Select Committee on Trade and Industry Written Evidence


Memorandum by Professor Keith Palmer, Rothschild



    —  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.


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.


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.


    —  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.


    —  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.


    —  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.


    —  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.


    —  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.


    —  New nuclear capacity:

—  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.


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.

    —  Two areas of concern:

—  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.


    —  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.


    —  Viability of almost all low carbon emitting technologies depend on a minimum "carbon premium" over whole asset life.

    —  But carbon premium is:

—  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.


  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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Prepared 21 December 2006