Electricity Market Reform - Energy and Climate Change Contents

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.


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]


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

previous page contents next page

© Parliamentary copyright 2011
Prepared 16 May 2011