Energy and Climate Change Committee - Draft Energy Bill: Pre-legislitive ScrutinyWritten evidence submitted by DONG Energy
1. DONG Energy Company Profile
1.1 DONG Energy is a leading energy company operating in Northern Europe and headquartered in Denmark. It is heavily expanding its UK business in renewable energy and Exploration and Production, and has invested around £4.2 billion in the UK since 2006. DONG Energy has a strong presence across the energy value chain, including Exploration and Production, Generation (thermal and renewable), Energy Markets and Sales. DONG Energy has recently acquired a gas retail business in the UK.
1.2 By 2020, DONG Energy aims to have reduced its CO2 emissions per kWh of generation by 50%, and by 85% by 2040 from a 2006 baseline. In order to achieve these targets, significant growth has been focussed on Renewable Power Generation. The United Kingdom has a major part to play in this development.
Exploration and Production (E&P)
1.3 DONG Energy is one of the largest acreage holders in the West of Shetland Region and a partner in the recently sanctioned Laggan-Tormore gas development. The company’s first operated well in the UK (the Glenlivet gas discovery) was drilled in the West of Shetland in 2009. It has interests in a further eight discoveries. Aside from the UK, DONG Energy is the operator of nine licences in Denmark, six in Norway and two in Greenland.
Renewable Power Generation
1.4 DONG Energy is one of the most active offshore wind operators and investors in the United Kingdom. The company currently operates 719MW of offshore wind generation comprising of five offshore wind farms (Gunfleet Sands 1&2, Barrow, Burbo Bank, Walney). It has approximately a 50% share of a further 1289MW currently under construction (London Array, Lincs and West of Duddon Sands) as well as an offshore demonstrator site (Gunfleet Sands 3). It also possesses a strong pipeline of potential future renewable projects in UK, including Westermost Rough, Extension projects, interests in Round 3 including the Irish Sea zone and the Heron Wind and Njord projects in the Hornsea zone.
Thermal Generation
1.5 In thermal generation, DONG Power UK has a 824MW gas fired power station at Severn in South Wales.
Gas Sales
1.6 DONG Energy has recently acquired a gas sales business. DONG Energy Sales supplies approximately 900 million therms per annum, equating to 11% of the industrial and commercial gas market share in the UK. This acquisition represents further investment in the UK energy sector by DONG Energy and supports the strategic platform for DONG Energy in the UK by tying together our assets with a retail downstream business.
2. Electricity Market Reform
2.1 DONG Energy continues to support the package of measures contained within the Government’s Energy Market Reform. Electricity Market Reform (EMR) project should create a framework for investment that is long-lasting, stable, predictable and transparent. This is central to allowing the UK to continue to attract investment into renewable generation. DONG Energy has been successful in achieving this, being a leading company in attracting external finance to offshore wind projects. It believes this can be continued under the reforms, a position that may even be strengthened by the price certainty of a Feed-in Tariff with a Contract for Difference (CFD FIT) over the RO. However, important details remain to be resolved and it is essential that resolution is achieved on key design details in order to maintain market confidence.
2.2 EMR must deliver a clear and transparent process for determining the level of support and the allocation of that support in future. It is clear that there is not unlimited funding available and it is right that projects should be competitive. However, the risks undertaken by the developers should be clear and manageable to ensure the expected cost of capital improvements by introducing a CFD FIT are achieved. Here, an important issue relates to the costs that developers have to commit prior to having certainty that a project will receive necessary consents and a CFD FIT. An increase in allocation of these costs and risks to the project will have a negative impact on the cost of capital.
2.3 Following the publication of DECC’s draft Operational Framework and the draft Energy Bill on 22 May, DONG Energy has four particular areas of concern discussed in detail below.
3. Timetable for EMR
3.1 DONG Energy welcomes the draft Energy Bill and the delivery timetable for implementation published alongside the draft Bill. This is a significant step towards successful implementation of EMR. However, despite the progress made, there is considerable work still required to develop the detailed design of the various policy instruments and associated processes; in particular for the CFD FIT and Capacity Mechanism. It is essential that the timetable is now held as any delays will damage investor confidence and cause delay in delivery of new renewable generation. In addition, to avoid delays to realisation of projects, DECC’s “FID Enabling” initiative must prove to be effective.
3.2 However, DONG Energy also notes that timely implementation should not come at the expense of good legislation. There is some concern that the current drafting of the Bill gives the Secretary of State wide-ranging and enduring powers to change industry agreements. This, if it is implemented, will introduce significant regulatory risk and uncertainty for investors. If this is the case, or is perceived to be the case, then the targeted improvements in cost of capital are less likely to be achieved. Previously, when seeking to achieve similar outcomes, the Government has left the market to deliver a scheme that it has directed through relevant licence and Code changes. This latter approach allows proper scrutiny of changes and as such has less regulatory risk.
4. Contract Allocation Mechanisms
4.1 DONG Energy agrees it is important for offshore wind to become cost competitive with other generation technologies. It recognises that there is an obligation on the offshore wind industry to reduce costs in order for the technology to be viable in the long-term. Within the company, DONG Energy is actively pursuing a programme of technology development and business efficiencies to ensure this target is met. Additionally, it is conscious that there will be a limit on the overall level of support that will be available for low carbon generation. However, the proposals for allocation rounds, with implicit caps on volume for specific technologies, raises significant concerns.
4.2 The UK has a world-class wind resource but in order to fully exploit this, reducing the cost of energy of offshore wind is a priority. Cost reduction requires not only technological innovation but also the ability to create a competitive supply chain, economies of scale, standardisation and optimisation of installation methods. This can only be achieved if there is sufficient scale in the development of offshore wind.
4.3 For offshore wind projects, new sites are being developed that are larger and further offshore. This increases the development expenditure and the need for new technologies such as HVDC transmission infrastructure and deep water foundations. In addition, there are supply chain constraints which require early commitments to be made if planned delivery dates are to be met. These early orders come with very significant cancellation liabilities that currently have to be borne by the developer, over and above those that are separately required from developers to underwrite grid connection liabilities.
4.4 The current risk profile for development spend prior to consent and final investment decision is clearly understood, ie it is recognised that consent may be delayed, restricted or refused. However, to date, the RO has guaranteed that a level of subsidy can be obtained subject to accreditation being achieved. This guarantee has enabled developers to take a view on the risks associated with cancellation liabilities; in many cases DONG Energy has managed to proceed with early supply chain commitments despite these liabilities.
4.5 Post-EMR implementation, it appears that in committing to long-lead time equipment, developers will need to take a view on the risk of uncertain subsidy allocations and levels in addition to the existing consent risk. Given the size of the cancellation liabilities it will not usually be possible for developers to make these commitments with this new uncertainty. This will be a significant problem when seeking to deliver the related agenda of demonstrating commitment to supply chains in order to reduce cost of energy, improving UK content and achieving timely operating capacity.
4.6 The current proposals increase development risk by introducing a risk that a CFD FIT will, at a late stage, not be allocated to a specific, and otherwise fully consented, applicant project. This may be due to over-subscription in one round, or indeed in the worst case, that no further subsidy will be available in any period; this could come either through an agreed spending cap being reached or a greater than anticipated volume of projects achieving a CFD FIT. The consequence of this is that there will be more caution in development, with projects being delayed due to contracts not being let ahead of receiving a CFD FIT and the required return for investors to balance these risks would rise significantly leading to higher cost of capital.
4.7 DONG Energy also notes that the Government is proposing to introduce penalties for projects that are delayed. There are already significant commercial incentives on developers and their suppliers to deliver projects to time, including significant financial consequences if projects are late. The introduction of penalties will add further risk (and therefore cost) without any apparent benefit to the scheme as a whole. Instead, the Government should consider alternative mechanisms to ensure projects with CFD FITs are delivered as planned, for example, evidence of significant installation progress and spend, and long-stop dates in contracts such as already exist within the seabed leases from The Crown Estate.
5. RO Transition
5.1 The change from the current RO regime to the new CFD FIT must be done as smoothly as possible to avoid any hiatus in investment. Whilst the Government has set out their intent to ensure that any investment delays are minimised through the use of “Investment Instruments”, there is still some uncertainty as to what these instruments will look like, how specific projects will secure access to the instruments, and the impact they may have on the ability of future projects to gain funding. It is essential that any instruments that are agreed are transparent and subject to scrutiny.
5.2 DONG Energy notes that the Government has been clear in its intent regarding the “grandfathering” of RO revenues in the final years of the scheme. It supports the proposals to the fix the price of ROCs issued between 2027 and 2037 and welcomes the detail provided in the Technical Update on the methodology to be used to calculate the fixed ROC value. However, it is concerning that the draft legislation does not match the commitments given in that it does not reflect the formula or the process in the Technical Update and instead provides more wide ranging powers to the Secretary of State, allowing changes to ROC values at any future date.
6. Payment Model
6.1 DONG Energy notes that ensuring investment into renewable projects requires both confidence in the revenue stream and a transparent and robust payment mechanism for receiving income; specifically the CFD FIT must be underpinned by a credit-worthy counterparty that takes into account the duration of the credit exposure a project will have to this counterparty. Additionally, the legislation must be clear in ensuring suppliers collect revenue from consumers to pay generators under the CFDs and that generators pay suppliers for times when prices exceed the strike price. These pre-requisites will ensure confidence in the investment community and should result in lower cost of capital for projects.
6.2 The proposals set out in the draft Operational Framework, and that are reflected in the draft Bill, do not meet these pre-requisites. During the initial discussions around EMR, there was a general expectation that the CFD FITs would be provided by a single counterparty and backed by Government. The move away from this model has a significant impact on the risk and credit assessment investors will make when considering investment in projects.
6.3 However, DONG Energy notes that DECC has been working with industry to address these concerns and has undertaken to review this option. This is welcome as the alternative payment model would include a single counterparty under a bilateral contract. It is important that under this model the identity and enduring robustness of the counterparty is addressed as a priority.
6.4 DONG Energy notes that the bilateral contract model must also account for dispute resolution under the CFD FIT and for change of law. As discussed, investors must have a clear and transparent view of the market, a part of which will be to understand what provisions are present that protect against future changes in law or disputes. However, again, this should be managed through industry processes as far as possible and not be subject to direct intervention by the Secretary of State.
6.5 Finally, DONG Energy notes that the process for establishing strike prices with the CFD FITs is fundamental to continued investment. Under the initial administrative period, companies must be able to see future strike prices and understand how they have been derived, including the assumptions underpinning the analysis and the methodology involved. DONG Energy welcomes the Government’s proposals to issue an early publication of draft strike prices by mid-2013 for the period 2014–2018 and final rates by the end of 2013.
6.6 Under the enduring process for price discovery, DONG Energy encourages the Government to provide as much stability as possible. The draft Operational Update suggests prices could be reviewed annually depending on the contracts allocated in any one year. Prices must not be reviewed more frequently than this and, if possible, should be fixed for a greater period. Frequent changes will make planning for projects more difficult and increase risk.
June 2012