Changes to UK wind: Between ROCs and a bad place
The period for industry submissions on the Consultation on Electricity Market Reform closed on 10 March. The consultation, run by the UK’s Department of Energy and Climate Change (DECC) is a primer to legislation that will be brought in late 2011 to retire the Renewable Obligation Certificates (ROCs) incentive regime.
The consultation seems a done deal: a feed-in tariff, most likely a contracts for difference model, will almost certainly be brought in. On the face of it, a feed-in tariff should be a good thing. The volatility in the price of ROCs increases the weighted average cost of capital because leverage is limited, especially without a long term offtake. However, the near to medium term impact of the uncertainty is a delay to the financing of offshore wind projects. Indications are the new regime could harm future wind development and there is speculation that the change could also trigger change in law clauses of some existing wind farm financings.
While the retirement of ROCs will impact all UK renewable projects, offshore wind is likely to be hardest hit by the changes because ROCs provided sponsors sufficient potential upside for the risks they are taking. Under a contracts for difference regime, technological innovation and calculated risk taking could be stymied.
Uncertainty surrounding the future regime and the government’s plans for grandfathering the ROC regime are causing sponsors to reassess their investment decisions and perhaps renegotiate power purchase agreements.
The retirement of ROCs is thought to be delaying both the project financing of Masdar’s 20% stake in London Array and progress on the Centrica/Dong/Siemens Lincs deal. Credit committee approvals for banks on the London Array deal have lapsed, but providing terms remain the same all the banks are expected to reapprove the commitments. The key question for these projects is how the government will phase out ROCs when the supply-side of the market will be completely removed after 2017. Sponsors on Lincs are also considering on-balance sheet financing if they cannot extract sufficiently good terms from banks.
The DECC proposes giving developers a choice of proceeding with a feed-in tariff or ROCs from 2013 before closing Renewable Obligations (RO) to new accreditation from 1 April 2017. All projects accredited under the RO would receive their full 20 years’ support. Therefore, the entire RO system would be ‘vintaged’ from 1 April 2017. The RO would continue to operate, but support levels in terms of number of ROCs will not change. The closure of the RO to new investment will create a closed pool of capacity which will decrease over time as it approaches the end date for the RO of 31 March 2037. According to one financier, as an obselete regime, the long term price of ROCs is unlikely to be favourable to sponsors.
The DECC is also speeding up the review of the banding of the Renewable Obligation so that the market has more notice of the banding levels in 2013 and beyond. The DECC will announce to the market in Summer the banding for consultation, and the government will give a definitive response in Autumn and the new bands brought into force April 2013.
The government is scrapping ROCs to bring down the weighted cost of capital and to open up the market to independent generators and foreign investors. ROCs favour utility-scale investors and while there is a rising demand for capital for renewable generation, it will be met in the context of a shrinking supply of capital from the incumbent energy utilities. According to the DECC: “there seems to be a broad consensus that the existing, vertically-integrated “Big 6” utilities (Centrica, EdF, Eon, SSE, Iberdrola and RWE) may struggle to invest in low-carbon generation at the scale and pace required to meet the UK’s targets between them.” Currently a third of on-shore and offshore wind projects in the pipeline at the moment are being developed by companies outside the “Big 6”, such as DONG Energy, Vattenfall and Statoil.
The bargaining position of the incumbent UK wind sponsors is weak as they can easily be accused of defending their own interests by protecting the status quo as one of the principal aims of the legislation is to bring new sponsors to UK wind.
The DECC’s proposed new regime is a tariff regime based on a contracts for difference because long-term feed-in tariffs would provide more certainty on the revenues. A reference tariff would be set whereupon sponsors would receive additional payment up to the reference tariff if their revenues fall short, or revenue would be clawed back if they exceed the reference. This model, according to the DECC, should control costs for consumers, provide stable returns for investors, and maintain the market incentives to generate when electricity demand is high.
This last point is important, otherwise generators are not incentivised to generate electricity according to demand. This contracts for difference model of feed-in tariff is used in the Netherlands for renewables (though they call it a “sliding premium”) and in Denmark for offshore wind. It provides a similar level of revenue certainty to a fixed FiT but by setting the level of support according to the average price preserves the efficiencies of the price signal, that is, generators will have an incentive to sell their output above the average price as they will keep any upside.
The DECC adds: “The rationale for choosing the FiT with CfD as a lead option is that it gives the best balance between the Government’s objectives of decarbonisation (including renewables), security of supply and affordability.”
Because feed-in tariffs result in a lower risk investment, they should be more attractive to a wider group of investors – in particular, smaller independent generators and institutional investors. The logic seems compelling: FiTs provide greater certainty on future revenues to investors than the current Renewables Obligation. ROC prices have a floor (the buy-out price), which guarantees a certain level of stability for investors. However, due to the way the Obligation is set at a higher level than expected generation, the value of a ROC is typically higher than the floor price, and this level can vary. Due to this variability, not all of this additional value is included in a project financing base case. Thus the additional value does not necessarily result in higher levels of renewable investment. A different instrument with a fixed level of payment (a premium FiT) could deliver the same level of deployment more cost effectively.
An aim of this policy is to introduce new market entrants. However, offshore wind development is inherently risky and perhaps only utility-scale sponsors or those with the financial clout and project know-how of Mubadala can stomach offshore construction risk. Institutional investors such as pension funds will not touch construction risk. So while the CfD may bring in other large foreign investors, and unintended consequence could be to actually reduce the pool of vaible investors if utilities deem the new system incapable of providing enough upside for the risks. And while this new regime will partially insulate sponsors from electricity price fluctuations a further unintended consequence may be to limit innovation and technology, again, as sponsors are using upside in ROCs as extra equity risk premia.
The overarching issue is that the rewards under the new system are unliklely to match the risks. An example of rewards matching the risk profile of projects is the OFTO (offshore transmission line) programme, where the low risk and low return projects were carved out from the offshore wind projects to lower the weighted cost of capital.
Since 2008, the Netherlands has used a FiT very similar to a FiT with CfD to incentivise renewable technologies (called a “sliding premium” because the size of the premium is related to the wholesale price). Generators have to sell their electricity (either into the wholesale market or in bilateral contracts) and then an energy agency pays them a top-up payment (differentiated by technology) up to the tariff level.
The tariff is decided by the government. Contracts are signed by the energy agency for 15 years. The reference price is the average annual spot market price. The top-up is paid out monthly to facilitate cash flow for smaller generators. It is in effect a one-way CfD in that if the electricity price goes above the tariff then the generator keeps all the upside.
Denmark has since 2005 operated a feed-in tariff for offshore wind which is also very similar to a CfD model. For major offshore wind farms the required support is set by means of a tender procedure.
There is still a great deal of uncertainty surrounding the new UK renewable incentive regime. It is not clear whether the tariff will be set by a competitive bid or by government. It seems unlikely that competitive bids will be used as there has been a trend in other jurisdictions to resort to tried and tested technology and a lack of innovation. The reference tariff is likely to be indexed to inflation and could be banded in similar way to the Renewable Obligation to take into account changes in technology, costs and the depth of water for offshore wind plants. Besides how the reference tariff will be set, there are other uncertainties such as who will be the payer/payee of the tariff, how the system will account for variable output (the imbalance risk of what a generator nominates it will generate and what it actually generates) and how grandfathering the ROCs would work. Also the profit motive mechanism does not work for wind generators as it will be impossible for them to time their dispatch over the average wholesale price to achieve a higher return.
Sponsors and banks on existing wind financings are also consulting lawyers as the changes to the incentive regime could trigger change in law clauses on some deals, which in a worst case scenario could see banks attempt to renegotiate terms.
The retiring of the Renewable Obligation seems designed to help develop the nuclear baseload but the consquences of a one-size-fits-all approach could be severe on the UK wind industry. A cleaner more transparent solution would be to offer a fixed feed-in tariff, as in the German and French regimes. This would cost the consumer more but it may be better than the unintended consequences of a CfD regime: reduced wind developer activity and a reduction in the use of new technology.
The Department of Energy and Climate Change proposals - Key points
- Introduce a feed-in tariff based on the contract for difference model from 1 April 2013
- Provide developers with a choice between the CfD and ROCs until 1 April 2017, when new accreditation of ROCs will end
- Publish the new RO banding for post-2013 by the end of 2011
- Grandfather the RO until 31 March 2037
The consultation seems a done deal: a feed-in tariff, most likely a contracts for difference model, will almost certainly be brought in. On the face of it, a feed-in tariff should be a good thing. The volatility in the price of ROCs increases the weighted average cost of capital because leverage is limited, especially without a long term offtake. However, the near to medium term impact of the uncertainty is a delay to the financing of offshore wind projects. Indications are the new regime could harm future wind development and there is speculation that the change could also trigger change in law clauses of some existing wind farm financings.
While the retirement of ROCs will impact all UK renewable projects, offshore wind is likely to be hardest hit by the changes because ROCs provided sponsors sufficient potential upside for the risks they are taking. Under a contracts for difference regime, technological innovation and calculated risk taking could be stymied.
Uncertainty surrounding the future regime and the government’s plans for grandfathering the ROC regime are causing sponsors to reassess their investment decisions and perhaps renegotiate power purchase agreements.
The retirement of ROCs is thought to be delaying both the project financing of Masdar’s 20% stake in London Array and progress on the Centrica/Dong/Siemens Lincs deal. Credit committee approvals for banks on the London Array deal have lapsed, but providing terms remain the same all the banks are expected to reapprove the commitments. The key question for these projects is how the government will phase out ROCs when the supply-side of the market will be completely removed after 2017. Sponsors on Lincs are also considering on-balance sheet financing if they cannot extract sufficiently good terms from banks.
The DECC proposes giving developers a choice of proceeding with a feed-in tariff or ROCs from 2013 before closing Renewable Obligations (RO) to new accreditation from 1 April 2017. All projects accredited under the RO would receive their full 20 years’ support. Therefore, the entire RO system would be ‘vintaged’ from 1 April 2017. The RO would continue to operate, but support levels in terms of number of ROCs will not change. The closure of the RO to new investment will create a closed pool of capacity which will decrease over time as it approaches the end date for the RO of 31 March 2037. According to one financier, as an obselete regime, the long term price of ROCs is unlikely to be favourable to sponsors.
The DECC is also speeding up the review of the banding of the Renewable Obligation so that the market has more notice of the banding levels in 2013 and beyond. The DECC will announce to the market in Summer the banding for consultation, and the government will give a definitive response in Autumn and the new bands brought into force April 2013.
The government is scrapping ROCs to bring down the weighted cost of capital and to open up the market to independent generators and foreign investors. ROCs favour utility-scale investors and while there is a rising demand for capital for renewable generation, it will be met in the context of a shrinking supply of capital from the incumbent energy utilities. According to the DECC: “there seems to be a broad consensus that the existing, vertically-integrated “Big 6” utilities (Centrica, EdF, Eon, SSE, Iberdrola and RWE) may struggle to invest in low-carbon generation at the scale and pace required to meet the UK’s targets between them.” Currently a third of on-shore and offshore wind projects in the pipeline at the moment are being developed by companies outside the “Big 6”, such as DONG Energy, Vattenfall and Statoil.
The bargaining position of the incumbent UK wind sponsors is weak as they can easily be accused of defending their own interests by protecting the status quo as one of the principal aims of the legislation is to bring new sponsors to UK wind.
The DECC’s proposed new regime is a tariff regime based on a contracts for difference because long-term feed-in tariffs would provide more certainty on the revenues. A reference tariff would be set whereupon sponsors would receive additional payment up to the reference tariff if their revenues fall short, or revenue would be clawed back if they exceed the reference. This model, according to the DECC, should control costs for consumers, provide stable returns for investors, and maintain the market incentives to generate when electricity demand is high.
This last point is important, otherwise generators are not incentivised to generate electricity according to demand. This contracts for difference model of feed-in tariff is used in the Netherlands for renewables (though they call it a “sliding premium”) and in Denmark for offshore wind. It provides a similar level of revenue certainty to a fixed FiT but by setting the level of support according to the average price preserves the efficiencies of the price signal, that is, generators will have an incentive to sell their output above the average price as they will keep any upside.
The DECC adds: “The rationale for choosing the FiT with CfD as a lead option is that it gives the best balance between the Government’s objectives of decarbonisation (including renewables), security of supply and affordability.”
Because feed-in tariffs result in a lower risk investment, they should be more attractive to a wider group of investors – in particular, smaller independent generators and institutional investors. The logic seems compelling: FiTs provide greater certainty on future revenues to investors than the current Renewables Obligation. ROC prices have a floor (the buy-out price), which guarantees a certain level of stability for investors. However, due to the way the Obligation is set at a higher level than expected generation, the value of a ROC is typically higher than the floor price, and this level can vary. Due to this variability, not all of this additional value is included in a project financing base case. Thus the additional value does not necessarily result in higher levels of renewable investment. A different instrument with a fixed level of payment (a premium FiT) could deliver the same level of deployment more cost effectively.
An aim of this policy is to introduce new market entrants. However, offshore wind development is inherently risky and perhaps only utility-scale sponsors or those with the financial clout and project know-how of Mubadala can stomach offshore construction risk. Institutional investors such as pension funds will not touch construction risk. So while the CfD may bring in other large foreign investors, and unintended consequence could be to actually reduce the pool of vaible investors if utilities deem the new system incapable of providing enough upside for the risks. And while this new regime will partially insulate sponsors from electricity price fluctuations a further unintended consequence may be to limit innovation and technology, again, as sponsors are using upside in ROCs as extra equity risk premia.
The overarching issue is that the rewards under the new system are unliklely to match the risks. An example of rewards matching the risk profile of projects is the OFTO (offshore transmission line) programme, where the low risk and low return projects were carved out from the offshore wind projects to lower the weighted cost of capital.
Since 2008, the Netherlands has used a FiT very similar to a FiT with CfD to incentivise renewable technologies (called a “sliding premium” because the size of the premium is related to the wholesale price). Generators have to sell their electricity (either into the wholesale market or in bilateral contracts) and then an energy agency pays them a top-up payment (differentiated by technology) up to the tariff level.
The tariff is decided by the government. Contracts are signed by the energy agency for 15 years. The reference price is the average annual spot market price. The top-up is paid out monthly to facilitate cash flow for smaller generators. It is in effect a one-way CfD in that if the electricity price goes above the tariff then the generator keeps all the upside.
Denmark has since 2005 operated a feed-in tariff for offshore wind which is also very similar to a CfD model. For major offshore wind farms the required support is set by means of a tender procedure.
There is still a great deal of uncertainty surrounding the new UK renewable incentive regime. It is not clear whether the tariff will be set by a competitive bid or by government. It seems unlikely that competitive bids will be used as there has been a trend in other jurisdictions to resort to tried and tested technology and a lack of innovation. The reference tariff is likely to be indexed to inflation and could be banded in similar way to the Renewable Obligation to take into account changes in technology, costs and the depth of water for offshore wind plants. Besides how the reference tariff will be set, there are other uncertainties such as who will be the payer/payee of the tariff, how the system will account for variable output (the imbalance risk of what a generator nominates it will generate and what it actually generates) and how grandfathering the ROCs would work. Also the profit motive mechanism does not work for wind generators as it will be impossible for them to time their dispatch over the average wholesale price to achieve a higher return.
Sponsors and banks on existing wind financings are also consulting lawyers as the changes to the incentive regime could trigger change in law clauses on some deals, which in a worst case scenario could see banks attempt to renegotiate terms.
The retiring of the Renewable Obligation seems designed to help develop the nuclear baseload but the consquences of a one-size-fits-all approach could be severe on the UK wind industry. A cleaner more transparent solution would be to offer a fixed feed-in tariff, as in the German and French regimes. This would cost the consumer more but it may be better than the unintended consequences of a CfD regime: reduced wind developer activity and a reduction in the use of new technology.
The Department of Energy and Climate Change proposals - Key points
- Introduce a feed-in tariff based on the contract for difference model from 1 April 2013
- Provide developers with a choice between the CfD and ROCs until 1 April 2017, when new accreditation of ROCs will end
- Publish the new RO banding for post-2013 by the end of 2011
- Grandfather the RO until 31 March 2037
Request a Demo
Interested in IJGlobal? Request a demo to discuss a trial with a member of our team. Talk to the team to explore the value of our asset and transaction databases, our market-leading news, league tables and much more.