Energy investment challenges

21st April 2016

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Stephen Gould

Auctions may not increase investment in renewables.

The UK government’s new renewable energy tariff scheme raises challenges for investors. Although the government has put contract for difference feed-in tariffs (CfDs) at the centre of its renewable energy policy, in fact the CfD auction process introduces significant uncertainty as to whether a project will be awarded a CfD. This may work to defeat the policy aim of increasing investment in renewable energy by providing normalised and stable long-term returns for investors.

The CfD scheme is intended to replace the Renewable Obligation Certificate (ROC) permit trading scheme and operates by awarding renewable energy generators a private contract with a government counterparty, the Low Carbon Contracts Company (LCCC). The renewable energy generator will agree a ‘strike’ price for the offtake of electricity per megawatt hour with the LCCC. The LCCC will pay the difference between the ‘reference price’ (a measure of the average market price for electricity in the UK market) and the strike price.

From an investor’s perspective, at least in theory, the removal of long-term price risk through the CfD mechanism should encourage investment in the renewables sector. It should also enable greater access to project financed leverage, as returns can be modelled with greater accuracy.

The first round, sealed-bid, CfD auction process was completed in February 2015 and required different renewable technologies to compete against each other, in two pots:

  • established technologies, limited to onshore wind, solar PV and energy from waste;
  • less-established technologies, a broader category which included offshore wind and more advanced conversion technologies.

In the first auction round, £259 million or 82% of the overall budget was allocated to the less-established technology pot, although this equated to only 57% of the total projected generation output. Based on these statistics, it is clear that if the technologies competed together in a single pot a greater capacity delivery could be achieved with the same overall investment.

The rationale was to encourage less established technologies to develop and to become more cost effective. However, it also reveals the UK government’s preference for offshore wind, which does not attract the same level of criticism regarding its impact on the environment and local area when compared to more established, land-based, technologies.

Investors making a CfD auction bid are required to indicate whether they could deliver at, or below, the auction baseline administrative strike price (a price per megawatt hour of electricity generated, below which they would be supported by subsidy payments). The opening bid price was set in the first CfD auction round at a level for each technology which was designed to reflect fair returns to investors.

In reality, however, the opportunity for predatory and strategic pricing could lead to bidders making offers with strike prices at levels that are not economically viable. This was the case with certain solar PV bids in the first auction round and several of these projects have subsequently been withdrawn. It is to be hoped that the government resists the temptation to use these strike prices as a market-tested benchmark, reflected in future auction rounds.

The initial auction process also highlighted other potential obstacles to investment. In particular, the costs of meeting the qualification criteria to participate in the bid process can be significant and the risk that these costs could be wasted may deter some developers, as well as restrict their access to construction finance.

At the end of 2015, the UK government announced that there will be a further CfD auction round commencing at the end of 2016. The indication is that this round will only be open to the less developed technologies class. The government also anticipated a further two CfD auction rounds before the end of the current Parliament, although decisions on when and how to proceed will be predicated entirely on the government’s cost-reduction ambitions.

The UK government has not, however, provided guidance on the exact timings for future auction rounds, the budget for each renewable technology, or a clear indication of the criteria for specified technologies’ inclusion within each auction round. Even less clear is how the policy landscape and government priorities will change after the scheduled 2020 UK election, not to mention any Brexit.

This uncertainty and the potential deterrents thrown up by the initial auction process could well result in a diminished investment pipeline for renewable generation projects over the medium to long term, contrary to government intentions.

This blog was co-authored by Matt Lewy, associate at Baker Botts.


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