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Energy Update – November 2013

Energy Update – November 2013

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21/11/2013

DECC Annual Energy Statement and Statutory Security of Supply Report 2013

The Department of Energy & Climate Change (DECC) published two policy papers on 31 October […]

The Department of Energy & Climate Change (DECC) published two policy papers on 31 October 2013: (1) its Annual Energy Statement 2013, and (2) the Statutory Security of Supply Report 2013.

Annual Energy Statement 2013
The Annual Energy Statement fulfils the commitment in the Coalition Programme for the Government to present an annual statement of energy policy to Parliament.

This Statement sets out the Government’s priorities in delivering the UK’s energy policies in the near term, and how the Government is delivering against the priorities. The Government’s three priorities in the sector are:

Helping households and businesses take control of their energy bills and keep their costs down
Unlocking investment in the uk’s energy infrastructure that will support economic growth
Playing a leading role in efforts to secure international action to reduce greenhouse gas emissions and tackle climate change.

Helping consumers take control of their energy bills

Consumer affordability is central to UK energy policy. The Government’s view is that the best way to achieve this is through an effective competitive market in energy, with the aim of helping people to get better value from energy companies and to waste less energy. Furthermore, the Government is determined to make it easier for people to find new innovative ways to get a better deal on their energy. Effective competition in the wholesale energy market is a key driver of lower prices and competition in the retail market. Through its regulation of gas and electricity networks, Ofgem is seeking to encourage investment in energy networks in a cost-effective way and to drive down costs for consumers too.

In January 2013 the Government introduced the domestic Green Deal and Energy Company Obligation (ECO) schemes, both of which establish new ways to pay for and install energy saving measures. These schemes will help households insulate their homes and upgrade their heating systems with low carbon alternatives, which will assist them in cutting waste and the cost of their bills, whilst reducing their energy demand and carbon emissions. The Government is helping businesses to cut the cost of their bills and reduce their energy consumption and carbon emissions through improved energy efficiency. Support schemes include: the non-domestic Green Deal and Renewable Heat Incentive; the CRC Energy Efficiency Scheme, and mandatory carbon reporting. Each policy provides a different solution depending on business need. In July 2013 the Government launched a consultation on the Energy Savings Opportunity Scheme (ESOS) to help large enterprises to identify cost-effective energy efficiency measures. The Government is in the process of exploring opportunities to maximise synergies between ESOS and other existing schemes.

Unlocking investment in the UK’s energy infrastructure
The Government’s energy policies are being delivered in a way that aims to maximise the opportunity for economic development, thus providing a significant opportunity to promote investment and support employment. During 2013 the Government brought forward key announcements on the Electricity Market Reform (EMR) programme, which will put in place the institutional and market arrangements to secure the private sector investment needed. To help enable investment decisions ahead of EMR implementation, the Government has committed to a programme of Final Investment Decision Enabling to offer investment certainty and support through ‘Investment Contracts’ (early CfDs). This is focused primarily on renewable technologies, but also reflects the approach being taken to build a new nuclear power station at Hinkley Point in Somerset. On 21 October 2013 it was announced that the Government and EDF Group have reached commercial agreement on the key terms of a proposed investment contract for Hinkley Point C. This will be the first new nuclear power station in the UK in a generation and will provide a stable source of clean power from 2023.

International action to tackle climate change
The Government is encouraging EU leadership to ensure that, as a community, the EU is “walking the walk” on the international stage. This includes continuing to press for a move to a 30 per cent. EU emissions reduction target for 2020 and the adoption of an ambitious emissions reduction target for 2030 delivered in a flexible, technology neutral way, and supported by a global agreement in 2015.

Statutory Security of Supply Report
The Government sees energy security as being about making sure consumers can access the energy they need at prices that are not excessively volatile. This report discharges the Government’s and Ofgem’s obligation under the Energy Act 2004 to report annually to Parliament on the availability of electricity and gas for meeting the reasonable demands of consumers in Great Britain. It also discharges the Government’s obligation under certain EU Directives to monitor gas and electricity security of supply issues and publish reports.

Electricity
To date Great Britain’s electricity system has provided secure supplies. However, the system faces some significant challenges over coming years. In light of the uncertain outlook for supplies during the middle of the decade DECC, National Grid and Ofgem have been working together to explore options for additional safeguards for consumers in the form of new balancing services, aimed at helping National Grid maintain system balance. According to the report, our electricity transmission and distribution networks remain extremely reliable, but continued investment is needed to maintain high quality networks and to ensure they facilitate the move to a decarbonised system.

Gas
Great Britain has the most liquid, and one of the largest, gas markets in Europe with extensive import infrastructure and a diverse range of gas supply sources. In 2012, around half of the UK gas demand was supplied through UK production, and the import infrastructure has increased five-fold over the past decade. All the sources can and are providing significant gas to meet the country’s requirements and mean that the Great Britain gas market is resilient to all but the most extreme supply disruption scenarios. To further strengthen security of supply for gas, the Government is facilitating exploration activity for shale gas, as domestic production of shale could add further diversity of supply sources. In addition, Ofgem is in the process of reforming the cash-out regime in an attempt to sharpen the incentives on gas market participants in order that they invest in measures to enhance security of supply.

Oil
Oil currently meets around a third of the energy demand and is the main energy source for transport meeting virtually all of the UK’s needs. Oil markets are international by nature and GB also exports and imports crude oil and refined products. The UK has enjoyed extremely good security of supply in recent years with supplies coming both from the UK Continental Shelf and from a diverse range of international sources. The majority of our imports come from secure and stable markets such as Norway. The international nature of oil markets mean that if there are issues with a particular supply source this is likely to impact on prices paid, as opposed to physical supplies, as other supplies step in to take advantage of higher prices on offer. However our dependence on imports is expected to increase as oil demand globally continues to rise, and as global production becomes more complex.

Further information
Full copy of the statement and the report can be found on the DECC website.

For more information on how Walker Morris can help you in relation to renewable energy or energy supplies, please contact David Kilduff or visit our website.

ROCs or CfDs – the choice is not clear cut

With the Renewables Obligation scheme ( ROCs ) of support for new schemes to be phased […]

With the Renewables Obligation scheme ( ROCs ) of support for new schemes to be phased out by 31 March 2017 and the replacement Contracts for Difference scheme ( CfDs ) coming into effect next year, there will be a period of time in which developers will have a choice of which scheme to seek support under. As more details of the Contracts for Difference scheme become available, we compare some of the key risks under each scheme

As we know, Contracts for Difference (CfDs) are envisaged to be introduced under the Electricity Market Reform (EMR). In essence, the clue is in the title, and payments will be made to generators by reference to the difference between a fixed notional price (the strike price) and the referenced electricity sale price (the reference price). Where the strike price is higher than the electricity price, the CfD counterparty is contractually obliged to pay the difference to the generator. Where the reference price is higher than the strike price however, (i.e. the price of electricity is greater than anticipated), the generator is obliged to pay the difference to the CfD counterparty.

CfDs will be available to new projects from some time in 2014, while the Renewables Obligation (RO) scheme will remain open to new entrants until 31 March 2017. Therefore, projects looking to commission between 2014 and the RO closure date will have a one-off choice as to whether to receive support under the RO or a CfD. Making that choice requires a detailed analysis of the risks and benefits of each support scheme and applying them to the particular project in question: different developers, funders and investors will have different approaches to risk.

With draft strike prices having been published, and the Government recently publishing a detailed update on the CfD scheme, generators will now be using this information as a yard stick for where their decisions in terms of future support should lie: for the time being, does the RO provide a subsidy that is tested and investors are relatively comfortable with, or are CfDs the future of sustainable investment into the low-carbon market? We set out below an evaluation of the different risk profiles between CfDs and the RO in light of what we now know.

What is the risk that a project won’t be eligible?

RO: accreditation granted on commissioning
CfD: CfD granted prior to the final investment decision
Risk balance: slightly lower risk for CfD as earlier certainty on eligibility. However, generators may be required to submit supply chain plans in respect of the CfD term. This could be onerous and the proposals in respect of this need to be considered once finalised.

What is the availability risk?
RO: low risk – if a project hits the eligibility criteria support will be available
CfD: CfD not guaranteed even if the eligibility criteria met and availability of contracts will potentially be limited. Availability risk increases as time goes by
Risk balance: higher risk under CfDs.

What is the risk if the project energy yield is lower than anticipated?
RO: income calculated by reference to metered output (at the point of generation)
CfD: income calculated by reference to metered output (at point of connection to the grid) and a ‘loss adjusted metered output’ will also be made
Risk balance: slightly higher risk for CfD (particularly for offshore technologies) as potential transmission losses between generation and grid connection point, as well as loss adjustment calculation.

What is the risk that revenue will be lower than forecast?
RO: two revenue sources – electricity sale and ROC sale, and market fluctuation risk in respect of both
CfD: two revenue sources – electricity sale and difference payment, but strike price reduces revenue fluctuation risk
Risk balance: forward selling/monetisation used to mitigate RO risk not necessary for CfD as difference payment is a mitigation in itself. CfD should therefore have a lower risk profile, subject to potential negative price risk if Reference Price is higher than Strike Price.

What is the risk if the electricity sale price is lower than anticipated?
RO: generator risk that electricity and/or ROCs sold below market price
CfD: reference price is linked to indices rather than real market price therefore generator risk that sale price is lower than reference price. Further risk that reference price is greater than strike price and payment is then due from generator to CfD counterparty
Risk balance: increased risk for CfDs currently. Potential clarification in respect of setting of indices from DECC anticipated.

What is the risk if the output delivered to the grid does not match the forecast output?
RO: risk passed to offtaker through power purchase agreement (PPA), subject to any tolerance provisions in the PPA
CfD: similar risk but PPA market more uncertain
Risk balance: similar risk. However, with RO balancing costs can potentially be mitigated by increases in energy prices. Less potential for CfDs as strike prices linked to index, (unless a pass through cost protection is developed).

What is the risk that the fuel cost is greater than anticipated for the life of the project, or that fuel will become less or unavailable?
RO: generator risk, mitigated by long-term supply contracts
CfD: generator risk, likely to also be mitigated by long-term supply contracts
Risk balance: similar risk (but note that there is no provision for amendments to the strike price in respect of fuel availability).

What is the risk that the relevant support payments aren’t paid out?
RO: risk mitigated by selling to offtakers with good credit standing, or requiring guarantees to ensure ROCs are purchased
CfD: risk uncertain – what will happen if the CfD counterparty is able to pay? CfD counterparty has been made ‘insolvency remote’ as it will not be required to pay out under the CfD until it has been paid by the supplier, however, how will the generator recover non-payment?
Risk balance: increased risk under CfDs, subject to revised proposals anticipated from DECC to protect generators.

What is the risk that a change in law affects payments?
RO: RO payments are grandfathered, so guaranteed
CfD: protection provided by CfD contractual provisions however no protection against wider industry regulatory changes or the possibility that the power to invoke a reduction in the strike price will be used
Risk balance: increased risk for CfDs – current gaps in protection under the contract.

What is the risk that the generator loses its entitlement?
RO: generator risk that ROC will be revoked or accreditation withdrawn, but circumstances limited
CfD: generator risk that CfD may be terminated, with significant list of events of default set out in CfD
Risk balance: possible greater risk under the CfD (pending clarification in respect of cure/remediation periods for events of default).

What is the risk that the project cannot secure finance?
RO: generator risk, but well understood
CfD: generator risk. Less exposure to electricity price volatility should be a positive for investors, but there may be increased price risk in respect of other risks under the CfD structure
Risk balance: current uncertainties and flaws in CfD lead to greater investor risk, however will these be ironed out? Will the market become more confident over time?

Conclusion
To conclude, there are still a number of question marks over the risks levels under CfDs as compared to the RO regime. Whilst the Government is keen to persuade that CfDs will provide a stable and long-term incentive to the low-carbon industry, for the time being the RO regime at least has the benefit of being well understood by generators and investors, with risk mitigation having been practiced. However, will fortune favour the brave and have the investors at EDF’s Hinckley Point C seen the future?

For more detail on the RO, CfDs, Electricity Market Reform or energy in general, please contact David Kilduff.

State intervention in the European electricity market

On 5 November the European Commission published a Communication, ‘Delivering the internal electricity market and […]

On 5 November the European Commission published a Communication, ‘Delivering the internal electricity market and making the most of public intervention’. Public, or state, intervention can be at regional, national or local level and can take different forms, such as: state aid to certain sectors or companies in the form of grants or exemptions from taxes and charges; imposing public service obligations; or regulation through general measures.

This Communication is the latest in a line of documents emanating from Europe around energy. It has been issued now because the EU has set a deadline of 2014 for the completion of the internal EU energy market, where cross-border markets for gas and electricity must be up and running in all parts of the EU, but there is concern that this deadline will not be met.

It is specifically focused on the electricity market although the principles can be applied in other energy sectors such as gas and heating. The Commission has focused on reviewing public intervention in the electricity market in particular because such intervention has a significant influence on the cost and prices of electricity. There is a need for public intervention to secure a level playing field, overcome market failures, foster technology and innovation, and, more generally, support the market in delivering appropriate investment signals. If not done properly, public intervention risks being counterproductive and distorting the functioning of the internal market, leading to higher energy prices for both households and businesses.

The Communication sets out principles for state intervention in:

National support schemes for renewable energy (mostly solar and wind)
Setting up back-up capacities for renewable energy (mostly fossil fuels), for when renewable energy is not being generated/times of peak demand.

Renewable energy support schemes
The Communication recommends the following best practice principles:

Financial support should be limited to what is necessary and should help to make renewables competitive
Support schemes should be flexible and respond to falling production costs. As technologies mature and investment costs fall, they should be exposed to market prices and eventually support must be fully removed. In practice this means that feed in tariffs (a fixed price per kWh) should be replaced by feed in premia (i.e. the market price plus a premium) or other support, such as quota obligations (energy suppliers having to ensure that a certain quota of the electricity they supply comes from renewable sources), that gives incentives to producers to respond to market developments
Avoid unannounced or retroactive scheme changes. Investors’ legitimate expectations concerning the returns on existing investments must be respected. The UK has learnt this the hard way with its early and frequent changes to the solar PV tariffs, subsequently resolving this problem by implementing a system of tariff degression linked to deployment levels.
Member states should better co-ordinate their renewable energy strategies to keep costs low for consumers.

Back-up capacities for renewable energy
The increase in renewable energy makes it more of a challenge to keep producing electricity when the wind is not blowing and the sun is not shining. The Communication therefore also gives guidance on how member states can design back-up capacities (such as coal and gas power plants) in a cost-effective way that takes full advantage of the European market:

Before deciding on capacity mechanisms, governments should first analyse the causes of inadequate generation
Secondly, they should remove any distortions that may prevent the market from delivering the right incentives for investment in generation capacity, such as regulated prices or high subsidies for renewable energy
Governments should ensure that renewable energy producers react to market signals and promote flexibility on the demand side, such as different tariffs to incentivise consumers to use electricity at off-peak times (“smart grids” and “smart metering”)
Back-up capacity mechanisms should be designed with a European perspective, not just the national market.

What does this mean for UK’s electricity market reform proposals?
The Commission has developed this Communication in tandem with revising the guidelines on state aid for environmental protection as part of its state aid modernisation programme. It will follow the main principles set out in this Communication when it is assessing whether public intervention in renewables support schemes or to promote generation adequacy constitutes a state aid or not. It appears that the new guidelines on state aid for environmental protection will be based on the idea that public interventions should, wherever possible, be more market-based, more open to cross-border solutions and allow for more competition between supported technologies. Watch this space!

Further information
For more information on state aid, please contact David Kilduff or Richard Auton.

Time to say grace? DECC sets out its proposals for RO grace periods

With the Renewables Obligation (RO) scheme of support for new schemes to be phased out […]

With the Renewables Obligation (RO) scheme of support for new schemes to be phased out by 31 March 2017 and the replacement Contracts for Difference scheme coming into effect next year, there will be a period of time in which developers will have a choice of which scheme to seek support under. For those that elect to seek support under the RO, generally speaking the facility must be commissioned and accredited by 31 March 2017 otherwise it will have to seek support under the Contracts for Difference scheme. However, the Government has recognised that there may be some reasons outside the developer’s control that a project may be delayed beyond 31 March 2017 and so has issued a consultation on what grace periods will be available in such circumstances.

The Government’s position is that, in general, operators of projects which have commissioning dates on or close to 31 March 2017 have the option of applying for a Contract for Difference, which would give them clear assurance of receiving support even if the project suffers unexpected delay. Because developers have known about this date for several years, DECC remains minded to keep grace period eligibility minimal. It recognises that there are certain specific challenges which developers are experiencing at present, which it believes can best be addressed via more substantive grace periods, but proposes to target grace periods directly at those challenges, and where appropriate, rather than considering more extensive grace periods in general.

“Clearly defined and limited grace periods”
DECC is proposing to offer four forms of clearly defined and limited grace period, as follows:

a 12-month grace period to address radar and grid connection delays (which were not due to the developer), where the project was scheduled to commission on or prior to 31 March 2017
a 12-month grace period for projects which have signed Investment Contracts under FID Enabling, should these contracts fall away or be terminated under certain specific circumstances. Initially, DECC is proposing that this is limited to termination due to lack of State Aid approval, in recognition of the fact that developers are likely to be making their choice of scheme in advance of the investment contracts receiving State Aid clearance and at a time when EMR has not yet been implemented in full
a 12-month grace period for projects able to demonstrate that substantial financial decisions and investments have been taken prior to 31 July 2014 (i.e. in the period prior to the launch of the CfD scheme), where the project is scheduled to commission on or prior to 31 March 2017. To be eligible these projects will have to undergo a notification process by 31 July 2014
an 18-month grace period for projects allocated an unconditional place under the 400MW dedicated biomass cap, in recognition of the fact that some projects had their timetables delayed while the detailed policy arrangements in relation to the 400MW cap were put in place.

The consultation sets out the Government’s reasons for proposing these forms of grace period. It also details the steps a developer must take, and the evidence it must provide, in order to benefit from the relevant grace period.

Our view
The consultation is to be welcomed, as it provides further detail on one of the key issues associated with the phasing out of RO support for new projects, and replacing that with support under the Contracts for Difference scheme. While the circumstances giving rise to the right to claim one of the grace periods is very limited, developers will no doubt welcome the certainty and will be able to plan accordingly. Those that are still to let construction contracts for their projects will be able to include some of these grace periods in those contracts, in particular the evidence requirements, and tie the contractor as closely to the support scheme as possible.

Next steps
The period for responding to the consultation is short, and closes on 28 November 2013. DECC expects to publish its response to the consultation towards the end of the year.

Subject to the responses received to this consultation, the Government’s aim is to implement the proposals via a Renewables Obligation Closure Order 2014, anticipated to come into force in Spring 2014. Of course, like all other aspects of Electricity Market Reform, the proposals are subject to the Energy Bill, which is currently before Parliament, Parliamentary approval of the Order, and any State Aid clearances that may be required.

Further information
The consultation can be found on the DECC website here.

For more details of the Renewables Obligation, Electricity Market Reform or energy projects more generally, please contact David Kilduff.

Contacts

David Kilduff, Partner, Energy, Infrastructure & Government

David Kilduff
Consultant
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