(This article was carried by the Guardian web site on 24.12.2014).

A mantra is inscribed on the walls of the UK Treasury. It reads ‘No subsidy without additionality’. In layperson’s language, this strange phrase means that the only justifiable purpose of handing a business a cheque is to get it to do something it wouldn’t otherwise do.

This golden rule was spectacularly flouted in the UK electricity capacity auction that was concluded last week. A billion pounds will be handed to generators in 2018 in return for doing precisely what they would have done anyway. Negligible amounts of new electricity generating capacity was drawn into the market and existing plants will not change their behaviour. Later in this article I’m going to look briefly at two successful participants in the auction – the pumped storage reservoirs and the nuclear fleet – to show why this is so.

The capacity auction got few headlines in newspapers. It sounds technical, abstruse and probably a nasty mixture of economics and physics. Actually, it was quite simple. All the electricity generators in the UK, plus quite a lot of owners of generating capacity that nobody quite knew existed, got together to offer to promise to keep their equipment working over the 2018/19 financial year.

The government wanted commitments from about 50 gigawatts of power generation (about the maximum demand likely to be placed on the National Grid in the winter of 2018/19) that the plants would be available during a ‘stress event’, or the couple of hours on a mid-December early evening when the lights might otherwise go out. Having got us all worried whether enough generating capacity will be available in the UK to meet peak demands later in the decade, the auction drew bids from far more generators than were actually needed.

Each generator, including all the nuclear power stations and the gas and coal station, put in its figure for the minimum price it would accept and these bids were ranked from zero upwards. The government looked at the price that was offered by the generator that just pushed the auction over its target of 49 gigawatts and agreed to pay that price to all the bidders. This was around £19 per kilowatt of capacity. In other words, if you have a 100 kW diesel generator at a factory, you will get a fee of £1,900 a year to guarantee that the generator will be available at all times. If it actually produced any power, it would in addition get paid at prevailing market rates for that electricity. Failure to respond to the call for power would cause the diesel generator to lose some (but not a lot) of its payment.

The supply and demand curves in the UK electricity capacity auction of December 2014. The generators are put in ascending order of their bids up to nearly 70 GW of capacity. Source: DECC report  on the operation of the auction. — The supply and demand curves in the UK electricity capacity auction of December 2014. The generators are put in ascending order of their bids up to nearly 70 GW of capacity. Source: DECC report on the operation of the auction.

When DECC first had the idea for a capacity auction, observers hummed with sympathetic approval. It sounds a very good way of keeping the lights on and incentivising new supply. If investors thought that they’d get a guaranteed yearly payments for a new gas turbine plant, they’d be more likely to stump up the cash to build the generating station.

Unfortunately the plan failed. Only a tiny amount of new capacity ‘won’ in the auction. When the full history is written, it’ll be seen that the failure occurred because, perhaps paradoxically, the price was too low. £19 a kilowatt a year may mean that consumers will have to pay an extra billion pounds for their electricity but it isn’t enough to get shareholders to stump up, for example, £800m or so for a new 1 gigawatt power station, earning about £19m a year from the capacity auction.

And why was the price so low? The reason is that existing power plants can easily offer to cover 49 gigawatts of need. Because these plants won’t actually have to do much - if anything - beyond their normal activities to guarantee to produce power at times when electricity is in shortest supply, they didn’t actually need any incentive. In fact, about 30 gigawatts of electricity generation was offered for virtually nothing. (But the rules of the auction said that the price that they will actually be paid is the price offered by the last winning bidder. This is a conventional feature of auctions).

Consider two important sources of electricity at the times of greatest demand at 5pm on mid-winter weekday evening: nuclear and pumped storage reservoirs. EdF put in bids to the capacity auction offering 7.9 gigawatts of power. (I mustn’t digress but I don’t think that EdF has actually delivered 7.9 gigawatts from its nuclear power stations at any stage of the winter so far, so its ability to deliver on the commitment must be questioned). Nuclear power station are meant to run all the time. It costs money to shut them down or run at a reduced load. No operator would ever voluntarily not have its nuclear stations working. There was no point whatsoever in allowing these power plants into the capacity auction and paying them about £150m a year to carry on doing what they want to do anyway.

Pumped storage plants, principally the fabulous Dinorwig plant in north Wales, present an almost equivalent absurdity. The role of Dinorwig is to buy electricity when it is cheap at 4.30 am, use it to pump water up hill and sell it when it is expensive at 4.30 pm by letting flow downhill through turbines. This is largely what the plant does every day of the year. Yet it is now being paid extra to perform what it is already very heavily financially incentivised to do.

In the case of Dinorwig’s owners, GdF Suez, the extra booty is about £35m a year. This is on top of the reported profits for last year of well over £100m for the mainstream operation of the plant. A plant, incidentally, that was built with state (CEGB) money initially and then sold at what must now seem a knockdown price in the flurry of privatisation twenty five years ago.

In all probability, Dinorwig and its three smaller cousins will not adjust their business tactics one iota as a result of the extra profitability they have been gifted by the capacity auction. So the UK has not gained any security of supply. And, we should add, the penalty for not being to deliver power at a ‘stress event’ in the early evening in December is just one month’s capacity payment of about £1.60 a kilowatt. Should Dinorwig’s owners spot a price spike that they can sell their power into for several hours, thus losing the capacity to provide electricity for a ‘stress event’ later in the same day, they may well choose to do so and pay the penalty.

This leads us to the most fundamental failure of the capacity auction; the almost complete absence of new electricity generation that has been successful in getting extra money to enter the UK electricity market. One obvious example is the proposed new pumped storage plant called Quarry Battery, located not far from Dinorwig in North Wales, which backed out of the auction before it finished.

Quarry Battery, which will cycle water between two old slate quarries at very different heights on a mountain, is a small (50 megawatt) generator that is exactly the type of new capacity the UK needs. For this plant, £19 a kilowatt probably isn’t enough. It has to raise private finance of over £160m and the annual capacity payment of about £1m would not make much difference to its cash flows, particularly since the 2018/19 auction would have meant a costly speeding up of its construction. The capacity auction has simply added to the income of existing generators, without pulling any new storage plants into the market. This is despite repeated assurances by government that enabling new storage to be constructed was a principal aim of the capacity auction.

Over on the continent observers frequently say we are watching ‘the utility death spiral’. As renewables gain in importance, power stations using fossil fuels are working fewer and fewer hours each year. The old generation companies are losing money. New coal and gas plants are almost impossible to finance. Eventually the old utilities will die. In the UK it looks as though the major generators have staved off the death spiral a little by capturing another billion pounds from consumers. That billion could have gone into energy storage units, power to gas facilities or renewable generators, such as anaerobic digestion plants, that can modulate their output to help match supply and demand, thus easing the transition away from carbon-based fuels. Unfortunately, the auction just bought off the large generators instead.