Green Investment Bank

Written evidence submitted by Scottish and Southern Energy (GIB 22)

It is estimated that the UK’s energy infrastructure will need at least £200 billion [1] 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 £8bn annually, a significant increase from levels in the 1990’s, and this has resulted in the sector becoming very highly leveraged i.e. 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 bn 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 [2] .

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 - e.g. 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 [3] , 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 £5bn of investment a year for the next decade [4] .

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 £2bn of initial capital but SSE would question whether this figure is enough. An offshore wind farm, for example, costs £3bn per GW, and therefore 50% of a 500MW project would be around £750m. Given that the Bank would probably want to spread it's capital over at least four projects to reduce exposure, the implication is that £2bn would not be sufficient.

SSE therefore believes that, providing the capital is being recycled every 2-3 years, the GIB would have to be c apitalised to at least £4-£5bn 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