Investor confidence in the UK energy sector Contents

4The Levy Control Framework

56.A large number of the responses to our inquiry mentioned the influence of the Levy Control Framework (LCF) on investor confidence. In this chapter we focus in depth on the LCF, its role in shaping policy and the way in which it affects investors.

57.One of the Government’s key tools for signalling the level of intended public investment in the energy sector is the LCF. The LCF was established by DECC and HM Treasury in 2011 in order to cap the cost of levy-funded schemes and ensure that DECC “achieves its fuel poverty, energy and climate change goals in a way that is consistent with economic recovery and minimising the impact on consumer bills”.73 The LCF is “supposed to provide certainty to investors whilst also attracting financiers by reducing the impacts of the cost of developments”.74 It was also designed to drive long-term change in the energy mix and has been successful in doing so.75 The Government has put a limit on the amounts that can be raised and spent through this mechanism, which means that the LCF also serves to protect consumers by controlling the impact of a low carbon transition on energy bills.

Box 3: The Levy Control Framework

What is it?

The Government funds some of its energy and climate change policies directly through consumer energy bills rather than through funding from general taxation. The LCF is a cost control mechanism, which allows the Government to set an overall cap for the amount of money that can be raised and spent through this mechanism in support of low carbon electricity.

Why is it needed?

The LCF budget is a helpful signpost for investors about the amount of funding that is available to help support the investment required to replace ageing energy infrastructure, maintain secure energy supplies and meet legally-binding environmental targets. The cap on the budget is in place to minimise the impact of this investment on consumer bills.

What schemes are included in the cap?

Renewables Obligation (RO): Support mechanism for relatively large scale renewable electricity projects. This scheme will be closed to all new generation projects from 1 April 2017.

Feed-in-tariffs (FITs): Support mechanisms for relatively small scale renewable and low carbon electricity projects.

Contracts-for-Difference (CfDs): Set to replace the RO. Scheme designed to give greater certainty and stability of revenues to electricity generators by reducing their exposure to volatile wholesale prices.

How much money is available?

The cap was originally set to grow year-on-year in line with investment in low-carbon projects. The cap was set at £2 billion in 2011–12, rising to £7.6 billion in 2020–21 (in 2011–12 prices). A “headroom” of 20% on top of the cap was provided to deal with uncertainty (for example, external factors like unforeseen changes to wholesale prices).

58.A number of witnesses to our inquiry mentioned the LCF in their responses.76 Donald MacDonald, Chairman of the IIGCC, told us that mechanisms such as the LCF were “hugely” influential in investment decisions.77 At a very high level, the LCF provides some reassurance to investors for two reasons. First, it sets out how much money will be available under the various support schemes, which provides some visibility on the future size of the market. Second, it provides an assurance that costs to consumers will be kept under control, which is important because uncontrolled costs can undermine public support for policy measures, in turn leading to greater instability, more upheaval and change.78 SSE said:

The Levy Control Framework is not a perfect arrangement, however, alongside well-designed funding allocation mechanisms, it can help to control costs and provide a clear commitment about the volume of support available to low-carbon generation. This is an important principle for investor confidence.79

59.Witnesses identified a number of flaws with the LCF as it is currently configured and explained the impact on investor confidence. These flaws are:

The rest of this chapter explores these flaws and suggests ways in which they might be rectified.

Not all levies are included within the cap

60.A common criticism of the LCF is that not all levy-funded policies are included within the spending cap. Currently excluded policies include the Capacity Market, the Warm Home Discount, and Energy Companies Obligation (ECO) even though these policies are also paid through levies on consumer bills. This sends a skewed signal about where support is being deployed, resulting in a disproportionate focus on the cost of supporting renewable energy and low-carbon generation, while less attention is paid to the cost to consumers of maintaining energy security or delivering energy efficiency.

61.The Government’s rationale for this is that the cap only applies to levies raised to fund electricity policies and not to non-electricity policies that are levy-funded, like the Warm Home Discount and ECO.80 This is difficult to square with its LCF Update (published July 2013) which states that the LCF caps “are intended to cover electricity policy in general, and would therefore apply equally to any future levy-funded electricity policy”.81 The Capacity Market, although excluded, is clearly an electricity policy. DECC’s 2014 Annual Energy Statement stated:

The Capacity Market will be paid for through the Levy Control Framework, but Capacity Market spend will be in addition to existing £7.6 billion Levy Control Framework cap for low carbon electricity. The first payment for the main Capacity Market scheme will be made in 2018–although payments under the transitional arrangements will commence in 2016. Updated Capacity Market budgets will be set for each capacity year following the outcome of the auctions for that year.82

62.No revisions to the LCF budget to account for the Capacity Market have yet been made. The latest Office for Budget Responsibility (OBR) figures forecast spending of £1.1 billion in 2020–21 on the Capacity Market; a not-insignificant sum.

63.In its 2013 report on the LCF (written before the Capacity Market auction process had begun), the NAO said:

Including some consumer-funded electricity market support schemes but not others also risks undermining the utility of the Framework as a mechanism for considering the affordability and relative merits of spending on different interventions.

[ … ] The Capacity Market and, within it, Electricity Demand Reduction measures would involve payments by a government-owned body, which the Department assumes will ultimately be funded by a charge on consumers. Bringing all such arrangements within a single Framework would give Parliament and consumers transparency on: costs, the consequences of decisions on individual measures for other schemes in the Framework, and on any trade-offs made.83

64.Witnesses told us that they wanted greater clarity about what the LCF was for. Lilia Stoyanova, Director at the Townsend Group, investment managers for the Environment Agency Pension Fund, told us: “I think it would help if it was clear what the LCF stands for. What is it trying to achieve? How does it fit within the overall framework of reaching the 2020 goals?”84

65.The rationale for introducing a Levy Control Framework (LCF) is sound: it is important that the costs to consumers of providing secure, low-carbon energy infrastructure are affordable and able to be managed in a transparent manner. However, the rationale has become blurred over time, particularly since the Capacity Market has not yet been incorporated into the LCF. We call on the Government to set out clearly the purpose of the LCF and to explain why the Capacity Market is not currently included, when it is clearly an electricity policy that results in levies on consumers’ bills.

Failure to take a holistic view of gross vs net costs to consumer

66.Although the rationale behind introducing the LCF was to control the costs paid by consumers towards levy-funded policies, there are some important technicalities about the way in which it is measured that mean that increased spend under the LCF doesn’t automatically result in increased costs to consumers.

67.Emails between DECC and HM Treasury released under a Freedom of Information request in January 2016 enabled the website Carbon Brief to compare forecasts made by Government in November 2014 and those made in May 2015. This revealed that although the Government had increased its forecast of the amount consumers would be paying under the LCF in 2020 from £92 to £104, the forecast for the average total bill had come down from £1,319 to £1,222.85 In other words, the latest projection showed consumers spending less on their energy bills in 2020 than had previously been forecasted, even when LCF payments were taken into account. Abid Kazim, UK Managing Director of Next Energy Capital, believed that it should be these net costs that were monitored, rather than the gross costs under the LCF.86

68.There are two factors at play when considering why an increased cost under the LCF doesn’t necessarily mean an increased bill for consumers:

1. Contract-for-Difference (CfD) design

69.Under the CfD, payments to generators—against the agreed strike price—will be greater the lower the wholesale price. However, as illustrated in the analysis above, this will not necessarily lead to higher bills as the lower wholesale price itself reduces the bill.87 Ultimately, consumers should not notice any difference in the price they pay because lower wholesale prices should offset the impact on bills of the increase in CfD costs.

70.As DECC itself has acknowledged, the fall in global fossil fuel prices in recent months has been partly responsible for the projected increased spending under the LCF.88 Carbon Brief has calculated that £0.5 billion of the projected £1.5 billion LCF overspend is caused by the impact of falling fossil fuel prices on CfD costs.89 That is, there will be no net impact on consumer bills associated with this £0.5 billion overspend.

2. The Merit Order Effect and full system costs

71.When wind and solar power are feeding into the energy mix, they also have the effect of lowering the wholesale electricity prices. Wholesale prices are set based on the system operator always purchasing sufficient electricity to meet demand at the lowest marginal cost possible—the merit order. As there are no fuel costs for wind and solar they have zero marginal cost and therefore they will be called upon first to meet supply, with the effect of lowering the overall cost.90 A gross rather than net approach to LCF cost calculation does not reflect this benefit. Matthew Knight, Director of Energy Strategy and Government Affairs at Siemens Plc, explained:

The political instinctive statements about the Levy Control Framework are unhelpful because they betray a lack of awareness of what is really going on. That is what gets us scared. We hear somebody from the Treasury talking about spending the money too fast and, by our own analysis, we cannot see that, and we also know things, like the merit order effect that for every pound that is spent on subsidising onshore windfarms you are getting about 60 pence back in a lowered wholesale market price.91

72.A separate effect, pulling in the opposite direction, are the so-called “balancing costs” (that is, the costs of providing back up for variable sources of generation such as wind and solar), which are currently spread across all generators, rather than paid according to the impact of each technology. In her “reset” speech, the Secretary of State said:

In the same way generators should pay the cost of pollution, we also want intermittent generators to be responsible for the pressures they add to the system when the wind does not blow or the sun does not shine. 92

DECC has reportedly commissioned Frontier Economics to conduct a review of full system costs of different technologies.93

73.The Committee on Climate Change (CCC) has previously recommended that:

In judging the level of subsidy paid to low-carbon generators (e.g. onshore wind), the Government should consider the full costs of the low-carbon option and the alternative:

–This should include any system integration and security of supply costs, for example reflecting that variable renewable capacity will generally need to be backed up by flexible capacity that can operate on demand. [ … ]

–The appropriate comparator is not the wholesale electricity price, but the alternative means of providing generation. Where this is unabated gas generation, its costs should be judged across its lifetime, assuming that it would face the full costs of its emissions.94

Lack of transparency on spending forecasts

74.The LCF cap was set at £2 billion in 2011–12, rising to £7.6 billion in 2020–21 (in 2011–12 prices). A “headroom” of 20% was provided to deal with uncertainty. Where spending exceeds or is projected to exceed the headroom, DECC must agree a plan with HM Treasury to bring spending back down to the agreed level.95

75.The OBR regularly forecasts the level of spending under the LCF in its Economic and Fiscal Outlooks. DECC also published in October 2014 a more detailed forecast in its Annual Energy Statement 201496, in that it projected that LCF spending—on the RO, FIT and CfDs—would be £6.25 billion in 2020–21 (in 2011–12 prices).97 An updated forecast by the OBR in July 2015 indicated that projected LCF spending would breach the cap by reaching £9.8 billion in 2020–21 (in 2011–12 prices). The OBR’s most recent forecast, in November 2015, showed a projected spend equivalent, in 2011–12 prices, to £9.5 billion.98 This means that in the space of a year the forecast has increased by £3.25 billion (in 2011–12 prices). This is a huge change over the course of a year, and calls into question the reliability of both forecasts from OBR and DECC.

76.The Government has been clear that this projected overspend on the LCF was the trigger for making the numerous policy changes announced over the summer in 2015. DECC told us:

As announced over the summer, the latest forecasts under the Levy Control Framework show that uptake of Government’s renewable energy schemes is much higher than previously expected, compounded by accelerated developments in technological efficiency. The projected future spend under the LCF is set to be £11.4bn (in nominal prices) or £9.1bn (in 2011/2012 prices) in 2020/21. As the Government has set a limit of £7.6bn in 2020/21, the current forecast is £1.5bn above that limit, a cost that is paid through additions to consumers’ electricity bills. As a result, the Government has decided to act quickly to get its costs under control.99

77.The scale of the change in forecast spending took many stakeholders by surprise.100 DECC attributed the change in the forecast to three factors: accelerated developments in technological efficiency, higher than expected uptake of demand-led schemes and changes in wholesale prices.101 Witnesses told us, however, that they were not satisfied by this explanation. Some suspected that changes to underlying assumptions may also have played a role.102 The detailed assessment that underpins the LCF budget forecasts has not been made public and we heard a united call from stakeholders to put this information in the public domain.103 Energy UK told us:

One example of where industry would ask for further transparency from government is on the projected overspend of the Levy Control Framework which was announced following a report by the Office for Budget Responsibility (OBR) in July. The figures published by the OBR in July were radically different to the figures the OBR had published in March and so it came as a surprise to many in the industry. Industry would like to see a new calculation be published, taking account of recent developments, and including more clarity on the modelling which was used to calculate the results. Some months have now passed and the relevant information has still to be made public.104

Schroder Investment Management said:

Increased transparency of budgets and forecasts is critical. For example, in July the Office of Budget Responsibility (OBR) stated that the LCF Budget will reach £9.1bn in 2020/21, some 20% over the £7.6bn forecast cap for that year. However, none of the assumptions that underpin the forecasts have been made available. This makes understanding the context to investment decisions difficult and raises the return we would like for them which ultimately increases costs for consumers.105

78.We heard that it is important for investors to understand more about how the figures in the LCF projections are calculated. First, because it will help them to understand differences between their own calculations and those of the Government.106 Second, it will help anticipate LCF budget availability and allocation if investors understand how assumptions in key areas are being arrived at. And third, there is a more fundamental question of trust. A lack of transparency about assumptions and methodologies invites speculation about whether the numbers are being manipulated in some way, especially when the policy changes that were triggered by the projected overspend have been so dramatic. Trade association RenewableUK told us:

Lack of transparency in the numbers used to justify this claim has led to a perception that there is some kind of ideological motive behind the moves to limit spending, which will take some considerable effort to overcome if Government wishes investors to trust their new policies, when they are finally revealed.107

79.The Department told us in October 2015 that “DECC intends to provide further clarity on the LCF overspend and details of future CfD auctions shortly.”108 In January 2016, Andrea Leadsom MP told the House “we will publish an updated set of LCF projections as well as the assumptions underpinning the latest forecasts in due course”.109 At the time of writing [February 2016] this information had not yet been published.

80.The Levy Control Framework will play a central role in shaping the direction of near-term energy policy in the UK. There is no logical reason why the assumptions and methodologies used to calculate the projected spending should remain undisclosed, particularly given its importance to investors in assessing their risks. DECC Ministers have promised to make this information available on several occasions but seven months after the OBR’s surprising figures were published there has been no further clarification from Government.

81.We call for the Government to improve transparency around its LCF spending calculations. It should make the assumptions and methodologies used in its calculations available publicly. In particular, it should answer the following questions:

i)What assumptions are being made about how much capacity will be built?

ii)What load factors are being assumed?

iii)What assumptions are being made about the number of projects in the pipeline that will actually go ahead?

iv)What assumptions have been made about future wholesale energy prices?

v)What assumptions were made about the proportion of the budget going to CCS (before the competition was ended)?

82.We note that the National Audit Office has recently announced that it will be updating its 2013 review of the LCF, with a report due in summer 2016.110 We urge the NAO to consider the points we make in this chapter.

83.Two years ago, our predecessors called for “a single annual report covering all the DECC levy-funded schemes, along with other Government initiatives which affect energy bills but which fall outside of the Levy Control Framework (LCF), such as the Energy Companies Obligation (ECO)”.111 The Government did then subsequently publish this information as an annex to its Annual Energy Statement 2014.112 Unfortunately, there has been no such statement published in 2015.

84.We urge the Government to reinstate its annual reporting of DECC levy-funded schemes and other Government initiatives which affect energy bills but which fall outside of the Levy Control Framework.

Uncertainty on dealing with projected overspends

85.At the time the LCF was introduced, HM Treasury set out a requirement that when spending exceeded or was expected to exceed the cap (including the 20% “headroom”), DECC would have to agree a plan with Treasury to bring spending back within the agreed range. The plan should “set out the adjustments that DECC proposes to make to its policies to reduce their spend, and the impact by year of taking action”.113

86.As mentioned above, the projected LCF overspend, as reported in the OBR’s July 2015 Economic and Fiscal Outlook, appears to have triggered the recent round of policy changes. It is not clear to us whether DECC agreed any kind of plan with HM Treasury ahead of making the changes, but from the outside, the perception was that the changes were being made in a “piecemeal” way.114 Investors want more clarity about the Government’s approach. The Aldersgate Group called for:

the introduction of guidelines that provide a mechanism for accountability. The government must make clear how it intends to respond if circumstances turn out differently to those currently assumed, for example, if the assumptions on the future cost or generation output from renewable technologies were to prove incorrect.115

87.We recommend that DECC develops and publishes a structured response plan, setting out how any future overspend would be dealt with, in order to increase transparency of the Government’s approach. This should set out criteria against which DECC would assess changes to policies and support levels, in the event of future overspend, including the anticipated impact of proposed changes. This should be done explicitly on the basis of grandfathering existing support levels (unless otherwise agreed), against an agreed timeframe, and preferably with consultation.

Lack of clarity on the LCF beyond 2020

88.In 2012, a year after the introduction of the LCF, the Government announced an upper limit of £7.6 billion (in 2011–12 prices) for 2020–21.116 At this point in time investors had visibility of the envelope of spending available eight years ahead. Given the long lead times for energy projects, this forward visibility has been helpful. Now, in 2016, investment decisions are taking place about projects that will be developed through the 2020s. Many witnesses have therefore told us that they want to know what is going to happen to the LCF beyond 2020.117 For example, SSE told us:

[A] major concern for SSE at present is the lack of sight of the LCF budget beyond the existing settlement to 2020/21. The Government recently committed to make an announcement about the LCF and this is welcomed, since without an understanding of the Budget’s trajectory it is challenging to commit to projects which are due to commission in the next decade. Whilst SSE acknowledges that that UK must meet its legally binding climate change targets, SSE takes no firm view of the level of funding available in the LCF or the generation mix, but as a developer, it does require clarity to properly assess where to commit its capital.118

The Institutional Investors Group on Climate Change added:

In the medium term, DECC in consultation with HMT needs to clarify the scale of the levy control framework (the UK’s low-carbon support budget) beyond 2020/2021. This framework should be defined at least until 2025, in line with advice from the Committee on Climate Change, so that investment decisions with long lead times can be taken.119

89.Our predecessors agreed with the need for forward visibility. They recommended in March 2015 that:

the Government clarifies the future of the LCF beyond 2020–21 as soon as possible after the General Election. Rolling forward projections of LCF funds should be published annually thereafter, so that investors are always able to look at least seven years ahead to make their investment decisions.120

Soon after the election, in June 2015, the Government responded that it recognised the “importance of long term budget visibility for industry” and that it would be “setting out its plans for delivering a new generation of cost effective, secure, electricity supplies in the near future”.121

90.Since then we have heard that a 10-year rolling horizon for the LCF would help to reduce policy uncertainty and increase investor confidence.122 This was one of five main recommendations made by the Committee on Climate Change (CCC) in its 2015 Progress Report to Parliament. The CCC called on DECC and HM Treasury to:

Ensure the power sector can invest with a 10-year lead time: as soon as possible, set the Government’s carbon objective for the power sector in the 2020s and extend funding under the Levy Control Framework to match project timelines (e.g. to 2025 with rolling annual updates).123

91.DECC told us in the autumn that it was “working to set out more detail on the post-2020 LCF budget shortly to give investors certainty for the long-term and provide support for investment into the next decade”.124 Further details on the post-2020 LCF budget have not emerged in the months that have since passed.

92.The Government should urgently set out what the budget for the LCF will be post-2020, but this must be done in the context of the 4th and 5th carbon budgets to ensure the available funding is consistent with meeting our longer-term carbon commitments. We also urge the Government to introduce rolling annual updates on a ten-year horizon, as recommended by the Committee on Climate Change.

73 HM Treasury, Control framework for DECC levy-funded spending, March 2011, para 1.1

74 RWE (ICE 0067)

75 Q 172 (Abid Kazim)

76 Q 112 (Andrew Koss; Paul Spence), Q 170 (Paul Barwell), Greenpower Developments Ltd (ICE 0103), IREGG (ICE 0089), UKERC (ICE 0073), Green Highland Renewables Ltd (ICE 0008), RWE (ICE 0067), CCSA (ICE 0055), Carter Jonas (ICE 0017), Energy UK (ICE 0086), Schroder Investment Management (ICE 0051), RenewableUK (ICE 0095), Nextenergy Capital (ICE 0090), VPI Immingham (ICE 0020), Solar Trade Association (ICE 0048), Statkraft UK (ICE 0071), Statkraft UK (ICE 0069), RES (ICE 0062), Lark Energy Commercial (ICE 0043), SSE (ICE 0013), Scottish Power (ICE 0091), Velocita (ICE 0006), Green Alliance (ICE 0021), E.ON (ICE 0036), ENGIE Energy-UK Turkey (ICE 0102), 2020 Renewables (ICE 0026), Vattenfall UK (ICE 0094), Drax (ICE 0058), Scottish Renewables (ICE 0050), Smartestenergy Limited (ICE 0040), NIA (ICE 0045), IIGCC (ICE 0041), Friends of the Earth (ICE 0074), Enviva (ICE 0064), Dr Emma Dawney (ICE 0015), ETI (ICE 0031), ECA (ICE 0093)

77 Q 283

78 Q 244 (Alejandro Ciruelos, Carol Gould)

79 SSE (ICE 0013)

83 National Audit Office, The Levy Control Framework, 27 November 2013

84 Q285 (Lilia Stoyanova)

86 Q 169 (Abid Kazim)

87 The opposite is also true: if wholesale prices increase, the level of support paid will decrease and if the wholesale price goes above the strike price, the generator must pay back the difference.

88 Lord Bourne, Written statement to Parliament, Levy Control Framework cost controls, 22 July 2015

90 UKSIF (ICE 0028), Greenpower Developments Ltd (ICE 0103), Nextenergy Capital (ICE 0090), Siemens (ICE 0076)

91 Q 203 (Matthew Knight)

93 Policy Exchange, What exactly is ‘subsidy free’ onshore wind?, 16 September 2015

96 Department of Energy and Climate Change Annual Energy Statement 2014, October 2014, p 75

97 Department of Energy and Climate Change, DECC Annual Energy Statement 2014, October 2014, table p.75

98 Office for Budget Responsibility, Economic and fiscal outlooks, supplementary table 2.7: nominal forecasts July 2015 £11.5m (RO £6.3m, FIT £2.1m, CfD£3.1m), and November 2015 £11.2m (RO £6.2m, FIT £2.2m and CfD £2.8m), adjusted for using Jan 2016 GDP deflators published by HM Treasury

99 Department of Energy and Climate Change (ICE 0088)

100 RWE (ICE 0067), Energy UK (ICE 0086), SmartestEnergy Ltd (ICE 0040)

101 Lord Bourne, Written statement to Parliament, Levy Control Framework cost controls, 22 July 2015

102 Q 112 (Andrew Koss), RWE (ICE 0067)

103 Q 112 (Andrew Koss; Paul Spence), Q 170 (Paul Barwell), Greenpower Developments Ltd (ICE 0103), IREGG (ICE 0089), Green Highland Renewables Ltd (ICE 0008), RWE (ICE 0067), Aldersgate Group (ICE 0068), ScottishPower (ICE 0091), CCSA (ICE 0055), Carter Jonas (ICE 0017), Energy UK (ICE 0086), E.ON (ICE 0036), Schroder Investment Management (ICE 0051), Nextenergy Capital (ICE 0090), RenewableUK (ICE 0095), Green Alliance (ICE 0021)

104 Energy UK (ICE 0086)

105 Schroder Investment Management (ICE 0051)

106 Q 203 (Matthew Knight)

107 RenewableUK (ICE 0095)

108 Department of Energy and Climate Change (ICE 0088)

109 Department of Energy and Climate Change: Public Expenditure: Written question - 22454, 18 January 2016

111 Energy and Climate Change Committee, Eighth Report of Session 2013–14, Levy Control Framework: Parliamentary oversight of Government levies on energy bills HC 872

112 Department of Energy and Climate Change Annual Energy Statement 2014, October 2014

114 Q 258 (Donald MacDonald)

115 Aldersgate Group (ICE 0068)

117 Q87 (Paul Spence), Q103 (Andrew Koss), ENGIE Energy-UK Turkey (ICE 0102), UKSIF (ICE 0028), Scottish Renewables (ICE 0050), ScottishPower (ICE 0091), IIGCC (ICE 0041), Siemens (ICE 0076), ABI (ICE 0032), Schroder Investment Management (ICE 0051), UKERC (ICE 0073), CCSA (ICE 0055), Green Alliance (ICE 0021), RenewableUK (ICE 0095), Aldersgate Group (ICE 0068)

118 SSE (ICE 0013)

119 IIGCC (ICE 0041)

120 Energy and Climate Change Committee, Eighth Report of Session 2014–15, Implementation of Electricity Market Reform, HC 664

122 CCSA (ICE 0055)

124 Department of Energy and Climate Change (ICE 0088)

© Parliamentary copyright 2015

Prepared 1 March 2016