Can we mandate electricity markets to deliver a decarbonised grid by 2035?

Comment by George Day

Head of Markets Policy & Regulation

The government’s net zero strategy includes a commitment to fully decarbonise our power system by 2035, along with other commitments around nuclear power, offshore wind and CCUS. But major questions remain about the detail of how to adapt policy and market mechanisms so that they drive the right mix of investment for a zero carbon grid. In other words, the policy framework for delivering a balanced and efficient Net Zero electricity resource mix by 2035 remains unresolved.

Over the last decade we have relied largely on centralised contracting mechanisms like CfDs and the capacity mechanism to underpin investment in new low carbon resource. These have tended to focus support on particular technology categories, with less focus on how the whole system fits together.

At Energy Systems Catapult we are making the case for “EMR2.0” – a new phase of ambitious, innovation friendly reforms to electricity markets. We argue for a much stronger focus on whole system outcomes like decarbonisation and reliability, in our report Rethinking Electricity Markets – The case for EMR 2.0  published earlier this year (Figure 1).

Rethinking Electricity Markets

An Energy Systems Catapult initiative to develop proposals to reform electricity markets so that they best enable innovative, efficient, whole energy system decarbonisation.

We need to reform electricity markets and market mechanisms so that they bring forward innovation and investment in a more efficient mix of low carbon generation, network enhancements and flexibility.

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Figure 1: EMR2.0: The six key reforms

Figure 1: EMR2.0: The six key reforms

We have in mind:

  • A reduced reliance on centralised (levy-funded) contracting to “procure” the resource mix
  • Much more accurate and granular locational and real time price signals to accurately reflect value across the system
  • A simplified policy framework that focuses on decarbonisation as an outcome instead of  technology support mechanisms
  • Electricity markets playing a larger role in shaping the mix of resources; and financial markets playing a larger role in managing price & revenue risks.
  • More innovative retail markets focused on consumer needs and great service.

We argue that the industry is much better placed to manage market and other risks than in 2010. An approach anchored around the outcome of decarbonisation by 2035 could shape much stronger and more balanced incentives for investment and innovation throughout the supply chain:

  • on project developers of new generation capacity
  • on investors in both generation and, crucially, new forms of flexibility,
  • on new trading intermediaries and
  • for innovators creating new propositions (and smart technology) in the demand side and retail markets.

Our most controversial reform proposal is to phase out CfDs and replace them with a new market-wide ‘electricity decarbonisation mandate’ to drive investment in a balanced mix of resources.

So what could such a market-wide decarbonisation mandate look like? How would it work in practice? And what advantages would it bring over the existing regime of CfDs and revenue support?

What could a new electricity decarbonisation mandate look like?

At its most basic level, a market-wide decarbonisation mandate could take the form of an obligation on suppliers (and major industrial customers) to reduce the average carbon content of their electricity purchases in line with a required standard.

The carbon standard might be expressed as an average carbon intensity and would be set to tighten progressively every year until it reaches zero in 2035.

The standard could also be backed by a trading scheme, allowing parties whose portfolio of electricity purchases outperforms the standard (ie contains less carbon on average than the required standard) to sell their ‘surplus’ carbon credits. These credits could be purchased by other parties who need them to comply with the standard (i.e. who are in ‘deficit’ in relation to the standard, see figure 2 below which shows an illustrative example). This approach would give flexibility in compliance and also enable a carbon price to emerge, which could be linked to the UK Emissions Trading Scheme.

Figure 2: Illustrative example of a carbon intensity standard

Figure 2: Illustrative example of a carbon intensity standard

Similar mechanisms have been used successfully around the world in a variety of contexts, including:

  • the California Low Carbon Fuel Standard which requires oil refineries and distributors to ensure that their portfolio of transport fuel sales meet declining targets for carbon intensity.
  • Performance standards under the US Clean Air Act regime for SO2 and NOx which applied across a firm’s portfolio of emissions sources.
  • EU automotive emissions standards for the fleet portfolio of manufacturers’ sales of new cars.

How would an electricity decarbonisation mandate work in practice?

The main practical impact of a decarbonisation mandate would be to rebalance markets in favour of low and zero carbon resources. An obvious approach would be to align a tightening trajectory for a carbon standard with the pace of electricity decarbonisation needed to meet carbon budgets. This would give strong investor credibility by embedding the standard in legally binding carbon targets, and the robust and transparent carbon budget process that sits behind them.

Complying with the standard would force suppliers and industrial users to contract upstream for low and zero carbon generation resource, along with complementary flexibility resources (e.g. storage, or demand side aggregators). This would drive up the demand for, and value of, low and zero carbon resources while making carbon intensive generation less valuable. Fixing the trajectory of the standard would provide a clear line of sight and enable investors to assess the value of projects. Taken together this would provide a clear technology neutral investment signal for zero carbon resource and crucial complementary flexibility resources.

Suppliers would also have stronger incentives to build (or partner with those who can build) detailed understanding of customers’ needs and the smart solutions that can work with the fabric of people’s lives and they buildings they live in. Why? Because these demand side details strongly condition the options they can use for matching demand with a supply portfolio dominated by variable renewables (i.e. sufficiently low carbon to meet the standard).

Suppliers who understand and unlock flexibility on the demand side will gain a competitive advantage in a future electricity grid that is likely to be dominated by variable renewables. This would drive a stronger focus on integrating behind the meter technologies, smart controls & appliances, building fabric improvements and hybrid technologies (which in turn could enable the vector switching and customer-side energy storage that give valuable flexibility and resilience in meeting the decarbonisation mandate).

What are the advantages a decarbonisation mandate could bring?

An electricity decarbonisation mandate would be a major change for the sector. Fundamentally it would shift policy to focus on driving demand for zero carbon electricity and away from mechanisms that seek to ‘force’ it onto the system. It would need to be introduced carefully, without creating any investment hiatus, and while honouring existing CfDs through to maturity.

However, we believe there is a strong case for ambitious reform (Figure 3) because it could:

  • deliver a genuinely technology neutral market driver for decarbonisation throughout electricity value chains, enabling a more coherent and balanced set of drivers for flexibility and demand side resources, while avoiding some of the negative effects (e.g. price cannibalisation) exacerbated by the current policy mix;
  • enable significant simplification of electricity policy, reducing the need for interventions and government-led procurement of low carbon resource (while also allowing existing CfD contracts to be honoured through to completion);
  • incentivise market players to compete and optimise measures to cut emissions throughout the value chain (from generation through to customer side measures) and across energy vectors (electricity, heat vectors, including hybrid technologies). Empirical evaluations of these kinds of instruments (e.g. of US SO2 & NOx emissions regime) indicate the value that can be unlocked by this dynamic of optimisation and accelerated reduction of compliance costs.
  • It would offer a stable way to internalise carbon within electricity prices, giving clarity and confidence to investors in low carbon resources, while allow a carbon price to emerge through trading in credits that aligns with the UK Emissions Trading Scheme (ETS).
  • An electricity decarbonisation mandate could also be closely aligned with the structure and functioning of the UK Emissions Trading Scheme, potentially enabling it to become the means by which the UK ETS cap is applied for electricity.

The challenges we now face are different to those faced when CfDs were introduced.  We now need to phase in new policy tools that are specifically focused on driving the transition to a fully decarbonised electricity system. Our current policy mix is increasingly in tension with the efficient functioning of markets, bringing significant risks if we stand still and remain reliant on mechanisms like CfDs.

Conversely, introducing a market wide electricity decarbonisation mandate can be the centre piece of a new wave of ambitious policy reforms to make the UK a world leading and rapidly decarbonising electricity market. In turn this can unlock a range of new opportunities and innovation that will save costs and deliver better service outcomes for consumers.

Figure 3: The benefits of shifting policy to whole system outcomes

Figure 3: The benefits of shifting policy to whole system outcomes

This comment piece first appeared in Cornwall Insight Energy Spectrum, 8 November 2021.

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