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22/01/2016

Assessing the Cost of the Strategic Reserves

In response to the shutdown of several thermal units and the uncertainty around the availability of nuclear power plants, the Strategic Reserve (SR) was introduced by the Belgian Federal Government through a law in 2014, to secure the electricity supply during winter months.

For this winter 2015-2016, Elia, the Belgian Transmission System Operator, was requested to build up a capacity reserve of 1555 MW. The SR, composed of several generation facilities and – to a lesser extent – demand management, is functional since the 1st of November and will be available until the 31st of March.  

In this article, Sia Partners sheds light on the context of SR and puts it into the perspective of the broader concept ‘Capacity Remuneration Mechanism’ (CRM), which accepts different models. Recent information on Doel 1, 2, 3 and Tihange 2 nuclear reactors availability enable to draw solid assumptions on the use of the SR this winter. Hence, Sia Partners built a model that presents expected costs of the SR for Belgian consumers. Those are then compared to similar SR mechanisms in European countries.

Context

A changing energy landscape

The Belgian electricity market is facing a double challenge: first, it has to adapt to the major energy transition rising under the form of decentralization and decarbonization of generation units; secondly, the level of investments in new generation facilities remains anecdotal due to a constantly changing regulatory framework and to low spark spreads. Those factors put pressure on the Energy-Only market[1], in which energy producers are paid solely on the volume of electricity they generate (€/MWh).

As shown on Figure 1, favored low-carbon renewable energy sources (RES) generation units benefit from a nearly zero marginal cost[2], and are therefore leading the way for electrical generation, according to the merit order[3]. As a result, conventional power plants are pushed out of the merit order by RES, resulting in a lower energy price and a lower quasi-rent[4]. Conventional power plants (especially gas-fired generation) are specifically hit by this phenomenon.

Figure 1: Evolution of the Marginal Cost due to the emergence of renewable

Missing money problem

Building power generation units requires important upfront expenditures whereas the declining market prices and utilization rates, due to RES, allow no incentive for future investments. Clean spark spreads (CSS)[5] are negative a great share of time. This is the reason why the gas-fired power plants are no longer profitable, and this lack of profitability forces producers to shut down their power plants. This issue is called “missing money problem”.

The paradox of the situation is that conventional thermal power plants are nowadays critical to ensure security of supply and to mitigate the intermittency of renewable. Security of supply is the capacity to respond to unexpected imbalances, but another key concept is adequacy, which refers to the capacity to meet demand at any time.
 

CRM in Belgium

Path to a strategic reserve

To ensure an adequate level of generation capacity, to solve the “missing money problem” and to mitigate the intermittency of RES, Capacity Remuneration Mechanisms (CRMs) have been implemented in several countries. CRM can be seen as an insurance of security of supply for a market featuring a high share of intermittent renewable energy sources. These mechanisms consist in remunerating available generation capacity, not only sold electricity, to encourage producers maintaining a sufficient level of facilities.

In July 2013, the Belgian government asked Elia, Belgian Transmission System Operator (TSO), to form a Capacity Remuneration Mechanism - known as “Strategic Reserve” - that can be activated in times of scarcity during the winter months (from November, 1st to March, 31st). This reserve had to be made up with either facilities (excluding nuclear power stations) which shut down had been notified but not yet effective or facilities that were already temporarily closed. Therefore, this system directly addresses historical market players that are operating ageing infrastructures.

In order to ensure adequacy, Elia estimated the size of the reserve to be about 3500 MW for winter 2015-2016, taking into account uncertainties concerning the Belgian nuclear power generation facilities. However, the dimensioning has later been revised and reduced to 1555 MW (due to extended power plants, to the operating of Doel 1 and to a decrease of the estimation of the peak consumption). Figure 2 shows the different components constituting the 3500MW capacity required to ensure adequacy for winter 2015-2016.

Figure 2 – Building the Strategic Reserve – Winter 2015 - 2016

On 17th November 2015, the Federal Agency for Nuclear Control (AFCN) announced its green light on the restart of the nuclear power plants Doel 3 and Tihange 2, adding an extra 2014 MW generation capacity on the grid. Moreover an agreement was reached with the Belgian government on the prolongation of Doel 1 & Doel 2 units. All nuclear generation units should be available and online by the end of the year[6]. As a consequence, it seems very likely that the SR won’t be activated this winter.

Impact of the strategic reserve on the electricity bill

The strategic reserve can be activated through two triggers, related to two prices:

  • The ‘economic trigger’, when the total demand for energy on Belpex Day-Ahead Market exchange exceeds the total energy supply. If this happens, the strategic reserve will be activated the day after at the maximum price on Belpex (3000€/MWh). 
     
  • The ‘technical trigger’, when a structural shortage is detected by Elia, the day before its outbreak through technical indicators. 

If this shortage is confirmed on the considered day, the players on the wholesale electricity market who are not able to meet their customers’ demand for electricity will have to pay the imbalance tariff of 4500€/MWh. The purpose of this tariff is to give to market players an incentive to balance their injections with their offtakes. When the reserve strategic is activated while a market player also has an electricity surplus (which is not sufficient to compensate the structural shortage), this player sells then this electricity at 4500€/MWh and the strategic reserve compensates the remaining part of needed electricity, as presented on figure 3.

Figure 3 – Exchanges between market players during a structural shortage

Market players operating the units constituting the strategic reserve will have their activation costs covered. The imbalance tariff being significantly higher than the reserve activation costs (variable costs of the SR), one could argue that the TSO makes profit in case of structural shortages. Indeed, Elia would collect more money from the players that are facing an imbalance than it would give away to cover the activations costs of the reserves. The difference between the money inflow and outflow is assumed to amortize the reservation costs (fixed costs of the SR).

Following those functioning principles, the longer the strategic reserve is activated, the lower the impact on the electricity bill of the end-consumers as the mechanism is partly financed by the actors facing an imbalance. Figure 4 presents the impact of the strategic reserve on the price of the megawatt-hour, according to various scenarios of activation. As mentioned above, the final cost decreases with the severity of structural shortages. The highest cost of the strategic reserve is reached in a scenario without any activation, only to compensate the reservation of the available capacity. In this case, the mechanism represents a cost of up to 0,67€/MWh that is added to the 2016 electricity bill for winter 2015-2016. This only represents about 2,5 €/year on average for a household. But for a SME that consumes 1 GWh per year, it already represents an additional cost of 670 €. For a large industry consuming 150 GWh, it rises up to 100.000 €. Theoretically, the Strategic Reserve could generate money for the TSO if the reserve is activated at least 2 times with a minimal total duration of 8 hours.

Figure 4 – Cost borne by the end consumer depending on the activation of the SR

The ultimate objective of the Belgian strategic reserve is clear: to ensure an adequate level of generation capacity and consequently to minimize the threats of load-shedding and black-outs during the winter. However, a strategic reserve is not the only way ensure the security of electricity supply. In fact, there exist various Capacity Remuneration Mechanisms models among the European countries.
 

European benchmark

Europe is heading towards a patchwork of different CRMs at national levels

CRMs allow producers to be remunerated for the amount of capacity they provide to secure the generation adequacy rather than the electricity they produce. Such mechanisms are either price-based or volume-based. On the one hand, a price-based CRM fixes the remuneration level [€/MW], identical for every potential capacity provider. On the other hand, a volume-based CRM fixes the needed capacity [MW] which is set by the authority or the regulator. The price consequently emerges from the market as a result of a tendering or auctioning process. The costs are usually charged to the consumers as an additional service, in exchange for their guaranteed security of supply.

Many European countries have set up mechanisms with various architecture choices. CRM choices are often driven by local market characteristics, national needs and the emergency horizon, as described in the table here below.

Every mechanism presents its own characteristics, and an extra cost for the final electricity consumer (€/MWh). In order to assess the performance of the Belgian strategic reserve, the European benchmark developed hereunder compares the features of several European mechanisms. 3 characteristics have been retained to select the countries, in order to compare mechanisms implemented in countries with similar electricity markets, giving the following results:

CRM models across Europe

  • Ireland has established a mechanism of capacity payments. Capacity payment mechanisms correspond to a price-based CRM in which an independent party fixes the price per MW. The value of the annual capacity depends on two factors, the amount of capacity required to exactly meet the security standard and the annualized fixed costs of the best new entrant peaking plant. The capacity requirements for 2015 are 7046 MW. Such a mechanism is also currently deployed in Spain and Portugal.
  • Finland and Sweden have established a mechanism of strategic reserve, as did Belgium. Strategic reserve corresponds to a volume-based mechanism where a certain amount of capacity is set aside and only activated in case of scarcity. For 2015-2017, the amount of strategic reserve needed is 299 MW and 1000 MW in Finland and Sweden respectively.
  • Italy has implemented the capacity auction mechanism. Capacity auction is a volume-based mechanism where the capacity is procured centrally by the TSO to cover the estimated future peak loads several years in advance. The price is set by an auction and the costs are allocated to the network users, in exchange of their guaranteed security of supply. As opposed to the strategic reserves mechanism, the contracted capacity can be offered by power plants which are not necessarily off the market. With the first auctions expected by the end of this year, delivery of the capacity will likely to be 2019 or 2020. Such a system is also to be deployed in the UK in the near future, and is already put in place in the United States (PJM grid).
  • Finally, a last existing CRM in Europe is the capacity obligation mechanism. It corresponds to a volume-based scheme where large consumers and suppliers are entitled to reserve an amount of capacity according to their power offtake, either by relying on their own means (production plant or demand response capacity), or by buying capacity certificates on the capacity market. The contracted facilities are obligated to provide the sold capacity during power shortages, based on a specific signal triggered by the TSO. This system is deployed in France and the United States (CAISO grid). Capacity auction is completely similar to the capacity obligations except it is centrally handled by the TSO.

  
Comparison of Strategic Reserves costs

Finland collaborates with Sweden to provide together a strategic reserve of 1300 MW for winter 2015-2016. This capacity is locally referred as Peak Load Capacity, although it is completely similar to the common strategic reserve. Eventhough the Northern and Belgian mechanisms are quite identical, their cost are however somewhat divergent.

The Finnish share in the Peak Load Capacity reaches 299 MW. It is composed of two fossil-fired generation units (Naistenlahti 129 MW and Haapavesi 160 MW) as well as demand management (Suomenoja heat pump 10 MW). They are contracted for 2 years in a row. The cost of the reserve is evaluated at 13,4 M€. The annual electrical consumptions of Finland and Belgium are quite similar, 80 TWh and 81 TWh respectively, although Belgium’s population is two times larger. Assuming that both reserves would not be activated[7], the cost charged to the consumers would be about 0,08€/MWh in Finland.

The Swedish share in the Peak Load Capacity is 1000 MW. It is composed of one generation facility (E.ON Värmekraft 660 MW) and demand management (Holmens Bruk 290 MW and Stora Enso 50 MW). During winters 2013-2014 and 2014-2015, Sweden contracted 1500 MW of reserve capacity at a price of 138 and 112 million Swedish crowns respectively, which comes down to roughly 15 and 12 M€. By downscaling the average procurement cost to the current need of 1000 MW, the estimation of the reserve’s cost for winter 2015-2016 lies around 9 M€. The annual electrical consumption of Sweden being around 135 TWh, the procurement of the strategic reserve results in an increase of the electricity bill, approximately up to 0,07 €/MWh, close to the Finnish related cost.

Figure 5 – Comparison of SR in Finland, Sweden and Belgium

Finnish and Swedish costs of strategic reserves are almost ten times lower than those in Belgium, at 0,67€/MWh, for a most likely un-activated reserves scenario. However, the difference in the final price is not as important due to the electrical consumption per capita (in MWh), being higher in Finland and Sweden than in Belgium during winter months.

Conclusion

The Belgian strategic reserve was a good solution adapted to the short term need of security of supply. However, it does not encourage investments in new infrastructures and it favors historical producers operating ageing plants. Furthermore, with the availablility of the nuclear power plants announced after the sizing of the SR[8], it is very likely that the strategic reserve won’t be activated during winter 2015-2016. Finally, whereas there is no obvious risk of shortage for this winter, the customer pays for the strategic reserve, and for the short term decisions taken by the authorities. The highest cost of the strategic reserve (0,67€/MWh) will not really impact residential customers but the financial impact upon large, industrial companies will be significant.

The European context does not look serene either as the juxtaposition of different national mechanisms results, in the end, in an over-capacity of  flexible generation facilities, detrimental to European customers as they have to bear the costs of those policies. However, the creation of a European-wide mechanism would avoid this issue as the peak load of the whole European synchronous power system is significantly lower than the sum of the peak load of all its constituting national grids. More than 60 years ago, the European Coal and Steel Community, set up by Belgium, France, West Germany, Italy, the Netherlands and Luxembourg initiated the first steps of a European energy policy. Those countries could become tomorrow leaders for the emergence of unified capacity remuneration mechanism, relying on a single model.

Sources

ACER, “Capacity remuneration mechanisms and the internal market for electricity”, 30 July 2013

EGMONT PAPER, “The rise of capacity mechanisms: are they inevitable in the European Union?”, September 2015

Energiavirasto Energimydigheten, “Energy Authority has adopted two power plants and one DSF facility for electricity peak load capacity reserve system”, 23th of April 2015

EUI - HENRIOT A., GLACHANT J.M., “Capacity Remuneration Mechanisms in the European Market: Now but how?”, 2014

KU Leuven Energy Institute, “EI Fact sheet Capacity Mechanisms”, March 2013

 Ministry of the Environment and Energy Sweden, “The Strategic reserve - why and how? “, 2015

CREG, http://www.creg.info/pdf/Decisions/B658E-32FR.pdf, consulted the 10th of July 2015

CREG, http://www.creg.be/fr/producte9.html, consulted the 15th of July 2015

CREG, https://www.google.com/url?q=http%3A%2F%2Fwww.creg.info%2Fpdf%2FEtudes%2FF1422FR.pdf, consulted the 15th of September 2015

Elia, http://www.elia.be/~/media/files/Elia/users-group/Taskforce%20Strat%20Reserve/Winter_2015-2016/SFR_Regles-Fonctionnement-Reserve-Strategique_03-2015.pdf, consulted the 15th of July 2015

Elia, http://www.elia.be/~/media/files/Elia/users-group/Taskforce%20Strat%20Reserve/Winter_2015-2016/20150724_AuditionParlementaire0714AddOn_FR_ppi.pdf, consulted the 1st of August 2015

Elia, http://www.elia.be/fr/a-propos-elia/questions-securite-d-approvisionnement-et-penurie-en-Belgique, consulted the 10th of November 2015

ENGIE, http://transparency.gdfsuez.com/FuturesAvailability.aspx?CommodityId=3, consulted the 17th of November 2015

International Energy Agency, http://www.iea.org/statistics/statisticssearch/report/?country=BELGIUM&product=electricityandheat&year=2013, consulted the 20th of November 2015

Nord Pool Spot, http://www.nordpoolspot.com/message-center-container/nordicbaltic/exchan..., consulted the 30th of November 2015

Nord Pool Spot, http://www.nordpoolspot.com/message-center-container/nordicbaltic/exchange-message-list/2015/q2/no.-262015---finnish-peak-load-capacity-arrangement-period-from-1-july-2015-to-30-june-2017/, consulted the 30th of November 2015

Copyright © 2015 Sia Partners. Any use of this material without specific permission of Sia Partners is strictly prohibited.

 

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[1] Energy-Only market: market in which the source of revenue for the generator solely comes from selling energy to the market (remuneration for MWh). It is the normal operating for any energy market.

[2] Marginal cost: Cost of producing one more unit of a good [Stiglitz, Principles of Microeconomics],

[3] Merit order: order of generation units per ascending marginal costs.

[4] Quasi-rent: when the price is greater than the marginal cost, the quasi-rent is the money earned by producers to compensate fixed costs. In other words, it represents the profit for the producer on the variable operating costs, which is used to compensate the fixed operating costs.

[5] Clean Spark Spread: net revenue a generator makes from selling power, having bought gas and the required number of carbon allowances

[6] Based on information published on http://transparency.engie.com

[7] Several hints are backing up this hypothesis: All Belgian nuclear power plants will be operational as of begin 2016. Consequently the risk of supply shortages is almost non-existant in the Belgian control area; Regarding Finland, its strategic reserve has not been activated last winter nor the winter before and only one single time during the winter 2012-2013.

[8] Doel 2, Doel 3 and Tihange 2

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