Introduction

Following publication of the Electricity Market Reform (EMR) consultation, after months of consultation, analysis and lobbying, the Government has published its White Paper 'Planning our electric future: a White Paper for secure, affordable and low-carbon electricity' (the White Paper) together with the UK Renewable Energy Roadmap (Roadmap).

Our view

  1. The White Paper seems to have taken on board many of industry's concerns.
  2. The broad architecture of the EMR proposals has been respected and there are no real surprises.
  3. Uncertainties surrounding some key details including who will be the counterparty for contract for differences (CFD) and how the CFD strike price will be set still remain.
  4. Transitional arrangements may pose risks for projects currently in development.

 

Renewable energy roadmap

The Roadmap sets ambitious targets for renewables, such as an 18GW target for offshore wind by 2020, which is to be warmly welcomed. However, it does not extend beyond 2020 and appears to be aimed squarely at those who are sceptical about the UK's ability to achieve its target under the Renewable Energy Directive (RED).  That target is for 15% of energy consumption in 2020 to be from renewable sources.

The Government's willingness to try to "pick winners" is evidenced by the fact that the Roadmap identifies the eight technologies "that have either the greatest potential to help the UK meet the 2020 target in a cost-effective and sustainable way, or offer great potential for the decades that follow." 

These technologies are:

  • onshore wind
  • offshore wind
  • marine energy
  • biomass electricity
  • biomass heat
  • ground source heat pumps
  • air source heat pumps
  • renewable transport

The Government seeks to reassure investors that it is aware of the hurdles with which they are confronted in respect of the key technologies identified above and that these are being addressed.  Many of these are of a generic nature, such as improving planning and consenting and completion of the accelerated banding review, implementing EMR and finalising the transition between this and the Renewables Obligation (RO).  Others are more specific, such as development of the supply chain for wind or supporting innovation in areas such as advanced conversion of waste.

 

White Paper proposals

The White Paper confirms the implementation of a package of measures in line with the EMR consultation:

  • a Carbon Floor Price (already implemented)
  • new long-term CFDs for low carbon generation, replacing the RO
  • an Emissions Performance Standard (EPS)
  • a Capacity Mechanism to ensure sufficient electricity supply

 

Emissions performance standard

An EPS regime applicable to new fossil fuel power stations will be introduced. The EPS will initially be set at a level equivalent to 450g CO2/kWh (at baseload) for all new fossil fuel plant, except for the UK Government's four intended Carbon Capture and Storage (CCS) demonstration plants. At this level the EPS does not impact on new CCGT projects.

The EPS will not apply retrospectively.  However, it will be reviewed as part of the process of three-yearly reports on decarbonisation under the Energy Act 2010 and once a frame-work is in place it will be tempting to tighten it.  Any changes in the level of the EPS will not apply to plant consented under the framework for a specified period.  Details of this 'grandfathering' will be determined following further engagement with stakeholders.  

 

Capacity mechanism

Higher levels of inflexible nuclear and intermittent wind generation will increase the risk of there being insufficient capacity to avoid generation-related supply interruptions or voltage reductions. In the absence of any intervention, the Government forecasts unacceptably low capacity margins. As such the Government proposed in the EMR consultation to introduce a capacity mechanism.

As a result of the concerns raised in EMR consultation responses, the Government has now issued a separate consultation alongside the White Paper, seeking views on alternative approaches to the introduction of a capacity mechanism.  The proposals are for either a targeted capacity mechanism which would be coupled with a strategic reserve or for a market-wide mechanism in the form of a capacity market.  It will need to be determined what the impact of these proposals may be on market prices more generally.

Contract for differences for low carbon generation

The White Paper is unambiguous in its intention to replace the RO for all new renewable generation projects from 31 March 2017 by the introduction of CFDs and the extension of this financial support to all large scale low-carbon electricity generation: nuclear power and coal-fired generation with CCS as well as renewable energy (low-carbon generation).

Although not widely reported, by a written ministerial statement on 18 October 2010 by Chris Huhne, the terms of the Coalition Agreement were "clarified" that "there will be no levy, direct payment or market support for electricity supplied or capacity provided by a private sector new nuclear operator, unless similar support is also made available more widely to other types of generation". This forms the political basis for provision of financial support for nuclear power.

What is a CFD?

Readers will by now be well versed in the concept of a CFD. In general terms a CFD is a contract to pay or be paid the difference between a notional market reference price and an agreed "strike price" (so that if the generator can sell its electricity into the wholesale market at the notional reference market price, it will receive in aggregate a revenue stream equal to the strike price). CFDs are intended to shift electricity market price risk from the generator to the consumer, reducing risk and the cost of capital for investors, allowing decarbonisation to be achieved at a lower cost.

The White Paper sets out more detailed plans regarding the model of CFD which will be introduced:

  • CFDs are expected to be signed from 2014. Renewable generators will have a choice between CFDs and the RO until 31 March 2017 when the RO will close to new projects.
  • CFDs will be technology specific and their design will alter according to low carbon generation type. The White Paper distinguishes between 'intermittent' and 'baseload' low carbon generation. However none of the CFD models will enable generators to retain electricity price up-side.

  •  

     Intermittent

     Baseload

    Contract form

    Two-way FiT CfD

    Two-way FiT CfD

    Strike price

    Annual inflation indexation

    - Annual inflation indexation 
    - Minded not to include fuel indexation
     for biomass. To be confirmed for CSS

     Market reference price

    - Day-ahead price
    - Choice of baseload or hourly prices
    - Not averaged over a longer period

     - Year-ahead baseload price

     - Choice of price sources

     Contract volume

     Metered output

    To be confirmed, metered output or firm volume
  • In the first instance, the strike price for different renewable technologies is to be determined centrally. However, the Government remains committed to looking for ways to move to auctions for different technology categories towards 2020.  Tenders will be introduced sooner for nuclear and CCS generation, from as early as 2017.
  • For renewable generation the reference price will be set according to day ahead market indices, selected when the CFD is entered into. Renewable generators will be paid according to actual output and, in the event they are constrained off due to actions of the System Operator, the Government is minded that generators are rewarded on the basis of their availability.
  • The White Paper does not identify the CFD contract counterparty and leaves open whether this might be a body or bodies within the public or private sector and indeed mentions suppliers.
  • The White Paper does make clear that the contracting entity will be at arm's length from Government and touches upon options for reassuring investors that payment commitments will be met. Details of institutional arrangements will be announced towards the end of this year and the body/bodies will be selected based on a number of criteria including accountability, independence, creditworthiness, skills and value for money.
  • There will be no obligation on utilities to offtake low carbon electricity. The White Paper acknowledges the concerns of independent power producers that power purchase agreements (PPAs) will only be available at a significant discount. However, the Government undertakes to keep the position under review and, if necessary, to take measures which will secure viable routes to market.

Whilst the White Paper answers some key questions, inevitably, given its ambition, it does not go into sufficient detail to enable a full assessment of the proposals. A number of questions are left unanswered:

  • How will CFDs apply in the devolved administrations where a significant proportion of UK renewable resource is located?
  • How will investors gain visibility of the strike price in time-scales to support their investment decisions?
  • How will any credit-support from generators for the difference payments owed to the contract counterparty where revenues exceed the strike price be calculated?
  • When will CFDs be signed and what are the eligibility criteria (e.g. planning consent and grid connection)?
  • Will a penalty apply for failure to achieve commercial operations date by a given deadline following CFD signing?

It's clear there are a number of decisions which are still to be made around the specific design of the CFD and the reference prices. The challenge will be to ensure that these can be taken in a manner informed by industry views and yet still keep to the implementation time-table envisaged in the White Paper. It is likely that more consultation will follow.

CFDs and liquidity

The Government acknowledges that for CFDs to be successful generators need viable routes to market, liquidity and a robust reference price and undertakes to work with Ofgem in its review of market liquidity, under the Retail Market Review. Ofgem is already consulting on a licence condition which would require the 'big 6' utilities to participate in mandatory auctions of between 10% - 20% of their power generation which would help to derive reference prices. How Ofgem will act to improve liquidity in electricity markets is an important missing piece of the regulatory jigsaw.

CFDs and the Carbon Floor price

Proposals for a Carbon Floor Price have already been put forward in the Finance Bill 2011 for introduction from 1 April 2013. The target carbon price for 2013-14 will be around £16 per tonne of carbon dioxide (tCO2) (which is £19.16 in 2013-14 prices).  The price floor will target £30 per tonne of carbon dioxide in 2020, rising to £70 in 2030 (based on 2009 prices).  This cost will underpin the electricity price and support demand for low-carbon generation which would not attract the charge.  As many commentators have mentioned, the fact that it is a tax makes it susceptible to political pressure and investors may discount its value.

What does the White Paper mean for renewables?

'Vintaging' the RO

  • Impact for existing projects

    Arguably the most important aspect of the reforms is the impact on existing projects.  If investors feel they have been short-changed by retroactive application of rules which may reduce their returns or increase their risk, they will be very reluctant to invest in new projects under the new support system no matter how generous it might be (or they will require significantly higher returns than would have otherwise been the case).

    The White Paper confirms that from 1 April 2017 the RO will become a closed pool in that no new projects will be able to access the RO (although note the discussion further below regarding grace periods for projects prevented from reaching accreditation). The White Paper proposes a hybrid approach to 'vintaging' the RO from this point - one that seeks to maintain industry confidence for investment decisions made on the basis of RO support. This approach is likely to build on the existing system, using the headroom and fixed target underpin. However, at some point the level of the obligation will be fixed by headroom alone and will therefore reduce as generators fall out of the ROC pool. The RO will then switch to a fixed ROC price from 2027 for the final 10 years of RO support.

    This structure means that DECC will retain the burden of administering the scheme until 2027 and the associated risk that the obligation is set at the wrong level. However, it has the benefit of retaining ROCs as well as the buy-out fund and the recycle fund payments for existing operational projects. It is the Government's belief that this approach should avoid any significant disruption to existing offtake and/or financing arrangements (as these will likely expire before 2027).

  • Which schemes will be grandfathered?

    The Government has also taken a sensible approach to the grandfathering of RO support for different technology classes. Rather than be obliged to conduct banding reviews for the limited class of technologies not grandfathered as at 31 March 2017 the Government has simply proposed to grandfather all RO support at the level applicable at 31 March 2017. 
  • What does this mean for existing PPAs?

    PPAs in place for the majority of renewables projects in the UK govern the sale and purchase of electricity and any associated benefits (such as ROCs). In a project financed power project, PPAs underpin the debt financing and provide a route to market, allowing the generator to access market prices.

    The White Paper proposals have been designed to minimise the impact on existing PPAs. For already operational projects they have largely succeeded in this by retaining the key elements such as ROCs which form the basis of PPA pricing.

    However, for projects in development which will accredit under the RO in 2012 or later, PPA terms may require urgent review. PPAs with 15 year terms (calculated from the commercial operations date) will need to provide for a transition to a Fixed ROC from 2027.

Transitional arrangements

Central to investor confidence, and thus avoidance of a hiatus, is assurance that the regime which underlies the project investment base case can be accessed. In light of the on-going development of the details of the new support mechanism to be available from 2014, the transitional arrangements to ensure continued access to RO support in the period prior to 1 April 2017 are critical. The White Paper has addressed this by confirming that generators will have the choice of RO support until 31 March 2017. Government has also sought to provide some comfort that this date will not become an untenable cliff edge for new generators that need to make an investment decision on the basis of RO support but who may not have complete confidence of reaching accreditation by 31 March 2017.

  • Is there a risk of missing the accreditation date?

    The White Paper proposes limited grace periods which, although still to be fully worked out, would mean that generators could accredit under the RO if the deadline for full accreditation was missed due to very limited circumstances being grid connection delays due to the network operator or procuring radar mitigation. Where a grace period was allowed, the White Paper suggests the RO would however only be available until 2037 and so delays are likely to curtail the duration of support offered.

    Where generators miss the deadline for RO accreditation in other circumstances (even those which would normally be considered force majeure), it is unclear whether there will be the option to elect for a CFD once the project is already built. Where the CFD does not yield the expected returns (either under an internal investment case or under project finance loan agreements), there is a risk of default. This may be of particular concern for complex build projects with long construction times where the potential for delays is high.

  • The problem of phased offshore wind

    Considering the importance of offshore wind to UK 2020 targets (today set under the Road Map at 33 - 59 TWh per year by 2020), it is of concern that the one area where the transitional arrangements are not clear is for significant offshore wind projects. This derives from the approach taken to the phased accreditation of such projects. Under current RO support mechanisms offshore wind projects can phase their access to RO support by proposing a maximum of five phases over a five year period. Despite recognising that a number of planned offshore wind projects will not have completed all phases prior to the accreditation deadline in 2017, the White Paper proposes to not offer RO support for such later phases. Instead the generator will need to access the new support mechanism. This leaves a significant renewable sector in the unfortunate position of having to wait until greater detail is available regarding that new support mechanism before reaching a decision to proceed on any project that would have phases likely to complete after 1 April 2017.

Investing under a CFD

  • How will the strike price be determined?

    Initially the strike price will be set centrally, possibly under a similar process to that already in place under the RO banding reviews. However, by contrast, the RO banding reviews are closely regulated, take place at 4 year intervals and may only be reviewed in circumstances specified in legislation. It is unclear whether similar principles will apply to the strike price for CFDs.

    CFD auctions will be introduced before the end of the decade as a means of setting the CFD strike price. Auctions will be technology specific, designed to reveal a bidder's underlying costs.  For certain technologies, including offshore wind, CCS and nuclear, the specific factors affecting the underlying cost of each individual project are likely to be so different that a level playing field for any technology is unlikely to be achieved.

  • What is the risk of future 'tinkering'?

    Whilst efforts have been made to simplify the CFD design, they cannot be described as simple. Complexity increases the risk of 'refinement' as well as acting as a barrier to new entrants to the UK market.

    The White Paper also proposes periodic reviews, beginning from 2016 including consideration of amendments for future schemes.

    Further risk of review is introduced because of Treasury spending limits. The introduction of new low-carbon CFDs may not mean an end to Government intervention. The White Paper makes clear that the UK Treasury publication entitled "Control framework for DECC levy-funded spending" published in March 2011 will apply. This means that DECC are subject to restrictions on levy-funded spending and are required to achieve their policy goals through measures that do not exceed the spending cap set out in the periodic Spending Review and annual budgets. As such these will be annual restrictions. Where the cap is exceeded in any year, DECC will be required to agree a plan with Treasury to bring spending back down to the agreed level. The explicit policy is that there is a finite 'pot' for low-carbon revenue support which must be allocated between the competing technologies.

    Crucially in this context, when electricity reference prices are low (which usually coincides with tighter economic times), CFD payment obligations increase, accelerating the consumption of the CFD 'pot'. In order to manage this risk, Government may seek to manage spend for example by reducing forecast volume requirements

 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.