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UTILITY WEEK | 5TH - 11TH FEBRUARY 2016 | 11 Policy & Regulation Analysis W hen the government set up the capacity market, it would not have been pleased to see headlines shouting about "dozens of dirty diesel gen- erators". Yet, when the second auction came to a close this winter, it once again became clear that small-scale diesel generators had ended up among those subsidised. The cost this time? Some £176 million on small-scale diesel generation over 15 years – even more than the £109 million in the first auction. Experts have told Utility Week that without changes to the market it could be even worse in the next round. While the primary purpose of the capacity market may be to ensure security of supply, it does not exist in isolation. It wouldn't be necessary if the government wasn't also try- ing to cut carbon emissions. The government's dilemma is that, in try- ing to achieve one of those objectives, it is apparently compromising the other. On the one hand, it's committed to closing all of the UK's coal-fired power stations by 2025. On the other, it's subsidising one of the few forms of generation that is equally carbon intensive in order to replace lost capacity. Jimmy Aldridge, senior research fellow at the Institute for Public Policy Research (IPPR), tells Utility Week there are "…more bill-payers' subsidies going to the dirtiest form of generation available at the same time that the government was over in Paris trying to negotiate a climate deal, and doing good work towards that end. From our perspec- tive, that's a step in the wrong direction, in trying to come up with a sustainable energy policy". Small-scale diesel generation produces 1,010gCO 2 /kWh, according to figures from IPPR. By comparison, the combined cycle gas turbines that the government was hop- ing to contract in the auction produce a mere 378gCO 2 /kWh. How did this happen? It isn't because diesel generation is itself particularly cheap, as Tom Porter, partner at consultancy firm LCP, explains: "In a competitive market, we would not expect diesel generators to be as cost efficient as new gas generators." Instead, it's the multiple sources of rev- enue they're able to take advantage of that have made diesel generators competitive. There are, of course, the capacity pay- ments themselves; £18/kW in the most recent auction. There are also contracts for National Grid's Short Term Operating Reserve. In his report for IPPR, "Mad Maths: How new die- sel generators are securing excessive returns at bill-payers' expense", Aldridge calculated that for a typical set of diesel generators, this could be expected to bring in £20/kW a year. However, the most important source of revenue is triad avoidance payments. Because the small-scale diesel generators are "embedded" in the distribution network, they are exempt from transmission network use of service (TNUoS) charges. This means diesel generators can help energy users to reduce their peak load and therefore their TNUoS charges, without incurring the charges themselves. Aldridge calculates this could bring in yearly revenues of £35/kW. On top of all this, diesel generators have been able to avoid several restrictions faced by others. They are small enough to be exempt from the EU's Industrial Emissions Directive, which places limits on nitrous oxides, sulphur oxides and dust. The same is true for the European Union Emissions Trad- ing Scheme, which would otherwise require them to obtain allowances for the carbon dioxide they emit. At first glance it seems that stopping die- sel generators from winning capacity con- tracts should be simple: just ban them from entering bids. However, EU competition rules state that the capacity market must be technology neutral, and therefore particular forms of generation cannot be barred. Aldridge's report suggests emissions limits are a way around this, calling on the government to "introduce an amendment to the Energy Bill… that prevents any genera- tor with an instantaneous carbon intensity over 450gCO 2 /kWh from accessing 15-year contracts". Diesel generators would be pre- vented from entering bids, without explicitly banning them. Another alternative is looking at the exemption from TNUoS charges. A joint report published by LCP and Frontier Eco- nomics calculated that triad avoidance pay- ments make up 60 per cent of the revenue stream for a typical diesel generator. It suggests getting rid of the exemption for the "sunk cost" element of the TNUoS charges, describing it as "wasteful and distortionary". Without this source of income, the report says diesel generators "would require a capacity price of £55/kW" in order to be prof- itable – more than three times the final price in December's auction. "It would level the playing field and there- fore bring a result more in line with what would have been expected," the report's co- author, Tom Porter, tells Utility Week. As things stand, the government has yet to acknowledge the problem fully. When the energy secretary, Amber Rudd, was challenged in the Commons by shadow energy minister Lisa Nandy, she responded: "Diesel will form a part of the future, but only in very small amounts. Let us remember that it is there as a back-up and will be switched on occasionally when it is needed. The addition of the capacity market to people's bills will be a matter of a few pounds." Dave Jones, policy analyst at environ- mental campaign group Sandbag, says the government might be hesitant to make any drastic changes: "If they're too big, the UK may need to bring the whole capacity mech- anism through the European state aid case again." However, he believes something needs to be done: "There's very much a kind of momentum from people suddenly realising the investment opportunity for diesel." Jones adds: "There's no reason this couldn't snowball and we end up with even more being contracted in next year's capac- ity mechanism." That's a scenario the government will want to avoid. As ministers review the out- come of last December's auction, watch this space. The dirty diesel dilemma Subsidies paid to small-scale diesel generators soared in the latest capacity auction and could rise even higher if the government doesn't limit their many sources of revenue, says Tom Grimwood.