Energy and Climate Change Committee - Draft Energy Bill: Pre-legislitive ScrutinyWritten evidence submitted by Air Products
Introduction
Air Products, a leading global provider of industrial gases and equipment, energy and environmental systems and an inward investor in the UK, welcomes the opportunity to input into the Energy and Climate Change Select Committee’s pre-legislative scrutiny of the Draft Energy Bill published last month.
Air Products has gained planning permission to build a 49MW advanced gasification energy from waste plant in Teesside, with development intended to start later this year. This will create up to 700 construction jobs, over 50 permanent jobs, divert up to 350,000 tonnes of waste from landfill per year and produce enough predictable, controllable, clean electricity to power up to 50,000 homes. If successful, four further projects of a similar size are possible with a total capacity of roughly 250MW of renewable electricity and a significant potential investment potential.
As a large international investor in a global market for energy products and services the UK’s combination of low carbon political commitment and predictable and comprehensive policy framework, most notably the Renewables Obligation (RO), has historically appealed to Air Products. However, more recently there has been a steady and worrying increase in delays, uncertainty and perceived (if not real) political interference in energy policy which has caused a growing concern amongst our US-based investment management team. The perception is that UK policy is becoming more uncertain and more unpredictable, particularly concerning the future of renewable energy post-2020. It would be very helpful if Government could declare their long-term interest in renewables and low carbon energy in legislative form to demonstrate the rationale and commitment to renewables that is driving this revised legislation. Whether this is based on a revised renewable target or a low carbon target, it would be helpful to have some aspect of these drivers written into the legislation. We are still very keen to do business in the UK but it is crucial that Electricity Market Reform (EMR) is as simple, transparent and expeditious as possible to avoid losing the confidence of potentially large investors such as ourselves.
With the new EMR mechanism set to come into force in 2017, it is envisaged that our first two proposed projects will fall under the current RO scheme. However the following three will likely be subject to the new EMR mechanism. Air Products was initially in favour of retaining the RO, as it has proved to be a workable and reliable system of support which has increased renewables deployment in the UK. However, given the Government’s intention to move away from the RO to a new Contracts for Difference (CfD) mechanism for all forms of low carbon technology, Air Products is looking to constructively work with Government to ensure the new system works for the sector, and in particular for new technologies for Energy from Waste.
Therefore, as a prospective large investor in the UK with potentially three out of the five projects looking to come on-line after 2017, the new system of support must provide certainty, longevity, and transparency in order to maintain confidence, bring these investments forward and help the Government meet their own 2020 targets. A timely delivery of EMR is also critical to Air Products’ ability to invest in these additional projects. If the proposed timescales slip further, it is vital that a “Plan B” is put on the table, such as extending the RO deadline from 2017 to 2020, in order to continue our development effort.
Overall, Air Products believe that the Draft Energy Bill is a positive step but some alarming gaps remain, with further detail and clarification on several key aspects of the Contracts for Difference (CfDs) mechanism urgently needed. Air Products would therefore recommend the following four points, which are explored in more detail in the next section:
The contracting counterparty must be revealed as soon as possible and must be a tangible, credit-worthy, legal entity.
The contracts themselves must be legally robust, be based on firm or indexed pricing, and run for the lifetime of projects.
Contract allocation needs to provide early certainty in the project development process.
The process and detail on the strike price must be revealed as soon as possible.
The Contracting Counterparty
From the Draft Energy Bill, it is not clear who will play the critical role of the contracting counterparty. From looking at the White Paper published last Summer and from the Impact Assessment published thus far, it seems that the CfD arrangements were originally designed with one contracting party in mind—the Government. However, it now seems that the Government is unwilling to take on this role, as is National Grid, with concerns around state aid implications. This opens up the question of who is going to carry out this important role.
If this entity is not well defined, it is impossible to make any serious judgment about the legal enforceability of the contracts themselves and the dispute resolution process. The counterparty must therefore be clearly defined, legally established, credit worthy and have the ability to write bilateral contracts with generators. A contract with one supplier versus multiple suppliers versus an entity like National Grid could have radically different consequences, especially if the entity was to have any financial difficulty in meeting the contract terms. This begs the question of what entity (if any) will backstop each of these contracting parties if they can’t honour the contract. Without a legally robust backstop, it will be difficult for investors to take any decision on developing a project. If the intent is to stay with the CfD, the only model that seems to address these issues is to have the contracting counterparty be an individual supplier with the group of suppliers and/or the Government back-stopping the individual supplier. In this way, the risk can be spread but the contract would still be with a single entity.
In addition to this, although DECC believes that National Grid is well qualified and would have no conflict of interest in fulfilling the role of System Operator, we have concerns over their ability to effectively carry out this role. It is difficult to see how a commercial entity deeply involved in the energy space should have access to highly sensitive information which may be required to be shared in the submission of a request for a CfD. In addition, we are unsure that National Grid has the necessary resource and expertise to carry out this administrative function. An alternative solution could be to have a CfD contract selection committee which is comprised of members from National Grid, DECC, and Ofgem (and potentially others) so that the potential commercial interests of National Grid are counter-balanced by other committee members.
The Length of Contracts
The current proposals suggest that the length of contracts for renewable energy generators should be 15 years. We strongly believe that, in order to recover the cost of capital for a project such as ours, 20 years should be a standard contract length. This would cover the economic life of the plant and would be consistent with the approach currently taken under the RO. To sign a contract that covers less than the economic life of the facility presents a “contract-matching” problem. In order for a project to be bankable, the CfD will have to be of the same length as the life of the project; if not, the bankability of the plant is only as long as its shortest contract, shortening the economic life of the whole development. If the returns for a project are tight to begin with, the only two remaining choices if the life is diminished to 15 years are to raise the strike price of the CfD or not go ahead with the project at all.
Furthermore, in a similar way to the lack of clarity on the contracting counterparty causing too much uncertainty to invest, a lack of clarity on key contracting terms other than the contract length may also halt development. Without the answers to such fundamental questions such as what recourse might a company have for non-payment, what liabilities they will have to sign up to or how a force majeure is defined, it is equally impossible to spend any significant money developing a project.
We propose that once the contracting counterparty has been defined, that model agreements for different classes of technologies be developed in conjunction with DECC and some developer and supplier representatives to define must-have terms on both sides and options on nice-to-have terms that can be defined and potentially later refined. There will likely need to be at least two versions, one for intermittent technologies and one for baseload technologies, but this would at least give developers a sense of what terms they could be signing up to so that they can decide if those terms meet their business needs.
Contract Allocation
Our understanding of the CfD proposal as defined in the Energy Bill is that a developer will need to take their project to the point of financial close, or Final Investment Decision (FID), before applying for a CfD. This will add another layer of risk and uncertainty to the process with a developer having to commit significant amounts of capital towards a project in the development phase (front end engineering, planning approval, environmental permits, etc…) without any guarantee of being a allocated a CfD at the end of the process.
The issue that we and other investors are likely to have with this allocation process is that it varies quite significantly from the RO in the level of certainty that one can have at an earlier stage of a project where less money has been invested. Under the RO scheme, if a project obtains pre-accreditation at an early stage (post-planning permission receipt but pre-financial close), an investor can be fairly certain that they will be fully accredited and receive ROCs as long as they continue to build what they say they are going to build. In a case like ours, this might equate to a multi-million pound investment. However, if we waited until FID and then applied for a CfD, we could easily have spent three times that amount and still be unsure that we will get a CfD. Under such a scenario, we would quite likely not proceed or even consider investing in the UK for projects burdened by such a spend with no guarantee of a renewable power contract. We, in turn, propose that DECC consider adopting a pre-accreditation procedure to allow developers to “hold” a CfD commitment for a set period of time (eg 18 months) which can then be secured at FID.
The allocation must also be technology specific to take into account early stage technologies such as ours where the number of players in the market will necessarily be smaller. Whilst auctions may be attractive for more mature technologies such as onshore wind, where the market is more competitive, they should not be introduced to earlier stage technologies such as advanced gasification until the technology has had a chance to develop and make improvements based on some operations history. Auctions are a component of EMR which are not very applicable for developing technologies and will also increase the chances that contracts can’t be signed.
The Government is also proposing to allocate contracts every six months. We believe that this will unnecessarily increase risk and the likelihood of delay with the prospect of a project that has met all the other requirements failing to sign a CfD if they narrowly miss the allocation window. If conditions are met, then CfDs should be awarded as applications are received on a first come, first served basis rather than having windows which will simply create bottlenecks creating peaks and troughs in the project development process. This would, however, necessitate either more frequent reviews of renewable energy projects being awarded CfDs or a matching of those projects with the caps that are established on a periodic basis.
The Strike Price
It is the Government’s intention to have the first CfDs signed in 2014. Therefore it is critical that the current timeline of having draft strike prices published as early as April 2013 is kept in order to allow for a year lead in time before they become live.
In order to accurately set the strike price, a new cost assessment of all technologies will have to be carried out, replacing the previous ARUP study which we believe didn’t reflect the reality of the market place for earlier stage technologies. With the ARUP study, only a very few number of respondents actually submitted cost data in certain segments, which skewed the results of the evaluation by 30–50% or more in their first round of evaluations. We do not want to see a similar process for any new cost assessment carried out without the opportunity for input being sought from project practitioners and developers.
Finally, strike price reductions or contract term penalties (when projects are built) will make investment riskier and increase the cost of capital. Developers could invest significant resources and money by submitting an application and going through the development process, which is sufficient incentive to get the project completed as early as possible without having to pay a fine for delays, especially minor ones.
June 2012