APPENDIX 45
Memorandum by Professor Keith Palmer,
Rothschild
FINANCING NEW
ELECTRICITY SUPPLY
IN THE
UK MARKET WITH
CARBON ABATEMENT
CONSTRAINTS
OBJECTIVES
— Lowest cost energy supply consistent
with other objectives.
— Deliver environmental goals—carbon
and other.
— Acceptable risk—security of
supply and other risks.
— Timelines—supply increases
to match rising demand and meet government carbon reduction targets.
It is assumed that the objectives of energy
policy are energy that is as cheap as possible consistent with
meeting our carbon abatement targets and security of supply concerns.
ELECTRICITY SUPPLY
INVESTMENT DECISIONS
What we need to know...
— Future electricity demand (UK, connected
markets)
Fuel costs
— What will oil and gas prices be over
next 30-40 years?
— How will coal prices change as oil/gas
prices change?
Conversion costs
— What productivity "progress"
is likely for "old" and "new" technologies?
— What is the cost of capital for different
technologies?
Carbon costs
— What will be the cost to generators
of emitting carbon over next 30-40 years?
Whatever the type of generation the cost of
carbon abatement is a key issue. Carbon emitting technologies
have to pay an extra cost whose amount is a function of how much
carbon they emit. Non-carbon emitting technologies eg renewables
and nuclear benefit in relative terms because they do not have
to bear these costs.
Fossil fuel technologies require a judgment
about the future cost of fuel ie gas, coal, oil etc. This is inherently
uncertain and adds to investor risk.
For nuclear there are low fuel price risks.
For financiers the big risks for nuclear are the cost of capital
(primarily a function of the market risk) and how much of a premium
non-carbon emitting technologies will earn as a carbon premium.
IMPACT OF
CARBON ABATEMENT
POLICIES ON
INVESTMENT DECISIONS
EU Emissions Trading Scheme (ETS)
— The EU Emissions Trading Scheme (ETS)
raises the market price of electricity (the carbon premium).
— The carbon price is a policy determined
number reflecting the stringency of the carbon abatement policies
and other factors.
— The carbon premium in the UK electricity
market is set by the carbon price and the amount of carbon emitted
by new combined cycle gas fired (CCGT) plant (see left bar of
graph on slide 3).
— Non-carbon emitting technologies
(eg renewables, nuclear etc) capture this carbon premium because
they do not emit carbon (see middle bar of graph on slide 3).
— High carbon emitters eg coal pay
higher carbon abatement costs than CCGT plant, raising their total
costs.
EXPECTED COST
OF NEW
ELECTRICITY SUPPLY
— The three lines on the graph show
the electricity price at which new CCGT plant is economic for
three oil price assumptions across a wide range of carbon prices.
— Data on the cost of new CCGT generation
is widely available and very reliable other than the cost of fuel
and the future carbon price.
EXPECTED COST
OF NEW
ENERGY SUPPLY
— This is the same graph as slide 4
with the addition of the estimated cost of new nuclear shown as
a range from £30-37/MWh.
— The assumptions used to estimate
the cost of nuclear were based on the following: a 1,200 MW single
unit "first of a kind in UK" plant using PWR Gen III+
technology; 40 year life; 85% load factor after two years at 80%;
build period from construction start six years; costs built up
from separate review of planning and design costs, construction
costs, non-fuel operating and maintenance costs, front-end fuel
costs, back-end fuel costs (waste disposal), decommissioning costs
and various economic and financial assumptions including investors'
required return on capital. The derived price is the levelised
price that generates the required return on investment over the
plant life. These base case assumptions are best characterised
as relatively conservative.
— In addition a range of sensitivity
analyses were undertaken to take account of the uncertainties
around some of the assumptions. The range on the slide reflects
this sensitivity analysis. The most uncertainty surrounds planning
and design costs, waste disposal costs, the construction period
and the cost of capital. Of these the first two are uncertain
but have a limited impact on the economics of nuclear because
they are a relatively small proportion of total costs. The latter
two are much the most important in forming a view about the economic
price.
— Similar estimates have been made
taking account of the evidence that subsequent plants of the same
design tend to be cheaper than "first of a kind" plant.
We assume a 5% saving in construction costs for each doubling
of capacity of the same type.
— The lines bounding the cost of nuclear
are horizontal because nuclear bears no carbon abatement costs
ie the costs do not vary with the carbon price.
— The intersection of the nuclear cost
lines with the CCGT lines indicate the crossover point where nuclear
is cheaper than CCGT after taking account of the costs of carbon
abatement. For example, if the oil price is $40/bbl over the life
of the plant and the cost of nuclear is at the top end of the
indicated range then nuclear is cheaper if the carbon price exceeds
about £28/tonne over the life of the plant.
EXPECTED COST
OF NEW
ELECTRICITY SUPPLY
— This is the same graph as slides
4 and 5 but also showing the carbon price ranges at which other
non-carbon emitting technologies are economic (ie earn an adequate
return on capital when the carbon premium is taken into account).
— For example, it shows that new onshore
wind is competitive with CCGT when the carbon price is in the
range £20-30/tonne and carbon sequestration when the carbon
price is in the range £30-50/tonne whereas offshore wind
is only competitive with CCGT if the carbon price remains at around
£60-70/tonne. Marine technologies—many of which are
much more expensive again at present—would require even
higher carbon prices than offshore wind.
— The data on which the graph is based
are derived from a review of the best available public sources
and work undertaken for Ofgem.
— A key observation is that nuclear
is a much cheaper way of abating carbon than offshore wind even
when very conservative assumptions are used.
ACCEPTABLE RISK
FOR PUBLIC
— Many dimensions of risk.
— Security of supply risk (physical availability,
price volatility).
— Nuclear accident risk.
— Economic risk (uncompetitive energy users,
energy poverty etc).
— Climate change risk.
— Need to adopt a portfolio approach
to risk management and define "acceptable risk"—as
has always been done in electricity industry.
— Mostly to do with resilience and
flexibility of supply side and retention of adequate "planning
margins".
— Issue is whether market rules are
compatible with retention of desired resilience and flexibility.
Every technology has risk but the key risks
differ with the technology.
A portfolio approach is the way forward—the
question is the right balance between different technologies to
meet all the objectives including "as cheap as possible"
and security of supply.
GAS DEPENDENCE
AND SECURITY
OF SUPPLY
— In all UK energy futures (with/without
nuclear, renewables etc) the electricity price will be linked
to international gas prices.
— In fact there is broadly comparable
gas price risk facing consumers whether or not a major new build
of nuclear occurs and whether the 20% of renewables target is
met.
TIMING ISSUES
— Even if "go" in 2006 first
output unlikely before 2015.
— Aggregate new nuclear capacity of 5,000
MW very challenging before 2016.
— Before 2013 key to CO2 reduction
is more coal to gas switching. Coal is 2.3X more carbon polluting
than gas. Switching 60TWh coal to gas would reduce CO2 emissions
by 35mte CO2 (=predicted 2010 target shortfall).
— Many proposed carbon abatement "solutions"
either still in development phase and/or uneconomic (carbon sequestration,
marine renewables). Reliance on these solutions is very high risk
for carbon abatement targets.
New nuclear would replace old nuclear and not
add net new capacity.
Key timing issue is whether it can be available
in time for closure of old nuclear. Our estimate is that fastest
development would be first plant producing energy by 2015 and
about 5,000 MW producing by 2016-17.
DELIVERING THE
DESIRED ENERGY
FUTURE
Can the new supply be financed?
— "Shortage" of capital is
not an issue.
— The issue is whether the energy and
carbon markets (net of government policy interventions) offer
investors an expected return commensurate with the risks (after
risk management strategies).
— Cost and performance risks can and
should remain entirely with the private sector.
— Whether NETA will deliver timely adequate
new capacity.
— Whether the carbon market risks are manageable.
Plant cost and performance risks can and should
be taken by private sector.
Key issue for financing is the future electricity
price including the carbon premium.
Reducing the risk around the future electricity
price including carbon premium thereby reducing the risk premium
in the cost of capital.
IS ELECTRICITY
MARKET FIT
FOR PURPOSE?
— Absence of buyers offering long term
contracts increases investor risk and therefore the cost of capital.
— Will NETA give price signals to deliver
sufficient timely new capacity? Is absence of capacity price a
problem?
— Integrated generation/supply companies
best placed to manage the market risks.
— Renewable obligation mechanism further
complicates the picture. If RO capacity not delivered is there
sufficient conventional capacity to meet peak demand?
— All these issues favour new CCGT
because it can be installed quickly in "small lumps"
and at low capital cost per MW.
— Same issues increase risk and cost
of capital of capital intensive technologies such as nuclear.
A particular issue for nuclear is the very long
life of the plant and therefore price risk over the very long
term.
Managing this price risk is a difficult problem.
The UK integrated generation and supply companies
are best placed to manage this risk—likely to have a key
role if new nuclear proceeds.
IS THE
CARBON MARKET
FIT FOR
PURPOSE?
— Viability of almost all low carbon
emitting technologies depend on a minimum "carbon premium"
over whole asset life.
— Determined by governments.
— Known for only a short period ahead.
— No mechanism currently exists to
manage carbon price risk over medium and longer term:
— ETS.
— RO obligation.
— Investors in low carbon emitting
technologies will be very slow to invest where viability can be
destroyed after capital is "sunk" by changes in government
policy.
— Major impediment to investment in all
carbon abatement technologies.
— Important reason why offshore wind is
developing slowly.
Key policy challenge is to reduce risk around
future carbon price
Answer at present—a definite "No".
ETS market is only set for a few years at a
time and is highly volatile.
Need a mechanism to add certainty to the longer
term carbon price. This is crucial for financing all non-carbon
emitting technologies in a carbon abatement world.
Not a plea to help nuclear—viability of
all non-carbon emitting technologies depends crucially on being
able to predict and manage the carbon premium in the electricity
price (eg carbon sequestration and offshore wind).
There are mechanisms that could be put in place
that do not involve a taxpayer subsidy or require agreement of
all EU countries to address this problem.
SOME PROPOSITIONS
AND QUESTIONS
FOR DISCUSSION
1. New nuclear is the lowest cost of the
low carbon emitting technologies. Offshore wind is very much more
expensive and has high security of supply risks.
2. New coal-fired plant has no (significant)
place in a low carbon energy future.
3. Will the electricity market as currently
designed deliver the "right" amount of new capacity
on a timely basis??
4. Unless the "carbon price risk"
issue is addressed, the default outcome will be lots more gas-fired
CCGTs and failure to meet the carbon reduction targets.
5. Unless "new" nuclear sufficient
to replace closing "old" nuclear is built, it is very
unlikely that the long term carbon reduction targets can be met.
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