Energy and Climate Change Committee - Draft Energy Bill: Pre-legislitive ScrutinyWritten evidence submitted by Balfour Beatty plc

Executive Summary

With the purpose of increasing supply chain investment and creating new UK jobs, this paper promotes a number of considerations within the context of the new Energy Bill that would improve the certainty of future generation projects being progressed and encourage supply chain development as well as investor certainty and minimising costs to the electricity consumer. It also articulates how better returns on investment could accrue to the UK taxpayer, and in particular to future generations who would benefit from the lower carbon emissions, decreased price volatility and technology opportunities resulting from a refinement of current policy proposed in the Bill.

The key points are:

Confidence in policy, strategy and implementation needs to be enhanced from its current level to attract investment. Whilst some moves have been made to link policy and strategy following the 2011 Ofgem review1, there is little feedback from implementation (success or failure) back into policy or strategy on an ongoing basis. Government could facilitate the development of a policy/strategy/implementation scorecard that could result in pro-active actions to maintain implementation in line with policy and strategic goals.

Recognising that the Government does not wish to be prescriptive on the mix of different generation types, nevertheless the use of targets for different categories of generation is helpful as illustrated by the increase in renewable generation projects following the 2020 EU target. We believe the three broad categories of generation are low carbon non-renewable (eg nuclear and CCS fitted thermal), renewable (as per the Renewables roadmap) and lower carbon thermal (eg baseload and peaking gas). An overall generation roadmap would be helpful.

Better articulation of the long term benefits of some forms of generation—particularly those capital intensive low carbon forms of generation which have asset lives significantly longer than their financing periods. The argument for investing in these types of project (nuclear, pump-storage & hydro, tidal range) is different from more conventional forms of generation and serves to reduce the cost of energy for future generations.

The benefits of a foreseeable and stable generation strategy in terms of the supply chain—for example long term, value based procurement methods that encourage alliancing which has been shown to reduce costs and spread risk in other market segments, including water, gas and electricity transmission.

Introduction

The Energy Bill is needed so as to create greater confidence for investors, utilities, supply chain members and the public. More certainty will create an environment of investment which will result in more efficient, better value and more sustainable (economically, environmentally and socially) solutions.

The Government’s three pronged energy strategy of low carbon, low cost and security of supply has a tension which demands compromise. However the issue is that, in establishing a vision, the Government needs to demonstrate its commitment and not allow doubts to surface, for example when responding to some MP’s concerns on wind farms or the cost of energy. Investors are encouraged by consistency, predictability and opportunity. The Electricity Market Reform (EMR) is designed to achieve this but its complexity and the fact that some of the provisions are new and uncertain introduces risk which needs to be mitigated through firm Government commitment.

The central point of this feedback is that there is an increasing cost as time goes on delaying the reduction of the low carbon element. Therefore by taking a low cost, high carbon option today, payment will need to be made with interest tomorrow. It is inevitable therefore that electricity prices will rise—no matter how the ultimate solution is packaged.

Although offshore wind may provide improved annual energy contribution—say 20% by 2020, it cannot be relied on to deliver on demand at peak times and therefore a back-up facility is required. Currently the natural and most cost effective solution is to supplement wind with gas power stations as back-up, even though this is philosophically challenging in the context of the Government’s wider long term decarbonisation objectives

New technologies continue to offer hope but they are unlikely to be available to satisfy demands over the next 10 years. However, they require early investment if they are to give the UK longer term opportunities. Therefore tidal, wave and carbon capture solutions need continued attention from the research institutions and industry whilst at the same time ensuring that decision makers pursue the goal of balancing:

Nuclear.

Gas.

Wind.

Following the introduction of the EMR, policy should continue to guide the market achieve the right mix of these three main sources for 2030 and ensuring that new technologies are available to enter the mix as and when they become commercially deployable. The EMR’s different instruments, including capacity auctions and contract for difference feed-in-tariffs, are contract rather than market based and there is insufficient detail available as yet to determine how effective they will be in stimulating investment in different technologies.

It is worth noting that although targets can only be targets, they have a positive effect in encouraging industry to focus on specific technologies. The EU renewables target, for example, has had a positive effect in driving investment into the offshore wind sector at a much higher rate than would have been the case had a target not existed. This point needs to be carefully considered when the 2030 EU targets are negotiated. A key question is whether a “low carbon” rather than a “renewable” target will be sufficient to drive further investment into offshore wind—in practice, both a low carbon and a renewable target would be preferable giving nuclear and renewable developers incentives to invest in a market where they will both be required.

Even taking account of the significant investment in demand reduction, such as the Green Deal, there is an anticipated shortfall of supply from 2016 and 2021 and the only one of the big three technologies that can fill the gap is gas. Therefore the need for gas is a flexible one—firstly to provide capacity to 2021 and thereafter to 2030 to provide back-up support. Grandfathering of the Emissions Performance Standard in relation to gas will therefore be a key consideration for investors in new gas capacity. It is also worth noting that electricity demand will grow significantly in subsequent decades as the transport and heat sectors (collectively responsible for over 60% of carbon emissions) increasingly use electricity to reduce carbon emissions and achieve the UK’s 2050 Climate Change Act requirements. Such an increase is after taking account of demand side reduction measures such as smart metering, energy efficiency improvements and greater investment in electricity storage and inter-connectors. Significant increases in generation capacity will therefore be required over several decades.

Creating Investor Certainty

New energy policy is needed to assure utilities and their stakeholders a predictable return for their investment.

Investment is not limited only by the provision of finance from the markets or balance sheet for the construction of projects. With the required expansion of new generation assets to replace existing assets, to meet future demand and to meet the requirements of the Climate Change Act, investment is also required from organisations wishing to develop new projects over and above those already operating in the market as well as in the supply chain.

Supply chain investment is complicated by the increasing number of different technologies identified to be part of the UK generation mix with different skills and capabilities being required for offshore renewable by comparison with conventional thermal plant and different again for new nuclear.

The goal of creating investor certainty was at the heart of the Electricity Market Reform objectives. 18 months later and energy policy development is maturing with a new Bill to be presented to Parliament in 2012/13, national policy statements confirmed and electricity market reform measures in hand, although much of the detail is still to be finalised.

It would, at this stage, be damaging to investor confidence to change the existing policy direction but there is an ongoing need to add or refine policy to meet specific short or longer term needs arising, for example, from unexpected events, market failure or policy failure in delivering expected outcomes.

The slower than expected roll-out of new nuclear projects, the failure of the first CCS competition, the rising costs of offshore wind and the retirement of 25% of the UK’s existing generation capacity by 2017 are all examples of such events. Taken cumulatively, they should force consideration of additional policy interventions that may be needed to mitigate the effects of these and future events in the market place.

The new Gas Strategy (to be published in Autumn 2012) is welcome in providing greater clarity for investors in new gas plant, which is urgently required if such plant is to be commissioned before the energy gap manifests itself. However, a new gas strategy in itself, will not deliver the carbon emission targets reflected in Government’s own carbon budgets or the ultimate goal of 80% reduction in emissions by 2050. The provisions within the new Energy Bill are designed to lower carbon emissions over time and there is a strong argument to suggest that carbon budgets should be included within the Bill.

Energy planning is a long term process. Sufficient lead time needs to be given to ensure that decisions relating to planning and support mechanisms are in place sufficiently early. These will enable investors, both in the project itself and the supply chains that are required to construct them, to proceed on the basis of predictability of outcome, including planning consents, connection requirements and timings.

An example of this is new nuclear, where the Energy White Paper of 2006 confirmed that new nuclear would form part of the future generation mix. However, a consenting decision on the first new nuclear plant at Hinkley Point is not expected until March 2013, with construction completed around 2020. It remains the only new nuclear project to have been formally submitted for planning consent.

The withdrawal of RWE and E.ON from the nuclear market creates further uncertainty for investors in the supply chain. Balfour Beatty has been active in establishing a nuclear power supply chain in the UK since the new nuclear programme was announced. Balfour Beatty’s construction philosophy has been extensive involvement of SME organisations within its supply chain and the relatively slow pace of new nuclear role out creates delay and uncertainty. Delay has a direct impact on job creation, particularly in the generation sector where 90% of the jobs created are during the construction phase.

There continue to be uncertainties regarding many aspects of the EMR. For example, the time to obtain state aid approval, the possibility of not getting approval or the possibility of judicial review if strike prices are awarded via the FID enabling process are concerns. Continued uncertainty, both in terms of timing and outcomes, damages the prospects for UK companies to invest in their supply chains and gain competitive advantage over non UK organisations who have had the benefit of building their supply chain capabilities in their domestic markets, not just in new nuclear, but in offshore wind and increasingly in carbon capture and storage.

It is appreciated that the Government recognises this and is attempting to take a leading position in CCS and marine renewables and their prospects for enabling UK plc to export its expertise, whilst at the same time supporting development of the nuclear and offshore wind supply chains in the UK.

Parsons Brinckerhoff, Balfour Beatty’s professional services arm, has invested heavily in developing capability in both CCS and marine renewables since 2006. It has benefitted from securing, in competition, major studies from DECC between 2008 and 2011 which have provided a partial return on that investment. However, the volume of opportunity that is required to secure a return on that investment is not evident in the market place in 2012. Further renewed investment by the supply chain will be required over the coming years. For example, Parsons Brinckerhoff is playing a significant role in the South West Marine Energy Park with resource being provided on a pro-bono basis.

The appetite for supply chain investment is real, as illustrated above, but requires continued confidence in the market’s ability to deliver against Government’s policy and strategic objectives. As and when this is disrupted, we believe Government needs to be in a position to react quickly to ensure that supply chain and investor confidence is maintained. This suggests that policy and strategy needs to be continually informed by progress on implementation and adjusted as appropriate. Confidence in the market also spawns investment in community based initiatives. Forecast progress against carbon targets may activate the mechanism through which such intervention is warranted. A requirement will be to ensure that such intervention is based on appropriate evidence.

A tangible pipeline of projects and a co-ordinated approach has been demonstrated in other sectors to realise significant cost savings. It allows the use of more effective procurement strategies, such as alliancing2, which have realised savings of between 10 and 30% in the sectors in which it has been used. The use of alliancing has also been proposed as an opportunity to reduce offshore wind costs in the recent report from the Offshore Wind Cost Reduction Task Force.

Electricity Market Challenges

Although electricity demand is currently flat, some estimates3 predict that it will be approximately double the current demand by 2050 as the heat and transport sectors turn to electricity as they seek to reduce their carbon emissions. This is after an assumed 25% reduction in today’s demand driven by energy efficiency measures. Government policy recognises this but progress in the market to deliver the long term policy objectives is challenging from the perspectives of investor certainty, the transition from fossil to low carbon technologies, the acceptability of the costs involved and the market’s ability to meet the policy objectives. To reduce the whole life costs of a plant, suppliers need the market reassurance to establish the best horizontal and vertical relationships with strategic partners and supply chain members.

Analysis of the electricity sector demands between now and 2050 suggests that the electricity supply sector as we know it will be fundamentally different both in its cost base and the supply chain and investment demands. The stated objectives of the Energy Bill are to meet the UK’s decarbonisation and renewable targets, at least cost to consumers whilst ensuring continued secure energy supplies and creating the right conditions for markets and private investment, through greater regulatory certainty and clarity.

These objectives are logical but tensions are inherent within them. For example, the goal of reducing Government subsidies, increasing low carbon generation and maintaining competitiveness with global energy costs are conflicting.

A challenge is that electricity charges will have to rise over time because the costs of meeting the new objectives have costs associated with them. However, as the Stern Report identified, there are new benefits associated with these additional costs—or at least minimising indirect costs that would occur if the carbon emissions policy was relaxed. It is the latter point which, to those of us at Balfour Beatty engaged in the energy sector, appears not yet to have gained recognition in the public domain. The long term benefits identified by Stern do not appear to be reflected in the Energy Bill’s Impact Assessment.

Commentators are looking at electricity costs in isolation, using economic models that have not changed and which reflect private sector cost of capital and excluding the wider environmental and social benefits arising from reducing carbon emissions. The reason for this is clear: a private sector power plant developer will not realise these indirect benefits and cannot raise finance at Government social discount rates or the lower rates used in the Stern report.

Equally, the consumer and politicians support the development of low carbon electricity but their willingness to pay for the longer term benefits identified by Stern is tempered by their ability to pay and, in the case of business, the impact of such costs on their competitiveness.

It is likely that it is these concerns which create some of the tensions between setting policy and its ultimate delivery. The balancing factor in the equation to date has been subsidy through ROC’s, and in the future FiT’s or CfD’s for low carbon generation. However, much of the language around subsidies has revolved around the cost of generation rather than a proxy for the benefits that arise from pursuing a low carbon agenda.

As a consequence, the public perception is that low carbon electricity is relatively expensive. This leads to an argument that competitiveness is compromised if businesses are required to pay the full cost. In addition, low carbon generation is seen as having no improved benefit over and above fossil fuels other than reducing carbon emissions in a world where the rate of increase in carbon emissions is not under the UK’s control.

The public at large understand the argument for pursuing low carbon but the consumer’s willingness to pay for the associated benefit is less tangible, partly because carbon emissions are a global rather than local issue and partly because many of the benefits accrue to future society rather than directly to today’s electricity consumer.

A high energy consuming business competing internationally is arguably more concerned with maintaining competitive advantage than providing financial support to the Government for the benefit of future society. There is therefore some logic that the tax payer rather than the consumer should support longer term carbon reduction goals. The EMR focuses on the market considerations and seeks to drive unit electricity costs down over a prescribed time period within the context of the overall low carbon framework irrespective of the project’s economic life. As a consequence, it can be argued that longer term options and their associated benefits are not adequately assisted by the EMR.

Understanding the Different Requirements of the Future Generation Mix

The increase in generation capacity for the UK over the next 40 years requires all assets at its disposal, whether they be shale gas, natural gas, new nuclear, renewables, coal or gas baseload with CCS, grid balancing mechanisms such as interconnectors, pumped storage and smart grids and energy efficiency measures to significantly reduce demand. However, the wide variations in characterisation of such assets in terms of cost/time and longevity of generation plant do not lend themselves to a “one size fits all” approach of evaluation which may, in some cases, delay or halt potential projects, even though their overall benefits are aligned with Government policy. EMR recognises different technologies but only over the shorter term and as a consequence the long term benefits for society in the future, as exemplified by Stern, are absent.

The methodology used to assess the whole life cost of different forms of energy is flawed. There is a need to develop is an alternative meaningful way of measuring the benefit cost ratio of different forms of energy.

Those in the supply chain have grown used to projects either being delayed or shelved. This creates a cynicism which militates against investment in new techniques, productivity gains, relationship building, recruitment and developing skills. EMR is designed to mitigate these concerns but only if, when the detail is published, it provides a stable investment environment. The length of CfD contracts will be a critical consideration from a financing perspective and will need to be sufficiently long to allow project finance to be viably applied. The financing of generation projects is critical but some forms of generation have a significant asset life after the financing phase is complete.

Frustratingly many projects are evaluated in a simplistic and truncated manner which fail to take into consideration these wider benefits. Projects developed in the private sector have to demonstrate relatively high returns on investment in relatively short periods of time with little recognition of wider or longer term benefits. As a consequence, projects with lower capital costs but higher running costs are inherently more attractive to banks who are limited in their power to lend for periods longer than 20 years, or even shorter in the UK.

However, new nuclear, hydro and tidal power all have relatively long asset lives, 60 years in the case of nuclear and over 100 years for hydro and tidal power. Unfortunately, using private sector hurdle rates means that the low operating costs and associated high revenues experienced after the financing period are effectively ignored, meaning that between 50 and 75% of the project’s whole life costs are effectively worthless by the time they are discounted back to a net present value. As a consequence, whilst seeming attractive in principle (extensive life and low running cost), this is not reflected in the financial analyses which are skewed towards short term returns.

Ironically, this benefits nuclear to some extent as future decommissioning costs are discounted back to a small net present value. Decommissioning costs would be better accommodated by establishing a sinking fund and accounting for this as part of the annual operating costs whilst refining the methodologies used to compute levelised costs and total carbon savings to reflect the differences in different generation mixes. This would advantage both nuclear and hydro/tidal power projects by comparison with other forms of generation on a whole life basis. However, it would not assist with how the high capital cost can be financed, nor the time period over which the financing was available.

Current policy, as set out in previous sections of this paper, is to treat the low carbon forms of generation as high cost rather than high benefit and to support the high cost through revenue support mechanisms. The attraction of revenue support mechanisms is presumably driven by the private sector characterisation of the electricity supply market where funding originates from the customer over a prolonged time period rather than at the time the cost is incurred. The only issue with this is that capital support mechanisms are inherently more efficient than revenue support, particularly for capital intensive projects. A good example of where Government is using a capital rather than revenue support in a privatised industry is high speed rail and the fast rural broadband initiative. In these cases the benefits are given much more emphasis than the costs and it has state aid approval from Europe. There are also examples in the low carbon innovation programme such as capital support to demonstration projects in CCS, marine, nuclear and offshore wind. Whilst CfD’s will be effective, subject to its contract length, for projects where the useful economic life is relatively short—say less than 30 years—a different form of incentive based on capital rather than revenue support is more attractive for high capital cost energy projects with low carbon emissions and longer lives. Capital support would, through lack of revenue subsidy, recognise the long term benefits and liabilities of such projects and enable this to be reflected in consideration of its future value. Such an approach for these types of project would represent a better return to the consumer and allow the cost of financing to be reduced, enabling projects to be promoted and developed more quickly, albeit within the constraints of the Planning Act. It would also enable longer life projects with low running costs to demonstrate the positive impact they can have on reducing subsidies and applying continued downward pressure on future energy costs, simply because once the financing period is over, the cost of energy drops dramatically.

Summary

With the purpose of increasing supply chain investment and creating new UK jobs, this submission promotes a number of considerations that would improve the certainty of future generation projects being progressed and encourage supply chain development as well as investor certainty and minimising costs to the electricity consumer. It would also represent a better return on investment to the UK taxpayer, and in particular to future generations who would benefit from the lower carbon emissions and the technology opportunities resulting from a refinement of current policy.

The key points are:

Electricity demand is set to double by 2050 as the transport and heat sectors are decarbonised and the population continues to increase;

Energy planning requires long timescales and a long term approach;

Investor certainty requires commitment to the existing policies and the new Electricity Bill, but it does not preclude more advantageous support mechanisms where the existing policy is failing to deliver the throughput of projects required to meet Government targets and/or where future benefits are being undervalued;

Given the long planning and development timescales, urgent decisions are required where predicted outcomes fail to materialise in practice (eg slower nuclear and renewable build-outs, uncertainty over gas investment, delays in CCS commercialisation). In this context, the introduction of the FID enabling provisions in the Energy Bill are welcomed;

The UK supply chain, if it is to create new jobs in the energy sector, needs tangible opportunities to invest in the development of appropriate capabilities and a confidence that planned projects will come to market quickly and sustainably;

The consumer and tax payer are not necessarily achieving best value if the future generation mix is financially incentivised to attract lower capital cost, short operating life generation assets;

The new Gas Strategy is welcome as it will promote a sensible balance in the generation mix and address concerns currently limiting future investment in gas, given its relative importance in the future generation mix. However, higher capital cost but longer life projects still appear to be less competitive in cost terms when only short term benefits and costs are considered, even after the recent electricity market reforms;

The consumer today, and tomorrow’s tax payers, would both benefit from an EMR+ approach where the currently proposed reforms were applied to shorter life assets such as gas and wind and an additional mechanism was applied to low carbon assets with asset lives significantly longer than the maximum financing period;

An EMR+ approach that included a capital rather than revenue support mechanism for long life low carbon forms of generation would reduce financing uncertainties, and reflect the benefit to society (rather than consumers) of future low carbon emissions, as well as being more cost efficient than revenue based mechanisms; and

If such a move accelerated the progression of new nuclear and other forms of long life assets such as tidal power, the UK supply chain would benefit and invest accordingly.

The supply chain can assist in reducing costs as a consequence of predictability of policy and commitment of the market in general. Erratic or unpredictable project pipelines create cost in the supply chain as they have to cover staff and other costs during unproductive troughs in the market and pay additionally to cover peaks. Loss of continuity also reduces value as invested knowledge and experience in teams is lost. Targets or roadmaps that recognise different options help address the urgency required in decision making, noting that taking a project from inception through consent to construction and commissioning can take between five and 15 years. It is also worth noting that several projects, particularly gas, have received consents but have not been constructed due to specific market issues causing further uncertainty for supply chains.

A concern has been the means by which the benefits of the new low carbon generation mix have been articulated—changing the language to reflect the real reason why low carbon forms of generation are preferred and reflecting the fact that lower carbon benefits accrue to society as a whole rather than the developer of the generation asset. Whatever generation mix is adopted in the future, impacts on fuel bills will be higher because of the short period of time we have allowed ourselves to replace aging generation assets and investing in new, cleaner generators that will benefit future generations. This includes greater transparency on the types of benefits and costs that accrue from different forms of generation and continued investment in new forms of generation that will provide the UK with new jobs and opportunities for inward investment and export.

Finally, there is a need for continued focus on developing (not changing) policy that is agile in respect of encouraging the market to invest, particularly in longer term solutions that can operate and generate benefits beyond their financing periods. This will provide new opportunities for the supply chain as well as enhancing the value of action taken today for future generations.

June 2012