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Competition in the Electricity Sector

December 2010

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Table of Contents

1. OVERVIEW OF tHE ELECTRICITY SECTOR .........................................1Table 2: Share of Installed Generation Capacity by Company 2006-2010 onthe island of Ireland ...............................................................................4Electricity Transmission and Distribution on the island of Ireland.................. 5

The Electricity Transmission System .........................................................5The Electricity Distribution System ...........................................................6Interconnection of the NIE and ESB electricity transmission systems ............ 6Ownership of the transmission and distribution systems.............................. 7The Single Electricity Market....................................................................9Competition issues in the electricity sector .............................................. 13A. Appendix A ................................................................................. 15

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1. OVERVIEW OF THE ELECTRICITY SECTOR

1. The electricity industry consists of a number of distinct activities atdifferent segments of the supply chain: generation and wholesalesupply, transmission, distribution and retail supply.

2. The Irish electricity sector is dominated by ESB and its 75 subsidiarieswhich comprise a vertically integrated electricity business. As shown inTable 1, ESB is active at all levels of the electricity sector in the State,namely: power generation, electricity transmission and distribution andthe wholesale and retail supply of electricity. ESB is also active in theprovision of engineering consultancy services1; for the most part itprovides these services to businesses engaged in the construction andrefurbishment of thermal power plants and wind farm developmentsboth in the State and internationally.

3. Legislative provisions govern the regulation of the electricity sector inboth the State and Northern Ireland.2 In the State, the regulator is theCommission for Energy Regulation (CER). In Northern Ireland, theprincipal regulator is the Northern Ireland Authority for UtilityRegulation (NIAUR).

4. ESB was established under statute3 and operates as a State OwnedEnterprise (SOE). ESB is majority owned by the Irish Government withthe Minister for Finance and the Minister for Communications, Energyand Natural Resources holding 85% and 10% respectively of ESBsissued share capital. The remaining 5% of the issued share capital isheld by an Employee Share Ownership Trust.

5. ESB is the licensed owner4 of the electricity transmission anddistribution systems in the State.

6. For the year ending 31 December 2009, ESB Group generated aworldwide turnover of approximately 3,014 million including a

turnover of approximately 2,829 million in the State.

1 Engineering Consultancy services include the provision of project management, surveying,

electrical, mechanical and civil design, environmental studies and the preparation of submissionsfor planning consents.2 In the State the granting of licences for the ownership and operation of electricity transmissionand distribution systems is governed by the Electricity Regulation Act, 1999; the EuropeanCommunities (Internal Market in Electricity) Regulations 2000 and 2005; the ElectricityRegulation (Amendment) (Single Electricity Market) Act, 2007; and, the European Communities(Internal Market in Electricity) (Electricity Supply Board) Regulations 2008. In Northern Ireland,the electricity sector is governed principally by the Electricity (Northern Ireland) Order 1992 (asamended) and the Energy (Northern Ireland) Order 2003 (as amended).3 ESB was established by the Electricity (Supply) Act 1927 and operates pursuant to theElectricity (Supply) Acts 1927 to 2006.4 The licensed operator of the electricity transmission system is EirGrid plc. ESB NetworksLimited is the licensed operator of the electricity distribution system in the State.

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Table1: Overview of the Electricity Sector in the State and NorthernIreland

The State Northern Ireland

Segment Owner Operator Regulator Owner Operator Regulator

GenerationESB andothers

ESB andOthers

CERESB andothers

ESB andothers

NIAUR

TransmissionSystem

ESB EirGrid CER NIE SONI NIAUR

DistributionSystem

ESBNetworks

ESBNetworksLtd

CER NIE NIE NIAUR

Suppliers

(SEM) (ESBand others)

N/A Various CER N/A Various NIAUR

Source: Market inquiries by the Competition Authority

7. Although ESB has also established a retail presence in Northern Irelandthrough its subsidiary ESB Independent Energy, this company onlysupplies electricity to industrial and commercial customers. ESB doesnot at present supply electricity to domestic customers in NorthernIreland.

8. ESB is also active in electricity generation in Northern Ireland throughits ownership and operation of the Coolkeeragh CCGT plant. As an

electricity generator, wholesaler and retail supplier on the island ofIreland, ESB is obliged to compete in the Single Electricity Market onthe island of Ireland.

9. The Single Electricity Market (SEM) came into operation in 2007 andis based on the concept of a gross mandatory pool.5 This requiresthat all generators with a generation capacity of 10MW or greatermust, as part of their licence conditions, make their output available tothe SEM. In addition, generators are prohibited from entering intoagreements for the supply of their output outside of the SEM.

10. All electricity generators in the State must obtain, from the CER, anAuthorisation to Construct or Reconstruct a Generating Station and aGenerator Licence. Over the past decade, the amount of available

installed generation capacity across the island of Ireland has increasedby over 90%.6 The increase in new capacity has come partly fromindependent generators and partly from entities connected to theincumbents such as ESB Independent Generation (which is obliged tooperate at arms length from its parent via a ring-fencing

5 Electricity Regulation Act 1999 (Market Arrangements for Electricity) Regulations 2003.6EirGrid plc, the electricity transmission system operator in the State, prepares an annualgeneration adequacy report, the latest edition of which is Generation Adequacy Report 2010-

2016.

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arrangement). Figure 1, below, illustrates the growth of installedcapacity by company from 2002 to present.

Figure 1: Growth in all-island installed capacity by

company

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

MW

Wind NI

Wind ROI

Bord Gais

AES

Premier

Power

Tynagh

Aughinish

Edenderry

Viridian

PPB

Endesa

ESBI

ESBPG

Source: SEM Market Monitoring Unit August 2010.

11. There is currently about 1,400 MW7 of renewable electricity generation,mainly in the form of wind farms, connected to the electricitytransmission and distribution systems in the State. This figure isexpected to rise sharply over the next few years as a further 1,500 MWof generation capacity from wind farms which are currently under

development becomes available. There is currently 297 MW ofrenewable electricity generation capacity connected to the transmissionand distribution systems in Northern Ireland with a further 1,200 MWof capacity from new wind farms due to become available over thenext few years.8

12. In keeping with the Irish Governments decision to increase its targetfrom 33% to 40% of electricity consumption coming from renewablesources by 2020, the CER set the size of applications it would considerfor connection to the transmission and distribution systems in the thirdround of connection offers known as Gates9 at 3,900 MW.10

13. Due to their smaller size, relative to conventional power plants, windfarms are in most cases connected to the distribution system ratherthan to the transmission system. The CER adopts a Group Processing

7 Mega Watts (MW)8Planning permission has not yet been secured for 961 MW of this figure of 1,200 MW. Source:EirGrid, Renewables Integration Development Plan.9Gate 3 is the third in a series of CER renewable connection decisions since 2005, under theGroup Processing Approach to Renewable Connections. The process allows for a large number ofapplications for system connections to be dealt with simultaneously.10National Renewable Energy Action Plan, submitted by the Government of Ireland under Article4 of Directive 2009/28/EC.

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Approach for connection of wind farms under which a number of windfarms in close proximity share the same connection line. Thisapproach ensures that new capacity is added to the electricitytransmission and distribution systems in a scheduled way allowing forany related re-enforcement of the electricity transmission ordistribution systems to be conducted ahead of the connection.

14. Table 2 below provides an overview of the main electricity generatorsin the State and their estimated market share of electricity generationin the SEM.

Table 2: Share of Installed Generation Capacity by Company 2006-

2010 on the island of Ireland

Company 2006 2007 2008 2009 2010

AES 0.0% 0.0% 0.0% 0.8% 0.7%

Aughinish 1.8% 1.7% 1.7% 1.6% 1.5%

Bord Gais 0.0% 0.0% 0.0% 0.0% 3.9%

Edenderry 1.3% 1.2% 1.2% 1.1% 2.0%

Endesa0.0% 0.0% 0.0% 9.7% 8.9%

ESBIg 7.9% 7.5% 7.1% 6.9% 7.4%

ESBPG 48.8% 46.1% 43.8% 32.6% 29.8%

PPB 18.2% 17.2% 16.4% 14.2% 13.1%

Premier Power 0.0% 0.0% 1.7% 3.3% 3.0%

Tynagh 4.3% 4.0% 3.9% 3.7% 3.4%

Viridian 3.8% 7.8% 7.4% 7.2% 6.6%

Wind ROI 8.1% 8.2% 10.1% 12.0% 12.3%

Wind NI 1.3% 1.9% 2.7% 3.0% 3.4%

MoyleInterconnector 4.5% 4.3% 4.1% 3.9% 3.6%

Total100.0% 100.0% 100.0% 100.0% 100.0%

Source: SEM Market Monitoring Unit August 2010

15. ESBs market share of generation has fallen over the past four years;however, it maintains considerable price setting ability through itsownership of peaking plants, which set the price in the SEM when thesupply margin is tight. Endesa, a Spanish-owned energy company,entered the market in 2009 through the purchase of a portfolio ofplants and potential sites from the ESB with a capacity of 1,068 MW.Bord Gis has built a portfolio of generation plants through theacquisition of a renewable energy company, SWS, and the constructionof a 445 MW Combined Cycle Gas Turbine (CCGT) plant in Whitegate,County Cork.

16. Although a number of companies have entered the generation marketin recent years, ESB, Viridian and their affiliated companies retainsubstantial interests in electricity generation. ESBs two key electricitygeneration portfolios are ESB Power Generation (ESB PG) and ESBIndependent Generation (ESBIg) with a combined market share of37.2% of installed capacity. Viridian Power and Energy (VP&E) ownsconventional (thermal power plants) and renewable generation (wind

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farms) in the State while NIE PPB11 is Viridians power procurementbusiness in Northern Ireland.

17. The regulatory obligations faced by generator operators in the Stateand in Northern Ireland are sufficiently homogeneous to suggest thatthere is a single electricity generation market on the island of Ireland.Once connected to the electricity transmission systems in NorthernIreland or the State, the electricity generator is required to sell all itsgeneration capacity through the SEM.

Electricity Transmission and Distribution on the island ofIreland

The Electricity Transmission System

18. In the State, ESB is the licensed owner of the electricity transmissionsystems assets (TAO). EirGrid plc (EirGrid), a state-ownedcommercial company and independent of ESB, is the designatedlicensed operator (TSO) of the electricity transmission system.

19. The terms of the TAO licence issued by CER to ESB12 require that, inthe State, ESB must ring-fence its electricity transmission systemownership business from its generation and supply interests. Also,ESB must separate its electricity transmission system ownershipbusiness from its other business activities.13 To comply with thiscondition, ESB Networks, an independently managed business unit ofESB, exercises the ownership functions. Other conditions contained inthe TAO licence include the following requirements:

ESB must have separate TAO accounts from its electricitygeneration and supply businesses;14

ESB must ensure that its TAO business does not give subsidy orsubsidies to any of its electricity generation and/or supply

businesses;15

and

ESB must preserve the confidentiality of any commerciallysensitive information received by its TAO business.16

20. As stated above, EirGrid is the licensed operator17 of the electricitytransmission system in the State and, in accordance with its statutoryand licence obligations, ensures the operation, maintenance anddevelopment of the electricity transmission system.

21. ESB, through ESB Networks, is required to ensure the maintenanceand construction of the electricity transmission system in accordancewith the development plan of EirGrid. An infrastructure agreement,18approved by CER, facilitates the operational interaction between ESB

Networks and EirGrid.

11NIE Energys Power Procurement Business.12 The TAO licence was issued by CER to ESB in 2001 in accordance with the EuropeanCommunities (Internal Market in Electricity) Regulations 2000, S.I. No. 445 of 2000.13 Condition 13 of the TAO licence Separation of the Transmission System Owners Business.14Ibid, Condition 14.15Ibid, Condition 15.16Ibid, Condition 16.17 CER issues the TSO licence to EirGrid pursuant to S.I. 445 of 2000.18 This Infrastructure Agreement was entered into on 1 July 2006.

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22. In relation to its electricity transmission system ownership business,ESB earns revenue principally through (a) connection charges onelectricity generators for the cost of building a connection to thetransmission system and (b) Transmission Use of System (TUoS)charges, which are designed to cover the cost of operating anddeveloping the electricity transmission system. The TUoS is calculatedto recover 25% of the electricity transmission system related costsfrom electricity generators, with the remaining 75% being recoveredfrom customers.

23. TUoS charges are regulated by CER and collected by EirGrid. Thisrevenue is then passed on to ESB Networks to pay for the maintenanceof the electricity transmission system and funding of its transmissionasset base.

The Electricity Distribution System

24. In the State, ESB (through ESB Networks) is the licensed owner of theelectricity distribution system assets (DAO). ESB Networksgenerates revenue from charges for DAO functions.

25. The operation of the electricity distribution system in the State isconducted by ESB Networks Limited, a separate wholly-ownedsubsidiary of ESB. ESB Networks Limited, as the licensed distributionsystem operator (DSO),19 is responsible for planning, development,construction, operation, maintenance and connection to the electricitydistribution system. ESB Networks Limited is also responsible for theinstallation, maintenance and reading of electricity meters. ESBNetworks Limited, as DSO, earns revenue principally through chargesfor these DSO functions. These charges are regulated by CER.

26. According to the terms of the DAO and DSO licence, the ownership andoperation functions are ring-fenced from ESBs electricity generation,transmission and supply businesses.

Interconnection of the NIE and ESB electricity transmission systems

27. Connectivity between the two electricity transmission systems islimited at present and as a result the flow of electricity across theisland of Ireland is constrained. The electricity transmission systemsare currently linked by a 275kV double circuit line between CountyLouth in the State and Tandragee, County Armagh in Northern Ireland.Also, there are two 110kV stand-by North-South Interconnectors whichprovide an alternative connection in the event of an outage of the main275kV line. The diagram in Annex 1 illustrates the electricitytransmission systems in Northern Ireland and the State.

28. At present the electricity transmission system in Northern Ireland islinked, via the Moyle interconnector, to a transmission system inScotland. Capacity on the Moyle interconnector is largely confined tothe import of electricity. Construction is under way on the East-Westinterconnector, between the State and Wales, which will allow theimport and export of up to 500MW of electricity.

29. To increase the electricity transfer capacity between the two electricitytransmission systems a new North-South interconnector is (subject to

19 DSO licence issued pursuant to S.I. No. 280 of 2008.

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planning permission) planned. According to CER, this new North-Southinterconnector will reduce the electricity transmission systemsoperating costs, strengthen electricity supply on both systems andsupport greater competition in electricity generation and supply on anall-island basis.20

30. Through the development of the East-West interconnector, and thusfurther interconnection with neighbouring EU Member States,competition in the SEM is expected to improve. The East-WestInterconnector will have a capacity to import 500 MW onto the Irishtransmission system from other Member States. The additional importcapacity is likely to reduce the market share of incumbent generatoroperators on the island of Ireland. The East-West interconnector isexpected to result in an increase in the amount of available powerequivalent to that of a large CCGT generation plant.

31. The interconnector is expected to increase the quantity of electricityavailable on the island of Ireland and make it easier for retail suppliersto purchase electricity in the quantities that best fit the consumptionpatterns of their customers.21

Ownership of the transmission and distribution systems

32. Under the current arrangement, the ESB as TAO owns the transmissionnetwork while Eirgrid as TSO is responsible for planning and day-to-day operations.

33. The Competition Authority supports the preference of the EUCommission for unbundling of the electricity transmission systemsfrom other stages of the electricity production process. Compulsoryvertical separation of the contestable stages of the electricityproduction process (generation and retail supply) from the naturalmonopoly element (transmission and distribution) is a key feature ofliberalised electricity markets internationally and has been applied in a

limited form in the State and Northern Ireland.

34. From a purely competition perspective, unbundling improves thecompetitive landscape by ensuring that all generators, whether theyare incumbents or new entrants, have equal access to the network andthat they are treated in a non-discriminatory way with regard tomaintenance of existing connection lines.

35. A vertically integrated firm has an incentive to shift costs from thecompetitive business to the regulated network. In doing so, the firmcan inflate the cost of the regulated portion of its asset base and soaim to increase the level of allowable network charges of all networkusers. At the same time, the cost base for the competitive business islowered through cross subsidies which distorts price competition

among competing generators.

36. The inclusion of the assets of a monopoly network as part of itsregulated asset base (RAB) gives the ESB a considerable advantage

20 According to information published on the website for CER at: www.cer.ie21With the increase in interconnectivity between the two electricity transmission systems it islikely that in the future, just as with the SEM, the regulatory conditions in the State and NorthernIreland may be sufficiently homogeneous to suggest a single electricity transmission system.However, this does not affect the Authoritys competitive assessment in relation to the proposedtransaction.

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over its competitors in raising finance for new investment. The ESBSdiverse portfolio of risky generation plants and riskless network assetslowers its overall risk profile allowing the company to raise capital at alower rate of interest than its privately owned competitors.

37. Regardless of the best efforts of regulators to ringfence certainmonopoly functions from its more competitive activities, there stillexists an implicit assumption among competitors that the ESB hascertain financial and informational advantages over its competitors.

38. Unbundling benefits the network as a whole if it lowers the cost ofcapital expenditure. New investments in transmission have to beundertaken carefully because they are essentially irreversible andaffect the operation of the system as a whole. Utilities that are naturalmonopolies can raise finance through debt at a significantly lower costthan a firm engaged in competitive activity.

39. As the amount of capital expenditure on the all-island transmissionsystem is expected to increase in the near future as the transmissionand distribution systems must be extended to transport renewablegeneration from remote areas, the cost of financing this investment

will become an increasingly important component of the overall priceof electricity paid by Irish consumers.

40. Transmission assets have a very long life (often 20 to 40 years or evenlonger), and systems have built up over many decades. These systemsare not generally optimised to current generation and load profiles butrather must take a forward looking view of the system as a whole. Forthe purposes of ensuring transparency and accountability this approachrequires long term planning and implementation by an independentagency that has no conflicting economic interest in generation orsupply.

41. A dominant generator may be reluctant to invest in a regulatednetwork if it is obliged to share that network with its rivals as theexpansion of transmission capacity threatens the profitability of thegeneration business.

42. At present the CER approves the charges that Eirgrid can set for theuse of the electricity transmission systems following a review processwhich is conducted on a five-year cycle. This review process iscomplicated by the fact that Eirgrid does not own the underlying assetswhich it is responsible for managing and, as a consequence, many costfactors that determine the companys financial performance are outsideEirgrids direct control. Transferring the assets to Eirgrid would place agreater degree of accountability on Eirgrid both in terms of how itmanages the networks existing asset base and in how it financesfuture capital expenditure.

43. Regulating a utility is a difficult and complex task requiring an in-depthknowledge of the industry and close supervision by the regulatorybodies. It is not the role of the Authority to comment on the CERsapproach and methodology for setting network charges but it wouldappear that this task would be more straightforward and transparent ifthe transmission assets were owned and operated by a single companywhich would be directly accountable to the CER.

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ESBs acquisition of NIE Energy

44. In October 2010 the Competition Authority cleared the ESBsacquisition of the Northern Ireland electricity transmission anddistribution systems owned by NIE, a subsidiary of the Viridian Group.

45. The acquisition was cleared after an extensive preliminary (Phase 1)investigation in which the ESB offered proposals to address theCompetition Authoritys concerns that, post-acquisition, ESB would bein a position to acquire and use commercially sensitive information thatwould provide ESB with the ability and incentive to prevent, restrict ordistort competition in the generation and supply of electricity on theisland of Ireland.

The Single Electricity Market

46. The Single Electricity Market (SEM) came into operation in 2007 tofacilitate the purchase and sale of electricity at the wholesale level onan all-island basis. Legislation was enacted in both the State andNorthern Ireland to underpin the SEM: the Electricity Regulation(Amendment) (Single Electricity Market) Act 2007 in the State and the

Electricity (Single Wholesale Market) (Northern Ireland) Order 2007 inNorthern Ireland.

47. The SEM is based on the concept of a gross mandatory pool,22 whichrequires that all generators with a generation capacity of 10MW orgreater must, as part of their licence conditions, make their outputavailable to the SEM. In addition, generators are prohibited fromentering into agreements for the supply of their output outside of theSEM.

48. Ring-fencing arrangements were also imposed by the CER and NIAURon the ESB and NIE prior to the launch of the SEM. The generationaffiliates of ESB and Viridian must operate as separate businesses from

their retail supply businesses, ESB Customer Supply and NIE EnergySupply.23

49. Ring-fencing requires that the individual business must have separatemanagement and financial accounts. Ring-fencing also prohibits cross-subsidies and imposes an obligation that all contracts betweenaffiliates of the same company are on an arms length basis and onnormal commercial terms. In the absence of ring-fencing, generatorsmight have an incentive to sell electricity to their affiliated supplycompanies at below the price that other retail suppliers would bewilling to pay, to the detriment of rival suppliers.

50. The Economic Purchasing Obligation, (EPO), is central to the ring-fencing approach.24 The EPO requires ESB Customer Supply and NIE

22 Electricity Regulation Act 1999 (Market Arrangements for Electricity) Regulations 2003.23 The CER and NIAUR consulted on appropriate ring-fencing arrangements for incumbentSuppliers in August 2005 (AIP/SEM/74/05) and again as part of a broader consultation paper inFebruary 2007 (AIP/SEM/07/16) which was then followed by a decision in June 2007(AIP/SEM/304/07).

24 Under Section 9 of the Public Electricity Supply Licence granted to ESB Customer Supply, thereis an obligation placed upon the Public Electricity Supplier licence holder to purchase electricity onterms approved and /or directed by the CER. These terms are agreed between the ESB and theCER annually through the Hedging Methodology and Hedging Policy Statements.

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Energy Supply to purchase electricity from the SEM in a manner that iseconomic, fair and transparent.

Regulation of the SEM

51. The SEM Committee exercises regulatory functions on SEM mattersand is comprised of three NIAUR representatives, three CERrepresentatives, an Independent Member and a Deputy IndependentMember.25 The SEM Committee is empowered under legislationenacted in both jurisdictions to establish the SEM. The governancestructure of the SEM is outlined in figure 2 below.

Figure 2: The governance structure of the SEM.

Source: SEM Annual Report 2009

SEM Operation and Pricing

52. The day-to-day operation of the SEM is conducted by the SingleElectricity Market Operator (SEMO), a joint venture between EirGridand SONI. The activities of SEMO are overseen by CER and NIAUR.

53. The price of electricity (System Marginal Price) is set for each half-hour period of the day through a market clearing mechanism operatedby SEMO. The individual generation plants must submit bids thatreflect their individual Short Run Marginal Cost (SRMC). This principleof cost reflectivity is set out in two places: the generation licences26

25Further biographical details of the current SEM Committee members are available at:http://www.allislandproject.org/en/SEM_members_profile.aspx 26 CER Generic Electricity Generation Licence, Condition 15: Cost-Reflective Bidding in the SingleElectricity Market, available to download from the all-island project website:http://www.allislandproject.org/en/generation.aspx?page=2&article=f51097ff-25d3-40dd-8c73-48264829e2b2

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and in the SEMs Bidding Code of Practice. The generation licencesinclude as a condition, compliance with the Bidding Code of Practice.27

54. The SRMC principle is defined broadly in the generation licences as thecost of generating electricity minus the cost of not generatingelectricity. Therefore in addition to their fuels costs, generators mustalso provide technical data relating to their individual start-up costs,carbon emission costs and minimal ramping costs. The Bidding Codeof Practice stipulates that the cost of fuel commodities such as gasshould be referenced to the prevailing spot price of gas on a liquidaccessible market.

55. There is significant volatility in System Marginal Price (SMP) with theprice for each half-hour period ranging from 3.29/MWh to696.85/MWh, over the first 30 months of the SEM with an averageSMP of approximately 60/MWh.28 The price volatility observed is dueto the variety of factors that affect the SMP such as:

fuel prices typically the largest component of generatorsbids;

generator efficiency the efficiency at which a generation plantconverts fuel to electricity and affects the bids they submit tothe SEM;

generator availability from both the more predictable pricemakers and the less predictable price takers;

generator start-up costs included in the overall SMP, throughUplift; and

demand this normally follows a standard profile and load overthe day, while varying across the seasons. But demand can besubject to significant changes in the short term due toinfluences such as changes in temperature, and in the longerterm due to changes in economic growth.

56. In addition to the revenues from supplying the wholesale market atlowest cost, generators also receive a second revenue stream throughthe Capacity Payment Mechanism in which an annual capacitypayments pot is determined prior to the start of each year. This potis then collected from suppliers in accordance with the rules set out inthe Trading and Settlement Code.

57. Capacity payments are intended to incentivise generators to remainavailable to supply electricity whether they are dispatched or not.Peaker plants rely heavily on capacity payments as they are only calledupon during periods of high demand while baseload plants operate

continuously to supply the wholesale market.

27 The Bidding Code of Practice A Response and Decision Paper 2007. Available to download fromthe all-island project website: www.allislandproject.org

28 Market Monitoring Unit, SEM Market Power & Liquidity, State of the Nation Review, AnInformation Paper, SEM-10-057, published 23 August 2010.

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58. As Ireland becomes more dependent on renewable generation for itselectricity supply, and as wind is an intermittent source of electricity,peakers powered by conventional fuel sources will play an increasinglyimportant role in balancing demand and supply. Historically, peakerswere expensive to operate because of their fuel (oil) and the highramp-up costs of generating from a cold start. If they are to form thereserve for a system dependent on wind it is essential that peakersoperate as efficiently as possible to keep the cost of the last unit ofelectricity necessary to meet demand as low as possible. Open CycleGas Turbines (OCGTs) provide an alternative to oil burning plants andthe latest technology allows them to operate more efficiently than theirpredecessors.

59. There is concern among industry participants that the capacitypayments system in its current form offers specific incentives forinvestment in the latest peaker generation technology. A number ofpeakers still in operation in Ireland are at the end of their operationallives and would have been replaced by now if it were not for theavailability of capacity payments. The CER and NIAUR are planning aconsultation to review the capacity payments mechanism as there isconcern that the current arrangements favour the ESB as the legacy

owner of peakers plants.

60. The current mechanism rests on the assumption that the regulatorscan accurately estimate the fixed costs of a Best New Entrant plant.Since much of the data used for this calculation must come from theelectricity production industry itself it is in the collective interest of allmarket participants to submit data that inflate the costs of a Best NewEntrant in order to increase the size of the entire capacity paymentspot.

61. Retail suppliers purchase electricity from the SEM to fulfil theircustomers consumption requirements.29 The SEM operates as a spotmarket for electricity in which retail suppliers purchase electricity at

the SMP for each trading period. In addition to the SMP, retailsuppliers also pay for capacity costs and system charges. Given thatprices in the SEM are largely determined by international fuel pricesand suppliers are price takers, these firms are exposed to aconsiderable degree of short term price risk. Retail suppliers canachieve a greater degree of price certainty by the use of Contracts forDifference (CfDs) with generators. CfDs ensure that the two partiesto the contract (the generator as the seller and the supplier as thebuyer) are not exposed to volatile price movements in the SEM. If theaverage SMP is lower than the price struck (the strike price) by theparties to the contract then the retail supplier compensates (pays) thegenerator the difference. If the SMP is higher than the strike price,then the generator pays the supplier the difference.

62. The SEM features a range of market power mitigation measures thatspecifically address concerns about the high market shares ingeneration held by ESB and Viridian. These measures include:

29 In the State the retail supply of electricity was fully de-regulated in 2005. Examples ofcompanies active in this market are Airtricity and Brd Gais Energy. ESB Networks Limitedcontinues to provide meter reading and data management services for all suppliers andcustomers.

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(i) the principles contained in the Bidding Code of Practice whichstipulate that bids must reflect Short Run Marginal Cost;

(ii) ongoing market monitoring to enforce compliance with thebidding principles;

(iii) the obligation on generators with large market shares to makea portion of their capacity available to other market participantsthrough the provision of a particular type of CfD known as aDirected Contract (DC). These contracts are directed as theprices and quantities of the DCs are mandated by theregulators;

(iv) ring-fencing of each of the generation and retail businesses ofESB and Viridian, and

(v) a targeted package of certain local market power mitigationmeasures that must, if necessary, be operated for localtransmission concerns and are aimed solely at generators whoface no effective competition.

Competition issues in the electricity sector

63. In electricity as each stage of the production process is sointerdependent the choice appears to be between full deregulation ornone at all and the worst possible outcome is an unworkable hybrid ofthe two.

64. Considerable progress has been made in opening up the Irishelectricity sector in recent years and the creation of the SEM inparticular is a considerable achievement. However, there remain anumber of outstanding issues which must be addressed in order toensure that electricity is more competitively priced. The priorities forfurther restructuring of the electricity are:

The CER has committed to deregulating the retail supply marketonce ESBs market share falls to 60% which is expected to takeplace early next year based on current switching rates;

There is considerable potential for the development of asecondary market in supply contracts which would allowgenerators and retail suppliers to hedge their exposure to thevolatile spot market;

Full ownership unbundling of the transmission network toEirgrid would bring a greater degree of transparency inregulating the natural monopoly and hold a single entityresponsible for funding and execution of capital expenditure

projects; and

The current capacity payments mechanism could be revised tooffer greater incentives for investment in new peakers as thecurrent mechanism seems to be overly generous in payingoutdated plants which have been fully depreciated.

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A. APPENDIX A

Map of the Electricity Transmission Systems in Northern Ireland and

the State.

Voltage Total

(km)400kV 440

220kV 1,875

110kV 4,470

....

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