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      POWER- WHERE DO WE GO FROM HERE?

      business-insight-std-greenline

      by Alan White, Head of Conventional Energy

      This was the question posed by Ashurst LLP’s lawyers at a recent roundtable dinner, which I attended along with other industry specialists from the utilities, independent power developers, commodity traders and banks.

      The topic had been prompted by the recent announcement by the UK Government of a wholesale reform of the electricity markets as part of their overall strategy to move towards a low carbon economy, of which the power sector plays a significant part.  At present, generators and suppliers of electricity trade power on a bilateral basis with suppliers obliged to obtain an increasing proportion of electricity to meet the needs of their customers from renewable sources: the Renewables Obligation (“RO”).
       

      Renewables Obligation


      Under the RO the renewable generators are paid a premium for their electricity above the market price based on the volume of electricity produced. This effective subsidy is evidenced by Renewable Obligations Certificates which electricity suppliers are required to buy as proof of purchase of “green” power.

      Whilst the drive for a low carbon economy is a perfectly valid approach to adopt in these times of climate change, the mere nature of renewable energy sources, which tend to be weather influenced, is their intermittency along with their comparatively high capital cost when compared to traditional generation plants fuelled by coal or gas.

      The only truly low carbon based generation which can provide base load electricity irrespective of the weather conditions is Nuclear, which itself is very expensive and has other questions linked to it around the general public perception of Nuclear energy.

      The UK Government is therefore faced with a dilemma.  How to encourage the development of new low carbon generation, without the need for significant public subsidies and also maintain a steady availability of electricity for consumers?

      In seeking to address this they have embarked on a programme of consultation to be followed by a White Paper which will set out the mechanism which will be designed to encourage the development of new Nuclear capacity which will be fully paid for by the developer and therefore the consumer, and will not require the tax payer to separately support the sector.  In fact, the Government is expected to incentivise the development of low carbon capacity (in particular Nuclear) through the imposition of a price for every tonne of Carbon Dioxide emitted by fossil fuelled generators; effectively a carbon tax.

      Alongside this the expectation is that renewable electricity generators, e.g. wind and solar, will be able to sell their electricity to a central agency for a guaranteed price under a long term contract.

      Whilst this all sounds very sensible, the more pressing issue is that a large portion of the existing electricity generation capacity in the UK is due to close over the next few years through a combination of age and environmental legislation.  This will put considerable strain on the remaining plant and, without new plants being built, will result in a shortage of generation.  This is a real issue and one which the Government and the regulator are trying to address whilst maintaining the drive for low carbon emissions and minimising the cost to the consumer.  

      Whilst the growth of low carbon generation will continue, incentivised by the measures expected to be introduced in the White Paper later this year, the development time for a new Nuclear plant is a minimum of 6 years and the growth of large scale wind farms (many of which will be offshore) carries with it the lengthy time frame for construction, which itself is heavily influenced by the weather, and the inherent intermittent nature of generation from wind.

       

      So, where do we go from here?

      The easy answer is to build more gas fired generation plants as these are relatively quick to build, relatively cheap and relatively low carbon compared to coal or oil.  The general availability of gas in the UK, through pipelines and LNG imports, is also well tried and tested.  Why then are we not seeing these plants being built?

      Although gas fired plants are relatively cheap they still require a significant investment from the developers and also have to go through a planning process which takes time.  Once those hurdles have been cleared the issue then is how do they sell their power and can this be done in a way that would encourage banks such as Lloyds to provide project finance?

      When the UK electricity industry was privatised in 1990 the market operated on the basis of a Pool with a clearing price which meant that all generators received the same price for their electricity.  This led to a situation where those with low costs were making windfall profits and so, in 2001, the market moved to a bi-lateral contract structure.  Whilst this reduced wholesale prices it also restricted construction of new assets which did not benefit from the support available under the Renewables Obligation.

      The main buyers of electricity are the major utility groups which all have their own supply businesses providing electricity to consumers.  When the industry was privatised the supply companies at the time were willing to write long term contracts for the purchase of electricity at prices which provided a strong basis for project finance.  As their appetite for long term contracts reduced over time generators have been forced to look at shorter term contracts however the banks, which would prefer not to take price risks in relation to long term finance, have so far rejected this as a basis for the provision of finance.

      Developers of gas fired plants also face the problem of investing with a 20 year + horizon when they expect that their position in the market will change from providing base load capacity to more mid-load or eventually peaking capacity which is inherently more volatile.

      If we are to see the development of new gas fired capacity we need a combination of a market based recognition of the value of capacity combined with a recognition by investors and lenders alike that if a contract is available now for a medium term then there is a strong likelihood that similar contracts will become available over time.

      A conclusion of the discussion over dinner was that the current reforms of the electricity markets has introduced further uncertainty in the sector leading to a lack of appetite for developers to make major decisions until there is greater clarity from the White Paper.  Many of the attendees were concerned that this would in fact be only the beginning of a process which would take some time to play out, putting further pressure on the existing plants and increasing the risks of power shortages.

      Whilst this may all sound very pessimistic, there remains general optimism that new capacity is needed and therefore will be built and furthermore that the independent sector, supported by project finance banks including Lloyds, will have a major part to play in the future of the electricity sector in the UK. 

      Committed to the energy sector

      Within Project Finance we continue to work to find a way of working within the market conditions which prevail and also recognise the risk appetite which exists, not just within Lloyds but in the wider project finance on which we depend to be able to distribute assets.  The experience and knowledge that we have within the broader energy based franchise in Lloyds Bank places us in a position where we can provide the leadership that the banking market requires and which will enable the Government to achieve its aims of encouraging investment into the electricity sector.

      This has been specifically evidenced recently when Project Finance led the closing of the first project to be financed under the Government’s newly established Offshore Transmission Owners (“OFTO”) regime for the ownership and operation of the electricity transmission links between the UK’s offshore wind farms and the onshore national grid network.  This first project represents clear evidence of the thought leadership available within Project Finance in the energy sector and has further served to cement Lloyds Bank as a leading provider of project finance to the sector.

      The position we have as a leading lender within the OFTO programme has also established us with OFGEM as a Bank who has the necessary understanding and approach to the sector which will be of direct assistance to the regulator in establishing further mechanisms and regulation which will enable developers of new generation capacity, both renewable (low carbon) and fossil fuelled, to raise project finance debt, including accessing the debt capital markets.

      The OFTO regime is designed to encourage investment in the development of offshore wind farms around the UK coastline which forms a major part of the pipeline for Project Finance in the coming years.

      Whilst we are committed to the renewable energy sector as it stands currently, which in the UK is primarily in relation to the wind, solar and biomass sectors, Project Finance is also working to ensure that it is well placed to respond to clients’ requests for finance in the fossil fuelled and Nuclear segments of the electricity generation mix.

      We are working with senior management to explore the appropriate financing approach for merchant based generation post the expiry of the contracts available from electricity buyers which, as indicated above, are not sufficient at the outset to cover the full repayment term of project debt.  The ability to manage exposure to market based risks has already been shown to be perfectly possible with the right knowledge of the type we have within Lloyds Bank and Project Finance in particular.

      Concurrent to this work on the short term solutions to the UK’s electricity generation investment requirements, we are also working with Group Risk and other colleagues to establish a basis on which we will be able to provide finance to the development of Nuclear generation capacity; a key platform of the current Electricity Market Reform process.

      It was very clear from the discussions with the attendees at the dinner that they are looking for leadership in finding ways through the maze of issues which exist within the energy sector at present and that in this regard they are looking to Lloyds Corporate Finance to take a central role in this process.  The experience of the individuals in Project Finance is seen as key to this market leadership.

       

       

     
2/25/2018 1:32:12 AM