Electricity Market Reform: call for clarity

Transcription

1 Electricity Market Reform: call for clarity Energy players not yet persuaded by government plans for overhauling the electricity market Freshfields Bruckhaus Deringer llp

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3 Executive summary This research, conducted before the government s announcement on 23 setting out refinements of its Electricity Market Reform (EMR) proposals, was conducted to get a clear picture of the issues our energy industry and investor clients face as a result of the changes outlined in the 22 May 2012 Energy Bill and the overarching strategic elements of EMR. The anecdotal evidence we gathered before carrying out the research pointed to several areas of concern from investors and industry leaders. And while 73 per cent of respondents had a neutral or positive attitude to EMR, the results bore out the anecdotal concerns: 77 per cent do not feel EMR will enable the UK to meet its 2020 decarbonisation targets; and 64 per cent do not believe the UK will reach its 2020 private sector investment target. However, respondents see EMR as improving the investment case for nuclear, offshore wind and gas-fired generation, and urged cross-party agreement on EMR, over two parliaments. The 23 November announcement made subsequent to our survey does not, in our view, make changes sufficient to materially alter the above sentiments in fact, it raises more questions. The hope is now that the redrafted Energy Bill, expected imminently, will start to provide some answers. 77% do not feel EMR will enable the UK to meet its 2020 decarbonisation targets 64% do not believe the UK will reach its 2020 private sector investment target Freshfields Bruckhaus Deringer llp 1

4 More than a hundred senior energy executives and investment advisers were interviewed for this research. The results show broad support for government moves to reform the sector, but also confusion and lack of confidence over several aspects of the proposed policy. EU and UK decarbonisation targets are seen by many as out of reach, and there is widespread doubt that the necessary private sector investment will flow. 110 of private sector investment is needed to replace current generating capacity 2 bn

5 Summary of EMR proposals The 22 May 2012 Energy Bill and the EMR policy (as updated by the 23 November 2012 announcement by government 1 ) seek to put in place the measures necessary to attract the 110bn private sector investment needed to replace current generating capacity, to upgrade the grid by 2020 and to cope with rising demand for electricity. Measures include: contracts for difference (CfD) longterm instruments to provide stable and predictable incentives for companies to invest in low-carbon generation; creation of a CfD counterparty as announced on 23 November, the creation of a new government-owned company to act as the CfD counterparty with its own levy-raising powers, enabling it to raise funds from suppliers to meet its costs; investment instruments long term instruments to enable early investment in advance of the CfD regime coming into force; capacity market to ensure the security of electricity supply; conflicts of interest and contingency arrangements to ensure the institution that will deliver these schemes is fit for purpose; transitional arrangements for investments under the renewables obligation scheme; and emissions performance standards to limit carbon dioxide emissions from new fossil fuel power stations (though it is not clear from the 23 November announcement how, or if, this will be implemented). 1 See the Department of Climate and Energy Change Press Notice 2012/146 of 23. Freshfields Bruckhaus Deringer llp While the 23 November announcement clarified some of the detail of EMR, it also raised additional questions. What financial backing will the government-owned CfD counterparty receive? If none, how will generators get satisfied with the CfD counterparty credit risk? How will the government owned counterparty CfD levies be calculated and funded? Who will decide on the decarbonisation target, which has been pushed down to secondary legislation and out to the next parliament in 2016? When doing so, what weight will be given to the consideration of wider economic factors mentioned in the 23 November announcement? What other constraints will affect that decision? What effect will the announced review of the fourth carbon budget have will permitted emissions increase? Will the interim decarbonisation scenarios (that are to be set by government as an interim measure before the decarbonisation target setting decision in 2016) be sufficient to enable National Grid and others to make investment decisions fit for the future? What is the status of the emissions performance standards does this instrument, and its leading role in decarbonising the power sector, still stand? The answers may, or may not, come in the revised draft of the Energy Bill, the publication of which is expected imminently. The market is holding its breath until it sees what comes next. 3

6 What our respondents think Our respondents are leaders and senior investment advisers in the electricity sector. Yet only a few (10 per cent) claimed to have a thorough knowledge of the government s EMR proposals. Worryingly, 41 per cent said they had only a little knowledge of the proposals. Which of the following best describes your knowledge of the EMR proposals? More stability and simpler schemes are needed. As it currently stands, the government proposals are too complex. General manager, major power station 4 Freshfields Bruckhaus Deringer llp

7 Overall, respondents were mostly neutral-topositive towards EMR. However, a significant minority (26 per cent) viewed it negatively. Which of the following best describes your overall attitude to the EMR proposals? It s so complex. I would simplify it, because there are just too many competing policy objectives. MD of equities team, investment bank There s a lot of pie in the sky. Those of us on the ground are going to find it very difficult to deliver what the government is trying to achieve. The plans seem reliant on energy companies contributing substantially and that will mean drawing money in from every customer. Director, energy broking company Freshfields Bruckhaus Deringer llp 5

8 Will EMR enable the UK to meet its 2020 decarbonisation targets? There was little confidence that EMR would help the UK meet its tough decarbonisation targets for 2020 just 18 per cent felt it would. In addition to giving a yes-no answer, some of our respondents went on to state that the targets were over-ambitious even at the point at which they were set. Our overall view is that EMR creates confusion and is too expensive. Investment manager (utilities), hedge fund The targets aren t realistic. The government has cut feed-in tariffs in the past. The proposals should be made more attractive for low-carbon technologies. MD, solar power company The targets are pretty high for the time frame given. Director, major energy company 6 Freshfields Bruckhaus Deringer llp

9 Will the UK reach its target of 110bn in private sector investment for electricity generation by 2020? Respondents tended to believe investment targets were out of reach. EMR will need an effective doubling of current investment rates: 110bn may be needed by 2020, according to the latest government estimate. Some interviewees questioned whether it would even be possible to spend so much money by I think there are global investment opportunities offering much better returns than the UK energy market. I know we re a relatively stable country, but if I had 100, I wouldn t be investing it in the UK right now. Owner, renewable energy installer They won t be met unless the government gets consistent in its policies; there s just too much uncertainty. CEO, renewable energy consultancy EMR just doesn t address investment risks in our market. Head of analysis, power station operator Freshfields Bruckhaus Deringer llp 7

10 How does the lack of grandfathering protection affect the investment case? The lack of guaranteed financial compensation in the event of future legislative changes was seen by most to weaken the investment case. Our research revealed a market sensitive to future policy switches and a lack of faith in the stability of plans. 8 Freshfields Bruckhaus Deringer llp

11 What is your view on proposals to introduce feed-in tariffs in the structure of contracts for difference? The government s proposal of a feed-in tariff with a contract for difference divided opinion. It was seen as good by many. Where it was criticised, it tended to be for its complexity. More than a quarter of respondents knew little about the instrument or had no view on its potential effectiveness. Worryingly, parts of the investment community seemed perplexed or unconvinced. A feed-in tariff with CfD is too complex. It will not easily trigger investment that would favour the reduction of CO 2... I don t think the financial sector understands it very well. I know I don t! Portfolio manager, investment bank It s not entirely clear how any kind of capacity-based payments would work. If we go for the CfD system, how would they be priced? European equities fund manager, asset management firm Freshfields Bruckhaus Deringer llp 9

12 How does EMR affect the investment case for gas-fired generation? Investment in gas-fired generation, seen by some interviewees as the most promising strategic choice for emissions reduction, would become more attractive under EMR, according to just over half of our respondents. Offshore wind generation will, it was felt by most, become more investible under EMR. And the investment case for nuclear generation would improve, according to two-fifths of our respondents. (Note that our survey was run in October 2012, before the announced sale of Horizon Nuclear Power to Hitachi.) It s the worst of both worlds. It s creating more confusion and therefore more risk premium for investors. On the other hand, it still relies on pseudo free-market mechanisms, so there s a lot of interference. Investment manager (utilities), hedge fund 10 Freshfields Bruckhaus Deringer llp

13 How does EMR affect the investment case for offshore wind generation? How does EMR affect the investment case for nuclear generation? You d be crazy to invest in nuclear: the construction risk is horrendous. That s why the UK government is basically giving it to the French government to do. Financial analyst, brokerage Freshfields Bruckhaus Deringer llp 11

14 How would cross-party agreement on EMR over two parliaments affect the investment case? The possibility of long-lasting political agreement on EMR was seen as desirable for most respondents. The government s 23 November announcement on the increases to the Levy Control Framework (applying until 2020) is an example of what is required, but energy policy consensus on a much broader basis needs to emerge. In addition complexity and a lack of consistency were flaws of past and current government policy, according to some respondents. Others told us they were struggling to keep up with the government s plans. We need cross-party, 20-year thinking. The success of our business is entirely dependent on government incentives and these have not been managed correctly. Owner, renewable energy installer They should have some kind of legal framework that would make it a bi-partisan bill. It s such an important topic that it should be cross-party. Portfolio manager, investment bank 12 Freshfields Bruckhaus Deringer llp

15 View from the city Finance partner Alan Rae Smith describes an investment dilemma When London s smartest analysts admit they are stumped by the complexities and nuances of a proposed investment instrument, there is cause for concern. But such things can be ironed out, or alternatives found, and the government is now listening to experts in the city. More worrying is that these analysts are struggling to make the EMR investment case understandable and attractive for their clients. Our survey suggests that the figures involved are too ambitious, as is the time frame, and that the expected returns are too hard to gauge. The refinements of EMR announced by government this month do little to alter this. In a global market competing for private sector investment, this is not good news for the UK economy capital will flow to clearer, simpler investment terrains. A greater proportion of generation from renewables is central to the Energy Bill. But investors are unsure what their incentives are and what will happen to their money. For the money to come, investors are looking for a clear picture and government guarantees that will last beyond a single parliamentary session. EMR does not yet offer enough certainty. If there is insufficient clarity to attract the investment that will meet the government s decarbonisation targets, the default setting will, somewhat perversely, be more gas-fired power stations.... this is not good news for the UK economy capital will flow to clearer, simpler investment terrains. Freshfields Bruckhaus Deringer llp 13

16 An industry looking for policy that lasts Energy and infrastructure counsel Max Cairnduff sums up the mood of the sector EMR is welcomed, broadly speaking. Industry leaders we spoke to acknowledge the intrinsic need to make wholesale improvements if lights are to stay on, and daunting decarbonisation targets are to remain in reach. But this is a sector wary of policy change, as we see in the results, and the most recent policy shake up this month by government in the form of its refinements to EMR, which raise more questions than it provides answers, must only exacerbate that concern. Of particular note is the overwhelming support from the private sector for a cross party approach to EMR: the timescales involved make strategic progress within a single session or by a single administration virtually impossible. Only with a cross party, consensus-driven commitment will the sector get the long-term certainty it feels has been missing so far. The power companies face a double bind: they are expected to lead the reforms and draw investment towards low-carbon technology, but simultaneously to keep electricity prices in check and supply secured. This makes high-risk and costly investment decisions unappealing. More than half of our respondents see EMR as improving the investment case for wind generation, and 41 per cent believe nuclear will benefit. But plenty of our respondents are unconvinced with some prepared to say that only gas fired generation makes real sense right now. And so the sector is hoping for clear incentives for renewables, consistent policy with long-term commitments and the prospect of cross-party agreement. The 23 November announcement contains some steps in the right direction but, as evidenced by Ed Miliband s call to the government to set a 2030 target in the Energy Bill (made the day before the 23 November announcement and also committing Labour to setting one) 2, we are a long way from cross-party agreement. Only with a cross-party, consensus-driven commitment will the sector get the long-term certainty it feels has been missing so far. 2 See Ed Miliband s comments as reported in the Guardian (in an article by Damian Carrington Ed Miliband commits Labour to 2030 decarbonisation target on 22 ) and in Business Green (in an article by James Murray Miliband slams government for dither and delay over Energy Bill on 22 ). 14 Freshfields Bruckhaus Deringer llp

17 The upshot Leaders in the power sector acknowledge the need for fundamental market reforms. And the investment case for such reforms should, in theory, be robust. Ernst & Young, for example, calculates that the sector directly contributed 20.6bn to the economy during 2011 and that a pound invested in power and gas has a larger indirect effect on the rest of the economy than a pound invested in most other industries 3. But our survey revealed a lack of faith. The sector simply cannot square the competing objectives of secured supply, low energy bills and low carbon so-called threedimensional chess and does not believe the 2020 goals, nor the timeline, are realistic as 2020 investment decisions, given the time taken to achieve planning approvals and then to construct assets, have on the whole already been made. And we heard again and again that inherent complexity and a lack of consistency and continuity are dampening confidence. To push the decision on binding decarbonisation targets to after the next election is a good case in point the delay of difficult decisions, and the lack of clarity that creates, makes UK Energy PLC s investment case worse. Without strong, clear, long-term policies, investments will stall. Given the extended timescales involved, intra-governmental and cross-party agreement and collaboration are seen as essential everyone needs to be on the same page, pulling in the same direction. Further, incentives should be understandable and long-lived and built to neatly dovetail with international carbon markets, the EU framework and global climate agreements. Without such practicality and stability, entrepreneurial players will be squeezed out and low-carbon investors scared off damaging the long-term health of the industry, and undermining the 2020 and the 2050 goals.... our survey revealed a lack of faith... Without strong, clear, long-term policies, reforms will stall. 3 Powering the UK: The role of the power and gas sector in the wider economy, Ernst & Young, October 2012 Freshfields Bruckhaus Deringer llp 15

18 Your Freshfields contacts Our lawyers work as one team; together they have experience in every aspect of energy law. So we are well placed to help you prosper in a low-carbon economy. If you would like to discuss the matters raised in this research or need to assess how changes in electricity market regulation might affect your business, please get in touch. Alan Rae Smith T E alan.raesmith@freshfields.com Sally Roe T E sally.roe@freshfields.com Max Cairnduff T E max.cairnduff@freshfields.com 16 Freshfields Bruckhaus Deringer llp

19 Methodology and notes 101 interviewees, all in senior managerial, investment or advisory roles. Sample split across grid, generation, energy broking, financial institutions and research firms. Interviews conducted by telephone. Fieldwork managed on Freshfields behalf by Carnaby Co, an independent, Londonbased research and advisory firm. All data de-personalised before results were filed. The data remains the property of Freshfields. Reproduction is with permission, providing the source is referenced and the context kept. Freshfields Bruckhaus Deringer llp is a limited liability partnership registered in England and Wales with registered number OC It is authorised and regulated by the Solicitors Regulation Authority. For regulatory information please refer to Any reference to a partner means a member, or a consultant or employee with equivalent standing and qualifications, of Freshfields Bruckhaus Deringer llp or any of its affiliated firms or entities. This material is for general information only and is not intended to provide legal advice. Freshfields Bruckhaus Deringer llp,, 34705

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