The reference price for baseload generation under the UK FIT CfD contracts scheme (implementation thereof is intended in summer 2014 already) will initially be calculated from the two reference prices each year; one set every six months, however, the concrete set of indices and their weightings are yet to be confirmed, thus financial assessments are still not viable.

Moreover, the longer term intention is to move in that regard to year-ahead forward prices and the  unknown mechanics of this transition adds to the investors' risks.

 
Pursuant to analysis performed on the occasion of the UK energy market reform, capacity instruments will most likely not be a financial instrument for the purposes of the Markets in Financial Instruments Directive (2004/39/EC)("MiFID"). Such instruments would not be within scope of European Market Infrastructure Regulation (EMIR) as well. 
 

 

The intended UK capacity market, the major milestones thereof have been recently revealed, appears to reflect the key points of the European Commission' recent consultation on State aid criteria to be applied to capacity mechanisms.

 

The European Commission's consultation from 15/11/2012 to 07/02/2013 on generation adequacy, capacity mechanisms and the internal market in electricity has sparked a discussion regarding the role of State aid rules in the multiple capacity designs flourishing in Europe.
 
 
The major European Commission requirements in that regard have been described in Capacity markets vs. Internal Electricity Market – will State aid weapon be used?.
 
 
On 15 February 2013 ACER issued an opinion on the need for and the design of the energy capacity markets (see ACER's opinion and particularly interesting figure 1 on page 8 thereof showing the current state of  implementation of capacity remuneration mechanisms (CRM) in the EU Member States (with further differentiation into capacity markets, capacity payments and strategic reserve)).
 
Summary of the intended UK capacity market
 
Pursuant to the DECC Capacity Market Strawman v11 June 2013 the final design and documentation of the UK capacity market will be subject of the consultation in October 2013. The UK government reserves that this may also lead to further changes to the design.
 
A capacity price in the future UK capacity market (£/MW-year) is discovered annually by a competitive auction(s). These auctions are intended to remunerate capacity at the rate required to make the electricity market sufficiently profitable to attract an adequate quantum of reliable capacity. Competition in these auctions should result in capacity payments being at the minimum level necessary to meet the pre-set reliability standard.

The auction will result in Capacity Providers ("CP") taking on Capacity Obligations ("CO") and receiving up-front payments to reimburse them for the energy market's 'missing money' component. The CO is a promise to deliver energy and/or demand reduction in periods of system stress. A system stress period ('Stress Period') is defined as a Settlement Period where voltage reduction or controlled load shedding occurs anywhere on the system for 15 continuous minutes or longer; excluding faults or deficiencies on the transmission or distribution systems.

The System Operator (SO) will issue a Capacity Market Warning ("CMW") which will serve as a 4 hour notice to CPs to make good on their CO. Should a CP fail to perform in the first settlement period after the elapse of the notice they will be required to pay a penalty on their deficit based on the VoLL minus the prevailing System Buy Price (as that term is defined in the Balancing and Settlement Code).

This penalty exposure will be subject to a portfolio-wide cap based on the product of a multiple of CONE and the de-rated capacity of the portfolio.

CPs who increase their delivery output at times of system stress, relative to their status immediately prior to the CMW, will be eligible for a payment at the penalty rate from the moment the CMW has been issued, providing at all times that the CPs are in compliance with the Grid Code and any obligations arising from the Balancing and Settlement Code and other relevant requirements. CPs who decrease their output, relative to their pre-warning status, will be penalised. This method of calculation will last until the first settlement period after the elapse of the warning.
 
The scale of the potential needs for efficient capacity markets is underlined by the fact that under the rules of some intended designs the participation in the pre-qualification process is mandatory for all licensed generation that is eligible to participate. Pursuant to architecture prepared by the UK Government this will be enabled via a license amendment implemented by Ofgem (mandatory pre-qualification, however, does not change that participation in the auction is voluntary).
The executive summary of the intended capacity mechanisms laid down in ELECTRICITY MARKET REFORM: CAPACITY MARKET – DETAILED DESIGN PROPOSALS Presented to Parliament by the Secretary of State for Energy and Climate Change by Command of Her Majesty, June 2013 describes the relevant milestones of the UK electricity market reform in the following way:
 
The UK Government will run the first capacity market auction in 2014 for delivery of capacity from the winter of 2018/19.
 
The capacity market is designed to cost effectively bring forward the amount of capacity needed to ensure security of electricity supply. It will do this by correcting market failures and providing a predictable revenue stream to capacity providers. The level of revenue will be set through a competitive auction process and in return for payment successful providers must commit to deliver energy when needed or they will face penalties. The capacity market can be described in five operational stages:
 
a. Amount of capacity: Ministers decide the amount of capacity for which capacity agreements are to be auctioned based on analysis from the system operator on the amount needed to meet an enduring reliability standard.
 
b. Eligibility and auction:
• The capacity market will be technology neutral and all existing and new forms of capacity will be eligible to participate, except for capacity supported by Contracts for Difference, small scale Feed in Tariffs or the Renewables Obligation, and interconnected capacity.
• Demand side response (DSR) capacity will be eligible, and will be supported by transitional arrangements to develop the capability of the sector.
• Government has amended the Energy Bill so that projects that deliver permanent reductions in electricity demand (EDR) could also participate in the capacity market.
• Eligible capacity providers will offer capacity in a pre-qualification process run by the system operator.
• Pre-qualified capacity will enter competitive central pay as clear auctions also run by the system operator. There will be an initial auction four years ahead of delivery, and a further year-ahead auction
• Successful bidders will be awarded 'capacity agreements', which provide a steady payment for capacity in return for a commitment to deliver energy when required in the delivery year, or face a penalty linked to the value of lost load.
• Existing plants will by default have access to a one year capacity agreement. Existing plants requiring major refurbishment may have access to agreements with a term of up to three years, and longer agreements are expected to be available for new plants.

c. Secondary market:
• Between auction and delivery and in the delivery year, participants will be able to hedge their position through secondary trading.
 
d. Delivery:
• Capacity providers will receive payment for capacity in the delivery year.
• In return, they will be obliged to deliver energy in periods of system stress and will be financially penalised (following the publication of a capacity market warning) if they do not deliver in stress periods.
 
e. Payment:
• The costs of capacity agreements will be met by suppliers based on their market share.
• Payments will flow from suppliers, via a settlement body, to providers of capacity.
• Where penalties are applied to capacity providers, the funds will flow from them, via the settlement body, to suppliers.
• The upfront costs of capacity are expected to be offset by reductions in the wholesale electricity price.
 
Under the UK projected rules the right to exit the capacity market has been also envisioned. It may take place if the underlying electricity market develops sufficiently, particularly through development of greater market liquidity, an active demand side, and more interconnection. The need for a capacity market will also be reviewed every five years.
 

The System Operator will undertake several roles including providing advice on the level of capacity to auction, administering the auction and issuing capacity agreements.

A panel of technical experts will provide independent scrutiny of the system operator's advice on the level of capacity to auction. Ofgem will be responsible for governance of technical capacity market rules after the first auction has taken place and will continue to regulate the system operator and enforce the rules and competition law within the capacity market.

 

Settlement agent for the UK capacity  market

 

The intention to designate Elexon Ltd. as the capacity market settlement agent has been also announced. Elexon will be responsible for:

- The collection and administration of market and participant data relevant to the capacity market
- Calculating and administering payments due to capacity market participants,
- Calculating and administering charges due from capacity market participants,
- Calculating and administering penalties due from capacity market participants,
- Invoicing, collection and payment of the sums owing or due,
- Calculating and enforcing credit requirements where they are due,
- Administration of the governance of the capacity market,
- Collection and administration of bid bonds.

 

Secondary trading under the UK capacity market

Capacity obligations may be physically traded at any time from a year ahead of the delivery year provided sufficient notice is given to the system operator. The system operator's consent to these trades must be obtained and this will require an assessment by the system operator of the receiving party's eligibility and pre-qualification.
 
Parties eligible to take on additional obligations include:
• Plant that was unsuccessful in the capacity market auction; and
• New plant that had commissioned early
• Capacity that had not participated in the auction or opted out but that has subsequently been verified by the system operator as providing eligible physical capacity (for instance new demand side services (DSR) or a de-mothballed plant).
 
Plant that has taken on obligations, opted out or that had declared they would be retiring will not be eligible to take on additional capacity obligations. Plant that has opted out will be able to opt back into subsequent auctions - in which case the system operator will increase demand in that auction accordingly.
 
Where parties have traded obligations, the capacity payment goes directly to the plant taking on the obligation and the liability in an event is calculated according to the performance of the party taking on the obligation.
 
The penalties that apply to a new plant that fails to commission (i.e. the loss of the admin fee and the reduction in payment/contract length) will apply to new build even if they physically trade out of their position in the secondary market.
 
Providers that have acquired capacity obligation pursuant to the auction will not be permitted to take on further physical obligations (even outside of times of peak demand) though they will be able to hedge their position financially in private markets.
 
The system operator will develop an IT System which will serve as a registry for all capacity obligations and can be capable of becoming a platform for financial trading.
 
Capacity market's MiFID/EMIR treatment under UK rules

The above-mentioned DECC Capacity Market Strawman brings once more crucial remark when it comes to trading environment of the new capacity market, i.e. that the capacity instruments will most likely not be a financial instrument for the purposes of the Markets in Financial Instruments Directive (2004/39/EC)("MiFID"). Accordingly such instruments would also not be within scope of European Market Infrastructure Regulation (EMIR). UK government also believes that the intended capacity instruments will not fall under the proposed MiFID II new definitions of the multilateral trading facility and  the organised trading facility.
 
 
 

 

Capacity mechanisms attempt to ensure that electricity undertakings (often suppliers) assume the responsibility to provide or pay for generation capacity which they would not otherwise do, or at least not to the same extent, considering only their own commercial interests. According to the European Commission’s stance it is possible that such a mechanism constitutes a public service obligation and involve State aid. The above notwithstanding, UK prepares for capacity auctions from 2014 for delivery of capacity in the winter of 2018/19, if needed.