Electricity Market Reform - Energy and Climate Change Contents


Examination of Witnesses (Questions 181-204)

PETER ATHERTON, CHRIS HUNT, SHAUN MAYS AND SHAI WEISS

8 FEBRUARY 2011

  Q181  Chair: Good morning, and thank you very much for coming in. We can see your names and we know who you are, so I will dispense with the formal introductions. We are very glad to have you at this evidence session. This particular inquiry is well under way, and, as you may know, we've had several evidence sessions already. Obviously, it is an extremely topical and important subject. We have about an hour with you, if that suits you. We have another set of witnesses coming later.

  I will kick off by asking a general question. Each of you may answer any question, but don't feel that you have to answer every question. Do you think the present market arrangements make investment in low-carbon technologies too risky, or unnecessarily risky, and therefore unnecessarily expensive?

  Chris Hunt: My name is Chris Hunt. I am from Riverstone, a private equity house that specialises in energy investments. We cover the full spectrum of energy, but, more so than most firms specialising in energy, we tend to invest a fair amount in renewable energy. So I am coming in wearing the hat of specifically talking about renewable energy.

  If I am honest, the UK is investable. Under the current arrangements, we would come in and invest more money in the United Kingdom. In fact we have made several investments in the United Kingdom. We own offshore wind installation ships and a bioethanol plant, and we are investing in wind. So the UK is investable. However, I think that the electricity market reform will increase the amount of capital that we would be prepared to put here, not only because we would see the UK as a better place to invest, but in large part because I think our investors, who give us money, would see it as a safer place to invest.

  Shai Weiss: I represent the Virgin Green Fund, which is affiliated with the Virgin Group and Sir Richard Branson. Like Chris, we invest only in renewable energy in Europe and the United States. That is not to say that we would not invest right now in the United Kingdom. To emphasise what Chris is saying, we have always said that legislation in this market has to be three things. First it has to be clear, so that people understand the rules of the game. The EMR should do that. It should also give clear signals to the markets that this is something that the UK really wants to invest in and incentivise. Secondly, it has to be very loud. Everybody should know about it, particularly the people who provide the capital and the people who invest the capital. So the ecosystem should be clear.

  Thirdly, the legislation should be very stable. One of our recommendations is that we should choose a very good system and ensure that it is very, very stable for a very long period of time. Capital can adjust itself for risk/reward. You asked whether the UK is a risky place. Well, it is a pretty good place to invest in terms of risk/reward, but that risk/reward profile has to be extremely stable over the long run. If you give the markets these signals in a clear, concise and stable manner, you will see greater inflow into the projects; and when you see greater inflows into the projects, you will see that the ecosystems of companies distributed across the UK, not just in London and the south-east, will flourish based on that framework.

  Shaun Mays: I am Shaun Mays from Climate Change Capital. We have more than 20 renewable energy projects in the UK. Our investor base consists of the big pensions funds and insurance companies, who are looking for stable, inflation-linked returns to immunise their defined-benefit pension liabilities or to back their annuity products.

  To reiterate what Shai said, we think the existing system is fine, but it is obviously immature, so it hasn't drawn in a lot of capital at this stage. If you are patient and hold your nerve, the return expectations will adjust to the system and you will see a larger volume. Our investor base is not that entranced by the offshore wind sector at the moment, because it sees technology risk, policy risk and construction risk. So don't think that, just because today's policy is under review, there aren't other factors in offshore wind financing that won't come to bear.

  One of the crucial things about your review is whether, once the assets are operational, we can get the developer and construction cycle and the project finance money recycled into institutional money, because that is where the big pool of capital is, and they will want stable, predictable, probably inflation-linked returns. They will adjust the price and the cost of capital will come down if we can deliver that. That is the point we are trying to make.

  Peter Atherton: I am Peter Atherton from Citigroup. For the lawyers, my usual proviso is that I speak for myself and not for Citigroup.

  It depends on the technology. The current mechanisms and reward systems are very generous in many areas. Onshore wind works fine, if you can get planning permission. The current systems struggle where you have big construction risk and big technological risk, such as with offshore wind and, even more so, with new nuclear. In our view, new nuclear is uninvestable for private equity investors. Under the current mechanisms there is too much construction risk and too much power price risk. Offshore wind is in a borderline area, but onshore wind, for example, would be fine. Carbon capture and storage sits with new nuclear and offshore wind as being very difficult to invest in under the current arrangements.

  Q182  Chair: I should have drawn attention to my entry in the Register of Members' Financial Interests. I have interests in several renewable energy businesses.

  Do you think that the general tone of the package—what is out there for consultation now—is moving in the right direction, or has this process introduced an unwelcome, though perhaps only temporary, element of uncertainty?

  Shaun Mays: Any change brings an investment hiatus; we have to understand that. If we are looking at the investment side, the one big variable is policy uncertainty. If you go back to the UK's privatisation of traditional infrastructure, the thing that stabilised investment in that sector and brought large volumes was the fact that we had a regulated asset-based system with a five-year reset. We have to think about some sort of system like that, particularly around the carbon tax; the way the carbon tax is in the energy market reform at the moment looks like it is a bit too able to be adjusted at short intervals.

  There is a hiatus; people are waiting, and it is compounded by the fact that there has been policy risk in other geographies in this same sector, so institutional investors are sitting back and saying, "Until this is clear, I don't think I have the ability to invest; it is just too risky and I don't know what the returns look like or what might happen". You just have to understand that there will be, combined with the credit crunch, a different mindset. The credit crunch brought a different mindset to risk, and policy change also affects it. So we applaud the fact that you're trying to do this quickly and we'll get rid of that regulatory uncertainty.

  Chris Hunt: I would say, on balance, that I personally welcome this package. I have been investing in renewable energy for over 20 years and was even involved when one of the first major reforms in the UK was introduced back in the '80s. At that time, there was a different set of circumstances; introducing market reform and market-based mechanisms was definitely needed for the sector. But I think you can't necessarily fault the system that has got us to where we are today. If you look at the underlying statistics of how much capital has flown to low-carbon investment, you have to acknowledge that now is probably the time for another change. The timing and sequencing of things are following a logical course; it is time to make a change, to go down the route of policy signals that perhaps by some will be considered a bit more directive, a little less market-oriented, but aimed at achieving a goal.

  On balance, therefore, I think the timing and the general theme of what you're intending to do with the EMR is very appropriate. It will open up quite a bit of capital that to date has been sitting on the sidelines, so I am very much in favour of this package. Most people who look at it from the perspective of investment and yield investments and safe investments are favourably disposed to it.

  Shai Weiss: Just to add to that: what you can see from this package which, as Chris said, is kind of favourable for low-carbon technologies, is that there is a penalty on high-carbon. That is the first signal it gives you, which is a good thing, and you can debate how that is achieved. There are support mechanisms for low-carbon; the debate can go on in the Committee about whether, for example, a contract for difference or a feed-in tariff is the most appropriate, but that signal is a good one. Then there is an incentive for energy efficiency. When you combine these three things, it seems to address appropriately the market conditions and the change.

  The only note of caution that I would sound is that there is a lot of focus on capacity payments, so building extra capacity, which is really taking a snapshot of today and trying to forecast it into the future, and inherently there is a big tension—or a small tension, depending on where you sit—between the existing utilities and the new entrants into the market and the investors. That tension, through this package, should also be addressed.

  Peter Atherton: My answer is that I have no idea; it is way too early to tell. These are very big, complex reforms, interacting with a whole series of other, very big and complex policies. The question is whether these reforms achieve their goal, which is essentially about transferring risk. Essentially, the Government have decided that what they are asking the capital markets to do, predominantly through the utilities sector, is too risky for the rewards on offer. They can't really increase the rewards on offer any more, because that will have such a profound impact on prices, and the affordability issue is dampening their ability to do that. So they need to transfer risk. What they are looking to do is transfer big chunks of the power price risk from the developers to the consumer.

  Now, in principle, that should be good for the developers. However, it has a number of side effects. One is that you are also capping out returns, so it is not just a one-way bet: you are limiting returns as well as limiting risk. Secondly, you may be creating brand new risks, particularly to do with the direction of investment through the agency that is going to allocate the CfDs. How on earth will that actually work in practice? Is there some Government agency that will tell the industry what to build, when and where? Will those contracts be stickable with? What will the Government decide in future generations about the decisions made by their agency?

  There is nothing about construction risk or technology risk either. In fact, this may be exacerbating the construction risk, because you are basically asking people to build on a fixed-price revenue line, which may not be that attractive. So, yes, in principle, one of the major problems—the power price risk—is being to some degree neutralised and to some degree transferred to the consumer, but actually that may not solve all the problems, and it may create other risks as well.

  Chris Hunt: I agree very emphatically that it is still too early to say. I think the overall package that the EMR has introduced is the first of two steps. The broad general structure of it is perfectly fine. How it is implemented, how prices are set, what the tariffs are, it is still way too early to tell. One thing that I have learned in watching this sector over the last four or five years is that massive amounts of capital will flow to the market that offers the most attractive investment.

  For example, take solar power—which may not be the best example for the UK, given the lack of sun. When Spain put forward a certain tariff level the market responded, and billions of capital flew into that market. When Germany introduced a feed-in tariff that was attractive, capital flew there. And Italy. We are talking literally many billions of dollars or pounds of capital motivated to a market in a very short span of time. We don't yet know, under this package, exactly how tariff levels will be set, or exactly what the ultimate profitability will be, but the framework that you are setting up allows you to get to that point. Whether the capital actually flows depends on how you set the pricing.

  Shaun Mays: I think the market will adjust to risk, though. Don't let us give the impression that our investments will not take root. What we have to do is give them a clear sight of what risks they are taking. So I think that the wholesale electricity market reform is also very important, because that is a very opaque market. Some of the things that have been proposed, like the clawback provisions and the way the CfDs are issued—we have to look at those and say, they could create uncertainty around volume, price and risk, and that will mean that the cost of capital goes up. Then investors will demand a higher return.

  One of the challenges for you is to create a system where you bring the cost of capital down so that you get two things: lower expense of building and operating these projects, and secondly, bigger volume. That is the challenge, given that estimates are up to £200 billion by 2020. That is not an insignificant amount of money, even by the £3 trillion in the pension fund market—it is still a lot to allocate to this sector. The cost of a 1% or 2% change in the cost of capital therefore makes a huge difference to the amount of money that goes in. So we have to look at those elements and say that a lot of thought needs to be given to the clarity of the system—the transparency of it, in terms of volumes and price. Some of the things in the package at the moment suggest that those could be adjusted at the last minute, and all that will happen is that they will take the lowest common denominator—the lowest price—and any upside will go to the investors and not to the Government. We must think about that.

  Q183  Laura Sandys (South Thanet) (Con): The enthusiasm of three of you for the reforms seems obvious, which is very good, because we need the investment. But your enthusiasm also creates a question for me: will the reforms that we are putting in place be sustainable at a price that fits your investment model and also does not have to be changed by us, or a future Government, due to changing circumstances? The energy sector is going through huge revolutions, not just in renewables, but in new technologies coming through, new usages, efficiency and so on. There will be a moment when we set fixed values to all the different indicators, but they will change due to the circumstances. What one can't look at is something that is fixed for the next 30 years with a market that will, by definition, be on the move. I worry whether the point that we need the investment is going to be sustainable into the long term.

  Chris Hunt: It's a great question; thanks for asking it. I have a couple of thoughts. It might be a little discombobulating but I will try to present them as best I can. First, a lot of attention is paid toward the impact of renewable subsidies on the overall electricity price. One broad comment I will make is that every element of energy is a highly subsidised business. The only difference between renewables subsidies and subsidies in other parts of the energy business is that renewable subsidies tend to be more transparent. They tend to be talked about more and are more visible, but every element has them.

  Generally speaking, if you look at the impact of renewable subsidies across a wide range of economies, and you look at how much it actually increases the end bill to consumers, generally the number is far smaller than you would expect. It obviously depends on the economy, but generally it increases the end bill only in the neighbourhood of 2%, 3% or 5%. In some cases, if you have a huge penetration of renewables and you have gone for more expensive types, that number can be higher, but in most economies that have gone down this road before and achieved reasonably high penetration rates of renewable energy, you are generally seeing the end bill to consumers going up by only 5% or less. That is over a long-term average of what you would expect energy prices to be. If an economy were to face an energy shock—for example, if we were to have a sustained period of two or three years of high oil prices in excess of $100 a barrel—that would far overwhelm, in terms of cost to the UK, the cost of those subsidies. When you sit down and get to the heart of costing the numbers, it's really not that high.

  My last comment on the subject is that what you are setting up with the EMR is a framework. When you put in place, for example, a feed-in tariff, and say to a wind generator, "We are going to give you a feed-in tariff and you will get that tariff for 20 years," the Government are still able within that framework to reduce those feed-in tariffs over time. You might offer a certain price for projects that are built today, and then as technology matures and costs come down, you can lower that feed-in tariff for projects that are built five years from now, and lower it again for projects built 10 years from now. So it is not as if you are giving up the ability to reduce the cost over time; you are just creating a framework that allows you to have the broad structure.

  Shai Weiss: May I add to that? Chris is saying that the UK should benefit from that cost curve advantage. We are not saying that we are asking you to give up the advantage over time and simply give it to the investors, and the public do not benefit. It is fair to say that we are still in the very early days of this entire renewable energy cycle. Solar may not be attractive right now in the UK but could benefit the UK in the long run, just because of the improvements and gains in reduction of costs. Wind is improving all the time. Tidal has not even started; there is a huge technology risk there but it may ultimately benefit the UK, especially given its geographic location. All those things should be allowed for in a framework. Our enthusiasm is for a framework that is stable, that is rational and that adjusts, and fairly benefits both the public and the investors for gains. If that is achieved, I think you will see a lot of capital flow into the UK.

  The last point, to amplify what Chris has said, is that the subsidies are always taken in the context of a transfer for the feed-in tariff, so the price over and above that at which you can buy electricity. However, when you calculate the cost of ownership and the gains to the economy and job creation and so forth, you will see that that should also benefit the consumers over the long run.

  Q184  Barry Gardiner: Mr Hunt, you were saying that if the price of oil went above $100 a barrel for a significant period of time, that would have a far greater effect than renewables. But surely, if that were to happen and you had a premium FIT, the cost of the renewables would be even greater, wouldn't it?

  Chris Hunt: It would in fact, and our view is that that would be a windfall that is not necessarily appropriate to give to a renewable energy generator.

  Q185  Barry Gardiner: You would want us to impose a windfall tax.

  Chris Hunt: I actually don't believe in a premium FIT. I believe in a FIT, for precisely the reasons you stated.

  Peter Atherton: I—

  Q186  Albert Owen: I am sorry, Mr Atherton; I'll give you an opportunity in a moment. You have said that the current situation is quite high risk. We—or the Government—are only producing a framework here. Mr Weiss, you have twice mentioned stability: do you think this framework provides enough stability?

  Shai Weiss: I think the elements in here, once agreed and once they come to a rational conclusion, should provide sufficient stability. I did point a caution on building capacity when capacity is unnecessary, which, in my mind, truly promotes coal and nuclear. That is a whole, to my mind, excess capacity that the UK may not need and it is really over-emphasising security of supply. If you handle that and build what is necessary and promote the right things, it looks like a pretty solid framework. It's early days—

  Q187Albert Owen: That is the point; we are at the consultation process. This review will be going on and on, it will come before Parliament, and different elements will be discussed and debated. We are asking, is the consultation document in itself robust enough to provide that stability?

  Shai Weiss: I would say that it is almost too robust, in many ways. What you really want is a very simple framework, so if you just said to investors and to pension plans, "There is a feed-in tariff and it is fixed"—or a contract for difference, but not a premium, just a fixed feed-in tariff—"and the tariff is good. It promotes the following things, and you do it with a renewables obligation, grandfathering, and continue it," I bet that would be almost sufficient to improve the capital flows into the UK. Everything else is very important—that is the way it is done in the UK, in terms of the depth of the analysis—but I think simplicity here is key. The signals should be so clear that if somebody can explain it to an investor in 30 seconds, capital flows immediately.

  Q188  Albert Owen: Do you want to comment, Mr Atherton? I cut across you earlier.

  Peter Atherton: Yes, I was going to comment on affordability. My job is to speak to institutional investors—the 500 largest institutional investors who own the major utilities in Europe. I have probably met 120-ish of them to discuss the EMR since it came out. By far their biggest concern is affordability, because they have experienced what has happened in Germany, Spain and the Czech Republic over the summer. They are profoundly worried—the mechanisms are, frankly, irrelevant.

  The fact is that we are going to try and put these very expensive, not very robust, very challenging technologies on the ground very quickly. If we do that, the price of energy will be high—I am for ever shocked that anybody thinks anything other than that—and what's more, the profits are going to be high. What investors have to be able to imagine is a situation where, in 2018 or 2019, the Secretary of State is standing up to the media and Parliament and saying, "It is a really good thing that your bills have just gone up by 15%, and will be going up 15% next year, the year after and the year after. And it's a really good thing that SSE and the other utilities have just reported record profits, and will be reporting record profits for the next 10 years." Institutional investors ask, "Do we have confidence that, when that becomes the case, the mechanisms will be supported and fully kept in place?" Maybe if you have contracts for difference, the mechanisms stay in place, but you can just tax them in another way.

  To give you a feel for this, I actually ran it through my model of Scottish and Southern Energy last night—this is not a profits forecast, by the way.

  Laura Sandys: We are taking notes.

  Peter Atherton: Scottish and Southern Energy last year did 105p of post-tax earnings, so I thought I'd run through my model how much profit they would be making by the end of the decade if they were to do their proportional amount of this investment—around £4 billion a year. In 2015, their profits would have risen to 155p, but by 2020 they would be at 225p. Therefore, their profits are going up 15% or 20% a year at the end of the decade, just as bills are rising.

  We represent different types of investors here. My colleagues' here are predominantly people who can get their money out very quickly, whereas my clients are the investors who are there for a 10, 15 or 20-year payback period—they are the equity guys who will be sitting there into the long term. The question for those institutional investors is whether they have the confidence. They don't really have the confidence that this kit will work, for a start—so they don't have the technical confidence. They don't have the confidence of being able to bring them online in time and on budget, and they don't have the confidence that the policy mechanisms, whatever they are, will be sustainable. The Green Deal will perhaps offset that a touch, but don't forget that people have to pay for the loans. The Green Deal is not a grant; it's a loan. You are paying for the loan. Your overall energy bill may fall, but when you add the loan price back in, the cost doesn't actually fall for the consumer.

  Q189  Albert Owen: So the people you're talking to will be feeding into this consultation and saying, "Do what?" and "Change what?"

  Peter Atherton: I speak to hundreds of people, so it's very hard to paraphrase them, because they have different views. Actually, their advice will be to change the targets. That is what is driving it all. The targets are too much, too fast, and that scares my side of the investment community profoundly. I don't think that changing the mechanisms will necessarily release their flow of capital, because they just do not think that it's going to be affordable for the consumer, and therefore they do not believe whatever mechanism will be put in place.

  Maybe that can change. Maybe as you go through time, particularly as they become more comfortable with the construction risk and the technology risk, that will alter, but as we speak today, I think that would be a reasonable summary of what they say.

  Q190  Chair: On what you've just outlined, are there alternative areas of the world or alternative countries where the concerns that you have just expressed do not apply—in America, for example, where BP might think there is an element of political risk nowadays, or some of the Asian economies where there is perhaps a less regulated environment and a better expectation of economic growth?

  Shaun Mays: Well, they will still have feed-in tariffs. To go on from what Peter was saying, we will have technological change that will improve the returns from these investments over the next five, 10 or 15 years, and you have to be able to adjust for that. We don't want a Spanish situation or one like we had in our carbon fund with HFC-23, where the switch is on or off. We understand that volumes will increase, GDP rates change, wholesale electricity prices change and that technology changes. But it's like driving a car. You don't put your foot on the brake and then on the accelerator; as you're going along the road, you adjust to take account of traffic lights and other things. You need to build a system that has a clear framework, but is adjustable—just as we did with CPI-x for the utilities system before. Everybody knew that, after five years or whatever, it changed, and we reset it and went to a better system. That is what we're asking for here.

  We all represent investors who want to be in this sector for the long term. They can see both sides. They can see how they risk-manage their existing portfolio out of dirty technologies and dirty power production and how they can have an opportunity to invest in the future and clean and renewable energy. They want to do it, but we have to give them a stable system.

  Chris Hunt: Let me take a stab at the answer to your question in a slightly backward way. You have the benefit now of being able to look at the mistakes of other economies and their not necessarily better systems, and we can talk about what Spain and Germany did wrong. I agree with Peter in some respects. If you were to actually take a snapshot of Spain and Germany and ask whether it has worked, the answer is, in some respects, yes. They have both, as economies, motivated a tremendous amount of capital to go in and build low-carbon energy generation. However, they erred in a couple of areas. The main area in which they erred was that they tried to do too much, too fast. They went in at an early stage when costs of certain generating kit were very high.

  To put that in perspective, we own a solar company, which is installing solar generating kit today at less than half of what it was two years ago. If we draw the clock forward another two years, it will be less than half that. Over a four-year period, we're at a quarter of the cost curve. Germany and Spain, unfortunately, did not really cap or control the rate at which that investment went in, so whether they like it or not, they now have 20-year obligations at relatively high cost levels.

  If, however, the UK is sitting here right now and wants to set up a framework that says, "Hey! We want to do this stuff, but, by the way, we're going to manage this. We're going to feed in acceptable amounts each year, and we'll give you a 20-year tariff when we feed that in, but we're going to actively manage that cost curve down," then you're introducing this in a very rational and sane way, and the impact on the consumer will not be so bad.

  Peter Atherton: But that's not going to get you 20,000 MW of offshore wind by 2020 and 16 GW of new nuclear by 2024. I haven't verified this figure, but I was told by one of the major German utilities that in the current year they expect solar to produce 1.2% of power in Germany and to account for 8% of the bill to the consumer.

  Chair: That's very encouraging, given the ridiculous tariffs we have for solar in this country.

  Q191  Barry Gardiner: May I pick up on two things? The focus of my questions here is on the carbon price support mechanism, and I would invite you to put on the record your thoughts in relation to that. The Government obviously think that this will give good signals for investment into the market, but as a tax it's precisely going to be easy for future Administrations to vary it, to change it and to become dependent on it. I just wanted your quick views about how much stability and confidence that gives you if you go down that route.

  Shaun Mays: We've got a fairly large carbon fund, which trades in the ETS. In your report you hinted at the fact that you think that's underpriced carbon and had it as an unstable environment. When I look through, you can't really tell what the carbon tax price is when you look at the existing mechanism. The two guidances that I would give you from our point of view would be to set it for a reasonable period and properly inflation-link it, and then reset it again. That would be preferable to doing what you do, which is to tell us what the carbon price is after the event each year. That is the way it looks in your document.

  We are not talking about for 25 years; it can be a relatively short period, but when we model our investments at least that period will be predictable. We will take the risk for the rest, and once there have been two or three resets we will start to understand how the resets are working. I think if you're saying that it's backward-looking and every year, that will not be an easy system to work with.

  Peter Atherton: It's hard to see what the carbon price floor achieves if you have the CfD in there as well except as a tax-raising measure for the Treasury, which may or may not be a good thing. I am not sure what it achieves in the context of the reform package.

  Barry Gardiner: That was going to be my next question, only I would have asked it as a question rather than making it as a statement.

  Chris Hunt: They are certainly duplicative.

  Shaun Mays: But aren't you using it as a signal that you want to make the transition to the low-carbon economy? That's the way I viewed that particular element.

  Shai Weiss: It's slightly confusing politics with incentives. A political statement does not have to come through the form of taxes. It could come through the feed-in tariff, which is much clearer, much more precise and achieves probably the same outcome without the whole debate on it.

  Q192  Barry Gardiner: Well, it will raise the wholesale power price, but it is nullified by the CfD.

  Shai Weiss: That's right.

  Q193  Dr Whitehead: The whole question of carbon floor price, both as a signal and indeed as an actual incentive for low-carbon investment, seems to be very much bound around by several factors: by the duplicative process of measures in the EMR; by its relationship with ETS; and by factors such as the extent to which you could put a carbon floor price in and have an interconnector policy at the same time, where other countries perhaps don't have the same carbon floor price policy that you have. Taking those factors into account, do you think there is a serious possibility that a carbon floor price really could drive investment in this country in the way that some people suggest it might? Peter Atherton, you speculated that the carbon floor price as far as nuclear investment was concerned would need to be much, much higher than is predicted at the moment, and they would then, presumably, potentially run into those problems that I have already outlined.

  Peter Atherton: Sure. To make nuclear workable, they need a high electricity price. You might decide to get there through a CfD, for example.

  I gave some figures to the Committee before Christmas; after the EMR was published EDF held a UK investor seminar and gave us two pieces of information. First, their latest cost estimate for a twin EPR is £9 billion overnight price in today's money. Secondly, their cost of capital, taking into account the EMR, will be 10% post-tax nominal. Running that through our models, they would need a £78 per MWh electricity price to make that work—that's in today's money. If you roll in interest during construction (IDC) and inflation, they need about £105 per MWh to make it work. So those are the sort of numbers they would probably be looking to strike their CfDs at. Clearly if you get to those sort of numbers via a carbon price floor then the carbon price would have to be huge, though presumably you wouldn't—the carbon price floor would be set fairly low, and it would be the CfD that gets you up to those sort of minimum prices.

  Chris Hunt: The carbon floor price is a somewhat blunt instrument. My personal hesitation is that if you set a carbon floor price for a means of justifying a nuclear plant, I agree totally with Peter, it has to be very high to induce the investment you want. Personally, I'm not sure it is the best instrument to use—there are probably more efficient ways to get at what they're trying to get at. If it's truly the desire to build a nuclear plant, you can get there much better and much quicker in other ways.

  Peter Atherton: But your general point is, if you can import power produced on continental Europe where there is a much lower carbon price, then clearly people will, if they can.

  Shai Weiss: Which I think is an important point altogether, because we are now thinking about this only as an isolated market, but over the future there will be an interconnect, and the interconnect will import energy from lowest-cost provider to highest-cost provider. That is why, for me, you can do the carbon price but not unilaterally, because you can see future Governments saying this is a transfer of wealth from one country to another via a tax on the residents of one country. That will clearly be a political problem that will bring us full circle to the point where Governments will want to change it. If you're going on the carbon price, you are then in the realm of policy and politics—for example, between countries. I think there are other mechanisms to ensure that we are not doing things in isolation from the continent, where they will have, for instance, very efficient nuclear.

  Peter Atherton: But it's not just the carbon price itself, it's the whole set of policies and targets. At the end of the day, if they are successful—and we have offshore wind, onshore wind, solar, nuclear, in 10 to 15 years' time—the UK will have a very, very high fixed cost, very, very high operational cost, low variable cost power system. If that differs from our trading partners across the interconnectors, and fossil fuel prices happen to fairly modest at the time, then of course we will import a lot of power, and we should, because it will be an awful lot cheaper to do so than to produce it from our own very high operating cost system.

  Shaun Mays: I think you have to be a bit careful about time frames here because I will be very surprised, in my working life, that there is an interconnected power system. The way I viewed the carbon tax was quite simple. First, I though it was a political mechanism, obviously, a political signal that we are doing something about a transition to a low-carbon economy. I think that is an incredibly important signal. Secondly, it's a financial mechanism for taking money away from dirty coal power producers and allowing that transfer to the clean energy producers. So I think it is an important and necessary signal. In 20 years' time, when we are connected to the rest of Europe in a supergrid and power gets sucked into that system with no energy losses, and energy efficiency and smart group technology is phenomenal, there might be a change required. But at the moment it is an important signal, and I would think that we are a long way from importing power from Germany or France, although I could be wrong.

  Peter Atherton: Sure. We have a reasonable amount in interconnection already: the 2 GW for France, BritNed is now on, and Norway is almost certainly going to go ahead; 3 GW or 4 GW already is quite a reasonable amount.

  Q194  Chair: Just pursuing the logic of what you were saying there, would it be better for us, instead of tying up a lot of money in some low-carbon technologies that are sometimes slightly unproven but undoubtedly very expensive, just to have another a dash for gas so we don't mind being exposed to imports? That will get us through the next 10 years—to where we need to be—and then maybe the other stuff will have got a bit cheaper and we can put the investment in then.

  Chris Hunt: Do you want to go first?

  Peter Atherton: Well, we are straying slightly into the political arena rather than just the—

  Chair: Come on, stray.

  Peter Atherton: My lawyers are listening.

  Laura Sandys: From an investment perspective?

  Peter Atherton: From an investment perspective, yes absolutely because it's a proven technology, it's very simple. I think if the market was left to itself they would gradually and incrementally develop wind and offshore wind and things, and they would build a reasonable amount of gas. Does that leave the UK vulnerable? Potentially, of course it does. However, I would question this whole point of vulnerability. At the end of the day, you want to be like your trading partners. There is very little advantage in being very different.If we have a tremendous renewables-based system and in 20 years' time there is an oil price shock, then the transfer mechanism into the UK economy is through trade. We will have a recession like everybody else. Our recession might be slightly different from everybody else's but it probably won't be very different. France's ability to sustain the oil shocks of the '70s, because of their large nuclear fleet, was tiny. They did not benefit greatly from it. Where you run the real risk is, you build all this stuff, you lumber yourself with incredibly high fixed costs and a not very robust high-operating-cost system, and—you know what?—fossil fuel prices are modest. Nobody else has built it or nobody outside Europe has built it. That is your real danger. You want to look like everybody else; being in the middle of the pack is where you want to be on this.

  Q195  Chair: That sounds like a fund manager wanting to keep his job.

  Chris Hunt: I'll take a slightly different perspective on the issue. First, I'll comment as a firm that owns just as many megawatts of gas-fired generation as of renewable generation. We are, frankly, agnostic between the two. There is tremendous vulnerability to the economy of being too reliant on a single generating source. If you look the world over at rates of penetration of gas versus coal versus nuclear, for example, the UK, if it had another dash for gas, would be on the extreme of having an over-dependence on a single fuel source. We are talking about renewables as if they don't work and they are unproven. The truth of the matter is that we have had wind turbines up for 15 to 20 years, we know what they can produce and they are not unproven. Biomass plants are the equivalent of boiling water. We know how they work and it is not like it is new-fangled technology and something that doesn't work. Solar, admittedly, is on the newer side and is on a cost curve, so perhaps on solar there is some benefit in waiting. Certainly on tidal there is some benefit in waiting. But we do have options here to diversify and at an expense that is not extraordinarily higher than another dash for gas. So, on balance, while there is always some benefit in waiting, it would be a dangerous move to sit back and just allow another dash for gas.

  Shai Weiss: If you look at our counterparts, China last year invested—sorry, "invested" is a strong word here. They gave subsidies of about $37 billion to their solar companies by way of cheap loans. You don't have to wait much longer for the Chinese to promote solar, which they are doing; likewise on wind and many other technologies. There are great benefits from these alternative resources such as security of supply, which everybody knows. We should not forget, whether one believes or not—some people do believe that there is global warming, and we haven't talked about this at all. But if you do believe, then there are benefits from reducing your reliance on fossil fuel-based economies. Natural gas clearly right now is in vogue. It is very cheap and very available and very productive. We always think that it is good to have multiple sources of energy to avoid those shocks, and to be able to achieve other aims than just the lowest costs at a specific point in time.

  Shaun Mays: Decentralisation of the system is an important factor here. You have to look at the UK's competitive advantage. We will never be a big producer of solar power; Spain has a natural advantage over us. I think there are some elements where you just have to say the UK has an advantage; doing offshore wind and being able to get there first has been a big advantage. The financing challenge is not insignificant. I think the estimates for Hornsea alone are about £13 billion. It is almost the same as all our onshore wind put together. We need to create a system that can recycle capital. I agree that there is an opportunity for the UK to be at the leading edge of the competitiveness curve. We have to be realistic about time frames and the amount of money it takes to do that. There are some GDP reasons why you would do these things as well.

  Peter Atherton: I struggle to see where these benefits are. These jobs are costing a fortune. The ROC scheme has cost £1 billion a year already. That is money out of consumers' pockets that would create jobs if the consumers were left to spend it themselves. Where is the cost-benefit analysis that this creates more jobs than it destroys? It is a tax on consumption—a tax on energy. Having reliable and affordable energy is a really, really good thing. We are in danger here of forgetting that and letting other priorities completely dominate. We would all agree about some diversity and some development of these technologies. But the targets are driving the rate of change and that rate of change is creating the challenges and the risk; and now we are trying, mid-implementation of the targets, to reallocate that risk while trying to maintain affordability. That is an extraordinarily difficult balancing act to do mid-stream, when you have already set the actual targets.

  Chris Hunt: I think the data will prove out—they have proved out across economies that have taken this step. The impact, while it sounds like a big number, is not as big as we think and if you take price shocks into account—there are plenty of data; I could quote some—it comes out surprisingly low.

  Shai Weiss: And when you look at the cost curves of these alternative energies, they are coming down and competing on par with the basket of goods coming from traditional energy—definitely at the prices we are seeing today, and with further benefits yet to accrue.

  Q196  Laura Sandys: On feed-in tariffs specifically, some people have voiced concerns about the move away from the renewables obligation to feed-in tariffs and say that that will undermine investment in renewable electricity across the board. I add one other aspect of this. We have lots of different mechanisms and obviously, the feed-in tariff is an important, core one. Are all these different mechanisms relating, creating different and conflicting behaviours? In many ways, you will be looking at it from different investment perspectives and all these mechanisms will create different investment outcomes. How important is the feed-in tariff, how important is the renewables obligation and how do you see the move from one to the other impacting?

  Chris Hunt: Obviously, if the Government were to change the policy every five years, it would make things very difficult for investors. As long as there are relatively few regulatory approaches on the system at any given time, that is useful. When we invest in a project, we invest in the expectation that we're going to hold the project for 20 years—that is the useful life of most of these projects. When we invest, we make that investment decision based on the assumption that, whatever regulatory environment we invest in will be there for the duration of our investment period. The concern of people with the RO is that they invest in one scheme and if the system changes, they are worried that the fundamental basis under which they made their investment will be gone. That is a perfectly justifiable worry.

  As the data have shown, and as you look at the price curve for renewables obligation certificates, they all tend to be gravitating towards a certain common price, so in general terms, most of the people who have RO-based projects today probably have a reasonable degree of certainty that they will be coming out okay if you make a move over to feed-in tariff systems. It is a fair concern—they invested in one thing and want to make sure that they see a pay-out on their investment over an extended period; but generally, most people are satisfied that they're going to be okay. The FIT system still needs to be defined as to exactly what it's going to be, but as long as we go in with a system and stay with it for an extended period of time, it's a structure that's simple and people will get their arms around it and will put the development dollars and capital behind it.

  Shaun Mays: And I think you've got a pretty clear signal when you see that grandfathering is an important thing. If you invest on one basis and it changes halfway through, like Spanish solar has, it makes a big difference. I can see two risks with the ROC system. We've got quite a few projects now with ROCs. When the whole question mark over ROC grandfathering for biomass came up, we had two projects where we couldn't get finance: finance evaporated. That meant that other projects didn't go ahead—have gone completely, we will never do them now. So there has got to be a careful look. We try to entice finance into these areas, whether it be project finance or long-term pension fund money, and they do take these blips as a problem. The second thing I can see is, there could be gaming at the end between a ROC and a FIT, and you've got to find a way to prevent those of us who've got these projects from doing that little tweak at the end to get that little bit of extra return because there's more margin in the FIT than in the ROC. Again, I'd caution you to think through that.

  Q197  Dr Whitehead: The suggestion that has been made to us on capacity payments as one of the pillars of the EMR is that in other countries where they have been introduced they have often been changed significantly, after they were put in as part of the scene. First, do you think that the regulatory risk and the investment uncertainty may well be substantial, should there be a period of potential change in capacity payments? Secondly, on that basis, do you think there is perhaps urgency in nailing that down—particularly since we know that the increased intermittency, for example, of a substantial element of offshore wind in the system will mean quite a lot of additional stand-by capacity, the exact composition of which remains at present rather uncertain? Do you, for example, try to extend existing plants or effectively commission plants that are really never, or hardly ever, going to be run? Do you go for other forms of, say, interconnector storage which can actually provide that underpinning? Do we need to make some clear lines at an early stage for what I think is probably going to be a strange investment challenge in terms of underpinning that future capacity?

  Chris Hunt: I'll take the first shot at that question. Speaking with my gas-fired generation, rather than my renewable-fired, hat on, the capacity markets here could stand an overhaul. The system as it is now is uncertain; you're taking a fair amount of risk in just going forward and building peaking capacity in this country. But that said, the UK is not alone. I could point to virtually any open market in electricity—particularly in the US—where the capacity markets are very uncertain and hard to build into. So it is an endemic problem in the electricity industry or in the open electricity industries about how to get capacity payments right.

  Speaking more from the perspective of the US, the US divides itself into multiple different regions, so there are about 12 different electricity regions; five or six of them are what you would call open systems like the ones you have in the UK, and the other five or six are traditional state-controlled electricity systems. In the five or six open systems, we have been trying to get capacity markets right for 15 years and we have not got it right. You could look at the rules on capacity payments, and they would probably be four times the thickness of this bundle of papers. It is inordinately complex, and prone to regulatory review and change almost every other year. Fortunately for the US, it is in a slightly different circumstance because, in that country, if you don't get the capacity payment rule right, you can always rely on a neighbouring state to bail you out. There is much more interconnection capability there, just by virtue of lines connecting across states, than there will ever be here in the United Kingdom.

  I think this is an inordinately important part of this whole equation and you do need to do it, and you need to do it relatively quickly. Right now, there are a lot of different themes going on: you have National Grid out there, trying to arrange its own capacity through short-term operating reserve contracts; you have the overall system trying to set up its capacity payments, and you have yet another system now coming in through the EMR. It is ripe for rationalisation. You need to do it soon, because it takes a while for us to respond to it. If you make the rules now, we're not going to be in a position to be able to build for another five or six years. So I think your point about getting on with it is pretty important.

  Peter Atherton: I would agree with that. The only thing I find slightly odd about the proposals is that they don't allow existing fossil stations to benefit from the capacity payments, as I understand it. I find that very odd. Keep the oil fired stations and there is your capacity back-up there and then. They may only run 2% a year, but keep them. Don't shut them down—you don't need to do anything else. Just keep the oil plant.

  Q198  Dr Whitehead: What, the six oil plants that are going up?

  Peter Atherton: You might need a bit more eventually, but yes—

  Dr Whitehead: Mineral oil?

  Peter Atherton: Yes, but they won't operate much; they will only operate for short periods during the year. They serve that function now; they are the super-peakers on the system now. Just keep 'em.

  Chris Hunt: There are people out there now building under contract to National Grid, who are going to be building 1 MW and 2 MW power plants specifically for that purpose. They are no different from a farm tractor engine, there to operate, maybe as you say, one or two hours a year. That is not the most efficient way to solve the problem.

  Q199  Barry Gardiner: Turning to emissions performance standards, it seems there are two problems. One is that they are toothless. Secondly, if they are not toothless and you ramp them up to do more than just get rid of unabated coal, they may fluctuate and be subject to change. How much, from an investment point of view, would you be taking notice of them now? At what level might they kick in so that you do begin taking notice of them? How much would the grandfathering of them—if that were introduced—change your investment appetite?

  Peter Atherton: For the existing utility companies that are already operating under LCDP and the IED and emissions performance standards on top of that, it causes tremendous problems for them and their investor base. We are for ever shortening the life of their existing assets. Anything that significantly threatens their gas fleet in our modelling in terms of the valuation would be profoundly unhelpful to the share prices of those companies. Forget about security of supply issues. The share prices will all go down if we start assuming that all the gas plants have to have a major refit or closure in the early 2020s, which we certainly don't at the moment. We assume that they will carry on merrily through to the 2030s and beyond, with some re-planting of the turbines.

  If you start raising doubts in the minds of the shareholders of the major utility companies that the existing assets will operate, it is already very, very complicated. That is one of the reasons why the share prices have been performing so poorly. It is profoundly complicated already for investors to take a view on the life of assets that are on the ground at the moment. How are they going to operate over the next 10 to 15 years in terms of load factors and what their cost bases are going to be and so on?

  When we this model this stuff—investors do the same modelling—you can get wildly different outcomes in terms of valuation of plant. At the end of the day, these utilities are the sum of the parts of how much we think their power stations and their networks are worth. If we add that up it comes to a sum-of-parts valuation and that gives our share price target. If we start shortening the life of assets or assuming those assets are going to produce far less power than currently assumed, those valuations will fall, which means that the companies can invest less. There is a feedback loop through share prices.

  Q200  Barry Gardiner: Just to come back to grandfathering, for new assets grandfathering on an EPS would be something that you would see as de rigueur.

  Peter Atherton: Yes.

  Shai Weiss: But when you grandfather you really need to make sure that the incentives from that mechanism actually end in further investments, prioritising what we are trying to achieve. Grandfathering becomes an extension; then an extension becomes a new investment.

  Q201  Barry Gardiner: At the moment, how much incentive do you think there is for building new renewables from the existing EPS?

  Shai Weiss: I would say, not much. All you have to do is look outside; there is not a lot of it. If there is not a lot of it, I presume there are not enough incentives. Clearly, we do not represent the utilities, but the utilities are inherently—and we have no cloaked share in public securities—objecting to change. They like stability, so do their shareholders, and they are incentivised by capital investment in their existing assets and new assets of the same type. That mechanism can go on for another 20 to 50 years unchanged. We are talking about introducing change and uncertainty into this market. Clearly, that is going to have some kind of adjustment in terms of share prices. If done well, it should not hurt—if grandfathering is permitted—if they are incentivised to promote newer technologies within their basket of goods.

  Shaun Mays: I have had a lot of conversations recently with equity portfolio managers of the big pension funds—the same side that Peter deals with—and I would say that they understand the equation of having a lot of capital tied-up in old technology and having a vested interest of ensuring that that gets a return for a very long time. It's a capital-intensive business, and you have to acknowledge that. You invest for the very long term. Institutional investors are looking for a pure play into, for example, mature onshore wind assets, where they can invest in new technologies, which will offset the investment in a bundled-up old and new technology company. We have to look at it that way. We can't switch off—nor should we switch off—all the existing technologies, so we have to preserve and manage that. I realise that it's a delicate issue, but we need to move. We're only in the clean side, so it's easier for me to say, "Switch all the coal technology off, and let's get cracking on offshore wind." I can see that it's a delicate situation to manage.

  Chris Hunt: Grandfathering is important. If we see a circumstance where, after a plant is built, the rules change, it raises the cost of capital for all of us. On a technical point about the emissions standards, at what point do you declare an old plant a new plant? That is a mistake that the US got caught up in, which was very important, and it has been a mistake that we made that we haven't actually been able to reverse. In some cases in the United States, for example, you had a coal plant, and the US came in and said, "We're now going to impose higher standards on new coal plant builds." So what happened is that people who had old coal plants were reticent and hesitant about making any improvement to their plants. They didn't want to install scrubbers or desulphurisation or any of that, because if they made those improvements, they would be designated as new coal plants and would therefore be subject to a different regulatory regime and different emissions standards. As a result, that gave people the perverse incentive of doing nothing with their plant, which resulted in the worst coal plant possible.

  Where is that relevant in the UK? It is relevant around coal plant improvements generally—some of that is covered by the large combustion plant directive—but it is also relevant for biomass. If you wanted to take your existing coal kit and then convert that to be able to burn biomass, either in whole or in part—maybe 10% or 15% of your feedstock being biomass—we have to ensure that that does not make that coal plant be deemed to be a new plant and then be deemed to have to adhere to a higher standard. It's a technical point, but it's actually a very important one.

  Q202  Barry Gardiner: Thank you. That's very interesting.

  May I get a final question in here, Chair? I know that you want to press on. This is looking at different kinds of risk. Mr Atherton, if may just quote yourself back to you, you said, "I warn you that it is not a question of making the rewards more and more, because the more you make the rewards, the less trust investors will have that those rewards are going to be sustainable." If one looked at the alternative of a sort of regulated asset base and guaranteeing a regulated return where you could transfer the off-take risk, the electricity price risk and construction risks away from the generator, is that a more attractive way of doing this?

  Peter Atherton: Well, it's a different set of attractions, and it would all depend on the terms of the regulation. If it was very similar to the regulation of onshore networks—National Grid, for example—those assets are well supported by investors. The step up in investment that we're seeing in networks is generally well supported. The Ofgem regimes are generally considered to be okay. We have a new regime appearing in a couple of years' time with the RIIO system and things, so there will be some issues around that. Generally speaking, however, regulated networks are an attractive proposition. Companies can, are and have rounded up substantial amounts of new capex into them. Obviously, from the policy perspective of making offshore wind a completely regulated activity, you are transferring an awful lot of risk and you are capping out return. There will be issues around that in exactly how you deal with construction and things like that. It is, however, clearly an option. The Government looked at it, as far as the EMR, and they said that they would rather not go down that way, because they don't want to remove all the disciplines of individual companies making individual decisions and things like that. That is a reasonable decision, but would you get more built faster? Probably—at least in the short term.

  Shai Weiss: This is now going into macro-economics. If you look at regulated markets, they tend to be efficient in the short term and inefficient in the long run. There are no incentives to improve, and there are no incentives to pass on cost reductions or efficiency improvements. We see that as having a significant damping effect on the competitiveness of the market and, because of that, on the effectiveness of the companies supporting it. So it becomes less attractive in the long run.

  Q203  Barry Gardiner: Even though your first remarks to the Committee today were about the importance of stability?

  Shai Weiss: Yes. Stability in the framework is key. All we are asking is that you tell us the rules of the game, so that we understand them. If the rules are half fair, we will play in the game; and if they are not, we will find other places to put our capital to work.

  Barry Gardiner: Thank you very much.

  Chair: Unfortunately, we have run out of time. It has been a very useful and interesting discussion from our point of view. Renewed thanks for coming in and giving your time to us this morning.


 
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