The Capacity Market (“CM”) auction and all payments due under the mechanism have been frozen following a ruling by the European Court of Justice (“ECJ”) revoking State Aid clearance. The implications for existing and new build projects relying on Capacity Market payments is significant and undermines a multitude of investment decisions made across the UK power sector in the last five years.
Principle versus Process
The ruling from the ECJ says the European Commission did not properly investigate a legal challenge by Tempus Energy lodged in 2014 that the design of the Capacity Market scheme unfairly disadvantaged Demand Side Response (“DSR”). The complaint was on the basis DSR was only eligible for a 1-year CM agreement while other eligible generators could secure 15-year CM agreements.
Importantly this is not a verdict on whether the claim DSR has been unfairly disadvantaged but a ruling that a review, independent of the UK Government’s submissions, was not undertaken which assessed the incentives the CM would create in the market and whether these would potentially discriminate between capacity providers.
Has DSR been unfairly discriminated?
The first question to therefore consider is whether a more thorough review by the European Commission is likely to conclude anything different from the UK Government. If the answer is no, then it is reasonable to assume the CM will be reinstated as soon as the necessary study has been concluded. I would anticipate a minimum 6-month window is required to carry out this assessment.
If the answer is yes, then the UK Government will need to work with the European Commission to establish the impact (if any) on capacity providers in receipt of CM agreements from previous auctions and redesign future auctions so state aid clearance can be granted legally. Important considerations in this respect will be whether aid is:
- The minimum necessary to remedy the failure (proportionate);
- Really changing the behaviour of the organisation that receives it (incentive effect);
- The best way to address the failure (appropriate); and
- Beneficial enough to outweigh any negative effects on competition (balancing test).
Feeling the heat
State Aid rules are complex and understanding exactly how the Commission and the ECJ will assess state aid requirements issues is uncertain. While comparable state aid issues such as nuclear have been contested and subsequently defended successfully there is little precedence for an in situ scheme of this magnitude falling foul of procedural issues. In the event a further state aid assessment of the CM concludes the scheme does unfairly discriminates between capacity providers then there will be significant implications for both past and future auctions.
At the more extreme end of the spectrum there is the prospect that the results of all previous auctions will be invalidated with little means of recourse for those in receipt of CM agreements awarded. In this scenario investors in new build projects will need to decide whether they should commit further capital to reach commercial operations or halt development and construction until the issue is sorted. For existing capacity providers, the decision is whether to run in a purely merchant trading environment or shut down. For both a significant slice of the revenue stack will have been removed and question marks remain on the ability to capture value in a volatile market sustained by an existing but ageing generation fleet.
While it is unlikely existing generators will close this winter, allaying short term security of supply concerns, next winter parties may choose to exit prompting electricity prices to respond in kind. The implication is a shrinking capacity base, increasing security of supply concerns and the prospect of future price shocks. An additional and complicating factor is the energy price cap and how any price adjustment will disproportionately affect SMEs and other businesses already facing elevated uncertainty due to Brexit.
What happens next?
Given the impact on investor confidence and potential implications for future security of supply the most likely course of action for the UK government and the European Commission is to minimise any implications for past auctions while looking to address any issues identified relevant to future auctions. Various permutations are possible but key is to understand the timing implications of these and what existing and new build capacity providers can do in the interim.
National grid has issued advice for capacity agreement holders and CM applicants confirming:
- National Grid is looking to continue with activities which do not involve granting state aid, including completing the Prequalification process for 2019 in case it is required for future capacity market auctions.
- The Government is seeking a one off approval to run a replacement T-1 auction for delivery in 2019/20 and then a T-3 for 22/23 alongside a T-4 for 23/24 next year, all subject to state aid of the entire scheme.
This at least provides some guidance on the direction of travel being pursued albeit limited detail and assurance for those in the process of securing funding. Practical commercial matters capacity providers should consider in the short term include:
- Reassess working capital requirements;
- Review risk of breaching debt covenants;
- Seek clarity on CM development milestones and risk of termination;
- Consider project development timelines and potential for expiry of property and /or connection agreements; and
- Review material and adverse change of law provisions.
A broken developer model – when to pick up the pieces?
In the absence of secured capacity market revenues developers and investors of flexible generation and storage projects will need to consider how flexible commercial structures can be implemented allowing for extended project delivery timescales.
The ECJ ruling has created shockwaves in the UK power sector but it remains the issue in contention is one of process not principle. The biggest casualty from this debacle is the impact to investor confidence in the UK, once considered a bastion of regulatory prudence and good governance.
Looking ahead the path of least resistance will be for the Commission to undertake a further assessment of the scheme in its current form. If this concludes State Aid is not an issue, existing CM agreements will be reinstated while leaving the door open for future design changes as part of the UK Government’s five yearly CM review.
Head of Energy and Infrastructure Advisory
+44 (0)20 7399 5171