UK: The Challenge Of Energy Infrastructure: Energy, Security, Decarbonisation, And Affordability

Last Updated: 18 June 2014
Article by Clare Hatcher

The UK energy system faces a number of challenges as existing infrastructure closes, domestic fossil fuel reserves decline, and the system increasingly requires adaptation in order to meet low carbon objectives.

Changes are required to ensure that the UK has a secure energy supply in years to come and, already, the threat to supply security has been brought to the top of the agenda this year due to the political troubles in the Ukraine.

Background

The UK government has recognised that changes are critical to maintain security of supply and deliver the energy people need, where they need it. In its own words "Large-scale investment is required in order to achieve security of supply as the UK makes the transition to a lower – carbon economy"1.

This is reflected in the fact that GBP 147 billion of the total GBP 375 billion required investment in the National Infrastructure Plan (NIP) is earmarked for electricity generation. In fact there is a view that this may not be enough. A joint report by the London School of Economics (LSE) and nPower suggests that the energy sector needs record levels of investment of up to GBP 330 billion by 2030 if security of supply is to be achieved while carbon emissions are reduced. This in turn would enable the UK to achieve the EU's long term 2030 emissions reduction target.

Where is the energy investment required?

HM Treasury's "National Infrastructure Plan: finance update March 2014" (Treasury Update) accepts that the historical model of large utilities financing electricity generation on balance sheet is unlikely to deliver the scale of investment required. This is particularly the case when the traditional utilities are seeking to reinforce their balance sheets through asset sales and cuts in capital expenditure2. As a result, the way forward must include project specific investment in the electricity sector with finance through separate vehicles where the return is directly related to the performance of specific electricity assets.

The Treasury Update gives a useful summary of where investment is required and the total value of projects (by technology type) which are in the pipeline for the period up to 2020 (excluding those in construction or already part of an active programme.)

Nuclear

It is no surprise that a sizeable chunk of funds are required for Hinkley Point C, which is the first nuclear plant in the nuclear renewal programme regarded as essential to ensuring that the UK has a secure and low carbon electricity supply. In order to give investors the confidence to commit the billions necessary, the UK government has provided price certainty through contracts for difference for the power off-take at what is generally regarded as a very generous strike price. It also intends to provide support through the UK Guarantees Scheme.

Off-shore and on-shore wind

The off-shore wind sector potentially offers the largest investment opportunity pre-2020 with an estimated value of GBP 18.3 billion. On-shore wind, which is thought to have an existing established investment model using debt markets, is expected to generate projects with a value of up to GBP 10.4 billion. There is also help for developing offshore marine renewable energy (both tidal and wave) through demonstration projects such as the publicly owned Wave Hub in Cornwall.

Other renewables

While large scale renewable projects may provide suitable investment opportunities for project specific finance, small scale renewable projects (including solar, wind and anaerobic digestion), are generally considered too small individually to be suitable for a project finance solution unless bundled up into a portfolio sale. The government intends to continue the support for smaller scale projects through measures such as feed-in-tariffs. However large scale renewables (including solar) which have historically been supported through the Renewables Obligation regime, will continue to receive support as part of the government's Electricity Market Regime (EMR) policy through 'contracts for difference'.

Biomass

There is a GBP 900 million potential opportunity for investment in biomass where the government has supported conversion of one engine at Drax, the UK's largest coal power station, to biomass by providing a GBP 75 million UK Guarantee.

Gas

One of the key issues facing the UK energy market is the extent to which gas-fired capacity will be developed and a "dash for gas" will slow down the need for structural changes which are required to reduce carbon emissions. Although the construction of combined cycle gas turbines (CCGT) could result in short term price gains by switching from coal to competitively priced gas (while initially achieving moderate reductions in greenhouse gas emissions), this delays the long term investment required in low carbon plant if required emissions reductions are to be achieved.

It is interesting in this context to see that the government regards investment in CCGT as part of the energy mix. The Department of Energy & Climate Change's (DECC) EMR policy is to create a capacity market with 15 year capacity agreements available which should provide sufficient certainty to unlock investment in new gas plant. The government's recognition of the continued importance of fossil fuels as an important source of the electricity generation mix is also implicit in the allocation of GBP 1 billion of public funding to help develop Carbon Capture and Storage through a commercialisation competition.

Will investment be made?

The reality is that the government's energy and climate change policy has three competing objectives: energy security; decarbonisation; and affordability. These are enshrined in the Energy Act 2013 (Energy Act) which contains the legal framework for the government's EMR policy for long term support for low carbon electricity generation.

The conflict is reflected in the factors the government must take into account under the Energy Act when setting its decarbonisation target range. While the impact of climate change is relevant it must also consider the need for economic growth and the cost to consumers. There is no easy way to reconcile the fact that it costs more at the moment to provide power from low carbon technology than from traditional fossil fuel sources. The Labour opposition has politicised energy prices making it difficult to retain the current green levies which add a substantial amount to the cost of household bills. However some sting has been taken out of this debate by Ofgem's referral of the energy market to the Competition Markets Authority (CMA) who are unlikely to report until after the next election.

Given that the CMA's main focus will be to assess whether the "big 6" suppliers should be broken up, there are significant concerns that this will put a halt to the investment needed in UK power generation.

Despite this, there are a number of hopeful signs that investment to create green growth has started. A recent EY Renewable Energy Country Attractiveness Index3 indicates that the UK is now the fifth most attractive place in the world for renewables, the second for biomass and the first for off-shore wind. Further, according to Bloomberg, Britain saw record levels of investment in renewable energy in 2012 to 2013 which rose 59% to GBP 7.3 billion; placing the UK third in the world behind China and the US.

Finally, in late April, the DECC announced the first tranche of support under the new legislative framework for eight major new renewable projects ranging from off-shore wind to the conversion of a unit at Drax to biomass which will attract around GBP 12 billion in private investment. This will be followed by auctions for 'contracts for difference' to assist the low carbon transition. The UK is also now benefitting from some foreign direct investment in its renewable supply chain with ABP and Siemens making a GBP 310 million investment in Hull in two new factories to make turbine blades and assemble off-shore wind turbines.

The future of UK energy depends on continued investment. This in turn depends on ensuring the investment environment is favourable and one of the key conditions that must be satisfied to enable development is regulatory certainty. With more clarity emerging on the detail of EMR and the announcement of the first awards for support, there may now be a base on which investors can rely to unlock their funds.

Footnotes

1 HM Treasury and Infrastructure UK: National Infrastructure Plan: Finance Update, 19 March 2014.

2 Industry Outlook, EMEA Electric and Gas Utilities. Moody's Investors Service, 20 November 2013.

3 Ernst & Young: Renewable energy country attractiveness index, February 2014

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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