Effects of CfD and UK Market Reforms on US Wood Pellet Market

Background

Demand for US-produced industrial wood pellets is largely being driven by the multiple challenges the UK electricity market is facing. Department of Energy and Climate Change (DECC) models currently estimate that:

• As much as one-fifth of its generation capacity will close by 2020.
• Demand for electricity could double by 2050 as the UK economy grows and heat and transport systems are electrified.

At the same time that it is facing reduced supply and increased demand, the country must also meet its commitment to renewable energy production and greenhouse gas emissions reductions:

• Renewable sources of energy must make up 15 percent of all energy used by 2020.
• Greenhouse gas emissions must be reduced by 80% (relative to 1990 levels) by 2050.

To meet these challenges, DECC’s model predicts that an additional £110 billion (US $175 billion) of investment in new capacity will be required. While not all of this investment will be funneled into biomass power stations, the probability that UK utilities will continue to convert and construct biomass capacity is high, primarily because biomass can be used for base load power, unlike solar and wind, which are intermittent sources of electricity.

In order to shape the way these challenges are met, DECC introduced Electricity Market Reform (EMR) in 2012. According to DECC, “The reforms are designed to provide investors with transparency, longevity and certainty in order to attract £110 billion of investment to bring forward new low-carbon power generation for the 21st Century.” Simply stated, the goals of the program are “to decarbonize electricity generation; to keep the lights on; and to minimize the cost to consumers.”

Electricity Market Reform

EMR includes four main elements:

• Long-term Contracts for Difference (CfD) that are designed to boost investment in new, low-carbon generation.
• An Emissions Performance Standard (EPS) that will limit the amount of emissions new fossil fuel power stations can emit.
• A mechanism to establish a Carbon Price Floor (CPF), or minimum carbon price, which is intended as an early and credible signal for those making investment decisions.
• A Capacity Market that will support investment in generation and demand-side response capacity, intended to secure electricity supplies during times of peak demand.

Decarbonizing Electricity Generation at Least Cost to Consumers: CfDs

Contracts for Difference are Power Purchase Agreement (PPA) provisions. They are private law contacts between independent generators and suppliers that pay either the generator or supplier the difference between the reference price (an estimate of the market price for electricity) and the strike price (an estimate of the long-term price needed to encourage investment in a given technology). By reducing the commercial risk of price volatility, CfDs are intended to encourage investment in low-carbon power stations. When the reference price is lower than the strike price, the system will pay the generator the difference and when the reference price is higher than the strike price, the system will pay the supplier the difference.

The development of a CfD policy was specifically meant to encourage investment in independent generation. Acknowledging that large integrated energy companies alone will not be able to meet new levels of demand, the UK government was looking for ways to encourage a broad investment base.

Which Wood Pellet Buyers Qualify for CfDs?

Because CfDs will replace the RO program, they are the most important element of the EMR for industrial wood pellet manufacturers in the US. Which wood pellet buyers will be eligible for CfDs? Currently, the UK government classifies biomass facilities in one of four categories:

• Co-firing (coal with biomass)
• Conversion (from coal to 90-100 percent biomass)
• Dedicated biomass (90-100 percent biomass)
• Dedicated biomass (90-100 percent biomass) with combined heat and power (CHP)

Of these four categories only biomass conversions and dedicated biomass with CHP will be eligible to participate in the program. Why? DECC has declined to set a strike price for biomass co-firing plants from the program as a way of incenting full conversions, which are more sustainable and provide a higher level of renewable generation. They have similarly not set a strike price for dedicated biomass, as they wish to incent the more efficient technologies such as CHP.

Other EMR Provisions

While other provisions of the EMR will not directly affect the prospects of industrial pellet producers directly, they will work to incentivize investments in renewable energy sources, which overall has a positive effect on the industry.

• The Emissions Performance Standard will apply to all new fossil fuel power plants with a capacity over 50 MW. The carbon emissions cap will be set at 450 g CO2/kWh at baseload. Once in effect, the standard will allow the commissioning of only those new coal power stations that are fitted with Carbon Capture and Storage (CCS) technology.
• Finally, the Carbon Price Floor, which is already in effect, ensures that a minimum carbon price is maintained by imposing a tax on fossil fuel supplier to UK generators.
• Capacity Market: With the increase in the amount of UK electricity that is generated by nuclear and intermittent renewable sources like solar and wind, there has been some concern that the electricity supply might be insufficient to meet peak demand. To keep the lights on, DECC has proposed the formation of a Capacity Market that will work on both the supply and demand sides of the issue. The Government will hold auctions in which companies will bid either to provide an increased supply or agree to reduce their electricity use.

• Supply – Companies agree to set aside generating capacity that will only be used when there is a shortfall in electricity supply.
• Demand – Companies agree to limit usage during times of peak demand or permanently.