HC 742 Electricity Market Reform

Electricity Market Reform

January 2011


Mark Shorrock, CEO

Swan Yard, 9-13 West Market Place

Cirencester GL7 2NH

+44 (0)1285 380 050

Table of Contents

1. About Low Carbon Group Page 2

2. Executive summaryPage 5

3. Should the system of Feed-in Tariffs be focused on particular technologies or maintain a wider technology-based view? Page 6

4. Will market reform increase political risk for investors or create certainty?Page 8

5. What synergies and conflicts will there be between proposed mechanisms and policies already in place?Page 11

6. Will the Government’s proposed package of carbon price floor, EPS, FITs and capacity mechanism provide sufficient transformation to achieve goals on climate change, security of supply and affordability? Page13

7. ConclusionPage 14

About Low Carbon Group  

1.1. Low Carbon Group was established in 2010 as a renewable energy developer of solar, wind, hydro and tidal projects and as an investment management group offering individuals and pension funds access to long term investments in renewable energy.

1.2. The directors of Low Carbon have developed, financed and sold over 2500MW of renewable energy projects prior to forming Low Carbon Group. The directors have managed over £1,850m of capital dedicated to renewable energy and infrastructure prior to forming Low Carbon Group.

1.3. The team has a background in wind, biomass, waste to energy and solar and have developed or financed renewable energy projects in UK, Germany, France, Spain and Italy.

1.4. Low Carbon Group was established with a vision of giving individuals and communities the opportunity both to invest in local large-scale renewable energy developments, including green field solar projects, and to realise long term revenues from these opportunities.

1.5. We connect people to renewable energy projects through small and low risk investments, and over the next 18 months we hope to invest in 200MW of renewable energy in the UK with £500 million of funding.

1.6. Based in Cirencester, Low Carbon Group currently employs 40 people and expects to employ up to 70 by mid-2011.

1.7. Low Carbon Group welcomes the opportunity to respond to the House of Commons Energy & Climate Change Committee inquiry on the government’s Electricity Market Reform programme.

1.8. Our primary concern is to see Government maintain a reputable, consistent and trusted feed-in tariff policy against which we can spend high risk development capital.

1.9. The Feed in Tariff (FIT) is the framework by which we offer investors, big and small, certainty of returns and the confidence that should we get planning permission on a site, we know what revenues will arise.

1.10. Our position as a large-scale, leading renewable energy developer and investor and our collective experience in the sector over the last 9 years means that we are well placed to comment on the consequences of government policy on investor confidence in relation to FiTs.

1.11. To that end, in this submission we will respond to the following questions:

· Should the system of FITs be focused on particular technologies or maintain a wider technology-based view?

· Will market reform increase political risk for investors or create certainty?

· What synergies and conflicts will there be between proposed mechanisms and policies already in place?

· Will the Government’s proposed package of carbon price floor, EPS, FITs and capacity mechanism provide sufficient transformation to achieve goals on climate change, security of supply and affordability?

2. Executive summary  

2.1. In this response to the Committee’s call for written evidence, Low Carbon Group makes the following key points:

2.1.1. That all renewable energy technologies should be included in one Feed in Tariff mechanism that builds from the current FIT for sub-5MW renewables.

2.1.2. That FITs are expanded to include wave and tidal and energy efficiency. This will allow investors to make long term investment decisions that allow them to invest cashflows from one technology (e.g. green field solar parks) into tidal, wave and energy efficiency projects.

2.1.3. To attract the investment necessary to deliver energy infrastructure, the Government must act to provide transparency, long term tariff delineation, clear timetables, and a commitment to consistency of policy, in order to minimise political risk.

2.1.4. Institutional investors, seeking long-term, low-risk returns from investment in energy projects, are particularly susceptible to political risk. Low Carbon’s development activity, such as the launching of our People’s Pension fund and our marketing of renewable energy investments to very large pension funds, all require certainty.

2.1.5. The Government’s overall strategy must be to build credibility amongst the investors with an interest in the UK’s energy infrastructure. All reform to the electricity market must trust long term, transparent and clearly defined FIT policy so that long term investment decisions can be made in stable timeframes.

3. Should the system of Feed-in Tariffs be focused on particular technologies or maintain a wider technology-based view?  

3.1. Low Carbon believes that a full system of FITs should deliver the following:

3.1.1. Sufficient support for ground mounted solar to enable 3GW of capacity installed.

3.1.2. Sufficient support for onshore wind to enable 7GW of capacity of onshore wind to come forward.

3.1.3. Continued support for building integrated or building associated micro renewables.

3.2. An extension of the FiT to cover wave and tidal such that an initial 500MW of marine renewables can receive favourable returns in order to kick start the market before a series of degressions to the tariff.

3.3. As a general comment, the Committee should note that many investors, including Low Carbon Group, are currently focussing their support on specific technologies as part of a wider, long-term business strategy. Low Carbon Group will re-invest surplus cashflow from current FIT projects into new tidal and hydroelectric power projects and will widen its fund offerings to include wind, hydro and eventually tidal. Solar green field projects are enabling us to drive the take up of the other long term, necessary renewables that have great potential but require further development and will require us to take profits from solar to kick start wave and tidal deployment. Groups such as ours, seeking to grow the next, but sustainable versions of the large FTSE petro chemical giants, require the ability to bring enough capital into the market at an entry risk level to be able to transition that capital to higher risk renewables.

3.4. A full FIT system should offer clear consistent transparent and long term support for all renewable energy technologies. We believe each technology has its procurement, environmental impact, planning and financing challenges, but that in driving investment towards developing these technologies FITs have the capability to resolve them. As a result of the Government’s existing FIT scheme, high calibre management teams are now starting to enter the renewable energy arena, as a result of investment attracted by the certainty that FIT provides. That transformative human capital needs to be allowed to migrate to whichever renewable it finds most attractive.

3.5. RECOMMENDATION: Low Carbon strongly supports the inclusion of all technologies, including nuclear, under FITs, so long as all associated costs are made transparent. We strongly support this inclusion as a means of providing a level of transparency that will enable both investors and the public to understand the benefits and costs of renewable energy and nuclear technology. We believe that through a wider system of FITs, the Electricity Market Reform should create platforms but not pick winners.

3.6. Low Carbon is currently at a critical stage in the convincing of institutional investors to allocate to renewable energy as part of their investment strategy. This comes at a time when European Governments will have to attract about £870bn of investment to meet targets for developing renewable energy and cutting greenhouse gas emissions over the next 10 years, while also replacing ageing infrastructure. As a result, we believe that it is imperative that all technologies have their FIT banding to suit different investor tastes and the opportunity for their market take up to be as large as possible, such that costs come down and nascent economic sectors made robust.

3.7. FIT tariff banding needs to be sufficient to offer long term pension and individual investors the ability to achieve project level returns of 8.5 – 9% which is the market level return offered by other infrastructure assets such as ports, airports and toll roads. We strongly believe that the next 3 years are critical to the re setting of asset allocations within pension funds and insurance groups. We also believe that Government must maintain clarity for investors during this period of transition from allocations to equities, gilts, bonds, property to a significant allocation from institutions to renewable energy.

3.8. RECOMMENDATION: That FIT tariff banding levels are varied to suit the range of investor interests, with new, higher-risk technologies attracting a better tariff level to reward the risk taken on by the investor. At the same time, lower-risk, proven technologies should aim a return of c. 8.5% - 9% to mirror other similar infrastructure projects.

4. Will market reform increase political risk for investors or create certainty?  

4.1. Low Carbon believes that the EMR project has the potential to do either of the above, but that it needs to achieve the latter. The use of FITs to drive investment into energy infrastructure is the first and essential step to bringing investors on the journey of trust into UK Government, trust into the energy sector and trust into those few organisations, such as Low Carbon, who have managed money for some time in this area.

4.2. Low Carbon would like to draw the Committee’s attention to the recommendations of the Stern Review of the Economics of Climate Change, which is still regarded as the single most in-depth, authoritative piece of work on this matter. In that report, Stern concluded:

"Investors need a predictable carbon policy. Businesses always have to take uncertainties into account when making investment decisions. Factors such as the future oil price, changes in consumer demand, and even the weather can affect the future profitability of an investment. Business decision-makers make judgements on how these factors are likely to evolve over time.

"But unlike many other uncertainties that firms face, climate change policy is created solely by governments...Serious doubt over the future viability of a policy, or its stringency, risks imposing costs without having a significant impact on behaviour, so increasing the cost of mitigation. Creating an expectation that a policy is very likely to be sustained over a long period is critical to its effectiveness. [1]

4.3. FITs, if implemented in a long-term, transparent fashion that provide investor certainty, are more than capable of helping the UK meet its future energy needs. FIT schemes are purposely designed to attract institutional investors, such as pension fund and insurance companies, who seek long term, guaranteed returns from their portfolios. It is for this reason that the Government’s existing FiT scheme has been designed to deliver a return on investment rate of between 6% and 8%; which can be finessed up to 8.5%, an ideal rate for institutional investors. As well as leveraging finance, this helps reduce capital costs, which will inevitably be passed on to the consumer, and the EMR consultation document recognises this, outlining how FITs can reduce the Weighted Average Cost of Capital for energy projects.

4.4. The Government believes that a transparent approach to its energy strategy will help minimise the political risk attached to projects, and whilst this is welcome, this alone is not enough for the investment community. If the Government is intent on using FITs as the key vehicle for its plans, then it needs to understand that those investors with an interest in them are more likely than any other part of the finance industry to be deterred by any element of additional risk. Political risk is often hard to quantify and highly unpredictable but Low Carbon Group believes the Government should do more to address it.

4.5. Low Carbon’s recent experience of the Government’s handling of existing FITs provides a vivid example of our concern about the political risks in the energy arena. The recent Comprehensive Spending Review (CSR) was ambiguous in the news that the Government, for the first time, had decided to place cost constraints on FiTs. Then followed a period of uncertainty and it was only sometime after the CSR announcement that it emerged that the Government had decided to do so. This news came without any formal, public announcement and challenged investor confidence.

4.6. Recent Ministerial comments about the use of FITs to finance solar greenfield sites have posed a further threat to investor interest [2] in the UK’s energy infrastructure. Initiating an early review of FIT tariffs could threaten the revenues necessary to get the business operational and significantly hinder the ability of companies like Low Carbon’s to attract investment. Low Carbon Group would like to see a greater understanding at all levels of Government of the real and serious impact that this type of uncertainty creates.

4.7. Banks are reluctant to finance projects for 15 years or more without a certainty that the cash flows are valid. These judgements are supported by Government statements on policy.  In other jurisdictions where Government policy on renewables has wavered, the investment community as a whole has downgraded their assessment of the countries robustness in the face of discontinuity, elevating the cost of funding for all government enterprise. To meet the need for £200bn of investment by 2020, the Government will rely on major institutional investors (such as pension fund backers) for the funding for all technologies, including offshore wind and the green deal bonds. Those same investors have given us commitments for the first time via investment in UK solar under the sub 5 MW FIT scheme that current exists. Through this scheme, FIT supported solar is the perfect low risk entry level renewable for new investors just starting to show an interest in renewable energy investment who can then transition through to fund the other renewables.

4.8. As investors are buying cashflows to match against long term liabilities, they by necessity begin with the most well understood and least risky renewable. Once comfortable with it, they will move allocations from equities and property into renewable energy. Low Carbon has held conversations with two of the largest pension funds in the UK who cannot deploy less than £100m into this sector and need to know that the sector is big enough, certain enough of receiving returns above an agreed hurdle rate and not subject to any political risk.

4.9. To address these concerns, Low Carbon believes that the Government should return to the recommendations of the Stern Review, which concluded:

"Three essential elements for an effective policy framework are credibility (belief that the policy will endure, and be enforced); flexibility (the ability to change the policy in response to new information and changing circumstances); and predictability (setting out the circumstances and procedures under which the policy will change)."

4.10. RECOMMENDATION: If the Government is determined to provide transparency, longevity and certainty for investors [3] , then it should consider what legislative means it has at its disposal to do so. Low Carbon believes that enshrining FIT policy objectives (size, scope and characteristics of projects supported), the review process and that process’s timescales in primary legislation would be one effective way of doing this. Tariff levels would understandably need to be dealt with under secondary legislation, to provide Ministers with the flexibility to amend them in line with technology development, but clearly setting out the full process by which they are determined would significantly decrease levels of political risk.

5. What synergies and conflicts will there be between proposed mechanisms and policies already in place?  

5.1. The Government’s lead option to replace the Renewables Obligation is a new FIT scheme, called ‘Contract for Difference’. Whilst this mechanism differs from the UK’s existing FIT scheme in that it accounts for larger generators who sell electricity to the wholesale markets, it nevertheless seeks to create greater long-term price certainty by guaranteeing a tariff payment to a certain level. As the Government recognises:

"With a FIT contract the investor gets certainty about the level of support when the contract is signed. This is better than currently under the RO where an investor will not be sure of the number of ROCs they will receive until their installation is built and connected to the grid (accredited)." [1]

5.2. With this certainty at the heart of this mechanism, it is absolutely vital that a degree of trust exists between investment community and the Government so that large, low-risk investors are provided with the certainty they feel they need to support schemes. At present, many investors are considering investing in projects, but are closely watching Government behaviour before doing so. We are currently in a period when it is absolutely vital that the Government builds its credibility amongst the investment community.

5.3. Existing FIT policy will be viewed by many in the investment community as a litmus test for this credibility. A failure to provide that certainty risks undermining investor confidence, which the Government will need to instil to generate investment in energy projects via the Contract for Difference. We believe that within this context the Government should tread very carefully when approaching the FiT scheme that is currently in place and not hold an early review for the scheme, as it has previously suggested.

5.4. To date, the political risk around FITs stems from Treasury concerns around the level of costs passed through to consumers and the impact on their ability to pay tax rather than recognising the large scale upfront investment that provides an instant fillip to the national economy and the various tax takes it then benefits from in future years.

5.5. RECOMMENDATION: The Government has yet to clarify how the costs of a new Contract for Difference, if introduced as intended in 2013 – 14, would be viewed by the Treasury. We believe it should move to do so at the earliest opportunity, The recent uncertainty around the current FiT scheme originated from that Department’s decision to place a cost constraint on the scheme for the first time despite the fact that the ROC system has worked well for years with no constraint on it The Government has not clarified whether the Contract for Difference would have a similar constraint placed on it and, if it did, how those costs would be accounted for. Introducing a new cost constraint after launching the scheme would severely undermine the Government’s investment agenda and wider EMR programme.

6. Will the Government’s proposed package of carbon price floor, EPS, FITs and capacity mechanism provide sufficient transformation to achieve goals on climate change, security of supply and affordability?  

6.1. Low Carbon will restrict its comments to the role of capacity mechanism in this section of its response.

6.2. Within the context of capacity payments, the Electricity Market Reform project proposes the use of ‘negawatts’ to help improve energy efficiency through demand side management. The cheapest renewable energy by far is energy efficiency at a cost of £60,000 - £300,000 per permanent MW removed. This can take the form of lighting management control, building management control, motor replacement, waste heat recovery and the like. It is simple to baseline and report against ongoing performance. Performance will need to be monitored annually and metered just like the production of power. It is important that energy efficiency gets a weighting via the Electricity Market Reform. This will enable investors to unlock the impediment to the deployment of energy efficiency initiatives which is the low priority energy costs have in any corporate organisation.

6.3. The investment community is able to remove this obstacle by the creation of infrastructure financial products. Energy Efficiency Infrastructure Funds can own capital items that reduce energy use and can take the benefits from a negawatts payment and from electricity savings to deliver their 12% IRR hurdle rate. Low Carbon is able to offer the Committee examples of potential projects.

6.4. RECOMMENDATION: We believe the above use of negawatts is an essential part of the EMR. Investors need a clear year one baseline to invest in negawatt projects, and then a negawatts pay out for negawatts decrease in a buildings output.

7. C onclusion  

7.1. Low Carbon Group has made 230 presentations to pension funds and institutions in the last three years raising capital for renewable energy technology and projects. Our CFO has financed over £1bn of renewable energy projects. Based on this experience, our Group is very clear on the levels of certainty that investors require. We believe that the investment community requires the UK government to adopt a clear, transparent pricing table for renewable energy generators per technology per annum for the investment community to choose to invest in UK projects. Critical in this regard is to build in rolling three year reviews of tariff levels and also to have in primary legislation an absolute commitment to the uptake of renewable energy and energy efficiency. With such legislation, we are confident that each company such as ours will be able to bring £billions of new capital into this sector.

7.2. Low Carbon would like to see the EMR embrace all renewables, including allowing the large take up of solar power. We would like to see it envisage a well rewarded initial pricing for wave and tidal technology in order to kick start what can become a homegrown and large export industry. Low Carbon would like to see the EMR advocate the transparency of tariff levels for all energy sources and clear and long term pricing for the various renewable power choices.

7.3. Low Carbon believes that as long as incentives for the various renewables can deliver a return to investors of in excess of 12% post tax equity IRR in the next 3 years to then track down to 11% and on down to commercial property rental levels once the sector is large and accepted that the EMR will have met its objectives.

7.4. Finally, Low Carbon believes the EMR has the real potential to deliver the radical change to electricity markets that the Government has said that it wishes to see. The various policy streams have the ability to be transformational for society, enabling individuals to make investment choices into renewables at a local and national level that will really mean society can make a choice about what power it wants at what price.

7.5. We would be delighted to give oral evidence on the challenges of raising finance for our sector and the challenges of development in our sector.

[1] Chapter 15, Stern Review of the Economics of Climate Change, 2006

[2] “Clampdown pulls plug on march of solar farm speculators” , Daily Mail, 12.11.10. See: http://www.dailymail.co.uk/news/article-1328894/Clampdown-pulls-plug-march-solar-farm-speculators.html

[3] “Energising the Big Society - the role of industry in the local energy revolution” , Greg Barker speech to the Micropower Council, 23.11.10. See: http://www.decc.gov.uk/en/content/cms/news/micro_council/micro_council.aspx

[1] P. 48, Electricity Market Reform Consultation, 16.12.10