Tuesday, March 7, 2017
TWO CHEERS FOR HOUSE OF LORDS ON MARKET FAILURE. [2 of 3]
SUPPLY SECURITY AND THE PROPOSED ENERGY COMMISSION.
House of Lords Select Committee on Economic Affairs. The Price of Power. Reforming the Electricity Market. February 2017.
The Committee’s investigation began with the expressed wish to examine market failures in the power sector. In spite of some useful evidence and analysis their report ultimately fails to appreciate the fundamental nature of some of the current market failures. Its preference for “getting government out of the market” is at its root an ideological commitment to a market paradigm which will be increasingly untenable as power sectors move towards low carbon technologies. In consequence the report has some inconsistencies. In particular it fails to recognise the fundamental nature of the change brought about in moving away from an energy only market to include a capacity market overseen, implicitly at least, by a new agency, the Energy Commission. This inevitably brings a new “central” agency into all the most important aspects of investment choice. This may well be a good starting point for a solution, but it does not correspond to the unrealistic dream of “getting government out of the market”.
The analysis starts with supply security. The Committee is quick to point the finger at renewables, although there is in principle no reason why security should be an issue in a well-designed low carbon system with adequate storage and load shifting options.
A bigger issue is the inconvenient truth that there has been under existing arrangements for the sector no party in the power sector with a properly constructed statutory or other responsibility for this aspect of supply security – adequate generation capacity. There is no obligation on generating companies; there is no obligation on suppliers; and it has not been the job of the National Grid. This does not have to be a weakness of market led systems. The arrangements put in place at privatisation in 1990 were built around a de facto obligation to supply. Suppliers (then confined to the regional companies) were obliged to meet all demand or pay a penalty related to the value of lost load (VOLL). This value was inserted by administrative means into the pool price, and in principle performed the same function as a capacity market, namely the ability to reward generation capacity. But this approach was abandoned in 2000 and since then generation security has been a matter that for all practical purposes has been left entirely to the market. Blaming government interventions is convenient but by no means the whole story.
This discussion brings together approaches to supply security and the so-called “missing money” problem. This major flaw in the market was pointed out by many commentators and academics warning that failure to reward capacity would ultimately cause security issues. The position was neatly summarised by John Kay in the FT.
“But privatisation failed to provide a stable framework for planning new electricity generation. The initial regime reflected careful thought about appropriate incentives for capacity installation, but this regime was swept away in 2001 in favour of a simpler one modelled on other commodity markets and known as NETA (New Electricity Trading Arrangements), subsequently to be Betta (British Electricity Trading and Transmission Arrangements). As so often in commodity markets, this structure worked rather better in the short run than over the long term.”
The problems were concealed for a long time by an overhang of significant capacity surplus. But the essential point is that the root causes pre-date any significant impact of low carbon policies, good or bad, or the magnifying effect of zero marginal cost renewables. The Committee appears to be using these latter developments as a convenient scapegoat.
Market failure. Capacity markets as the solution.
One possible remedy is the introduction of a capacity market. The Committee focuses on this but does not deal comprehensively with the implications. It is deceptively simple to propose technology neutral capacity markets, appropriately designed, as a solution. It is quite another to deliver such a market, as the scope of the exercise will extend well beyond simple decisions on security standards.
A fundamental feature of capacity auctions is that they require someone to run them. Inter alia this means determining and setting a level of security, and hence the quantity of required capacity. That in itself represents a major market intervention, which can really only be decided by a public or quasi-public agency, and confirms the reality that security of supply is no longer being “decided by the market”. This is just the beginning. The complex tasks of defining capacity, and measuring and monitoring its delivery, will necessarily fall to the same agency.
This task becomes even more complex in the context of a growing proportion of low carbon generation, which has entirely different technical and economic characteristics from those of relatively homogenous fossil plant. We shall in the future be dealing with a diverse collection of generation and storage technologies, each with its own complex mix of technical, operating and economic characteristics. This diversity of low carbon generation militates against simple application of technological neutrality in plant choice. Balancing the “capacity parameters” of different technologies may require complex auctions in order to differentiate between very different technologies.
The Committee partially recognises this in its proposal for an Energy Commission to oversee energy policy and hence implicitly the process of capacity auctions. This can be viewed as a step in the right direction, towards a technically competent “arm’s length” agency with the responsibility for determining the investment mix, but the report seemingly fails to recognise just what a radical departure this will involve. It is prima facie at odds with the Committee’s apparent preference for minimising the role of government. The Energy Commission will be forced to consider numerous complex planning issues, and become a de facto central purchasing agency. In my evidence I proposed establishment of a technically competent agency to take on that role. If that is what the Committee has in mind for the Energy Commission, then it can be applauded as a sensible recommendation. But a lot of people will not view it as removing government from the market, in fact an unrealistic ambition.
 even citing my submission that “a system heavily dependent on renewables … could face longer periods of sustained shortage”. The report fails to qualify with the context and hypothetical nature of this observation, or my comment that this was “possible but not likely in the near term”.
 These are too numerous to list but certainly include Dieter Helm who gave evidence to the Committee.
 John Kay. FT. July 2013.
 A recent blog expands on this theme in the context of UK and New Zealand experience
 I have for some time pursued the line that there are a larger number of market failures, and that they all need to be addressed in order to have a well-functioning power sector that can still make the best use of market disciplines to produce efficient outcomes. One summary of this more general debate, which includes other aspects of market failure the Committee could have addressed, can be read on a separate page of this blog, LOW CARBON POWER.
 A typical example of the need for some form of central coordination is the need to maximise the capacity provision from offshore wind by capturing the benefits of weather diversity. The economically efficient outcome requires a spread across multiple locations, not just those with the most wind or the shallowest water. Similar arguments will apply in the context of tidal lagoons.