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UK government getting there on Electricity Market Reforms

The UK government is hoping investor appetite for renewables and conventional power generation will grow after unveiling the long-awaited update of its Electricity Market Reforms (EMR). Richard Saint, Managing Director, Corporate Advisory and Sue Milton, Senior Director, Energy Structured Finance at RBS, explain.

For years, investors have been calling for greater clarity on the reforms, which aim to ensure a sustainable energy supply over the next decade. However, some uncertainty will still need to be addressed before they have complete comfort. The government recently revealed eagerly awaited details of its plans for the industry, which needs GBP110 billion of new investment in the next decade. Currently before parliament, it is expected to be finalised by the end of the year.

The proposals promote new investments in low carbon energy generation and, through the introduction of the capacity market mechanism, growth in conventional (back-up) generation. Together, both these things should ensure greater certainty of electricity supply for the next decade.

Low carbon investment

One key element of the new plan involves Feed-in Tariffs for low carbon generation by way of Contracts for Difference (CfD), for which the draft strike prices for the period 2014 to 2019 are now published.

Through CfDs, the government aims to remove price volatility risk by agreeing upfront to give a subsidy to low-carbon generators if the agreed strike price of electricity is above the market reference price. If it is the other way around, the generator will have to pay back the difference. The success of the scheme will be determined by the ability of generators to achieve the reference price.

The new scheme will replace the existing incentive scheme of Renewable Obligation Certificates (‘ROCs’) from 31 March 2017 for new developments, but will be optional from 2014 onwards.

However, the reduced tenor of CfDs (15 years),compared with the current 20-year support offered by ROCs — without the corresponding uplift in strike prices — will result in an erosion of equity returns. To a certain extent this will be mitigated by the reduced revenue volatility associated with a CfD.

The government has also proposed to index the strike prices to the Consumer Price Index throughout the entire term. To remove this part of the price risk, generators could decide to use risk management instruments (inflation hedging).

Even more price volatility risk might arise for baseload plants such as CCS and Biomass as these have uncertain fuel costs. Strike prices will not be indexed to this key cost element and generators might therefore be forced to hedge fuel costs for long periods ahead to ensure certain returns, potentially impacting financing capacity.

For intermittent plants (wind, marine) the hourly day-ahead price will make it more interesting to sell the electricity in a daily auction. However, imbalance risk is not mitigated through the reforms proposed and therefore the need for Power Purchasing Agreements for intermittent generators remains.

Capacity market proposals

Another area covered in the recent announcement around the EMR plan is the introduction of capacity markets.

This aims to encourage investors to make available a range of new and existing power generation or demand-side initiatives. It should support the country’s security of electricity supply by providing sufficient remuneration for capacity held to ensure a certain return on investment.

It comes in response to around a fifth of power plants in the UK being due to close in the next decade – a process accelerated by regulation such as the Large Combustion Plant Directive and the Industrial Emissions Directive, which aim to reduce the country’s carbon output.

Auctions will see energy providers taking on ‘capacity obligations’ under which they will need to deliver energy or reduce their demand during peak levels while receiving upfront payments for what they promise to deliver. Failing to deliver once a stress level has been flagged by the system operator will lead to a financial penalty.

The proposals for capacity markets are to go to public consultation in October 2013 with legislation put in place by the summer of 2014. The first auction is expected to take place that year for capacity delivered in the winter of 2018/19.

Despite these announcements there is still some uncertainty in the market. The government’s plan is under consultation and will need approval from the European Union under ‘State Aid’ rules so is still subject to change. As such, clarity on the detail and enactment of legislation will be important to resolve the current hiatus on investment in flexible generation assets.

Utilities and developers must also be comfortable that an acceptable risk/reward allocation has been struck over the full life of the asset as they are accepting all the development risk with a pricing cap on potential returns. The level of protection afforded to developers in relation to changes in law is yet to be finalised. This means that uncertainty around whether the targeted internal rate of return will be realised remains.

Also, debt investors (banks and bond investors) will require full clarity to ensure certainty and visibility of sustainable cashflows from the assets they invest in.

In the run-up to the election, political pressure might increase to ensure carbon prices stay just low enough to keep coal burning, paving the way for voter-friendly, low electricity prices. It is encouraging, though, that 396 MPs backed the new plan with only eight opposing.

The government has gone some way towards resolving the issues of uncertainty that have plagued an otherwise strong market full of potential. However, all investors will be keen to see the finer detail agreed soon. 

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