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UK has the best energy market system

By Dave Elliott

The UK government’s response to an EU consultation on energy market design was pretty forthright: we had it right. The UK competitive market CfD system, buttressed by the new Capacity Market, was the best approach and would lead to a low cost, low carbon future. With support for some renewables being cut and the prospects for the £24bn Hinkley nuclear project looking very uncertain, doubts persist as to whether this approach would in fact deliver sufficient low carbon energy to meet the UK carbon reduction targets. But, in its EU response, the government remained very upbeat.

In its response, the government said ‘The UK has a clear preference for incentivising investment in low-carbon electricity generation, including but not limited to renewables, by means of private finance through revenue support based on metered output covering the expected financing period of the plant. We consider that the advantages in economic and financial terms over capital grants or capacity-based payments are compelling, ensuring that the costs are paid for at the time when benefits are accrued. Even in a stable, liquid market with good visibility of future demand and capacity, long-term contracts between market participants are necessary for investment to come forward. The only exception is for large, vertically integrated energy companies which are able to manage the risks internally’.

However, it noted that, in the UK, independent suppliers played a significant role and, like all suppliers, they needed longer term contracts, as offered under the Contract for Difference (CfD) system: ‘Experience in the UK has shown that significant investment does not tend to come forward without long term contracts’ which ‘help provide investment certainty for new generation capacity – investors generally require assurance that capital and operating costs will be covered by expected revenues, resulting in reliable repayment of debt and the delivery of reasonable returns to equity’. 

It went on to dismiss other possible types of support: ‘Renewable generation investors generally require assurance of subsidy to top-up market revenues and finance their projects. This can be achieved by a fixed feed-in tariff (essentially a long-term contract with consumers), a premium payment (often converted to a stable revenue stream through an offtake contract) or a variable premium (a long-term contract for difference with consumers). We believe the introduction of the CfD in the UK provides sufficient incentives for investment in renewable energy to come forward at a lower cost of capital and therefore at a lower cost to consumers. By providing support through a variable premium, the CfD gives investors price security throughout the duration of the contract, reducing their cost of capital, whilst protecting consumers from excessive support if wholesale prices rise. Costs are minimised further through competition, which has seen a significant reduction in the level of support provided to generators. Under the CfD, generators are required to sell their output on the market, and are responsible for any imbalance costs.’

Though the Capacity Market was also needed to buttress that, ensuring there was sufficient capacity to deal with demand peaks and renewable variations, and it involved independent generators too. It did involve creating a new protected market, but its competitive auction approach minimised the cost to consumers. So all was well.

That is a little odd given that the first round of the UK Capacity Market, with almost 50GW of capacity contracted via a competitive auction process, had focused mainly on existing gas plants and even (inflexible!) nuclear plants. That had led critics to say that it was just a backdoor way of providing an extra subsidy for old technologies, when it ought to have supported new balancing technologies like energy storage and smart grid demand side response (DSR). The German government also made it clear that they didn’t think this approach would work – it would protect old options, not support new projects and distort the market. Instead they proposed to toughen up market competition so that there would be an incentive to support balancing measures. It’s not clear how this would work either. The rise of marginal cost PV has pushed gas plants out of the German peak demand market, and there is no incentive to replace them. Getting rid of the FiTs might help, but could slow renewable development. Mind you some see that as the aim!

Given this background it is interesting to look at the UK response to the Euro-Commission consultation on this aspect. The UK government adopts a defensive line. It says the CfDs are ‘designed to work with the market by exposing generation to competition while minimising overcompensation’ while ‘our Capacity Market has been carefully designed to support and complement developments in the internal energy market and to be consistent with it and wider EU energy policies, for example the development of an active demand response, improved scarcity pricing, support for further interconnection and increased competition’.

Well maybe, but that’s not really happened yet – only a tiny amount of DSR got contracted (0.35% of the total) and no interconnectors. The UK response simply says the Capacity Market ‘brought forward 9.2GW of new plant bidding’ and was introduced along with other measures, including ‘day-ahead market coupling’ that ‘will lead to more efficient use of interconnectors’ and which ‘will enable a greater reliance on interconnectors for security of supply’. And on the fundamental issue of enhancing support for balancing, and the German-style market approach it says ‘in theory, the electricity market should provide incentives for investment in sufficient reliable capacity. However, the GB electricity market – like many others – faces market failures, exacerbated by new pressures such as the increase in intermittent forms of energy, which mean there is a significant risk that this will not be the case’, and it had identified market failure problems in relation to generation adequacy, ‘that scarcity pricing alone may not fully be able to address’. By contrast, the GB Capacity Market could, and ‘will not distort the functioning of the GB electricity market. Indeed, the Capacity Market has been designed to complement the market signals that already exist aimed at ensuring capacity adequacy in a market that allows for efficient dispatch decisions’. So all is well! And it looked to possible EU-wide involvement in the UK Capacity Market and similar arrangements elsewhere. Join us!

What next? The European Commission is keen on a fully competitive market approach, so it will be interesting to see how it responds. And Germany too, given that the UK response implicitly rejects their unified market approach to ensuring the provision of enough balancing capacity. But of course if the UK exits the EU, then it can ignore the EU targets and go its own way, although it has signed up to the Paris COP21 carbon targets.

* All this and much more gets a thorough exploration in my new Institute of Physics e-book, out later this year : ‘Balancing green power – how to deal with variable energy sources’ . It grew out of my short commentary on balancing options in the inaugural issue of Nature Energy in January:


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