Viewpoint Insights and opinions from Baringa Partners UK Contracts for Difference: Risks and opportunities
UK Contracts for Difference: Risks and opportunities The UK Government is set to introduce a Contracts for Difference (CfD) support mechanism for new low carbon electricity generation. Peter Sherry of Baringa Partners explores some of the key risks and opportunities for investors. In November 2012, the UK Department of Energy and Climate Change (DECC) presented its long awaited Energy Bill to Parliament. This marks the beginning of the final phase of DECC s Electricity Market Reform (EMR) project, which has the explicit aim of attracting the estimated 110bn of investment required to decarbonise the electricity sector and maintain security of supply. The centrepiece of the reforms is the proposed introduction of CfDs, essentially long-term contracts which will be available to all low carbon generation from 2014. The current Renewable Obligation, or RO (a tradeable certificates mechanism), will be closed to all new generation from 2017, and developers will be offered a one-off choice between the CfD and the RO mechanisms between 2014 and 2017. In this paper, we explore some of the key risks and opportunities, and explain how they may differ between the mechanisms. Policy risk One of the key objectives of the CfD mechanism is to provide greater long-term certainty to low carbon investors. The CfD will be a long-term contract where key terms cannot be altered, even in the event that a future government seeks to change policy objectives. At the time of contract award, investors will be able to lock in a CfD strike price for 15 years, set at a level sufficient to cover the long-run costs of their low carbon technology. Strike prices will likely be at least partially indexed to inflation, and for some technologies indexation to fuel prices may apply (e.g. coal/ gas with carbon capture and storage). There will otherwise be very limited circumstances in which the strike price can be altered. Therefore provided the developer can continue to sell power into the market and achieve close to the relevant reference price, locking the CfD strike price into a long-term contract should significantly reduce price risk for investors. Previous industry concerns around counterparty risk under the CfD mechanism now appear to have eased with the proposal for a single counterparty body owned by Government. Under the current proposal, all difference payments would flow through the newly formed counterparty body, with liabilities passed through to suppliers (as illustrated in Figure 1, overleaf). The RO allows for the support levels for each technology band to be locked in for a period of 20 years, and the value of Renewable Obligation Certificates (ROCs) in the market is held up by creating an artificial excess demand of 10% ( headroom ). To ensure certainty for investors as the mechanism winds down, the headroom will be maintained until 2027, at which point ROC prices will be fixed until the mechanism finally closes in 2037. However, investors under the RO remain fully exposed to the long-term wholesale price, which can be fundamentally affected by policy decisions of Government. 3 Viewpoint UK Contracts for Difference: Risks and opportunities
Figure 1: CfD payment flows Legal obligation to pay CfD costs CfD Suppliers Government owned counterparty CfD Consumers Bill Payments CfD paybacks CfD The variability in CfD support payments may introduce a risk for new investors looking to secure support. As the Treasury has placed a cap on total support payments (the Levy Control Framework, or LCF), the volume of investment that can be supported by the CfD mechanism will fluctuate over time, in particular with wholesale prices. Although the LCF also applies to support payments under the RO, the variability in payments is less of an issue. Investors looking to establish long-term supply chains in the UK may be concerned at the potential for the pipeline of support payments to dry up as wholesale prices reduce, or if the volume of large low carbon investment under CfDs (e.g. nuclear) is greater than anticipated. Long-term price risk The difference in long-term price risk is arguably the most fundamental difference between the RO and CfD mechanisms. The RO leaves developers exposed to long-term movements in wholesale prices, as it pays a Figure 2: CfD mechanism operation Price Generator pays difference between reference price and CfD strike price - - + Generator receives difference between reference price and CfD strike price premium on top of a variable market price. This creates both upside and downside risks for developers, as outturn total revenues could be higher or lower than expected at the time of investment. The CfD removes the exposure to long-term wholesale price movements, as support payments are variable based on the difference between the market reference price and the fixed strike price. This has the effect of stabilising revenues at the + Time + CfD strike price Reference price strike price, removing both upside and downside long-term price risk. Figure 2 illustrates schematically how the CfD mechanism operates. Given this difference in risk profile, investors are likely to seek higher returns under the RO mechanism relative to a CfD mechanism (all else being equal). The need for higher returns under the RO may be exacerbated by the long-term price- 4 Viewpoint UK Contracts for Difference: Risks and opportunities
cannibalisation effect, in which RO plant are exposed to diminishing returns as the volume of subsidised renewables on the system increases. The CfD mechanism is intended to largely shield investors from this effect. The potential for the CfD mechanism to lower the required rate of return for investors and thus costs to consumers, while maintaining market-based incentives, were the primary reasons offered by DECC for preferring it over alternative options under EMR. Short-term price risk The degree to which investors are exposed to within-year market price volatility is another potential area of difference. Under the RO, independent developers typically sell their power to suppliers under long-term Power Purchase Agreements (PPAs), alongside ROCs and Levy Exemption Certifications (LECs). The power element of the PPA is typically indexed to day-ahead or month-ahead prices, and there may be a floor price which sets a minimum level of revenues. The market index stipulated in the PPA affects the degree to which short-term price risk is shared between developer and offtaker. For example, a day-ahead index will expose the developer to increased risk (as total revenues will fluctuate with day-ahead prices), whereas a month-ahead index will deliver more stable total revenues. This risk allocation, as well as any floor price, will affect the level of discount applied by the supplier as a fee for managing physical offtake and balancing risk (and potentially LEC price risk). The CfD will pay the difference between the strike price and the chosen reference price index. DECC s current proposal is for intermittent generation technologies (e.g. wind, wave, solar) to be paid on the basis of an hourly day-ahead index. This reduces price risk for developers, given that the difference payments adjust dynamically with the reference price to ensure recovery of the strike price. Provided that the developer/offtaker can sell the intermittent power at the day-ahead price, the only basis risk that remains will be the difference between the day-ahead and the intra-day or balancing price. Much of the short-term price risk is effectively transferred to UK consumers via the CfD levy. The CfD reference price for baseload generation technologies (e.g. nuclear, coal/gas CCS, biomass) is yet to be confirmed, but DECC is mindedto adopt a basket of forward indices. This would leave an element of shortterm price risk with the developer/ offtaker, which DECC considers appropriate given that generation from these technologies is dispatchable. Offtake risk Independent developers have raised concerns that it is increasingly difficult to secure long-term PPAs on favourable terms with large energy suppliers, making financing of projects challenging. Further, industry has suggested that the big suppliers may become even less willing to enter into long-term PPAs under the CfD mechanism, since they will no longer be looking to purchase ROCs to manage exposures imposed by the RO. The reasons for the decline in PPA availability may include a preference for the large players to focus on their own projects, credit concerns surrounding smaller players, and nonfavourable treatment of PPA liabilities on constrained balance sheets (especially those with price floors). General policy uncertainty around EMR may also be an important factor in terms of current PPA availability. However, it is not clear that these issues in the PPA market will be made worse under the CfD mechanism, given that physical generation priced at or close to the reference price offers suppliers a hedge against exposure to the CfD levy. As DECC suggests, there may actually be a case for lower PPA discounts under the CfD mechanism, since the need for a floor price is removed. This may in turn lower CfD strike prices. 5 Viewpoint UK Contracts for Difference: Risks and opportunities
The 2014-17 period The 2014-17 period offers some interesting tradeoffs for renewables investors considering whether to seek support under the RO or CfD mechanisms. The CfD mechanism offers lower long-term price risk, and significantly lower short-term price risk for intermittent generation. The key decision points for project developers will be the level of the CfD strike price versus the RO band for their particularly low carbon technology, as well as their expectation of wholesale prices. Once clarity emerges on these parameters, developers will be looking to secure support as soon as possible to avoid the possibility of missing out under the LCF. In the operational phase, independent developers are likely to remain reliant on PPAs for a route to market under either mechanism, therefore Government and Ofgem initiatives to improve market liquidity will be important. The different long-term price risk profiles offered by the RO and CfD mechanisms may appeal to different investment classes. While some investors may prefer stable but lower returns (e.g. pension funds), others may prefer to take on the price exposure in exchange for a higher return (e.g. private equity). Figure 3: RO-CfD portfolio opportunities Return Lower hurdle rate investors (e.g. Pensions Funds) The introduction of CfDs offers the opportunity to tap into large pools of available capital from non-traditional sources, however it should be recognised that the lower risk profile may not suit all investors in the long-term. It may take some time for the new lower risk financing model to be established. The 2014-17 period may offer some interesting portfolio opportunities for all investors, as illustrated in Figure 3. CfD projects Higher hurdle rate investors (e.g. Private Equity) RO-CfD portfolio opportunities RO projects 0 Risk Some portfolio players may opt for the RO mechanism so as to maximise exposure to wholesale prices, in the knowledge that lower risk CfDs will be available to rebalance their portfolio in the medium to longer term. Others may seek to rebalance their existing RO portfolio with lower wholesale price exposure under CfDs at the earliest opportunity. Baringa Partners Wholesale Energy practice has a strong track record working with numerous companies in the international commodities trading markets. Our capabilities and experiences extend across gas, oil, power, coal, carbon, metals, and soft commodities markets. Our clients in the trading space comprise energy majors, oil majors, investment banks, regional utilities and funds. 6 Viewpoint UK Contracts for Difference: Risks and opportunities
For more information please contact: energyadvisoryservices@baringa.com or Phil Grant, Partner +44 7867 794 204 Duncan Sinclair, Partner +44 7887 500 856 About Baringa Partners Baringa Partners LLP is a management consultancy that specialises in the energy, financial services and utilities markets in the UK and continental Europe. It partners with blue chip companies when they are developing and delivering key elements of their business strategy. Baringa works with organisations either to implement new or optimise existing business capabilities relating to their people, processes and technology. In 2012, Baringa was named as the Best Place to Work in the UK for the third consecutive year, and fifth in Europe, by the Great Place to Work Institute, as well as winning The National Business Awards Employer of the Year category, reaffirming its status as a leading people-centred organisation. Baringa Partners is also Energy Risk s Consultancy Firm of the Year for 2012 and won the Commodity Business Award for Market Policy and Advisory. Baringa Partners LLP, 3rd Floor, Dominican Court, 17 Hatfields, London SE1 8DJ T +44 (0)203 327 4220 F +44 (0)203 327 4221 W www.baringa.com E info@baringa.com