Executive Summary

Background

As part of the wider Electricity Market Reform (EMR) being introduced under the Energy Bill, the UK Government has decided to change its approach to providing incentives for the generation of low carbon electricity. Instead of relying on the existing quantity-based Renewables Obligation ("RO"), renewable and low carbon electricity generators will soon have the option of entering a contract to produce electricity at a pre-agreed strike price. From 2017, it is expected that most new renewable generation will be contracted under these terms. The new support system will be based on Contracts for Difference ("CfDs") through which low carbon generators can receive a guaranteed and stable stream of revenues for their electricity production, composed of a market-determined price for their electricity, plus a "top-up" payment determined by the difference between a fixed "strike price" stipulated in their contract and a market reference price for electricity.

In July 2013, the UK Department of Energy and Climate Change ("DECC") issued a consultation in which, among other things, it proposed draft strike prices for a range of renewable technologies under the CfDs. DECC considered a range of factors in setting strike prices, including:

  • technology-specific factors such as capital and operating costs, financing costs as well as any build constraints;
  • market conditions such as wholesale prices and the discount which generators face when signing a power purchase agreement (PPA); and
  • policy considerations such as the specific contract design, choices about technology mix and meeting the ambition for renewable electricity.

Because the RO and CfD support mechanisms are intended to make investment in renewable electricity generation attractive to investors, they require DECC to make assumptions, inter alia, about how the up-front capital expenditure costs of different technologies will be amortised over time, to ensure that investors earn a fair return on their capital outlay. In particular, this has required DECC to make assumptions regarding the internal rates of return or "hurdle rates" that would be required by investors to finance such projects. Assumptions on hurdle rates have been used by DECC to calculate both the number of Renewable Obligation Certificates ("ROCs") given to each technology under the RO (the banding level), and the draft strike prices being proposed under the CfD regime.

Because the CfD would reduce the exposure of renewables investors to a variety of risks, relative to the RO, DECC has adjusted the hurdle rates originally used in the context of the RO to arrive at new hurdle rates relevant for the calculation of the CfD strike price.1 Assumptions about the expected changes to hurdle rates under the RO and the new CfD regime were used by DECC to calculate the strike prices published in the July 2013 EMR Delivery Plan consultation document.

To view this article and its footnotes in full please click here.

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.