System stress: the UK capacity market "standstill"

The electricity Capacity Market has been suspended as a result of a successful legal challenge of its state aid approval. In this article we consider the current status of the Capacity Market “standstill” and the implications for market participants.

Background

The Capacity Market (CM) was implemented in 2014, following the grant of state aid approval to the scheme by the European Commission (EC) on 23 July 2014.

On 15 November 2018 the General Court of the Court of Justice of the European Union found in favour of Tempus Energy, against the EC, annulling the EC's earlier state aid approval for the CM (the "Tempus Decision").

Tempus, a provider of DSR services, was successful in overturning the CM's state aid clearance by arguing that, in granting the CM state aid clearance, the EC should have found that sufficient doubt was raised as to compatibility of the CM with the internal market to invoke the formal investigation procedure provided for pursuant to Article 108(2) of the Treaty on the Functioning of the European Union.

Impact of the Tempus decision

Because the state aid approval of the CM scheme has been invalidated pursuant to the Tempus Decision, the CM was immediately suspended on 15 November 2018.The UK Government has advised that it is working to reinstate the full CM regime and is working with the EC to achieve this "as soon as possible". Until the CM can be fully reinstated, the CM is said to be subject to a "standstill" and this period of time is referred to as the "standstill period".

On 21 February 2019 the EC opened an in-depth investigation into whether the CM is compatible with EU state aid rules, but the outcome of that investigation is not expected any earlier than October 2019, and until there is a positive outcome of the investigation, the standstill cannot be lifted. The Tempus Decision comes at a time when a large number of capacity providers are already receiving capacity payments pursuant to capacity agreements, there are various projects currently being developed that hold capacity agreements, and electricity suppliers are making payments pursuant to the statutory scheme to fund the CM. The standstill therefore has had serious implications for a large number of market participants.

It is relevant to note that, pursuant to the terms of capacity agreements and the statutory framework for the CM regime, there is no mechanism for capacity agreement holders to terminate their capacity agreements on the grounds of the imposition of the standstill. Therefore, capacity providers are expected to continue to fulfil their obligations to provide capacity, in accordance with their capacity agreements, but on the basis that capacity market payments are suspended until such time as the CM is reinstated.

Government response to the CM standstill

Immediately following the Tempus Decision, the Government directed National Grid to postpone indefinitely the T-1 and T-4 auctions, which were previously planned to be held in January 2019, and requested the Electricity Settlement Company (ESC) to stop the making of capacity payments under existing agreements and (on the basis that there was not an immediate need to fund payments to capacity providers) to stop the collection of charges from suppliers.

As mentioned above, the initial advice provided to capacity providers was that in all other respects capacity providers should continue complying with their agreements. However, the Government subsequently decided to make some changes to the CM regime (following a public consultation on the issues) to apply during the standstill period, to deal with arrangements applying to existing capacity agreements, as well as modified arrangements to procure capacity by a replacement auction. These arrangements are discussed in more detail below. Independently of the impact of the Tempus Decision, the Government also conducted a five year review of the CM (as required to by the CM regime), which has also led the Government to introduce some changes to the CM regime.

T-1 auction

A replacement "top-up" T-1 (one-year-ahead) auction commenced on 11 June 2019 to procure capacity for the delivery year 2019/20.The auction concluded on 12 June 2019, procuring just over 3.6 GW of capacity at a record low clearing price of just £0.77 per kW — much lower than the previous top-up T-1 auction which resulted in a clearing price of £6.00 per kW, which was also considered to be low. Perhaps not surprisingly, given the low clearing price, battery storage represented less than one per cent of the successful projects, in terms of capacity, while Combined Heat and Power (mainly existing generating plant), Open Cycle Gas Turbine (existing generating plant), Combined Cycle Gas Turbine (one new build plant) and reciprocating engines (both existing and new build plant) made up a large proportion of the awarded capacity. These results do not bode well for the future success of renewables in the CM (see below).

The making of any payments pursuant to capacity agreements secured through this auction will be conditional on the timing and outcome of the EC's formal investigation. The Government originally said that it anticipated that State aid approval would be received ahead of the start of the 2019/20 delivery year (i.e. by 1 October 2019), allowing capacity payments to be made to successful bidders in accordance with the usual schedule, although it is unclear whether this timeframe can be met. In the event that state aid approval has not been met by the start of the 2019/20 delivery year, the capacity providers who have been awarded capacity agreements will be expected to provide capacity on the basis that back payments will be made to them once state aid approval is received after the start of the delivery year (as discussed further below). The Government is waiving the usual credit cover requirements for this auction.

Next T-3 auction

The Government intends to proceed with changes to allow a T-3 (three-years-ahead) auction to be held for delivery year 2022/23. This is intended to replace the T-4 (four-years-ahead) auction which was postponed because of the Tempus Decision. This T-3 auction is scheduled to take place on 30-31 January 2020, with the T-1 auction for 2020/21 to take place 1 week later, and the T-4 auction for 2023/24 to take place on 5-6 March 2020.There is some bad news for generators which have fully commissioned their generation plant since prequalification for the postponed T-4 auction last year, as the Government has confirmed that these generators will not be eligible for 15-year contracts in the new T-3 auction.

There will be some changes to the delivery milestones for the T-3 auction, to accommodate the condensed timeframe between the auction and the delivery year. The credit cover requirements for the 2022/23 T-3 auction, the 2023/24 T-4 auction, and the 2020/21 T-1 auction will also be suspended during the standstill period.

Participation of renewables in the CM

In a significant change to the CM regime, it is intended that renewable energy projects will be eligible for the first time to participate in the CM, from the 2020 T-3 auction onwards. There will be a new class of "Non-Dispatchable Generation". These renewable, intermittent generators will have de-rating factors applied to them, which will be calculated on an Equivalent Firm Capacity basis, similarly to the de-rating factors applied to battery storage projects. De-rating factors are intended to reflect the anticipated availability of participant technology types during system stress events. De-rating means that, in effect, for the purposes of calculating capacity payments, the capacity of the relevant generator is deemed to be the actual capacity multiplied by the relevant de-rating factor. The indicative de-rating factors that may be applied to renewables are set out in figure 1. Any renewable energy projects that already receive support under the Contract for Difference, Renewables Obligation or Feed-in Tariff schemes will not be eligible to participate in the CM.

Figure 1 - indicative de-rating factors for wind and solar

Source: National Grid ESO, De-rating Factor Methodology for Renewables Participation in the Capacity Market, 25 February 2019

Changes to the CM regime as it applies to existing capacity agreements

Credit cover

All capacity providers (referred to as CM Units or CMUs) that have credit cover currently lodged with the ESC (including those CMUs pre-qualified for the T-1 auction which was planned for January 2019) may request this be returned. In other words, the requirement to maintain credit cover has been waived during the standstill period. In line with this approach, the Government has also proposed to suspend the requirements for prequalified CMUs for the replacement T-1 auction to post credit cover in order to participate in the auction, although some new fees will be payable to replace credit cover, with an option for credit cover to be posted voluntarily instead of payment of the fees.

Payment of deferred payments

In the event of a positive final state aid decision, deferred payments will be made to capacity providers who have met their obligations during the standstill period. The arrangements relating to capacity payments during the standstill period are implemented under the Electricity Capacity (No.1) Regulations 2019.
Deferred payments will be conditional on (a) the EC's state aid approval following its formal investigation and (b) capacity providers' continued compliance with the obligations under their capacity agreements (as amended during the standstill period).

Deferred payments will replace the missed capacity payments from 1 October 2018 to the end of the standstill period, taking into account any deductions for termination fees and penalty charges. If a capacity agreement is terminated during the standstill period, any termination fees owed by a CMU will be offset against any deferred payments owed. The calculation of the deferred payments will also take into account the imposition of penalty charges accruing from non-delivery in any stress events during the standstill period.

Compliance by capacity providers with existing obligations

The Government's view has been that existing capacity agreements should continue to be administered and enforced during the standstill period to help ensure security of supply and to put capacity providers in a position to be eligible for deferred payments (subject to state aid approval). However, the Government has also recognised that, in light of the uncertainty created by the judgment and standstill period, capacity providers (new build projects in particular) may find it difficult to achieve compliance with these obligations by the set deadline in some instances.

Therefore, the Government decided to modify certain obligations for capacity providers during the standstill period: in some instances by extending the time for capacity providers to meet certain milestones that fall during the standstill period, and in other instances by waiving certain obligations that arise during the standstill period.

These changes include the following:

• Financial Commitment Milestone (FCM) (for new build CMUs with capacity agreements for the 2021/22 delivery year): the FCM is being extended to whichever is the later of 31 March 2020 or five months following the end of the standstill period.
• Credit cover: the increase in credit cover, due by 13 March for those new build CMUs with capacity agreements for the 2021/22 delivery year that have not achieved their FCM within 11 months of the 2018 T-4 auction, will also be waived.
• Connection agreements: originally, new build, distribution-connected CMUs with capacity agreements for the 2020/21 delivery year were required to submit a distribution connection agreement by 29 March 2019. The deadline has now been extended in the same way as the FCM.
• Metering assessments: originally, unproven DSR CMUs with capacity agreements for the 2019/20 delivery year were required to complete a metering assessment by the end of May 2019. The metering assessment deadline has now been delayed until 16 September 2019 (although aggregators should continue to aim to complete this as soon as practical to provide time for metering tests (if necessary) and DSR tests ahead of the start of the delivery year).
• Metering tests: originally, existing CMUs and Proven DSR CMUs with capacity agreements for the 2020/21 delivery year were required to complete a metering test by the end of March 2019. This deadline has now been delayed until 20 June 2020 or five months after the end of the standstill period, whichever is the earlier.
• Mock stress event: the requirement for the System Operator to run a mock stress event is being waived during the standstill period.

National Grid (the System Operator) will continue to administer and monitor compliance with the obligations under capacity agreements during the standstill period. This will include issuing Notices of Intention to Terminate and Termination Notices as necessary. However, termination fees will not be imposed during the standstill period. Instead, following the end of the standstill period, capacity providers will be invoiced by the Settlement Body and termination fees will be payable within one month from the date of the invoice. Similarly, CM penalty charges for non-delivery during system stress events will not be payable during the standstill period. However, any penalties incurred during the standstill period will continue to be recorded and adjustments made to the value of the deferred payments as necessary.

Impact on suppliers

The Government received representations across industry, including from capacity providers, suppliers and investors, that these industry participants would like to see the resumption of the Supplier Charge (i.e. the charge paid by suppliers to fund capacity payments) during the standstill period. Nonetheless, these payments have not been resumed on a compulsory basis, although suppliers are encouraged to make voluntary payments to the Settlement Body to cover their supplier charge obligation.

In a separate step, in December 2018 a CHP generator proposed a modification (P378) to the Balancing and Settlement Code (BSC), through the BSC modification process, to introduce a new time-limited monthly BSC charge on suppliers to be known as the CM Supplier Interim Charge. The charge was intended to cover the annual amount that suppliers would have expected to pay under the CM Regulations before the standstill in respect of the CM Delivery Year October 2018 to September 2019. However, the modification was rejected by the regulator, Ofgem, on 20 February 2019. Ofgem said that it has taken the view that it does not have the power to approve the modification.

What happens if the standstill period does not end?

Ultimately, there is a possibility that the CM regime is not granted state aid approval and the CM suspension is not lifted. For this reason, Regulation 6 of the Electricity Capacity (No. 1) Regulations 2019 provides that if the Secretary of State is satisfied that there is no reasonable prospect that the EC will grant state aid approval before a deadline of 1 October 2020, the Secretary of State may give notice terminating existing capacity agreements. If this happens, then such agreements will be terminated immediately and capacity providers will not receive deferred payments. Furthermore, any penalties or termination fees that accrued to capacity providers during the standstill period will not become due, and any payments made by suppliers and held by the Settlement Body during the standstill period will be returned to suppliers with interest. It should be noted that these arrangements do not take into consideration any potential impact of Brexit. If no state aid approval is granted, this would also raise questions about the impact on payments that had already been made to generators before the start of the standstill period: the legal position is not clear, but any requirement to repay such sums would obviously give rise to practical difficulties and further financial detriment to capacity agreement holders.

The CM five year review

One piece of good news for the industry is that the UK Government, at least, considers that "there is a strong need to maintain the CM". This was the finding of a review of the first five years of the CM, published on 22 July 2019. While the review was commenced with a call for evidence on the CM, in August 2018, before the Tempus Decision, the review does not ignore the current standstill and acknowledges that its proposals are subject to state aid approval — but there is definitely an expectation that in the future it will be "business as usual" for the CM, with a timetable of various reforms to the CM being planned. The planned reforms focus on the following key areas:

• futureproofing and technology neutrality—this may include measures such as strengthening the penalty regime and simplifying the de-rating for all technologies, as well as implementation of a new carbon emissions limit for all plant participating in the CM, in line with the EU's Clean Energy Package;
• simplification —this may include simplifying prequalification and secondary trading;
• procuring the right amount of capacity—this may involve reviewing the reliability standard used to determine how much capacity is required.

The new state aid investigation

As mentioned above, the EC formally opened its new state aid investigation into the CM on 21 February 2019. The EC's decision is not expected until later in the year. In a separate development, in January 2019 the EC lodged on appeal against the Tempus Decision and the UK Government is supporting this appeal. This appeal has no immediate impact on the current state of play and the EC's new state aid investigation will be proceeding in the usual way. In a further complication, in March 2019 Tempus Energy launched a further legal action relating to the CM —this time, a judicial review claim against the Government, challenging the Government's ability to introduce the interim arrangements for the CM during the standstill period, including the replacement T-1 auction and arrangements for deferred capacity payments.

While it is hoped that the state aid position of the CM will be resolved as soon as possible, there are no guarantees about whether and when this will happen. Another issue to consider is the potential impact of Brexit. While currently the position is far from clear, in a "no deal" Brexit scenario the UK will no longer be bound by the EU state aid regime. If the terms of the Withdrawal Agreement are agreed as intended, then the EU state aid regime will apply during the implementation period, to be subsequently replaced with a domestic state aid regime which will be enforced by the Competition and Markets Authority.