBEIS, July 20166

Success in reducing costs of renewable energy

As generating capacity has increased, the low-carbon support mechanisms have also been highly successful at driving down the costs of renewable energy. Evidence of this dramatic price reduction is most notable in Solar PV where FiTs for small scale solar PV installation have fallen from a peak of 43p/kWh in 2011 to current rate of 4.1p/kWh. Other generating technologies such as Wind Energy (onshore and offshore) have also seen impressive cost reductions.

Increased burden on back-up forms of energy generation

Critics of the low-carbon support mechanisms argue that the "strike price" does not reflect the true cost of energy since the intermittency of renewables places increased burden on other forms of energy generation which are still required as back-up to deal with intermittency of renewables. Another criticism levelled is that renewables, who have priority access onto the grid, are also distorting the wholesale market thus making it increasingly difficult for traditional thermal generation to compete.

Capacity Market7,8,9

The capacity market was introduced in 2014 as part of the Electricity Market Reform. The capacity market is the government's primary policy for ensuring security of electricity supply. It offers payments to power generators for being available to generate at certain times, and to demand response providers for being able to reduce electricity demand.

The market takes the form of an auction, held every year, for capacity to be delivered in four years' time. Firms bid into the auction at the price they need to stay open to generate electricity, or to be built from scratch in time to generate.

Existing power stations benefitted from the '14 and '15 capacity market auctions

It had been hoped that the Capacity Market would provide a mechanism to encourage the development of new CCGT power plants but to date there has been little progress in this area. The first two auctions, held in December 2014 and 2015, awarded a total of £2.8bn in subsidies. However, as can be seen in Figure 1 below, the majority of these subsidy payments have been made to existing power stations (only 5% of subsidies in the 2014 auction were awarded to new capacity)8.

UK Capacity Market, Is the Capacity Market slowing UK power decarbonisation? Sandbag, December 2014
UK Capacity Market, Is the Capacity Market slowing UK power decarbonisation? Sandbag, December 20149

Flaws in the capacity market system

Although proponents of the scheme argue that it is fulfilling its primary role providing security of supply by ensuring there is sufficient capacity of dispatchable generation to meet demand, critics of the scheme7,8 point to three main flaws:

  • Value for money – The vast majority of subsidies has gone to existing power stations, which arguably did not require further subsidy to continue operating, rather than encouraging investment in more modern, efficient, cleaner power stations.
  • Decarbonisation – The scheme is arguably working against decarbonisation objectives. Previous auctions have provided a lifeline to several old coal-fired power stations, which received a total of £373 million in subsidies from the 2014 and 2015 auctions. It has also heavily incentivised the proliferation of new diesel generators, which are even more polluting than coal and which were awarded a total of £176 million in subsidies in 2015. In fact, the current market provides a bizarre contradiction where the carbon price floor penalizes coal-fired power stations at the same time as the capacity market rewards them.
  • Barrier to innovation – The capacity market has traditionally favoured large fossil fuel and nuclear plants rather than new technologies which can reduce costs to bill payers by shifting demand. Such technologies could reduce the need to build expensive new power stations and the amount of time that the most expensive stations need to run.

Some of these criticisms, such as the proliferation of diesel generators, were addressed under the March 2016 consultation on reforms to the Capacity Market. However, analysis of the results from the most recent (T-4) auctions that concluded in December 2016 indicate that the majority of subsidies were still awarded to existing plants with less than 7% (capacity) being awarded to new generators10.

Heat and Transport

To date much of the focus has been on electricity support mechanisms, which have helped deliver significant progress in the sector. However, as noted in the June 2016 Committee on Climate Change report11, the majority of emissions reductions in the UK have been driven by the power sector alone and significant acceleration will be required in heat and transport sectors to ensure the UK can meet its legally binding targets under the Climate Change Act11. The two principal support mechanisms under the heat and transport sectors are the Renewable Heat Incentive (RHI) and the Renewable Transport Fuel Obligation (RTFO), which are discussed in more detail below.

Renewable Heat Incentive (RHI)5

The RHI provides long-term financial support to renewable heat installations to encourage the uptake of renewable heat. The scheme has been introduced in two phases. The first phase began in November 2011 with long-term tariff support targeted at larger heat users in the non-domestic sectors, including the industrial, business and public sectors. The second phase was launched in April 2014, expanding the range of technologies, and is open to homeowners, private landlords, social landlords and self-builders.

The RHI provides a financial incentive to promote the use of renewable heat. Switching to heating systems that use eligible energy sources (ground and air source heat pumps; biomass boilers; and solar thermal) can help the UK reduce its carbon emissions and meet its renewable energy targets.

In the domestic sector, those who join the scheme and stick to its rules receive quarterly payments for seven years for the amount of clean, green renewable heat it's estimated their system produces. This approach is different from other support schemes where measured quantities of performance are required.

Need more emissions reductions in the heat sector

Unlike support mechanisms in the electricity sector that have shown dramatic reductions, the tariffs under the RHI were recently (December 2016) increased, reflecting the need to accelerate progress in emissions reductions in the heat sector.

Renewable Transport Fuel Obligation (RTFO)12,13

The Renewable Transport Fuel Obligation (RTFO) was introduced in April 2008 as a mechanism to reduce carbon emissions from vehicles. The RTFO has similarities with the Renewable Obligation requirements although there are several important differences. The operation involves an Obligation based around a system of Certificates issued on the basis of the volume of non fossil fuel contained in the supplied fuel (Renewable Transport Fuel Certificates (RTFC)). The RTFO applies to all organisations supplying more than 450,000 litres annually. Compliance with the Obligation can be achieved by blending fuels like biodiesel with fossil diesel or bioethanol with petrol. Initially the scheme applied to Road Vehicles, but in 2013 it was extended to cover Non-Road Mobile Machinery (NRMM), which covers use of fuels in vessels, and agricultural machinery.

In some respects the RTFO is similar to the operation of the Renewable Obligation. It is expected that a given percentage of compliance is achieved by suppliers and if this is not achieved then a Buy-Out price is payable. Like the RO, the certificates owned by a supplier having more than achieved the required renewable component can be traded with another who has not. In 2016-17 the Buy-Out Price was 30p per litre.

Difference between RTFO and other support mechanisms

Unlike the other Renewable Energy support mechanisms (RO, FIT, RHI, CfD) that are defined in Energy Terms sometimes qualified by power rating, the RTFO is specified as a percentage requirement in terms of fuel volume. A further difference is that while other support mechanisms come under the remit of Ofgem or Department for Business, Energy and Industrial Strategy (BEIS), the RTFO falls under the responsibility of the Department for Transport. As the energy content and carbon factors per litre varies between different fuels such as petrol, diesel, bioethanol, biodiesel etc., the impact on carbon reduction does depend on which fuel is being used.

The percentage requirement in each of the years of obligation has increased from around 2.5% when the scheme started in 2008 to around 9.75% for 2020.

Conclusions

With wholesale power prices sitting below the levelised cost of energy for most new-build generating plants, energy support mechanisms play a key role in encouraging development of new generating capacity. The principal support mechanisms introduced under EMR were designed to encourage the development of new low-carbon generating capacity, through Contracts for Difference, whilst ensuring security of supply via the Capacity Market.

Whilst both support mechanisms have proven successful in their primary objectives (developing new low-carbon generation and ensuring sufficient supply capacity to meet demand), developing a one-size-fits-all support mechanism that fulfills requirements of the "energy trilemma" continues to prove challenging. Progress in emissions reduction in the heat and transport sectors lags significantly behind the power sector and continued commitment on tailored support mechanisms in these sectors is vital if the UK is to meet its legally binding climate change targets.

Sources:

  1. Department for Business, Energy and Industrial Strategy; 2017; Electricity Market Reform (EMR)- Contracts for Difference
  2. National Grid; 2014; EMR Delivery Body - About Us
  3. Department for Business, Energy and Industrial Strategy; November 2016; Electricity Generation Costs
  4. ICE; 2015; The Energy Policy Trilemma, briefing sheet
  5. ICE; 2014; Climate Change Policy Mechanisms, briefing sheet
  6. Department for Business, Energy and Industrial Strategy; July 2016; Digest of UK Energy Statistics (DUKES) 2016
  7. Byron Orme, Institute for Public Policy Research; March 2016; Incapacitated: Why the capacity market for electricity generation is not working, and how to reform it
  8. Byron Orme, Carbon Brief; April 2016; Guest post: Understanding the government's capacity market
  9. Sandbag, December 2014, UK Capacity Market, Is the Capacity Market slowing UK power decarbonisation?
  10. National Grid; December 2016; T-4 Capacity Market Auction for 2020/21- Final Auction Results
  11. Committee on Climate Change; June 2016; Meeting Carbon Budget – 2016 Progress Report to Parliament
  12. Department of Transport; 2016; Renewable Transport Fuel Obligation (RTFO) guidance: year 9
  13. Department of Transport; 2017; The Renewable Transport Fuel Obligations Order: Proposed changes for 2017

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