Written evidence submitted by Scottish
and Southern Energy
It is estimated that the UK's energy infrastructure
will need at least £200 billion[29]
worth of investment before 2020 if it is to meet its statutory
climate change and renewable energy targets, and enable the UK
to move to a low carbon economy. This investment is needed in
all areas of energy infrastructure from upgrading the electricity
grid to become smarter, to making the UK housing stock energy
efficient, to demonstrating Carbon Capture and Storage technology
and developing more sources of renewable energy.
Some of the areas which require investment are relatively
new and the risks involved are judged by the capital markets to
be high. Combined with the current economic climate the result
is that there is less capital available, and that the cost of
this capital is higher. Given the scale and pace of investment
required there is a genuine risk of a funding gap between what
is required to meet targets, and what it is possible for the industry
to raise and spend. This is of concern to both industry and Government
and the announcement of the creation of a Green Investment Bank,
the aim of which is to partially mitigate these problems, was
therefore welcomed on all sides.
However six months after the election there is still
a great deal of debate as to what a Green Investment Bank (GIB)
should look like, and what its role should be. Given its position
as the UK's broadest based utility with a five year, £6.7
billion investment programme SSE has been heavily involved in
these discussions, and has come to a number of conclusions about
how a Green Investment Bank could operate, and which areas it
should focus on:
The GIB should not attempt to provide finance to
a variety of different areas. Rather it should focus its resources
and expertise on a small number of areas, the risks of which are
currently not understood, and therefore overpriced, by the capital
markets. This will provide best value for money in terms of output.
The area in which the GIB could have the most impact
are the pre-construction stages of capital intensive, low carbon
electricity generation projects such as CCS, nuclear, and renewables.
It is anticipated that the UK will need 15GW of offshore
wind capacity by 2020 if it is to meet its renewable energy target.
This represents over 50% of the 27GW of renewable capacity required.
Given the need therefore for the UK to expand its offshore wind
capacity and to reduce the costs of this technology as much as
possible, SSE believes that the GIB should initially prioritise
offshore wind projects.
To operate effectively the GIB must have an adequate
investment capacity; SSE believes that it would need at least
£4-5 billion of initial funding to be effective.
What are the barriers or "market failures"
requiring the establishment of a Green Investment Bank?
The major barrier that the energy industry faces
is, simply, the scale and pace of the investment required over
the next decade. At present companies are investing more than
ever before, and this needs to be doubled (at least) if required
investment levels are to be met. The concern is that this increased
investment will not take place under current market conditions,
thereby potentially creating a significant funding gap. There
are two main reasons for this:
1. There is a limited amount of capital which
will be supplied to the energy sector
This is partly a reflection of a general scarcity
of capital, but more fundamentally it is due to the market failure
of the capital markets.
When investors consider whether to invest in a particular
project they look at each stage of that project, identify the
risks with each, and then set the cost of capital according to
these perceived risks; the higher the perceived risk the higher
the cost of capital. There are number of different types of risks
associated with energy infrastructure projects including: planning
- will a project receive planning consent; grid access - will
it be given access to the electricity grid in time and at what
cost; construction; operational; and price risk - the risk associated
with a fluctuating energy price.
At present the capital markets are not fully comfortable
with the risks involved with major energy infrastructure projects
such as offshore wind, CCS or new nuclear. These are relatively
new technologies, with no proven track record and take a number
of years to develop and build (long lead times).
As such investors are naturally cautious when it
comes to pricing the risk of each stage; this leads to the risk,
and therefore the overall cost of capital, being overpriced and
discourages development of new infrastructure. It has also become
increasingly evident that institutional investors - those providing
equity rather than debt - are unwilling to support new investments
in new technologies such as offshore wind.
2. Companies balance sheets are already stretched
The companies operating in the UK energy sector are
currently investing around £8 billion annually, a significant
increase from levels in the 1990's, and this has resulted in the
sector becoming very highly leveraged ie it has borrowed a great
deal already in order to implement its current investment programme.
In order to fill the funding gap companies would
have to increase total investment in the UK to £26 billion
a year for the next ten years, an increase of 210%. However, without
putting their credit ratings at risk, companies will not be able
to raise this level of capital through either debt or equity even
if potential investments are sound.[30]
Therefore, as things stand, the investment required
to upgrade existing, and build new, energy infrastructure is extremely
unlikely to happen. In order to overcome these barriers to additional
investment in the energy sector Government is considering some
alternative options; the Green Investment Bank and Electricity
Market Reform. It is hoped that one or both of these interventions
would enable investment to be delivered more quickly than it would
be under a business-as-usual scenario:
IMPACT OF
ELECTRICITY MARKET
REFORM
SSE feels that reforming the electricity market will
have a limited impact on the funding gap. This is because most
reform options - eg a move to a full feed-in-tariff for renewable
electricity generation - focus on price risk: reducing the risks
around the price of electricity which generators receive from
the project.
These price risks only make up a very small proportion
of the cost of capital - others, particularly construction risk,
make up a much larger percentage; therefore reducing the price
risks around a project only slightly reduces the average cost
of capital. SSE has calculated that it would reduce the cost of
capital by 0.5% for a wind project, and have a number of unintended
negative consequences.
In addition increasing revenues from generation projects
through higher subsidies for different technologies is also unlikely
to result in additional investment. Whilst this might seem illogical
from the outset (higher returns should result in more interest
from investors) it is as a direct result of the problem outlined
above: namely that capital markets are not providing the volume
of capital needed.
As such SSE feels that it is unlikely that electricity
market reforms will be able to fill much of the funding gap -
indeed, some of the proposed reforms will be ineffective unless
the cost of capital is reduced sufficiently.
THE GREEN
INVESTMENT BANK
The key question is therefore whether a GIB can fare
any better than market reforms in providing the additional financing
that the energy sector requires. SSE believes that it can if it
limits its role and objectives, and clearly prioritises its investment
areas.
What objectives and roles should the GIB assume,
which areas should it operate in, and what should its investment
priorities be?
In order to effectively encourage additional investment
in the energy sector to meet the potential funding gap the GIB
must focus its efforts on removing the existing barriers; the
overpricing of risk by the private capital markets due to a lack
of comfort with the technologies and rates of return; and the
impacts of the limited balance sheets of the major developers.
As such SSE believes that the role of the GIB should
be to fill the knowledge gaps left by the private markets, with
its objective being to become a specialist in its chosen areas
and to therefore price risk at a reasonable rate. In order to
do this effectively the GIB must limit the areas in which it operates,
otherwise it runs the risk of spreading itself too thinly and
diluting its potential impact - the GIB can not and should not
try to fund every facet of green energy.
However, although the GIB should be designed to plug
the gaps left by the private markets it should have a clear exit
strategy that allows it to gradually withdraw its support from
an area once the private markets have become comfortable with
the risks involved. It should not crowd out this investor, but
act as an interim source of funding until this investment is forthcoming.
It is also important to note that in order the GIB is to plug
the gaps left by the private markets it must employ, and retain,
experts who understand technology, construction and policy risks
better than the market.
If the areas in which the GIB operates are limited
then it is crucial that it focuses on the areas in which it can
have most effect. Clearly there will be a number of different
views as to what these are and all of these should be taken into
account when final decisions are made. SSE believes that a GIB
could be most effective in one area:
The pre-construction stage of capital intensive low
carbon technologies, particularly offshore wind.
The main financing constraint for the sector is at
the pre-construction stage of capital-intensive low carbon technologies
such as offshore wind, CCS, and nuclear. As noted above these
technologies have long lead times where there is not yet a track
record to allow financial markets to be comfortable with the construction
risks - as such these risks are being overpriced.
A GIB could provide equity or debt finance at the
construction stage of these projects at reasonable rates (which
private markets are not currently delivering) and would also allow
developers to spread the limited spare capacity on their balance
sheets over more projects as a result. This finance would then
be recycled with the Green Bank selling its stake once the construction
phase is complete.
Given the need to both decarbonise and increase renewable
generation capacity SSE believes the priority for investment in
the first instance should be offshore wind projects. Currently
the UK has 1.3GW of offshore wind capacity installed,[31]
but it is anticipated that the UK will need 15GW of offshore wind
by 2020 in order to meet its 27GW renewable targets. This equates
to around £5 billion of investment a year for the next
decade.[32]
An example of how the GIB might help move an offshore
wind project forward is illustrated below:
AN EQUITY-CO
-INVESTMENT MODEL
SSE envisages the Green Bank (GB) providing equity
co-investment for offshore wind with the following key features:
Investment would be made alongside sponsor(s) before
the start of construction;
The equity would be "passive" - the sponsor
would be responsible for project delivery;
The funding would be 50/50 matched funding with the
GB facing an identical risk profile to the sponsor(s); and
At commissioning, the GB would sell it's stake and
the capital would be recycled into other projects. At this stage
the sponsor(s) would have a call option to buy out the GB that
would be used to target a reasonable return for the sponsors.
With this type of investment the GIB would be "making
markets", rather than crowding out existing private markets.
In this way the bank could help resolve short and medium term
financing issues and lead to more infrastructure being delivered
to meet the Government's targets.
How should a GIB be funded?
This is a key question as the overall effectiveness
of the GIB will be limited by the amount of capital it can raise
in the first instance. SSE believes that there are three options
which are likely to most effective in raising funds for the bank:
Consumer co-investment:
this is a model suggested by Rothschild's and other financial
institutions and would have the benefit of taking funds off the
public balance sheet. Finance is provided by the private capital
markets but is underwritten by future consumer bills - in other
words if projects sponsored by the GIB fail and debtors can not
be paid from investment returns, a consumer levy could be applied
electricity and/ or gas bills to make up the shortfall.
Whilst using consumer bills as collateral may be
seen to be problematic, in practice it is extremely unlikely that
they would ever be needed if the GIB makes disciplined investment
decisions and diversifies the risk across enough projects. In
addition, if bills are not used to underwrite risk it is doubtful
as to whether investors would be willing to finance the GIB at
low enough interest rates.
Green Bonds: the
GIB could issue and market green bonds, which could be a way to
channel pension and insurance fund money into the sector. The
challenge however will be to ensure that these bonds have a high
enough rating to attract these typically risk-averse investors
- giving bonds a "green" brand will help to attract
the growing number of "ethical" investors, but to be
fully effective they must also be attractive to the entire market.
This is highly likely to require some form of underwriting by
either the Government or consumers.
Green ISA's: allowing
tax efficient investment by individuals could be an effective
way of raising funds and offers the opportunity for the public
to engage directly in the low carbon investment challenge.
Whichever funding route(s) are chosen it is important
that the amount of capital raised is sufficient for the GIB to
be effective. In the Emergency Budget in May the Government suggested
that a GIB would have around £2 billion of initial capital
but SSE would question whether this figure is enough. An offshore
wind farm, for example, costs £3 billion per GW, and
therefore 50% of a 500MW project would be around £750 million.
Given that the Bank would probably want to spread it's capital
over at least four projects to reduce exposure, the implication
is that £2 billion would not be sufficient.
SSE therefore believes that, providing the capital
is being recycled every two to three years, the GIB would have
to be capitalised to at least £4-£5 billion initially.
This was also the conclusion of the recent report by the Aldersgate
Group, and a recent report by Citigroup suggested that the level
would have to be even higher than this if the GIB was to be truly
effective.
15 October 2010
29 The future of UK energy (Speech by Charles
Hendry to the Fuellers lecture 25th Anniversary), 29 September
2010. Back
30
"The 1trn Euro Decade - Revisited" - Report by Citigroup
(29 September 2010); p. 17. Back
31
Figures from Renewable UK. Back
32
Based on a cost of £3 billion to build 1GW of offshore
wind. Back
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