UK: A "Trilemma" For Investors In UK Energy Infrastructure

Last Updated: 6 December 2011
Article by Mark Coker, Kevin Atkins and Raina Lal

Originally published Law360, November 30, 2011.

Law360, New York (November 30, 2011, 6:22 PM ET) -- At a recent London conference on low-carbon investment, the head of a private equity fund specializing in renewables chilled his audience with a report on the significant gap between investor expectations on risk and return and what was then being achieved under the United Kingdom regulatory environment.

Have the legislative developments in the last six months closed that gap?

The U.K.'s long-term energy policy revolves around three fundamental issues — low carbon, security of supply and affordability — the "trilemma." Each one of these issues in isolation can be solved; however, the key is to find a solution that manages all three of these drivers.

In particular, the reduction of carbon dioxide emissions requires significant long-term investment, and finding a way to achieve this while securing the U.K.'s energy needs without increasing the costs paid by the consumer is the current political imperative.

This situation is more acute in light of the U.K. government's initiative to set tighter carbon-reduction targets than are required by European Union standards.

To illustrate the trilemma further: nuclear energy may solve the problem of security of supply, but it, too, comes with extensive capital costs, both in the construction phase and in the decommissioning phase, along with environmental risks, which are all too public.

Natural gas is cleaner than existing fossil fuels such as coal, and new gas-fired combined-cycle generation facilities are relatively cheap to construct and to run, depending on commodity prices, but now natural gas is imported to the U.K. via international supply routes that can be subject to suspension through geopolitical fallout.

Against this backdrop, the government has announced proposals to address the energy trilemma and develop a long-term, low-carbon growth-strategy delivery plan for the U.K.

The proposals are based on increasing investment confidence through the reform of the electricity market, implementing a planning system that will encourage growth, and designing an economic model that is intended to result in no one particular class of party bearing a disproportionate share of the financial risk associated with investing in low-carbon initiatives.

Investment in low-carbon initiatives is perceived as too risky with investors not certain of the likely rate of return for their investment through a combination of market, technology and policy risks.

Investors are wary that the existing major utilities are the price-setters and can, therefore, pass through the variable price of carbon and gas feedstock into the cost of their power while low-carbon generators will be price-takers and unable to factor such variable costs into their economic model.

Moreover, recent economic pressures within different EU member states have caused their governments to revisit their renewables support policies, and so investment becomes subject to significant political risk.

If the funding gap is to be filled by institutional investors, the investment framework needs to address the risk-averse profile of this type of investor.

The U.K. government, therefore, proposes to incentivize investment in energy infrastructure by:

  • Undertaking the widest reform of the electricity market since the 1989 privatization to stimulate investment in electricity infrastructure;
  • Supporting low-carbon infrastructure and encouraging investment in renewable energy projects;
  • Providing targeted support for particular technologies;
  • Establishing the Green Investment Bank to facilitate enhanced private-sector involvement in infrastructure projects;
  • Implementing a new and transparent planning regime pursuant to the Localism Bill, which is intended to speed up the planning decision-making process for major infrastructure projects.

Electricity Market Reform

The Electricity Market Reform White Paper, published on July 12, 2011, sets out the government's commitment to "transform the U.K.'s electricity system to ensure that our future electricity supply is secure, low carbon and affordable."

This reform has four key elements:

1. Implementing long-term contracts for low-carbon energy to provide predictable revenues for investors;

2. Establishing a carbon price floor to prevent volatile price fluctuations and incentivize investment by reducing uncertainty as to the carbon price;

3. Introducing an emissions performance standard specifically to regulate the volume of CO2 that new generating plants are entitled to emit; and

4. Implementing a capacity mechanism for generators that will support backup power plants and ensure that there is sufficient electricity to meet peak demand.

Long-Term Feed in Tariffs with Contract for Difference (FiT CfD)

Long-term contracts will be the principal tool for incentivizing investment in low-carbon generation by providing greater revenue certainty and insulating investors from price risk, which are intended to increase the rate of investment and lower the cost of capital.

FiT CfDs will be long-term contracts between a low-carbon generator and a governmental counterparty, pursuant to which payments shall be made by the government to the generator when the market price for power sold by the generator is less than a predetermined strike-price set forth in the FiT CfD, and payments shall be made by the generator to the government when the market price for power sold by the generator is greater than the predetermined strike-price.

Carbon Floor Price

A floor price for carbon will come into effect starting April 1, 2013. The floor price is established by a combination of a tax levy on the use of fossil fuels and the EU Emissions Trading System carbon price.

U.K. government proposals project that this price floor will begin at around £15.70/metric tonne of CO2, rising in a straight line to £30/metric tonne of CO2 in 2020 and £70/metric tonne of CO2 by 2030.

The aim of the floor price is to impose a transparent, predetermined cost on greenhouse gas emissions to disincentivize polluting plants and incentivize investment in low-carbon technologies.

The use of these fossil fuels to generate electricity will become liable to new carbon price support rates calculated by reference to the relative carbon content for each fuel, e.g., the carbon price support rate for natural gas will be lower than the carbon price support rate for coal and oil.

Emissions Performance Standard

An emissions performance standard (EPS) will apply to new fossil-fuel generators. The EPS will impose a backstop on the volume of emissions that a new fossil-fuel generator can produce.

The EPS will not be applied retrospectively to existing fossil-fuel generators, except when such generators undergo significant life extensions or upgrades, and will initially be set at 450g of CO2/kWh (kilowatt hours). This level will not constrain investment in new gas-fired generating capacity.

Capacity Mechanism

This element of the EMR proposals is the least developed at the moment. The U.K. government has identified a need for a mechanism that addresses the likely reduction in capacity margins as older plants are decommissioned and new generation, such as nuclear, is still under construction or, in the case of renewables, is intermittent and requires backup.

To a certain extent, the capacity margin can be addressed by nongeneration measures, such as intelligent demand-side management, electricity storage and increased capacity on interconnections with continental Europe. The two alternatives for generation-side measures are likely to be based on either the creation of a strategic reserve or a market-based mechanism for capacity payments.

Carbon Capture and Storage

A key element of the U.K. government's infrastructure initiative is the focus on carbon capture and storage (CCS).

The U.K. government notes that CCS has the potential to reduce carbon emissions by up to 90 percent — although this does not take into account the fuel that will be expended in the process of capturing, transporting and storing CO2.

The U.K. government has declared a policy to support the cost of four CCS commercial demonstration projects at U.K. power stations.

It was recently announced that a procurement process for the first CCS demonstration project has been cancelled: this was reportedly as a result of a failure to reconcile cost projections for this development with the U.K. government's need to set a firm budget for its financial support.

Green Investment Bank

The Green Investment Bank is intended to complement the existing policy landscape and demonstrate the government's commitment to promoting green growth and ensuring that the U.K. makes a successful transition to a low-carbon economy by providing solutions to potential market failures that may affect the financing of the green economy and disincentivize green investment.

The U.K. will be the first country in the world to create a bank solely dedicated to facilitating its transition to a green economy. Although strategically aligned with the U.K. government's green-policy objectives and initiatives, the GIB will operate at arm's length to the government and in cooperation with private-sector players.

Investment Products

The GIB is expected to offer both equity and debt-investment products, including:

  • Subordinated debt during the construction and/or operational phases of a project to decrease the risk profile of the project and potentially attract other lenders;
  • Refinancing commitments to refinance existing borrowings to provide longer tenors consistent with the long-term nature of a capital-intensive renewables project;
  • Equity investment when the opportunities for lending are limited because of the lack of sufficient secured assets; and
  • Senior lending when there is insufficient commercial bank appetite.

Key Concerns

While FiT CfDs should, in principle, enhance investment in the electricity sector and the renewables market, their success depends on the formulation used to calculate the bench strike price and the relevant index on which the market reference price will be based, as these two elements form the basis of the contract.

Where the strike price is uncompetitive or the market reference price is volatile, investment may not be incentivized. Both the reference price index and the calculation of the strike price remain open issues.

Given the capital-intensive nature of renewable technology, investors need to consider whether nonvertically integrated renewable generators will be able to locate market purchasers for their power at a price that is economic for their particular renewable project.

Since the FiT CfD will eventually replace the Renewables Obligation, which would otherwise have imposed an obligation on power purchasers to acquire a certain proportion of power from renewable sources, the problem of market access may become worse.

Will the imposition of a carbon floor price adversely affect other heavy industries that are not involved in power generation, e.g., steel, chemicals and aluminium manufacturing or liquefaction processes? These heavy industries are already bound by emissions trading standards, and the imposition of an increasing carbon floor price passed through into higher energy prices may result in the loss of competitiveness for such U.K. industries.

Final Thoughts

It seems clear that the government is taking steps to resolve the energy trilemma and encourage investment in low-carbon technologies and energy infrastructure.

Despite these steps, however, there are still substantial uncertainties as to how the proposals will be funded and implemented. The government aims to address these uncertainties by introducing legislation in the parliamentary session next year.

Provided the legislative package is stable, clarifies the uncertainties and sets a FiT CfD strike price that is competitive and encourages investment, the message from the government appears to be that investment opportunities in the U.K. energy sector will very much be on the rise in the future.

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.

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