9 Investment: risks and returns
219. Our witnesses agreed that a coherent, stable
policy framework was needed to allow manufacturers and utilities
to invest for the long-term.[257]
Shai Weiss of Virgin Green Fund told us that legislative signals
must be "clear", "loud" and "stable".[258]
We are convinced that simplicity, confidence and fair rewards
are the key to attracting the large amounts of capital required.
220. In this section, we examine the how the EMR
proposals work as a package. We look at the signals for investment—risks,
returns, the simplicity of the package and the need for confidence—and
how the four pillars of EMR interact with one another.
The need for "fair"
returns
221. To bring forward the large amounts of low-carbon
generation necessary to meet the Government's targets, EMR must
provide adequate returns for investments in generation.[259]
Currently, returns for investment in low-carbon electricity generation
depend upon the wholesale electricity price, topped up by specific
subsidies. The wholesale electricity price depends on the marginal
unit of generation, which is typically gas or coal-fired generation.
Professor Grubb of the Electricity Policy Research Group (University
of Cambridge) pointed out that this means that "the price
at which a low-carbon investor can sell its product bears little
or no relation to its own costs. It depends instead upon
the volatile prices of coal, gas and carbon faced by the fossil
fuels generators".[260]
222. We have concluded that Feed-in Tariffs are
an effective way of creating adequate returns for investors in
new low-carbon generating capacity especially when combined, in
the long term, with a realistic and stable carbon price.
The need for confidence
223. Investors must be confident that any market
reform will be sustainable. The measures implemented should be
as impervious to short term changes in political or public opinion.
The problem of political risk has been raised with us in relation
to the longevity of FIT subsidies, the level of Carbon Price Support
and the possibility of unexpected changes in the Emissions Performance
Standard. Every extra measure introduces new elements of political
risk. Peter Atherton emphasised the importance of confidence that
the EMR package will be long-lasting:
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 [...].'
Institutional investors ask, 'Do we have confidence that, when
that becomes the case, the mechanisms will be supported and fully
kept in place?'[261]
224. E.ON UK explained that new investments in low-carbon
generation would depend on the incentives available after 2020.[262]
We are aware that changes in Feed-in Tariff levels in other countries,
such as Spain and the Czech Republic, have made investors nervous
about the credibility of long-term low-carbon subsidies.[263]
225. It is vital that the Government creates a
market structure that inspires confidence in investors. In order
to bring forward the huge sums of capital that are needed, the
market must be certain that risks and returns will remain stable
in the long run. In the White Paper, the Government must set out
its long-term intentions for each of the four pillars of Electricity
Market Reform: long-term contracts; Carbon Price Support; Emissions
Performance Standard and a capacity mechanism. It must explain
how these instruments may evolve in the run up to 2030 and under
what conditions revisions will be made to the levels set for each
instrument. It should also guarantee that revisions will be signalled
and consulted on with sufficient warning periods and guarantee
that any changes will not be made restrospectively.
The need for simplicity
226. Confidence in the reform proposals will depend
on their clarity. A package must be simple so that it can be easily
interpreted by investors and deliver a clear message. Over-complication
increases the political risks associated with instruments that
could be subject to change and increases the possibility of unexpected
and unproductive interactions between instruments.
227. Many witnesses attested to the need for simplicity
in investment signals.[264]
As RenewableUK pointed out, "the proposal does not
noticeably simplify Britain's relatively complex climate change
incentive structures, although this is an explicit (and laudable)
objective of the legislation".[265]
Rachel Cary (Green Alliance) said that one of the reasons for
moving away from the Renewables Obligation had been to simplify
the process, but that it was difficult to describe the EMR package
as a simplification.[266]
Simon Less of Policy Exchange went further, suggesting that "there
will be unintended consequences, and the risk of that will create
a lot of regulatory uncertainty. That itself will drive up the
cost of capital and the risks for investors, so there is merit
in a package that is simpler than this".[267]
228. There will be some overlaps and interactions
between the various measures canvassed in the consultation which
must also be considered. Many witnesses to this inquiry were concerned
that more thorough analysis of potential interactions should be
carried out to avoid unintended consequences.[268]
RWE npower told us:
[...] we believe that more work needs to be done
to understand the synergies and conflicts between the proposed
measures in the EMR package, to avoid over-design and policy redundancy
and to ensure that the EMR delivers its objective of the transition
to secure, low carbon electricity system at least cost to the
consumer.[269]
229. The potential for interactions and unintended
consequences also creates uncertainty and political risk for the
investors. E.ON told us:
Overall, the Government is proposing to introduce
four different policy mechanisms. This complexity in itself creates
risks that the interaction between them has not been fully understood
by Government or market participants. This may increase the risk
that there will be unintended consequences that will need to be
corrected.[270]
230. Shai Weiss (Virgin Green Fund) told us:
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 […] 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.[271]
231. The message from investors has been that they
will respond to simple and sustainable market signals. While the
rhetoric from Government supported this expectation, the EMR proposals
are in fact complex. Two areas of particular concern were highlighted
in the course of our inquiry: the interaction between carbon price
support (CPS) and feed-in tariffs (FITs); and the interaction
between FITs and a capacity mechanism.
INTERACTIONS BETWEEN CPS AND FITS
232. Both the CPS and FITs are intended to incentivise
investment in new low-carbon infrastructure: the CPS by improving
revenue from low-carbon generation relative to carbon-intensive
generation; and FITs by creating more certainty about the return
that can be expected from low-carbon generation.
233. Many of the submissions we received for this
inquiry suggested that if a FIT with CfD was in place, this would
effectively fix the returns for a project meaning that a CPS would
have little or no impact in terms of encouraging investment.[272]
E.ON told us:
At present it appears that the floor price, which
is being implemented through removing the exemptions on payment
of the levy for supply of fossil fuels for power generation and
the level of rebate from fuel duty provided for the purchase of
oil for power generation, will have a limited role in incentivising
new low carbon investment which will primarily be driven by the
FIT/CfD which largely fixes project income.[273]
INTERACTIONS BETWEEN FITS AND A
CAPACITY MECHANISM
234. There is also a potential interaction between
a FIT and a capacity mechanism—the amount and type of capacity
brought forward by a FIT will affect how much back-up capacity
is required to balance intermittency. The CHPA told us:
The greater the level of volumes potentially
contracted for under the FIT regime, so the smaller the volumes
traded in the capacity market and the greater the prices that
will need to be offered to capacity market participants to make
capacity available and respond to system requirements. In an extreme
situation, with excessive volumes of "must-run" FIT-rewarded
generation, the capacity market will be dominated by flexible
generation reducing output and by energy storage. A major challenge
for the Government will lie in achieving the optimum balance between
incentivising low-carbon generation and low-cost response.[274]
Other risks
235. The main effect of the EMR package should be
to reduce long-term power price risk, by insulating low-carbon
generation from volatile wholesale market prices through contracts
for difference. At the same time, our discussions with investors
and lenders have indicated that there are other risks associated
with low-carbon generation (such as planning, grid access, technology,
construction and long-term availability) which may also constrain
the availability of finance. Generators currently assess a number
of variables when they take investment decisions. These factors
include: technology choice; development and construction risk;
investment timing decisions; operating risk; fuel price risk;
carbon price risk; electricity price risk; and regulatory risk.
236. Shaun Mays from Climate Change Capital explained
to us that not all the investment risks associated with low-carbon
generation will be addressed by electricity market reform. He
explained that Climate Change Capital's investor base was "not
that entranced by the offshore wind sector at the moment, because
it sees technology risk, policy risk and construction risk"
and he advised us not to 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".[275]
Peter Atherton agreed that:
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.[276]
237. Potential investors were concerned that the
current Electricity Market Reform proposal will not win their
confidence. The inclusion of four "pillars", while trying
to address real and different problems, may in fact create an
overly-complicated bundle of measures with considerable overlaps
between instruments. Each extra measure creates new political
risk that the terms of the incentives for low-carbon generation
will change in response to future short-term political pressures.
238. The consultation has been an opportunity
for the Government to test out a number of ideas. In the White
Paper, however, the Government should aim for greater simplicity
and clarity. The Government should create a framework for Feed-in
Tariffs and for a capacity mechanism, but leave the details to
an implementing, independent and expert agency. It should either
abandon its half-baked Emissions Performance Standard proposals
or replace them with a much tighter option, with a long-term trajectory
for tightening the standard progressively over time.
257 Ev 137 (Statoil); Ev 208 (GE Energy); Ev158 (DONG
Energy), section 2.1 Back
258
Q 181 Back
259
Ev 126 (Carbon Capture and Storage Association), section 4; Ev
139 (RWE npower), section 11; Ev 143 (E.ON UK); Ev w19 (ESB International);
Ev 147 (Drax Power); Ev 191 (EDF Energy); Ev w32 (InterGen UK);
Ev w39 (Low Carbon Group), section 1.9 Back
260
Ev w50 (Professor Grubb), section 1 Back
261
Q 188 Back
262
Ev 143 (E.ON UK), section 2 Back
263
Q 188 [Mr Atherton] Back
264
Ev 158 (DONG Energy); Ev 130 (Good Energy); Ev w45 (IET); Ev 211
(Centrica); Ev 216 (RenewableUK); Q 132 [Ms Thompson]; Q 141 [Dr
Riley]; Q 196 [Mr Hunt] Back
265
Ev 216 (RenewableUK) Back
266
Q 103 [Ms Cary] Back
267
Q 104 Back
268
Q 104 Back
269
Ev 139 (RWE npower) Back
270
Ev 143 (E.ON UK) Back
271
Q 187 Back
272
Ev 153 (International Power), Ev 143 (E.ON UK) Back
273
Ev 143 (E.ON UK) Back
274
Ev w10 (CHPA) Back
275
Q 181 Back
276
Q 181 Back
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