Coming to terms with power

As the new UK government passes 100 days in office, it is clear that one issue high on the agenda of the Department of Energy and Climate Change is the shape of the power generation sector and its investment strategy.

With the UK facing up to challenging self-imposed emission targets, this one sector potentially stands between success and failure in meeting them in the years to come. There are really only four options for the UK on the table and the balance between them is all important. They are coal, gas, (offshore) wind and nuclear. One of the principle existing policy instruments designed to sort out this balance and guide investment over the coming decade is the EU Emissions Trading System (EU-ETS). The clear carbon price signal delivered by the market should provide the necessary driver for future projects. But there is growing concern from some quarters that the market is not doing its job!

A number of major projects will be required over the next 10 years just to meet demand so there will be significant investment activity. This will then set the emissions performance of the sector for the 2020’s and beyond. But with the carbon market again showing signs of surplus, this time due to the recession, the resulting price signal may be insufficient to set the UK onto the true low carbon trajectory it is seeking.

The response from the new government has been to propose two measures to address this situation – a floor price for the carbon market and an Emissions Performance Standard (EPS) for new generation capacity. The floor price is likely to be implemented through a levy approach (e.g. surrendered compliance allowances attract an additional payment where the market for the previous year has been below the designated floor) so that it applies to the UK only.

Both of these solutions are problematic in the context of the broader EU wide ETS. While a reasonably efficient EPS could be designed as an alternative to a cap-and-trade system, an EPS applied to electricity or other sectors already covered by an existing cap-and-trade system would be largely ineffective. If the EPS leads to emission reductions beyond those driven from the CO2 price, it would depress the CO2 price and reduce the incentive for emission reductions across the rest of ETS.  In other words, the leakage of emission reductions under the EPS would be 100%. Similar leakage problems will result from a UK only floor price.

In both cases, the proposed solutions will not mean any lower emissions across the EU as a whole so no net environmental benefit will result. Rather, the outcome will be that the UK economy picks up the cost of potentially more expensive reductions and although some EU funding will flow into the UK from allowance sales linked to any reductions made, the remaining EU economies will be better off as a result.

An alternative strategy for the UK to pursue would be to work with the EU Commission to define Phase IV of the ETS now and potentially establish a floor price for 2021 and beyond by creating an allowance auction reserve price within Phase IV. Such a mechanism would provide an immediate and powerful investment signal for new projects and offer support to the current market given the ability to bank allowances.

Because of the timeline associated with initial design and feasibility studies, planning approval, final investment decisions, ordering, construction and start-up, many new power projects being considered today will, in any case, see the majority of their economic return coming in the 2020s. For this reason a Phase IV based approach to supporting the ETS becomes a practical way forward and being EU wide would be preferable to a UK only solution.