The knowns, the unknowns and that fabulous nuclear contract (with apologies to Donald Rumsfeld)

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We know both are Donald...

We know both are Donald…

How can we characterise the much trumpeted ‘deal’ on Hinkley C now that it has (unlike poor Tian Tian’s baby) actually emerged?  Well it’s not much of a deal I guess, more a kind of semi crayoned-in statement of intent and a very expensive one at that.  The bit we do know is that if all the bits that aren’t yet crayoned in (e.g. all that stuff about state aid approval) are in the fullness of time, then we’re stuck with an upwardly indexable ‘Contract for Difference’ payment of £89.50 per mwh. Or if EDF don’t build any more reactors, a payment of £92.50 for, er, 35 years.   A deal where you get more payouts if you don’t deliver anything else than if you do is a new one to me but there you go.

At the moment there seem to be a lot more things that we don’t know than things we do know about this deal. Like, for example, exactly what form the contract to enable financial closure will look like. We do know that  ‘the government is in negotiations with NNB Genco ( a subsidiary of EDF) about a potential investment contract which might enable [their] final investment decision on the Hinkley C new nuclear power plant project’ because it says so on p.58 of the recent Electricity Market Reform: Proposals for Implementation document.

Perhaps we should turn to the Energy Bill (part 4, to be exact) to find out more about this contract. Well it will almost certainly be one of the special ‘varied’ investment contracts that the government is proposing to offer so that very large projects thinking of financial closure before CfDs come on line can get the certainty they need. The advantage of this kind of contract can be seen in the name; you can vary the terms (i.e. the strike price) subsequently if you’ve agreed to do so when you sign it. You also don’t need to tell anyone what you’ve agreed if it’s commercially confidential at the time. The amount we’re in for when the magic date of 2023 arrives could therefore be substantially higher than what we currently think we’re in for (that £92.50 for example).

So we don’t really know that then I suppose, but other things are a bit more certain, aren’t they? Like that 2023 date. Knowing that could be important, couldn’t it, because if you’ve signed an investment contract as an IOU for CfDs at a future date, it might be important to know when you can cash that IOU in. Important partly because it will be such an enormous amount of cash (this we do know).  Let’s say (kindly), that in its first year of operation as a new entrant, Hinkley C runs at about 80% capacity, then it will get, assuming a reasonable relationship between strike and reference price, about half of the £2.4 billion represented by strike price x output – just over a billion pounds.  That represents pretty much ALL the available CfDs for new entrants in any one year on the basis of the existing levy control framework. So if you are a renewable developer you might want avoid planning to start producing in 2023 because you won’t get a look in.

So do we know that for certain?  Well not really. Because it’s worth bearing in mind that EDF originally planned to start producing power at Hinkley C at the end of 2017 (and I’ve got the timeline chart they produced  in 2009 on my wall to remind me). Furthermore, the two other schemes they’re building in Europe are now either massively behind schedule, over budget or both.  So the point at which all those CfDs get hoovered up could be over a much longer timescale than we think. This might be a bit destabilising for everything else over that period.

But we do know they’ll have that investment contract in their pocket, don’t we, so it will be all right in the end, won’t it? Well…that depends on what we don’t know:  the terms for performance in the contract.  If it’s a standard CfD contract it will have a window in it to deal with reasonable variation in the project coming on stream and a longstop date, perhaps a year after the window closes. At the point of the longstop date you clearly can’t go on hanging around and hoping, so the contract is dissolved and that’s the end of you. We know this because it says it in the DECC Electricity Market Reform: Delivering UK Investment document that was issued this summer.

So we might reasonably assume that some sort of window and longstop arrangement will be in the varied investment contract once it’s signed. Ah but if there’s a serious prospect that EDF might lose their precious pile of CfDs because they’ve gone beyond the ‘longstop’ what then?  Well they might just not sign up in the first place. So the contract probably won’t even have the same sort of longstop in it as standard CfD contracts will, making it an even more unstable bomb under all other projects in the early 2020s than it is now.

Indeed, you might have to draw up what will look like a complete stand-alone contract, without the provisions likely to be set out in standard CfD contracts, to get the scheme away in the first place. But then won’t that look like special treatment for nuclear even more than an extra-lengthy, hyper-costly contract already does?  And won’t that be even more likely to trigger an adverse state aid rejoinder from the EU than is likely at present?  And that is where we were at when we started this piece.

So we don’t really know that much, do we? And what we do know is not a pretty sight.

 

 

 

 

Dead or Just Resting?

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Another DECC document lands on my desk. When I say ‘lands’ I should really say ‘thuds’ or ‘crashes’ – it’s a monster. ‘Electricity Market Reform: Consultation on Proposals for Implementation’ is 285 pages long, and that’s not including the various annexes which have been published at the same time.  Somewhat longer than the White Paper that started all this and with a key difference: the biggest single bit by far (120 pages or so) is about the capacity market and how to make it work. It’s fair to say that it’s now looming slightly larger in the overall scheme of things than the 19 pages it occupied in the white Paper.

I record this because the capacity market is, as the documents show, relatively easy to announce as a good idea but is also extraordinarily difficult to design and implement. And even then, by the way, there is no room for interconnectors to be included in early capacity auctions, because, er, well DECC haven’t worked out how to do it yet.

The capacity market is, of course, about a simple theory: we may run short of capacity (as we have been told repeatedly in various ‘lights out’ stories in the press) so Government better calculate what the capacity margin is likely to be in four years time and then effectively have an ‘auction of promises’. We’ll give you capacity payments if you promise to supply capacity when we need it.  I’ve discussed elsewhere how it may well be that we end up closing down perfectly serviceable older plants so that money can come the way of companies promising to supply through the new, shiny plants they will build instead. But that, I suppose, is by the way.

However, you might think to yourself that, complexity or not, it’s a jolly good idea to have someone thinking about capacity down the line and working out a system to ensure that we would have enough capacity because otherwise …well the lights would go out wouldn’t they? And probably all that complexity and possible gaming might still be worthwhile if they stay on.

Except, remarkably, before the White Paper came forth and announced that there would be a capacity market, there was someone thinking just those thoughts and doing something about it. Step forward, National Grid. They were running (and still are) a programme called STOR (Short Term Operating Reserve). This programme commissioned providers to supply the grid with capacity that might otherwise be unutilised on a short term basis. The aim of this was to help balance the grid at times of stress.  Then National Grid, in some of its later bidding rounds, decided to look further out at the capacity needs of the market and take bids for a much longer-term capacity reserve provision. Some of these bids were offered and accepted and exist today as a sort of small scale strategic capacity reserve.

Here’s what National Grid said about its long term STOR programme:  it was to ‘aid National Grid in meeting a significant future increase in our [sic] forecast operating requirements being progressively more influenced by variable renewable sources of generation.’

The long term STOR product,  they continued, ’ was also specifically designed to facilitate the building of new plant that could offer an economic reserve to National Grid, but required a long term guaranteed revenue stream to secure funding’.

Remarkable similarity to the intention of the capacity market you might say, but with far less complexity. National Grid was just quietly going about gathering long term capacity guarantees on a relatively simple basis and at a reasonable cost all round. So there must have been something significantly better to stop it, because stop it did, at the end of 2010.

And the big leap forward that caused it to stop? That would be: ‘the interaction of continued long term STOR procurement and Electricity Market Reform discussions’ (National Grid’s words). In other words, because thoughts were flying around about how to develop a strategic reserve arrangement, a strategic reserve arrangement that seemed to be working well had to stop.  And as we see, how prescient all that was, what with the unholy jumble of measures, counter measures, protocols and sub clauses that make up the still half-formed capacity market.

I wonder to myself how much human pain and suffering might have been avoided if National Grid had just been allowed to proceed with its long term STOR programme. You never know we might even have avoided some of the worst doomsaying about ‘blackout Britain’ because the long term capacity reserve would have been quietly accumulated in the intervening three years at no great cost and with no big fuss. Maybe someone might lead a deputation to National Grid to say ‘sorry – it’s all been a terrible mistake – can you start up long term STOR again? We promise we won’t pull the plug next time.’

Well that’s a fantasy of course, and anyway, National Grid does get something out of the new capacity market arrangements. Here’s what the implementation paper proposes (p. 150 since you ask):

‘To administer the capacity market, the Government will require annual advice on the amount of capacity needed to meet the reliability standard. Since National Grid will be the delivery body for the capacity market and it has considerable expertise in this area it makes sense for National Grid to provide this advice to government, starting in 2014.’

Scary Ed or scary George? Investors choose…..

So who’s scaring off investors more? This is one to puzzle over, especially with the emergence on Monday of a letter from a number of global ‘investors in the energy sector’ (covered in the Independent here) that George Osborne’s removal of a decarbonisation target from the Energy Bill  risked the ‘£110bn overhaul of Britain’s energy network’.

Last week, of course we had a similar claim from Centrica and others in some of the national press that Ed Miliband’s proposals for a freeze on energy bills from 2015-17 would lead to exactly the same risk to that ‘£110 billion overhaul’.

I suppose, just to put the cat among the pigeons, we might look at some of the evidence behind these claims. Incidentally the new paradigm for what it will cost for this ‘overhaul’ seems to be more modest in ambition than it was just two years ago, when we were supposedly in for £200 billion (here’s what I said about that at the time).  This figure is now expected to be about £100 billion by the early 2020s ; still a very large number I would agree. All these figures, though, do seem to be derived from various scenarios from Ofgems ‘Project Discovery Energy Investment Scenarios’ – last revised in 2010. These ‘scenarios’ veered between a pot of £200 billion for its ‘green transition’ picture (which envisages that ‘there is a rapid economic recovery and significant new investment globally’) and £95 billion for the ‘slow growth’ scenario (which posits that the ‘impact of recession and credit crisis continues…generation build dominated by CCGT energy efficiency measures have limited impact..’).

So I guess the new agreed investment figure is towards the ‘slow growth’ end of the scenarios. But even so, it is made up of a number of components such as interconnectors, offshore wind, smart meters, onshore/offshore transmission, grid-strengthening and so on, which have little to do with what many consider to be traditional ‘energy investment’. In fact only about a quarter of total investment will come from what we think of traditionally as old-style, centralised power plants. The other three quarters will come from those less-familiar components, with over half the total coming from renewable generation itself.

And the significant feature of these investment figures is that the Big Six utilities will not feature heavily in the investment profile for these categories. Indeed if we look at the balance sheets of the Big Six, four of the six have net debts of more than two thirds of their market capitalisation. This means that they are unlikely over the next period to lever themselves up still further in order to splash the cash for investment in any of the sectors at all. Most of the £110 billion will have to come from elsewhere and will indeed do so.

And, by the way, if there is to be investment coming from the profits ofthe Big Six, it will hardly be damaged by what may or may not happen to their retail arms, which, as we know, Labour want to separate from their wholesale businesses.  The aggregate profit margin made by the Big Six on generation in 2011, as Ofgem records, was 24.4%, whereas for supply it was 3.1%. Whilst of course there is a connection between generation proceeds and supply prices, these figures hardly suggest a drying up of profits on generation. Separate retail companies at that point, with lower returns, would probably value and work best on some form of regulated price and return regime (but that’s another point entirely).

So where does that get us to? Well it looks like most investment will have to come from non-Big Six companies not primarily affected by a retail energy price freeze, but far more affected by larger instability and long term uncertainty. Long term uncertainty in an investment market which is seeking to finance the equipment and transmission that will need to sit alongside the different form of energy economy that we are all supposedly signed up to. And they seem to be the ones signing letters to the Chancellor right now.