UK: Renewables Obligation - 2002 and Beyond

Last Updated: 9 July 2002

Nicola Foate and Peter Hawkes, of respectively Herbert Smith’s Energy and Environmental Groups, examine some recent measures of the British Government to combat climate change by encouraging the use of renewable sources of energy for generating electricity.

The international community has put in place a framework for action on climate change through agreement to the United Nations Framework Convention on Climate Change and the Kyoto Protocol. The UK Governmentintends to ratify the Kyoto Protocol before the World Summit on Sustainable Development in Johannesburg this summer.1 The UK’s target under the Kyoto Protocol to reduce its greenhouse gas emissions to 12.5% below 1990 levels by 2012 will then become legally binding on the UK Government. To ensure that this target, and its own more challenging target of reducing greenhouse gas emissions to 20% below 1990 levels by 2010, is achieved, the UK Climate Change Programme (UKCCP) was developed.

The Climate Change Levy, the UK Emissions Trading Scheme and the Renewables Obligation Order 2002 are key initiatives of the UKCCP. This article focuses on the Renewables Obligation Order 2002 now in force in England and Wales.

The Renewables Obligation Order 2002

The Renewables Obligation Order 2002 (the Order) is made under sections 32 to 32C of the Electricity Act 1989 and came into force on 1 April 2002. It requires each licensed electricity supplier in England and Wales to supply a certain percentage (currently 3% but increasing to over 10% in 2010) of the electricity they supply to customers in Great Britain in each obligation period from eligible renewable sources. The obligation period will be from 1 April to 31 March each year. There is a similar arrangement in Scotland in respect of Scottish electricity suppliers which also came into force on 1 April 2002. Consultation on similar arrangements for Northern Ireland is underway.

The Government has stated that contracts awarded under the Non Fossil Fuel Obligation (and comparable arrangements for Scotland) will continue to be honoured. Electricity from eligible renewable sources under this Order will also be exempt from the Climate Change Levy (CCL) under Part II Section 30 and Schedule 6 to the Finance Act 2000 which was introduced on 1 April 2001. The CCL, a tax on the business use of energy, encourages business to improve energy-efficiency and reduce emissions of carbon dioxide (a principal greenhouse gas). Under this Levy, industrial and commercial customers pay an additional 0.43 p/kWh for electricity purchased.

How Will It Work?

Ofgem will issue a Renewables Obligation Certificate (known as ROC) and Levy Exemption Certificate (LEC) to certify that 1 MWh of electricity has been generated from an eligible renewable source at an accredited generating station during a particular period and has been supplied to customers in the UK. These certificates will be issued by Ofgem to generators two months after the relevant period of generation and will bear unique registration numbers. These ROCs and their registered holders will be recorded by Ofgem on a public register.

Generators can sell both ROCs and LECs to suppliers together with the electricity they sell. ROCs can also be traded separately from electricity by anyone who owns them (not just generators). Anyone who wishes to trade ROCs can register with Ofgem for the purpose of becoming a registered holder of ROCs. LECs cannot be separately traded from electricity.

Each electricity supplier will have to produce sufficient numbers of ROCs to Ofgem at the end of each obligation period to prove that it has satisfied the Renewables Obligation. They must be the registered holder of those ROCs on Ofgem’s register. Suppliers can use "banked" ROCs which they purchased in the previous year to fulfil 25% of their then current yearly obligation. Suppliers in England and Wales can also present Scottish ROCs (and vice versa) in satisfaction of their obligation.

If a supplier cannot produce sufficient ROCs to satisfy its obligation, it must make a payment to Ofgem in lieu which will be calculated at the "Buyout Price" set in the Order. The Buyout Price is currently 3 p/kWh and will be indexed according to RPI each year.

In order to incentivise suppliers to purchase renewable energy rather than pay the Buyout Price, Ofgem will recycle the income it receives from payments of the Buyout Price back to electricity suppliers who have purchased renewable energy. The payment received will be in proportion to the percentage of eligible ROCs the supplier has presented against its Renewables Obligation.

Failure to meet the Renewables Obligation by presenting ROCs or paying the Buyout Price will expose a supplier to a financial penalty imposed by Ofgem under the Electricity Act.

Eligible Renewable Sources

Unfortunately a concise definition of ‘eligible renewable sources’ does not exist. Whilst there are similarities between renewable sources for LECs and ROCs (eg landfill gas, off-shore and on-shore wind, sewage gas, tidal power, wave power and photovoltaics), there are also significant differences (eg hydro stations, energy from waste and biomass). Importantly, Ofgem has developed a combined application form for accreditation of renewable sources for both the Renewables Obligation and the renewables exemption to the Climate Change Levy.

Calculations apply to determine the amount of electricity generated from eligible renewable sources and the amount of such electricity that is supplied to a customer. Article 5 of the Order provides Ofgem with the power to revoke a ROC if it is satisfied that the electricity to which the ROC relates was not produced from an eligible renewable source. This highlights the importance of the accreditation procedures and ensuring that calculations and declarations made are accurate and reliable – particularly considering that any revocation is likely to occur after the ROC has been traded.

The Order and the UK Emissions Trading Scheme

At the time of writing, the Rules of the UK Emissions Trading Scheme (UKETS) contain a procedure for converting ROCs into emissions allowances that could be traded in the UKETS. The procedure states that the Secretary of State will allocate allowances at the rate of 0.43 allowances for each ROC converted (rounding down to the nearest whole number). It is understood that this rate has been arrived at on the assumption that electricity from renewable sources displaces fossil-fuel based generation at a fixed factor. Suppliers will not be able to redeem allowances from the UKETS against their obligation under the Order.2

Ofgem’s Procedures

Ofgem has published its procedures and timetable for compliance with the Renewables Obligation Order on its website. They include the following:

1. Generators must have their generation stations accredited by Ofgem as capable of generating electricity from eligible renewable sources. A list of accredited stations will be published on Ofgem’s website (unless generators request that their details not be made publicly available). This accreditation will allow them to sell "green" energy.

2. Generators will need to take meter readings of the monthly output volumes in kWh of their accredited generation stations on the first day of each month and submit these to Ofgem.

3. Ofgem will issue ROCs and LECs in relation to electricity generated 2 months in arrears in units of 1 MWh rounded up to the nearest whole MWh. The first ROCs will be issued in July 2002.

4. Ofgem will publish ROCs issued on its website every month and record these ROCs on a register which notes the registered holder of the ROCs. This register will be updated to record transfers of ROCs between registered holders by Ofgem as and when transfers are notified by both the transferor (initially the generator) and the transferee. This will enable Ofgem to check a supplier’s claimed compliance with its Renewables Obligation against its register. Ofgem proposes to provide more guidelines on the Register prior to July 2002 when it will first come into operation.

5. Suppliers must notify Ofgem each month of the quantity of LECs purchased and the certificate numbers. Shortly after that notification Ofgem will confirm the number of LECs held by the suppliers.

6. By 20 June each year each supplier must notify the DTI of its total sales of electricity to customers in England and Wales. Suppliers must also provide the same data to Ofgem by 7 August each year.

7. By 1 October each year each supplier must submit a compliance report to Ofgem including presenting any ROCs it has purchased or paying the Buyout Price to Ofgem to satisfy its Renewables Obligation.

8. By 1 December each year Ofgem will pay a percentage of the total buyout fund to each supplier that has met its obligation by purchasing renewable energy.

9. By 1 March each year details of the amount of the distribution of the Buyout Price will be published in Ofgem’s annual report.

Implications

A number of issues and implications come immediately to mind when considering this new development.

  • Will there be sufficient ROCs to meet the demand?

Some commentators predict that there will be insufficient ROCs to meet the current need for 10 to 15 years. There is however a wide range of new renewable projects and new technology coming onto the market. When will such projects be commissioned? How many ROCs will they produce? These are all unknowns which will affect the supply and demand ratio in the coming years.

  • When will the market price for ROCs stabilise?

There is no transparency in prices for ROCs. Some industry players claim ROCs are being traded at prices well over the Buyout Price. Given the existence of the Buyout Price, however, one would expect to see suppliers bargaining for much lower prices for ROCs as well as packaged deals under which they agree to buy the energy, ROCs and LECs inreturn for signing a long term contract.

  • Cap on prices?

It has also been questioned whether the Buyout Price will represent a cap on prices which suppliers are prepared to pay for ROCs. Developers of renewable power will therefore be constrained in development costs. Initially, particularly where new and potentially unproven technology is being utilised, the numbers may not add up for developers.

  • Will Ofgem have the resources to maintain transfers of registration of ROCs efficiently so that suppliers can ensure they are purchasing from the registered owner?

Given that ROCs will not be issued until 2 months after renewable energy is generated, ROCs could potentially be sold more than once before the current owner is registered. Suppliers should therefore protect their position through contract. For example, by obtaining warranties as to title to the ROCs and putting in place mechanisms to manage any shortfalls in delivery of ROCs.

  • Is the Renewables Obligation going to force small suppliers out of the market?

Small suppliers may not have the resources to manage the cash flow problems caused by purchasing ROCs and LECs. If it takes two or more months for ROCs and LECs to be issued after the renewable energy is generated obvious cashflow problems will arise. Further risk arises from the nature of renewable energy. If, for example, a supplier agrees to purchase wind-generated electricity, it will be difficult to predict how much electricity will be generated and therefore how many ROCs will be issued. Suppliers could therefore over or under commit themselves by contracting to purchase ROCs.

  • Will banks lend money to renewable projects?

Apparently they will. There have, however, been few financings completed in the UK for renewable energy projects. Those projects which have achieved financial close are for small amounts compared to conventional power projects and have obtained funding at a lower leverage. The problem of financing renewables also seems to have been exacerbated by the recent poor performance of UK power project financings.

  • What additional risks do renewable projects face?

Unproven Technology

There is uncertainty as to whether new technology will work, and whether an energy source such as wind will prove to be reliable. On a more positive note, countries such as Germany, Spain and Denmark are mature renewables markets and much of the technology (albeit not in relation to offshore projects) has been proven in these countries. Scotland and Wales also historically have some of the windiest locations in Europe!

Uncertain Cashflows

There is not yet a liquid market in ROCs and their value is uncertain. This is in addition to the falling market for electricity prices. Imbalance risk under the new electricity trading arrangements (NETA) is also likely to be greater for small renewable projects particularly where the energy source is unreliable.

Planning

The slow pace of the UK’s planning process affects all power projects and is a risk that needs to be addressed early in the development phase of a renewables project.

Credit Risks

The recent demises of Enron and Independent Energy have meant that lenders now question more closely the credit quality of offtakers committing to long term agreements.

Change of Law

There is always the risk of changes to regulation in the industry, and this is fresh in everyone’s minds following the introduction of NETA. The new system of ROCs and LECs adds another layer of regulation to a project and is likely to be monitored closely over the coming years. Moreover, whilst the UK Government’s objective (to reduce emissions) may remain, the methods of achieving the objective may change.

Further Developments

At the time of writing, Energy Minister Brian Wilson recently announced the formation of the Renewables Advisory Board (RAB) to bring together key players from industry, the Unions and Government. The RAB is designed to drive forward crucial issues such as (a) research and development and capital grants programmes; (b) the development of a supply chain; and (c) infrastructure constraints.

On 17 April 2002, Mr Wilson granted consent under s36 of the Electricity Act 1989 for a 76MW offshore windfarm to be built at Scroby Sands (about 2.5km off the coast of Great Yarmouth in Norfolk). This is an £80m project which is a joint venture between Powergen and Abbott (North Sea Oil Services Company). This is the first of 18 offshore schemes in respect of which the Crown Estates Commissioner has granted Agreements for Lease for offshore wind farms around the UK. Wind power is expected to account for much of the renewable electricity being generated in the coming years.

The Performance and Innovation Unit Report released earlier this year called for the Renewables Obligation to be increased to 20% by 2020. Similarly, more challenging greenhouse gas reduction targets are expected to be set under the Kyoto Protocol beyond 2012. By making the Order and by committing similar policy to legislation in the future, the Government would certainly appear to have a renewable future in mind.

1 The European Union has also stated that it intends to ratify the Kyoto Protocol prior to the World Summit on Sustainable Development.

2 The UKETS market opened on 2 April 2002 after the Government’s auction of a financial incentive to potential Direct Participants. Emissions trading in the UK will develop further this year when organisations will be able to generate emissions allowances through specific emission reduction projects, and sell these allowances to participants in the UKETS. The ‘Project Rules’ are expected to be finalised by late June 2002. Additionally, companies in CCL negotiated agreements will be able to trade allowances through a "gateway" in order to meet their emission reduction targets at the end of this year. The ‘Agreement Rules’ are expected to be finalised shortly.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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