Political tension is undermining UK energy investment

Energy policy is one of the key ideological flashpoints in the internal conflict between the UK government’s coalition partners. Unfortunately there is increasing evidence that this conflict extends down into the government departments whose co-operation is required to deliver the government’s aggressive reform agenda. The Treasury appears to be increasingly at odds with DECC as to the direction of UK energy policy reform. This conflict is undermining investor confidence in UK energy markets.

August 20, 2012

Energy policy is one of the key ideological flashpoints in the internal conflict between the UK government’s coalition partners.  Unfortunately there is increasing evidence that this conflict extends down into the government departments whose co-operation is required to deliver the government’s aggressive reform agenda.  The Treasury (led by the Conservative Chancellor George Osborne) appears to be increasingly at odds with the Department of Energy and Climate Change (DECC, led by Liberal Democrat Minister Ed Davey) as to the direction of UK energy policy reform.  

As we have set out previously, this conflict is undermining investor confidence in UK energy markets.  There have been two clear examples of this damage over the last few months:

  • DECC was forced to delay its much anticipated announcement of ROC rebandings, as Treasury intervened to push for a 25% cut to onshore wind support vs the 10% proposed in the government’s draft Energy Bill (which was eventually passed in late July).
  • Treasury has blocked the use of a government backed credit guarantee to support DECC’s new FiT/CfD contracts, the key EMR tool to promote renewable investment.

 

ROC rebanding delay

Technology specific Renewable Obligation Certificate (RO) bands will be the critical driver of investment in renewable generation until the government implements its FiT/CfD mechanism.   Although there is clearly a subjective element to the setting of these bands, rebanding has not been overly politicised to date and equity investors and lenders are broadly comfortable with them as a support mechanism.

After being forced to delay the re-banding announcement, DECC eventually fought off the Treasury push for a 25% cut in support for onshore wind and announced a 10% reduction (with scope for further reviews in the near future).  In return DECC was forced to concede a reduction in the anticipated boost in support for biomass co-firing (0.6 ROCs vs the initially intended 1). 

A deeper cut to wind support would have represented a clear shift in the balance of power within the government towards the austerity driven Treasury agenda at the expense of  DECC’s focus on decarbonisation.  As things stand it looks more like the ROC re-banding disagreement was another round in an ongoing ideological conflict.  The uncertainty associated with this inter-departmental dispute is likely to have a more damaging impact on investment (via higher risk premiums) than the outcome of the ROC rebanding itself.  

 

FiT/CfD credit risk

The government anticipates replacing the RO with a FiT/CfD mechanism as part of the Electricity Market Reform measures under development (although the RO will remain in parallel until 2017).  But one of the key stumbling blocks in the FiT/CfD design is the treatment of credit risk associated with the contracts.

Given the FiT/CfD contracts will apply over many years, there is the potential for substantial credit exposure to build over the life of the contract if the market power price deviates from the CfD strike.  The safety of access to FiT/CfD cashflows will be a key driver of funding costs for renewable projects, particularly against the backdrop of a continuing deterioration in European credit markets.

DECC had consulted with the industry on the basis that the government would guarantee CfD payments.  However concerns from the Treasury have led to the replacement of this guarantee with a multiple counterparty arrangement that attempts to spread credit risk across market players.

Tim Yeo, Chairman of the UK’s Energy and Climate Change Committee, sums up the revised approach as ‘an alternative contract system so complex and confusing it may not be legally enforceable’.  In other words this represents a substantial stumbling block in the path of an effective implementation of the FiT/CfD scheme.

 

Market impact

The impact on renewable investment in the UK from these issues is likely to be twofold:

  • Direct impact from a cut to RO wind support (& revision to the proposed biomass co-firing band) and from the increased cost of funding projects under the FiT/CfD mechanism when implemented.
  • Indirect impact from the damage to investor confidence over the ongoing conflict within the coalition and the uncertainty associated with delays and politicisation of major energy policy decisions.

We have set out previously why we believe that the UK may significantly miss its renewable targets.  The developments we describe above, combined with a continuing tightening of access to capital, point to a further deterioration in renewable build rates this decade.  Next week we outline factors constraining renewable build in the UK and put some numbers around potential renewable development and output across the rest of this decade.  

 

Relevant articles:

The cracks in UK energy policy are widening

Electricity Market Reform: An orderly transition?

The UK generation capacity crunch in numbers