ENERGY STORAGE

Will proposed UK long duration storage cap and floor regime work?

The UK government has proposed a cap and floor mechanism to unlock private investment in long-duration storage, but there are doubts about whether it will plug all funding gaps, as well as concerns that asset operators may ‘game’ the system

BEN COOK

January 18, 2024

  • UK government has proposed cap and floor mechanism to ‘unlock private investment’ in long-duration storage
  • But sceptics say cap and floor may not work because long duration storage is not sufficiently well-established & mechanism would not plug all funding gaps
  • Concerns that asset operators could ‘game’ the cap and floor regime
  • Developers say cap and floor regime must be introduced as soon as possible to enable them to take final investment decisions

Last week, the UK government issued a clear signal that it supports the idea of taking steps to foster the wider deployment of long duration energy storage (LDES). In its consultation long duration storage document, the Department for Energy Security & Net Zero (DESNZ) cited research that showed deploying up to 20GW of long duration storage could result in  estimated “system savings” of up to £24 billion.

The business case is clear. However, there’s a problem. As the DESNZ highlighted in the consultation document, a previous ‘call for evidence’ on facilitating the deployment of LDES in July 2021 had identified several “significant barriers” that were prohibiting the necessary growth in long-duration technologies. The barriers included:

  • a lack of revenue certainty
  • high upfront capital costs, and
  • long build times.

Cap and floor regime proposed for long duration storage

So what is the DESNZ proposing as a potential solution to these problems. A key recommendation set out in the consultation document is the introduction of a cap and floor regime. One of the key reasons for proposing such an instrument is that the British electricity regulator Ofgem is already operating a cap and floor regime to enable investment in electricity interconnectors, which allow trading of electricity between Great Britain and neighbouring energy markets.

How does the interconnector cap and floor regime work? The regime provides a minimum revenue certainty for investors (floor) to provide debt security and a regulated limit (cap) on revenues to avoid excessive returns. When revenues fall below the floor level, they are topped up by consumers through the financing mechanism. Conversely, when revenues breach the cap, excessive returns are “passed on to the consumer”, according to the DESNZ.

Reducing the weighted average cost of capital

Having considered a number of options, the DESNZ concluded that a cap and floor mechanism is the “most appropriate policy” for enabling investment in LDES. “A cap and floor scheme would unlock investment from private sources by providing a revenue guarantee, giving investors reassurance that they will receive a return on their stake, as has been demonstrated in the interconnector scheme,” the DESNZ argued in the long duration storage consultation document. The DESNZ is also confident that a cap and floor regime for long duration storage would reduce the weighted average cost of capital (WACC) for LDES projects by reducing the overall investment risk, which, the department said, is particularly important in addressing the high upfront costs associated with developing LDES and overall system costs.

The renewables and energy storage sector’s response to the proposals for a cap and floor regime has been largely positive. The Association for Renewable Energy and Clean Technology said the proposals represented a “major win”, while pumped hydro storage operator Drax said it welcomed the government’s decision to opt for a cap and floor mechanism, saying “the existing lack of a suitable investment framework means it is challenging to secure private investment for projects such as new-build pumped storage hydro plants”.

What are the alternatives to cap and floor?

Opting for a cap and floor regime means the UK government appears to have ruled out other possible mechanisms for providing investors with certainty regarding revenues. Other possible options previously proposed included:

1. Contract for difference

Under this type of mechanism, if wholesale power prices fall below a defined level during certain time periods, providers would receive a £MWh strike-price for electricity discharged onto the system. Drawbacks: Critics say a contract for difference regime would be complex and costly to implement and fail to incentivise efficiency.

2. RAV model

Under a regulated asset value (RAV) mechanism, long duration energy storage assets are directly regulated with allowed revenues determined by Ofgem based on a RAV and a regulated allowed cost of capital. RAV is the value ascribed by Ofgem to the capital employed in the licensee’s regulated distribution or (as the case may be) transmission business (the ‘regulated asset base’) Drawbacks: Like contracts for difference, the downside of the RAV model is that it is complex and costly to implement and poses issues when trying to incentivise efficiency.

3. Reformed capacity market

This option would mean the existing capacity market (CM) could be reformed in order to ensure the sending of stronger long-term price signals for low-carbon flexibility. This option could potentially include a new auction for technologies with longer lead times. Another element could be the development of split auctions that allocate low carbon capacity first, allowing a potentially higher clearing price. Drawbacks: Some analysts argue that reforming the capacity market would not necessarily address the issue of “solving market failure”.

What are the potential flaws in a cap and floor regime?

However, while there is a view that, a cap and floor regime has fewer drawbacks that the aforementioned alternative mechanisms, there is a view that a cap and floor mechanism will be complex and costly and may distort the market. It is known that some consultants have warned energy storage companies that, while it may be possible to mitigate cost and market distortion-related issues, it will be a complex task. Meanwhile, it is also argued that the cap and floor regime was successfully implemented in the electricity interconnectors market because it was introduced at a time when that technology was much more established than LDES is.

How will cap and floor address technology risks?

Some analysts have also expressed doubts as to whether LDES technology risks will be effectively addressed by a cap and floor regime. The DESNZ’s proposal for addressing this problem is developing two distinct routes for applying, they are:

  • Stream 1: Established technologies with a Technology Readiness Level (TRL) of 9, a supply duration of at least 6 hours at a minimum capacity of 100MW
  • Stream 2: Novel technologies with a TRL of 8, a supply duration of at least 6 hours at a minimum capacity of 50MW.

The DESNZ claims that the creation of two streams “offers the fair balance of enabling investment in proven technology to be supported now, whilst also helping to mainstream less-developed technologies into the energy system, helping capitalise on the innovations and potential cost-reductions they offer”. However, sceptics will argue that this does not go far enough and that there will still be funding gaps that ultimately the government will be forced to plug. There is also a view that two separate funding streams adds further complexity to an already complex market.

Will asset operators ‘game’ the system?

Another concern raised is that asset operators, with the help of third parties, could ‘game’ the cap and floor regime by making agreements that exploit the cap and floor scheme for financial gain. In one possible scenario, an asset may have dropped below the revenue floor, meaning top-up payments are received from government, but the asset could – at the same time – sell electricity below market rate to a downstream supplier, as the asset will not lose-out on revenue as this will be topped up by the floor payments at the expense of the taxpayer.

Source: Department for Energy Security and Net Zero’s Long duration electricity storage consultation document

Cap and floor mechanism ‘needed by end of 2024’

Above all else, the UK government needs to act quickly. SSE Renewables has highlighted the DESNZ consultation paper as a “positive step forward” for the development of its Coire Glas pumped hydro storage project at Loch Lochy between Fort William and Inverness in Scotland’s Great Glen. However, Finlay McCutcheon, director of onshore Europe at SSE Renewables, warned that SSE’s ability to deliver a project on the scale of Coire Glas “hinges on reaching a positive final investment decision by late 2025 or early 2026 and will clearly rely on this consultation process yielding an investable cap and floor mechanism to be in place by the end of 2024”. And McCutcheon appears sceptical about the prospects of such a development. “Given the time taken to reach this point, much work is now needed to ensure an effective mechanism is finalised and put in place as early as possible this year to enable projects such as Coire Glas to move into construction.”