Environmental Audit CommitteeWritten evidence submitted by EDF Energy
Executive Summary
Faced with the closure of ≥30GW of generation capacity by 2025, the rapid decline in UK gas production and the requirement to de-carbonise the UK economy and to maintain security of supply, the UK has an urgent challenge in attracting high levels of investment to the electricity generation sector. In the current economic climate with significant pressures on household budgets, it is critical that investments made are cost-efficient.
The scale of necessary investment exceeds what the balance sheets of incumbent energy companies can alone support. The International Energy Agency estimates that globally, $16.9 trillion will need to be spent on electricity infrastructure from 2012 to 2035, of which $2.8 trillion is in OECD Europe.1 Alternative sources of funding must be ensured for the sector to reach the required levels of investment.
The global economic downturn moreover tightened the capital markets and made it harder for all projects to attract financing. However, there are now positive signs of developers starting to see some confidence returning.
Recognising the need to attract low-carbon investment, the Government has developed plans for Electricity Market Reform (EMR), as laid out in the Energy Bill. We believe these plans can provide the right framework for the UK’s low-carbon investment needs, while minimising the additional costs for customers. The implementation of this reform package will be a key step in attracting investment to the UK electricity sector. Policymakers need to complete the work to finalise details and to give investors and developers confidence that the framework will be both robust and stable.
The ability of low-carbon projects to attract financing depends on having acceptable returns from investment considering the risks involved. While investors must make reasonable returns, the outcomes must also represent fairness for energy users who eventually bear the costs of energy supply. We believe two-way Contracts for Difference (CFDs) for low-carbon generation, as set out in the Energy Bill, deliver fairness to both investors and customers. CFDs will contribute towards price stability to customers, provide revenue certainty for investors and remove the potential for excess investor returns that can occur during high wholesale price periods under the Renewables Obligation support mechanism.
By providing revenue certainty for investors, robust CFDs also reduce the cost of capital for projects (and help the sector to attract investment) and hence costs to customers. The cost of capital can also be addressed through a clear, predictable regulatory environment in general; and by helping projects to attract debt funding, including by leveraging the strength of the Government’s balance sheet through measures such the HMT’s UK Guarantees scheme.
Another key issue to be addressed is financing for projects during the construction phase, when many long-term investors are wary or excluded from participation due to specific risks involved. Measures such as UK Guarantees scheme and the Green Investment Bank can help to address the issue for some projects.
For low-carbon projects, long-term policy stability is essential due to long asset lifetimes, divergent national and international views on policy priorities, and uncertain pace of technology and cost evolution. It is important that the Government maintains its commitment to the emissions cap set in the 4th carbon budget and sets a compatible 2030 decarbonisation target for the UK power sector. The strength of cross-party consensus on energy policy will also be crucial, and there should be balanced public debates on the costs of achieving the UK’s energy policy objectives, which recognise the need for investors to be able to make adequate returns to pay back the upfront investments made.
The key to attracting capital to a specific project remains having a robust, deliverable and well-structured business or project. Only creditworthy projects should benefit from the available financing
In short, we believe the key issues related to attracting financing for low-carbon projects are:
Clear, stable long-term policy direction and targets, underpinned by cross-party political support.
A predictable, stable and robust market framework enabling a fair balance of investor returns vs. costs to customers.
Robust CFDs for low-carbon electricity generation that adequately protect against political and change-of-circumstances risks.
Improved availability of financing during construction phase, and of debt funding in general, through measures such as the UK Guarantees scheme.
More balanced public commentary on the need for energy companies to make returns over time that pay back the upfront investment made.
About EDF Energy
1. EDF Energy is one of the UK’s largest energy companies with activities throughout the energy chain. We provide 50% of the UK’s low-carbon generation. Our interests include nuclear, coal and gas-fired electricity generation, renewables and energy supply to end users. We have over five million electricity and gas customer accounts in the UK, including both residential and business users.
Our Responses to the Committee’s Questions
What are the main drivers behind institutional investors’ decisions on the type of investments they include in their portfolios?
2. Like other investors, institutional investors follow specific criteria on the types of risk they are willing to finance and the credit quality they expect to see; individual low-carbon projects must meet both to attract investment. Market arrangements and Government schemes can address some categories of risks; projects must be robust, deliverable and well-structured to address other risks and to meet credit-worthiness criteria.
3. One key issue is that risks involved during the construction phase of projects make many long-term investors wary of investing; measures such as UK Guarantees scheme (see paragraph 10) can help to address this.
4. Within the above-mentioned boundaries, institutional investors focus on financial returns available for a given risk profile, with the perceived level of risk affecting the discount rate applied to investments. While several types of risks are involved, we highlight two significant types:
(a)
(b)
How effective are the financial markets in matching available finance to the required investment in renewable energy and other green projects?
5. For financial markets to be able to guide finance to decarbonisation projects, the returns from investments must be appropriate compared to risks involved—thus the regulatory and market environment must provide both sufficient incentives to invest and long-term visibility to reduce risk (see paragraph 4). We believe the Government’s EMR measures will provide the right framework for projects to be able to attract financing. Emerging clarity on key parameters defining a project’s returns, such as the CFD strike price and the detailed terms on sharing of risks, will help project developers in the future to attract both equity and debt funding for projects. Policymakers need to complete the work to finalise details and to give investors and developers confidence that the framework will be both robust and stable; there also needs to be clarity on the potential evolution of key parameters over time.
6. The regulatory and market framework in turn must be based on clear policy direction that provides stability and long-term visibility on the sector’s expected development. Thus it is important that the Government maintains its commitment to the emissions cap set in the 4th carbon budget and sets a compatible 2030 decarbonisation target for the UK power sector.
7. A particular challenge for the low-carbon sector is to attract long-term debt funding from the financial markets, especially when projects are still under development/construction. This issue can, depending on project/technology, be addressed through either short- or long-term financing measures, discussed below (paragraphs 10; 27–28).
8. For financial markets to be able to guide financing to low-carbon projects, market players need to thoroughly understand the characteristics and risks related to specific types of projects. Such emerging understanding is starting to help onshore wind projects to attract financing during not only operational but also already during construction phases. A similar process of investor education still needs to take place for other low-carbon technologies.
What should the Government be doing to help redirect finance to help fill the £-multi-billion green finance gap?
9. The Government’s primary role in helping to ensure investment comes through is in setting and maintaining clear and stable policy targets and in creating a supportive, predictable regulatory and market framework (see answers to the previous question). As part of such a framework, we believe the CFD mechanism included in the Energy Bill can play an important role in guiding financing to low-carbon projects. It will enable the long-term, stable and reliable revenue that such projects need to justify the large upfront investment involved and allow companies to carry more debt and hence reduce their cost of capital.
10. In addition, measures such as the HMT UK Guarantees schemes can play an important role in ensuring the affordability of investment through leveraging the strength of the Government’s balance sheet. This scheme should help major infrastructure projects to access private finance and allow debt to be brought into projects earlier than otherwise possible. This will reduce the amount of equity funding needed for the project and help to attract other investors (assuming appropriate terms and conditions are agreed for projects). The guarantees are provided at commercial market rates, and their terms mean the UK taxpayer does not assume project construction risk. The scheme is open to a wide range of projects, for example, a guarantee has been provided for the conversion of part of the Drax power station from coal to biomass. We welcome the Government’s announcement that our proposed new nuclear power station at Hinkley Point C is eligible for a UK Guarantee. Over time, ways to further expand the total envelope of the scheme from the current £40bn (excl. housing guarantees) should be considered to ensure the scheme’s full potential can be utilised.
11. Specific Government-backed institutions or financial vehicles such as the Green Investment Bank (see paragraphs 26–30) can also play a role in providing debt and/or equity funding, to the extent allowed by their level of capitalisation.
12. Beyond the Government, the political parties and wider stakeholders play a key role in making the low-carbon energy sectors attractive for investors by reducing the level of political risk involved. Consensus on energy policy underpins investor confidence in the long-term stability of the regulatory framework and of policy targets; hence it is crucial that energy policy is not used for seeking political advantage. Similarly, it is important that public debates are conducted in a balanced way and with sufficient sophistication to recognise the need for investors to be able to make appropriate returns to pay back the upfront investments made and which are commensurate with the risks involved. Capital-intensive low-carbon projects, which have long lead and payback times and involve higher risks for investors than relatively less capital-intensive and less risky generation investments such as gas, require a return on investment over time to repay the initial investment. At the same time, the operating (especially fuel) costs of low-carbon generation are very low compared to significant and uncertain fuel costs for gas generation, which overall brings down the lifetime costs and risks from the perspective of customers.
How can “political risk” to investors from changes to the Government’s energy and environmental policies be reduced? Can the Government ever remove political risk or are more innovative financial instruments that offset those risks the solution?
13. Political risk is a key factor affecting the perceived level of risk in and hence returns required by energy infrastructure investors, considering both the important role of policy in driving energy sector development and the very long lifetimes and payback times of low-carbon investments.
14. Key factors that can provide long-term policy predictability and hence reduce political risk are long-term policy targets (see paragraph 6) and underpinning them, cross-party consensus on energy policy (paragraph 12). We welcome the overwhelming cross-party support expressed for the Energy Bill at its Third Reading in the House of Commons (396 MPs voting in favour vs 8 against) and encourage further development of energy policy in a constructive spirit and with cross-party cooperation.
15. With appropriate terms and conditions, the Government’s EMR proposals and specifically long-term, robust CFDs contracted with a single counterparty, can help in reducing political risk to investors.2 Yet it is critical that the conditions of CFDs provide CFD holders solid protection against changes of law, especially as with capped income resulting from a fixed strike price, they cannot recoup any additional costs resulting from changed laws via potential, simultaneously resulting changes to the wholesale power price (as may be possible for non-CFD generators). Low-carbon developers (alongside their investors and lenders) thus require robust, contractual protection for changes in law which are outside of their control to afford some comfort that they will be compensated for any resulting adverse impacts on their costs.
Is greater direction to banks needed to encourage them to increase their lending to renewable energy and green projects?
16. Following the financial crisis, and as a result of pressure on banks to reduce leverage and risk and of increased financing costs for banks, banks have overall become less prepared to provide long-term lending. Any measures to tackle this general issue affecting private-sector banks would likely be more appropriate in an economy-wide context.
17. However, another issue specifically related to low-carbon investment projects is that due to their long lifetimes, novel nature and associated risks, many project developers struggle to raise debt for projects. Here, Government measures such as the UK Guarantees scheme (see paragraph 10) can play a useful role in enabling low-carbon projects to attract debt financing earlier than would otherwise be possible.
18. For low-carbon projects to be delivered, it is necessary also to ensure that strong and viable supply chains exist to support investment delivery. Especially small supply chain companies often face challenges in managing their working capital during project delivery and often cannot attract debt funding to resolve the issue. Thus measures to increase the availability of debt to support working capital management should be considered, possibly including investigation of opportunities for lending with reference to specific (large) contractor.
19. However, under any measures it is important to maintain appropriate creditworthiness criteria on borrowing by developers of low-carbon projects, in order to ensure that only serious projects by credible developers are brought forward and benefit from the (ultimately limited) funding available.
How can pension funds and other investors be encouraged to re-direct their capital funds towards investments with green objectives?
20. The role of pension funds is to invest for the benefit of their members; thus their key investment criterion is that investments must have appropriate returns (in the form of stable, medium-to-long-term cash flows) considering the risks involved, and compared to other investment opportunities. They need to invest with consideration to the circumstances of the entity whose pensions they are entrusted with and manage risks by diversifying across markets and industries; their ability to invest freely for their members’ benefit should not be constrained.
21. Similarly as discussed in paragraphs 2–4, pension funds follow specific criteria on the types of risk they are willing to finance and the credit quality they expect to see. Pension funds’ risk analysis covers both country, political, regulatory and sector-specific risks; to enable them to invest in the low-carbon sector, clarity on risks involved, and hence measures to manage political and regulatory risks (discussed above) are key issues to be addressed.
Are fiscal incentives for people/institutions to put funds in green investments needed, and if so what?
22. Alongside other measures, taxation can be used to increase the attractiveness of investing in the low-carbon sector. The Government is using capital allowances for instance to attract global investment to UK research and development activities, but the allowance regime is much less generous for major infrastructure projects. Broadening the application of capital allowances could thus be one way to attract investment flows into the UK low-carbon sector.
23. The existing regime of tax relief on interest paid on financing costs is moreover another key way for the Government to ensure the attractiveness of the UK low-carbon sector to international investors and to keep the costs of financing decarbonisation from increasing.
24. Finally, the (now implemented) carbon price floor mechanism plays an important role in strengthening investor confidence in the political commitment to a low-carbon energy system; the stability of a known, increasing carbon price trajectory removes a significant risk around future prices of carbon that investors otherwise face.
What can the Government do to help increase the flow of finance to small and community-based renewable energy and green projects?
25. Low-carbon investment must be affordable to customers, and hence cost efficient. Small or community-based projects should thus not receive preferential treatment but rather be subject to similar cost-efficiency criteria as larger projects are. Moreover, any incentives provided to low-carbon project developers should be dependent on developer creditworthiness.
What impact is the Green Investment Bank likely to have on the green finance gap? Does it have the right investment strategy?
26. While the Green Investment Bank (GIB) can contribute to bringing investment to the sector, its initial capitalisation of £3 billion public funding is small compared to the UK’s investment needs; much greater scale would be required over time for it to play a major role.
27. Though thus constrained, the GIB can help in guiding private financing to the low-carbon sector. In addition to its directly contributing funding, and helping to improve overall project economics through debt funding, its role as co-financier can provide private investors with some protection against political and regulatory risk, which as discussed above is a major factor affecting the availability of financing for low-carbon investments.
28. Low-carbon projects in phases that still involve construction risks often face particular challenges in attracting (affordable) financing, while funding is more readily available for later-stage projects. Depending on project/technology, short-term financing approaches can sometimes be an appropriate solution to the issue. The GIB can help by providing access to short-term, flexible funding to projects in such phases, on the expectation of it helping to trigger also private-sector investment on a short- and long-term basis.
29. Finally, the GIB can also help in increasing investor understanding on the characteristics and risks related to low-carbon projects (see paragraph 8), and help individual projects raise their profile in the eyes of other investors.
30. EDF Energy supports the GIB’s strategy of making investments that are green, fully commercial and additional, and making these alongside utilities and other investors.
How should progress against the green finance requirement be monitored? While the Committee on Climate Change monitor progress on emissions reduction via the Carbon Budgets, and the Office for Budget Responsibility monitors progress on Government debt reduction, who should monitor progress on delivering the necessary green finance?
31. Success in attracting financing for low-carbon projects will be judged based on the amount of investment projects being completed. The financing is a means towards achieving the objectives of decarbonisation and security of supply and the Committee on Climate Change and Ofgem monitor progress towards these objectives, respectively. Hence no further monitoring body is required and it is indeed desirable to avoid unnecessary complexity and duplication in monitoring.
18 July 2013
1 IEA World Energy Outlook 2012 p. 74, Nov 2012.
2 However, CFDs will not remove all risks to investors: construction and operational risks will remain with project developers.