Market and regulatory design for a renewables dominated system

1. Market and regulatory design for a renewables dominated system David Newbery, EPRG, University of Cambridge Electricity systems of the future: incentives, regulation and analysis for efficient investment INI 18th March 2019

2. Outline Future utility challenges Recent GB/EU RES growth Principles for market/policy design Electricity Market Reform 2013 Why support renewables? Implications for RES contract design Pay for energy, capacity, quality Capacity auctions, reliability options, ancillary services Flaws in procurement, need for efficient pricing Financing low carbon investment Possible market designs Newbery 2 2

3. Future utility challenges Targets require massive growth of non-fossil plant Low variable cost, high capital cost PV, on-shore wind close to competitive but denied CfDs Off-shore, nuclear need subsidy => Require political support and suitable contracts Infrastructure & energy: capital cost dominates network designed for peak not average flows Growth of decentralised generation, peaky load: PV, micro-CHP, EVs, heat pumps => peakier net demand Falling capacity margins => higher fixed costs How can generators recover fixed costs? Newbery 3 3

4. Rapid increase in EU renewable electricity to 31% (EU-28) by 2017 UK second by 2015 Mostly hydro Pre-2000

5. UK RES catching up rapidly

6. National Grid Future Energy Scenarios 2018

7. Capacity under Gone Green 2016

8. Declining fossil plant load factors

9. Principles for market/policy design Correct market failures close to source CO2 and learning externalities Let prices reflect the value of all electricity services Energy, capacity, flexibility, quality Collect regulatory revenueshortfalls with least distortion De-risk financing of low-carbon investment Ensure contracts appropriate for plant characteristics Base-load or variable, shorter or longer lived See Newbery, Pollitt, Ritz & Strielkowski‘Market design for a high-renewables European electricity system Renewable & Sustainable Energy Reviews, 91, 695-707; https://doi.org/10.1016/j.rser.2018.04.025

10. GB Electricity Market Reform Energy Act 18 December 2013 to address: Security of supply – unwillingness to invest RES targets: costly and under-delivering problems with EU ETS, carbon price too low Market/policy failures To deliver securelow-C in UK affordably => capacity payments auctioned HMT sets Carbon Price Floor in 2011 for 2014 but reneged on it in 2014 de-risk investment => Contracts to lower WACC Originally bureaucratically set, now auctioned Newbery 2015 10 10

11. UK’s Carbon Price Floor - in Budget of 3/11 to £70/t by 2030 Budget 2014 Corrective tax CPS set 2011 too low As at 1 Jun 2011 D Newbery 11 11 11 Source: EEX and DECC Consultation

12. Combined impact of CPS and ETS

13. Coal displaced by RES & gas:carbon price floor working

14. Why support renewables? • Learning-by-doing creates unrewarded spill-overs that reduce later costs • Justifies large subsidy for solar PV at global level • Smaller if fail to form collective support via EU. Better under Mission Innovation • Secured at least cost in high insolation areas => subsidize installation,not output • Low carbon price => Carbon tax (CPS) • second best subsidize low-C for CO2 abated • subsidy per MWh at marginal CO2 displaced • e.g. Shortfall@ €20/t CO2=>CCGT displaced €9/MWh

15. Learning justifies support, mostly in production and deployment Double log scales Solar PV cost fall 20% for each doubling of cumulative shipments

16. Quantifying the spill-over benefit

17. RES CfD 2015 auction results Foolish bid - withdrew

18. UK Off-shore wind auction prices

19. Reforming RES-E support • Learning spill-overs need remuneration • Almost entirely from making and installing equipment • Contract €X/MWh for (e.g.) 30,000 MWh/MW, auction determines premium €X Reasons: • Subsidy targeted on source of learning = investment aid • Reduces cost of capital and risk via debt finance • Ideally associated with CO2 credit per MWh • Could expose RES to current locational spot price => incentivizes efficient location, connection • Does not amplify benefits of high wind/sun • Not over-reward favoured locations with same learning • Auction better than bureaucrats at minimizing cost

20. Location choices under LMP and spot pricing for wind N: 2,500 hrs/yr With ROCs wind farm inefficiently locates at N PN £35/MWh =>£87.5k/MW/yr =>£212.5k with ROC ROC = £50/MWh Pay wind for availability + average spot price => efficient E T cost £15/ MWh E: 2,000 hrs/yr C: £50/MWh PE £49/MWh =>£98k/MW/yr =>£198k with ROC

21. Electricity characteristics Electricity characteristics and cost drivers: capacity (MW):max demand on links &generation energy (MWh):nodal for each time period: fuel + CO2 quality (frequency, voltage etc.): nodal each second Pay networks for accessoption to take capacity Drives investment in T & D Some depends on system peak, some on local max. demand regulated – so need careful design QoS bundled with access, energy, capacity paid by final consumers to suppliers of service Procured by System Operator (markets, auctions, …) CO2 – EU ETS inadequate? Carbon price floors/tax

22. Paying for energy & capacity Pay for energy at efficient cost of supply System marginal cost, SMC variable cost of the most expensive in-merit generator Value/cost varies over time and space => locational marginal price varying every 5 mins (?) As in the US Standard Market Design Hedged with contracts struck ahead of time Pay for capacity= value of meeting demand Loss of Load Probability x (Value of Lost Load -SMC) full price = (1-LoLP)*SMC + LoLP*VoLL reflects probabilities of supply or lack of supply =SMC+LoLP*(VoLL - SMC) Energy+ capacity payment

23. Wholesale prices driven by fuel costs and market power

24. Supporting flexible back-up Ambitious RES targets need flexible back-up Normally comes from old high-cost plant = coal EU Large Combustion Plant Directive 2016 limits coal Integrated Emissions Directive further threat to coal GB Carbon price floor + hostility to coal => close old coal high (pre-2015) EU gas prices and low load factors gas unprofitable, new coal prohibited by GB EPS Future prices now depend on uncertain policies on carbon price, renewables volumes, other supports on policy choices in UK, EU, COP21, … Without a contract new flexible back-up too risky? Auctions for capacity Better still for Reliability Options

25. GB 2014 Capacity Auction Net CONE – predicted entry price £49 Auction clearing price £19.40/kW www.eprg.group.cam.ac.uk

26. GB Auction results 2014-18

27. Reliability Options to replace Capacity agreements • RO sets strike price, s (e.g. at €500/MWh) • Market price p reflects scarcity (Voll x LoLP) • SO sets floor price to reflect spot conditions • Wholesale price signals efficient international trade • RO auctioned for annual payment P • 7-10 yrs for new, 1 yr for existing capacity • Gen pays back wholesale price p • less strike price if available (p – s) • G chooses whether to be paid p or s + P • Suppliers hedged at strike price s for premium P Trade over interconnectors efficient No need to pay foreign generators

28. Ancillary services for QoS Fastermore flexible responses needed with high renewables Synchronous inertia – supplied by fossil generators, not by wind and PV Fast Frequency Response

29. Flaws in GB Capacity Procurement Transmission-connected generation TG pays full G TNUoS Distribution-connected generation DG receives L TNUoS But avoided cost at most the transmission demand residual = extra money to pay full cost less efficient charge of transmission represents extra £50/kWyr embedded benefit in 2018/19 Auction cleared at £20/kWyr DG gets £70/kWyr and TG gets £20/kWyr Large number of small (10 MW) diesel and reciprocating engines win capacity contracts on distribution network Over-encourages entry of costly subscale plant Newbery 29 29

30. GB Transmission demand residual – extra to DN connex Source: Ofgem (2017) Reduce TDR to £0 Embedded benefit not material

31. Efficient tariffs Distinguish efficient price and short-fall in required revenue Efficient peak T price is marginal expansion cost At best 30% average cost, less if demand falling Ramsey-Boiteux pricing => “tax” inelastic demand equi-proportional reductions in all types of demand incl. option to take up to N kW Diamond-Mirrlees: tax only final consumers T&D revenue shortfall on final consumption not net demand (at network connection) reduces embedded G benefit from £60 to < £10/kWyr Regulators need to compute efficient T&D tariffs and move faster. Auction in 1 day grants 15-yr contract Newbery 31 31

32. Fairness in tariff setting Generation increasingly high fixed, low variable costs BUT variable costs not zero; => ensure any subsidy is per MW capacity not per MWh output Networks and generation are capacity constrained Suggests charging for option to take max capacity at peak Perhaps with surcharge for taking excess (or discount for taking less) Easier with smart metering Public economics: balance fairness and efficiency Networks are a quasi-public good: charge ∝ willingness to pay Av cost – Marginal cost ≈ tax Newbery 32 32

33. Some energy contribution to fixed costs for low demand Payment £/quarter Marginal cost Av fixed cost Demand, kWh

34. Financing low-carbon generation Renewables: small units, quick build, 25 yr life Nuclear and CCS: large scale, high capital costs, long construction periods, very durable (40-60 yrs) Construction cost uncertain, designs in flux Credit time horizon (time before load repaid) (Avner Offer) Private sector happy with horizon < 10 yrs Unhappy with horizons > 10 yrs without assurance of stable revenue streams future energy revenue streams most uncertain no nuclear power ever financed in private sector without regulatory guarantees to pass costs through Hinkley Point C - the most expensive financing solution => New nuclear – finance as regulated utility (RAB) or on government balance sheet Newbery 34 34

35. Several possible investment solutions Real public sector interest rates now near zero Govt finance attractive when backed by productive assets Aggregate risks low, markets amplify company risks => finance low-C generation from state development banks Butneed contestability to deliver efficiency => auctions for PPA contracts (once commissioned OFTO contracts secured very low WACC => single buyer (ISO) for efficient dispatch? Or Pool? Design market to fit technology Newbery 2015 35 35

36. Possible Market Design Central dispatch in voluntary pool ISO manages balancing, dispatch, wind forecasting LMP + capacity payment =LoLP*(VoLL-LMP) Hedged with reliability option (RO) => reference prices for CfDs, FTRs, balancing, trading Auction/tender LT contracts for low-C generation? But need different contracts for nuclear/CCS Financed from state investment bank Credible counterparty to LT contract, low interest rate CfDs when controllable, Premium FiTs when not, or Capacity availability payment plus energy payment Counterparty receives LMP, pays contract Free entry of fossil generation, can bid for LT RO To address policy/market failures D Newbery 2014 36

37. Assessment Low-C investment is durable and capital intensive needs stable credible future pricesto invest and guaranteed contracts for cheap finance Two-part tariffs for energy and capacity/access? For generation needs Single Buyer EU policy is a messy 28-state compromise neither stable nor credible: => subsidiarity! Each country searches for best solution => some mix of contracts and capacity markets Gains from cross-border trading higher with RES share reserves & renewables to reduce investment Enable efficient solutions to drive out bad rapidly evolving environment for utilities D Newbery 37 37 37

38. Conclusions Support for RES needs change recognise learning benefitsby capacity support, CO2 per MWh needs better location and dispatch price signals => markets market responsive requires auctions and good network tariffs Efficiently pricing externalities and system impact key for efficient entry and exit decisions Tariffs and market design need reform to guide decisions network tariffs to avoid distorting embedded benefits reliability options better than capacity auctions for market Consumers can provide some DSR need to face efficient tariffs for networks – largely fixed charges and efficient electricity prices => lower off-peak; higher peak then can decide on PV, batteries, Electric Vehicles, etc. and/or provide some dispatchable automated services

39. Acronyms and appendices David Newbery, EPRG, University of Cambridge

40. Acronyms AC Average cost MC Marginal cost CCGT Combined cycle gas turbine CCS (generation with) Carbon Capture and Storage CfD Contract for difference CONE Cost of New Entry CPS` Carbon price support = carbon tax DG, DSRDistribution connected Generation, Demand Side Response ETS Emissions trading System EV Electric vehicle FiT Feed-in tariff ISO Independent System Operator, (T)SO = (Transmission) System Operator LMP Locational marginal price or nodal price LoLP= Loss of Load probability PPA Power purchase agreement RAB Regulatory Asset Base (value on which revenues paid at WACC) RES/RES-ERenewable electricity supply/ renewable energy supply of electricity RO Reliability Option ROC Renewable Obligation Certificate SMC System marginal cost T&D Transmission and distribution TG Transmission connected generation TNUoS Transmission Network Use of System, G =Generation, L=Load VOLL Value of Lost Load WACC Weighted average cost of capital 40

41. References • http://ec.europa.eu/energy/en/news/commission-proposes-new-rules-consumer-centred-clean-energy-transition gives links to the various directives • Clean Energy For All Europeans, COM/2016/0860 final at http://eur-lex.europa.eu/legal-content/EN/TXT/?qid=1481278671064&uri=CELEX:52016DC0860 • Michael Grubb and David Newbery UK Electricity Market Reform and the Energy Transition: Emerging Lessons, at https://www.eprg.group.cam.ac.uk/wp-content/uploads/2018/06/1817-Text.pdf • David Newbery, David Reiner, and Robert Ritz. When is a carbon price floor desirable? At https://www.eprg.group.cam.ac.uk/eprg-working-paper-1816/ • David Newbery, Michael G. Pollitt, Robert A. Ritz, WadimStrielkowski ‘Market design for a high-renewables European electricity system Renewable & Sustainable Energy Reviews, 91, 695-707; https://doi.org/10.1016/j.rser.2018.04.025