On 7 March, the Department for Energy Security and Net Zero (DESNZ) published the summary of responses to the consultation on the Review of Electricity Market Arrangements (REMA), which ran from 18 July 2022 to 10 October 2022. In this week’s Energy Perspective we highlight some of the key points emerging from the document, also in the light of the Spring Budget published on 15 March.
Announced in the British Energy Security Strategy in April 2022, REMA aims to tackle long-standing inefficiencies in GB energy market design. The government launched the consultation for REMA in July 2022, outlining several potential reforms. REMA’s scope is broad, as it includes non-retail aspects of electricity markets, with the aim of ensuring the balancing of supply and demand of electricity, and of implementing policies to promote investment in the assets that generate or use electricity. More specifically, the scope of REMA includes the balancing mechanism, ancillary services, the current Contracts for Difference (CfD) scheme, and the Capacity Market (CM).
A strong desire for reform
In the second week of March, the long-awaited results of the REMA consultation were published to offer an update to stakeholders on the feedback received, and what the next steps will be for DESNZ. Looking at the breakdown of consultation respondents by type, the first group is represented by generators and developers (55 respondents), followed by trade bodies (33 respondents). The more limited engagement of investors so far (only 9 respondents) arguably points to a more limited awareness of the potential impact of REMA among this constituency.
An overwhelming majority of the respondents (92%) expressed strong support for energy market reform that prioritises the traditional energy trilemma, constituted by decarbonisation, security of supply and cost-effectiveness. What is more, 80% of the respondents agreed that the current market arrangements are not fit for purpose. Hence, there appears to be a broad agreement with the REMA objectives, based on the consensus that existing market arrangements will not be able to ensure the degree of progress needed to achieve power sector decarbonisation by 2035. The summary of responses reveals a strong desire for reform, though there is not yet a clear consensus from respondents on which specific options should be taken forward, reflecting a variety of different opinions across the industry.
While the majority of respondents agreed with the options assessment criteria, some respondents questioned the concept of ‘least cost’, preferring instead ‘best value’, so to more adequately reflect overall system value, including reaching net zero commitments and ensuring fairness across society.
In terms of the options being considered, the consultation feedback helped to narrow them. Some less practical and potentially more disruptive options (highlighted in red), have been ruled out. Additionally, several of the options (highlighted in orange) will no longer be taken forward as standalone options but may still be combined as part of other packages.
Locational marginal pricing (LMP)
Several options that are seen as transformative – inasmuch as they could potentially disrupt the system while arguably bringing future benefits – have not been discounted. On this basis, locational marginal pricing (LMP), whose adoption will have a far-reaching impact by leading to a fundamental redesign of the energy system, is still being considered. However, it appears that this topic is providing a degree of uneasiness among several respondents, with some worried about its potential negative effect on investment sentiment. Hence, further consultation will be needed to assess whether to focus exclusively on zonal pricing, which is already adopted in several European countries, or whether to continue to consider LMP.
The document also shows an awareness that network charging reform could potentially help to address some of the underlying issues that LMP is meant to tackle, without the need for complex and time-consuming interventions. On a related topic, several respondents expressed concerns around pay-as-bid pricing, given the risk of tactical bidding under pay-as-bid pricing to determine dispatch. Generators could be bidding at the price of the expected marginal plant, thus precluding a decrease in consumer prices and potentially even causing distortions in the merit order, hence increasing overall costs. Based on those potential issues, pay-as-bid pricing has also been discounted as it does not satisfy assessment criteria such as investor confidence and least cost.
Investment in low-carbon generation
One of the key items being discussed within the consultation concerns how to accelerate investment in low-carbon generation. The majority of respondents are in support of centralised options, where the government decides the amount of capacity purchased through long-term contracts. On the other hand, support for decentralised options such as supplier obligations has been lacking among respondents, because of concerns around risks and thus a subsequent rise in capital costs.
Cognisant of these limitations, the supplier obligation for mass low carbon power has been discarded, although there may still be a role for suppliers in helping to deliver other REMA options. Also noteworthy is the acknowledgement of the potential role to be played by Power Purchase Agreements (PPAs) in increasing the installed capacity of low-carbon power. Some respondents not only recommended a widespread increase of PPAs but envisaged a role for the government in standardising PPA agreements, helping pool supply and underwrite agreements to reduce counterparty risk. With regards to the relationship between CfDs and PPAs, some respondents stressed the need to avoid the former crowding out the latter, with others going as far as seeing PPAs as a credible alternative to CfDs.
Flexibility is another important area covered by the consultation, with respondents backing proposals to reform the CM and introducing a cap and floor mechanism for flexibility. Also in this case, a supplier obligation will not be pursued as the main mechanism for flexibility in the short-term, though the role of suppliers in bringing demand-side flexibility in the short-term will still be explored. According to several respondents, the government needs to make sure that flexibility is more valued within the wholesale market, for example through reforms to the Balancing Mechanism. Suggestions were also made for the government to enable market arrangements for storage technologies, for example through long-term contracts like cap and floor mechanisms to reduce the risk of investment in long duration storage.
Other key highlights
A key point raised by respondents concerns the need to better assess consumer impact. Though the latter has not been adopted as a criterion in the consultation, the importance of this issue has been acknowledged, and will lead to the creation of an “end-user forum” to ensure that consumer impact is properly considered in the Review as well as further pondering on the key relationships between wholesale and retail market reforms. Another important issue is the need to achieve electricity demand reduction through the implementation of energy efficiency measures. While respondents highlighted the need to reinforce incentives for demand reduction, opinions vary on how this could be implemented in practice.
Overall, several respondents highlighted that incremental reforms to wholesale market arrangements may be more practical and effective than drastic changes. From the response to the consultation, it appears that the government is now considering whether updates to the vision and objectives are needed ahead of the next phase, which is likely to focus on further reducing the options on the table based on the stated objectives and criteria. While the publication of the consultation summary does not yet give clarity on future market design, it represents a significant step towards achieving an energy system that ensures security of supply and decarbonisation in a cost-effective manner.
While it appears clear that a holistic reform of the market design is needed, the summary also shows awareness that drastic change could potentially have unintended consequences, negatively affecting investor sentiment. Cognisant of this, the government is now set to assess whether to opt for incremental reform or more transformational change. It is yet to be seen whether legislating for REMA will be possible before the next general election, as that could potentially add another layer of uncertainty. A second consultation will be published in 2023 with decisions on shorter-term reforms to be taken forward where it is feasible to do so.
An overarching theme emerging from the consultation’s summary is the need to prevent an investment hiatus, by offering a clear route to reform while avoiding any disruptions during the transition period. Competition among countries to attract renewable capital is increasing following the enactment of the Inflation Reduction Act (IRA) in the United States. The European Union is also discussing policy responses to ensure the economic bloc maintains a competitive edge. Based on the proposal put forward by the European Commission on 14 March 2023, it appears that the EU is opting for incremental rather than radical reforms to maintain price stability without maintaining investor confidence, fostering long-term contracts such as CfDs and PPAs.
While the UK has made significant progress in attracting green capital in the last decade, particularly through its flagship CfD scheme which underpinned offshore wind’s success story, it is important to avoid any sense of complacency. Whereas after the Global Financial Crisis of 2008 abundant and cheap capital was chasing a limited number of energy infrastructure investment opportunities, we are now moving to a different environment, as we recently analysed in our paper WACC-A-MOLE –Implications of the rising cost of capital for the fifth round of the Contract for Difference scheme.
The Spring Budget published on 15 Mach 2023 (see page 7) contained some important measures for the energy sector, such as maintaining the Energy Price Guarantee at £2,500, reassuring households, businesses, and energy suppliers. It also included £20bn to support carbon capture, utilisation and storage (CCUS) as well as provisions for nuclear such as the establishment of Great British Nuclear and a commitment to a competition for small modular reactors (SMRs).
While all these measures are important, it is clear that they are not meant to deliver the step change needed to reach net zero; the role to outline the future vision for the energy sector belongs to REMA. As the policy initiative moves to the next phase, it is more important than ever to ensure that the future market design provides a long-term framework to ensure the achievement of net zero objectives as well as affordability and security of supply, bolstering the nation’s long-term competitiveness and prosperity. An upcoming paper by Cornwall Insight will discuss how the UK can maintain and boost its competitiveness within the global renewable race triggered by the introduction of the Inflation Reduction Act of 2022 in the United States. Cornwall Insight will keep on following any relevant REMA developments. In our What is REMA? portal, you will find analysis and insights that explore REMA and its potential implications for the energy sector and market participants.